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VENKATESHWARA BUSINESS AND INDUSTRIAL OPEN UNIVERSITY ORGANIZATION www.vou.ac.in

BUSINESS AND INDUSTRIAL ORGANIZATION BUSINESS AND INDUSTRIAL ORGANIZATION

BBA [BBA-303]

VENKATESHWARA

OPEN UNIVERSITYwww.vou.ac.in BUSINESS AND INDUSTRIAL ORGANIZATION

BBA [BBA -303] BOARD OF STUDIES Prof Lalit Kumar Sagar Vice Chancellor

Dr. S. Raman Iyer Director Directorate of Distance Education

SUBJECT EXPERT Dr. S. Raman Iyer Programme Director Dr. Richa Agarwal Assistant Professor Dr. Anand Kumar Assistant Professor Dr. Babar Ali Khan Professor in Commerce Dr. Adil Hakeem Khan Professor in Management

CO-ORDINATOR Mr. Tauha Khan Registrar

Authors S. Tripathy: Units (1.3, 2.2-2.4, 3.2-3.2.1) © S Tripathy, 2019 Anjani Singh Tomar: Units (Unit 4, 5.6) © Reserved, 2019 Harjit Singh: Units (5.0-5.5.2, 5.7-5.11) © Harjit Singh, 2019 KC Shekhar and Lekshmy Shekhar: Units (6.2-6.10) © KC Shekhar and Lekshmy Shekhar, 2019 Dr Premvir Kapoor: Units (7.2-7.3) © Reserved, 2019 Prasad G Godbole: Units (7.5-7.5.2, 7.6-7.7, 7.9) © Prasad G Godbole, 2019 Vikas Publishing House: Units (1.0-1.2, 1.4-1.9, 2.0-2.1, 2.4.1, 2.5-2.9, 3.0-3.1, 3.2.2, 3.3-3.8, 6.0-6.1, 6.11-6.16, 7.0-7.1, 7.4-7.4.4, 7.5.3, 7.8, 7.10-7.14) © Reserved, 2019

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Vikas® is the registered trademark of Vikas® Publishing House Pvt. Ltd. VIKAS® PUBLISHING HOUSE PVT LTD E-28, Sector-8, Noida - 201301 (UP) Phone: 0120-4078900  Fax: 0120-4078999 Regd. Office: A-27, 2nd Floor, Mohan Co-operative Industrial Estate, New Delhi 1100 44 Website: www.vikaspublishing.com  Email: [email protected] SYLLABI-BOOK MAPPING TABLE Business and Industrial Organization Syllabi Mapping in Book

Unit I: Nature and Scope of Business: Business, Trade and Unit 1: Nature and Commerce, Objectives of a Business, Problems before establishing Scope of Business a New Business, Social Responsibility of Business. (Pages: 3-20)

Unit II: Forms of Business Organisation: Sole Trader, Unit 2: Forms of Partnership and Joint company their characteristic features, Business Organization Cooperatives, Suitability of a form of Organisation. (Pages: 21-41)

Unit III: Public Enterprises and their Rationale, Public Enterprises Unit 3: Public Enterprises in India and their main contributions, Causes of low productivity and their Rationale and efficiency in Public Enterprises. (Pages: 43-58)

Unit IV: Home Trade Transactions: Different Forms and Unit 4: Home Trade Documents used in Home Trade. Transactions (Pages: 59-79)

Unit V: Functions and Organisation of wholesale and Retail Trade, Unit 5: Wholesale and Departmental Stores and Multiple Shops, Super market, Mercantile Retail Trade (Pages: 81-107) Agents and their functions.

Unit VI: Banking and Insurance Sectors and their functions. Unit 6: Banking and Insurance Sectors (Pages: 109-180)

Unit VII: Introduction to Business Combinations and their different Unit 7: Introduction to forms. Business Combinations (Pages: 181-249)

CONTENTS

INTRODUCTION 1

UNIT 1 NATURE AND SCOPE OF BUSINESS 3-20 1.0 Introduction 1.1 Unit Objectives 1.2 Business, Trade and Commerce: An Overview 1.2.1 Objectives of a Business 1.3 Problems in Establishing a New Business 1.3.1 Factors to be Considered While Starting a Business Enterprise 1.3.2 Key Areas for Assessing the Feasibility of a New Venture 1.4 Social Responsibility of Business 1.4.1 History of Corporate Social Responsibility 1.4.2 Theories of Corporate Social Responsibility 1.4.3 Benefits of Corporate Social Responsibility 1.4.4 Challenges to Corporate Social Responsibility 1.5 Summary 1.6 Key Terms 1.7 Answers to ‘Check Your Progress’ 1.8 Questions and Exercises 1.9 Further Reading

UNIT 2 FORMS OF BUSINESS ORGANIZATION 21-41 2.0 Introduction 2.1 Unit Objectives 2.2 Sole Trader 2.3 Partnership and Joint Company 2.3.1 Essential Characteristics of Partnership 2.3.2 Various Aspects of Partnership Firm 2.3.3 Joint Stock Companies 2.3.4 Forming a Company 2.3.5 Differences Between a Company and a Partnership 2.4 Cooperatives 2.4.1 Suitability of a Form of Organization 2.5 Summary 2.6 Key Terms 2.7 Answers to ‘Check Your Progress’ 2.8 Questions and Exercises 2.9 Further Reading

UNIT 3 PUBLIC ENTERPRISES AND THEIR RATIONALE 43-58 3.0 Introduction 3.1 Unit Objectives 3.2 Public Enterprises and their Rationale 3.2.1 Forms of Organization of Public Undertakings; 3.2.2 Rationale for the Public Sector 3.3 Causes of Low Productivity and Inefficiency in Public Enterprises 3.3.1 Performance of Public Enterprises 3.4 Summary 3.5 Key Terms 3.6 Answers to ‘Check Your Progress’ 3.7 Questions and Exercises 3.8 Further Reading UNIT 4 HOME TRADE TRANSACTIONS 59-79 4.0 Introduction 4.1 Unit Objectives 4.2 Different Forms of Trade 4.3 Documents of Trade 4.3.1 Importance of Trade Documents 4.3.2 Types of Trade Documents 4.4 Trade Documents Used in International Trade 4.4.1 Cash Discount and Trade Discount 4.5 Summary 4.6 Key Terms 4.7 Answers to ‘Check Your Progress’ 4.8 Questions and Exercises 4.9 Further Reading

UNIT 5 WHOLESALE AND RETAIL TRADE 81-107 5.0 Introduction 5.1 Unit Objectives 5.2 Retail Trade 5.2.1 Functions of a Retailer; 5.2.2 Retailing Principles 5.2.3 Retailing in India; 5.2.4 Retail Market Prospects in India 5.2.5 Retailing Across the Globe 5.3 Wholesalers 5.4 Organization of Wholesale and Retail Trade 5.4.1 Process of Organizing a Retail Firm 5.5 Departmental Stores 5.5.1 Multiple Shops; 5.5.2 Super Market 5.6 Mercantile Agents and Their Functions 5.7 Summary 5.8 Key Terms 5.9 Answers to ‘Check Your Progress’ 5.10 Questions and Exercises 5.11 Further Reading

UNIT 6 BANKING AND INSURANCE SECTORS 109-180 6.0 Introduction 6.1 Unit Objectives 6.2 Banking Sector 6.3 Commercial Banks 6.3.1 Functions of Commercial Banks and the Services Rendered by Them 6.3.2 General Structure and Methods of Commercial Banking 6.3.3 Earning Assets of a Bank 6.4 Systems of Banking 6.5 Investment Banking and Mixed Banking 6.6 Universal Banking 6.7 Merchant Banking 6.8 Virtual Banking 6.9 Green Banking 6.10 Central Banking 6.10.1 Functions of a Central Bank; 6.10.2 Secondary Reserve Requirements 6.10.3 As Banker and Advisor of the State; 6.10.4 Recent Trends in Central Banking 6.11 Insurance Sector 6.11.1 Insurance Transaction 6.12 Summary 6.13 Key Terms 6.14 Answers to ‘Check Your Progress’ 6.15 Questions and Exercises 6.16 Further Reading

UNIT 7 INTRODUCTION TO BUSINESS COMBINATIONS 181-249 7.0 Introduction 7.1 Unit Objectives 7.2 Different Forms of Business Combinations 7.2.1 Mergers; 7.2.2 Acquisitions; 7.2.3 Amalgamation 7.2.4 Takeovers; 7.2.5 Leveraged Buyouts 7.3 Motives for Business Combinations 7.3.1 Types of Business Combinations 7.3.2 Motives and Benefits of Mergers and Acquisitions 7.4 Regulation of Mergers 7.4.1 Organization Restructuring; 7.4.2 Mergers and Consolidations 7.4.3 Friendly vs Hostile Takeover 7.4.4 Merger Process: Target Identification, Negotiation and Closing Deal 7.5 Regulation of Takeovers 7.5.1 Takeover Tactics; 7.5.2 Defence Tactics 7.5.3 Anti-Takeover Amendments 7.6 Companies Law 7.7 Income Tax Law 7.8 SEBI Guidelines for Takeovers 7.9 Other Applicable Laws 7.10 Summary 7.11 Key Terms 7.12 Answers to ‘Check Your Progress’ 7.13 Questions and Exercises 7.14 Further Reading

Introduction INTRODUCTION

NOTES The business environment now is one of global competition, scarce resources, rapid technological changes, increasing demand for social responsibility and downsized organizational structures. Businesses are also realizing the importance of corporate restructuring in the form of mergers and acquisitions for not only the health of a particular business but also a nation. Further, larger communication networks, increasing internet resources and the emergence of a global village have all contributed to changing the face of business today. It is no wonder then, that Peter Drucker described the times that we live in as ‘age of discontinuity’. Thus, today’s businesses face a complex web of difficult and exciting challenges. And management has, therefore, never been more crucial for the development of an organization. This book attempts to address these issues in a way that will enable you to understand the complexity of today’s business environment. In doing so, it will further explain the nature of business, evolution of business in India over the years as well as various forms of business ownership. You will get an overview of the formation of a company, establishment of a business enterprise and finally the organization of trade. The liberalized financial and political environment in India has prompted a large number of new entrants into the country’s rapidly growing retail industry in the past few years. No doubt, the retail industry in India is in the throes of radical restructuring. The fundamental drivers of change are the increasing per capita income, growing GDP and availability of consumer finance. Today, it is the retail industry that provides the most employment to the Indian workforce, after agriculture. Further, the retail sector in the country is set for a big boom, especially after the announcement of huge investments by Indian and foreign corporates. The success of a retail store depends on how efficiently a retail store performs its day-to-day operations. This book, Business and Industrial Organization, has been written in the SIM (Self Instructional Material) format for distance learning. Each unit begins with an Introduction to the topic, followed by a list of the Unit Objectives. The detailed content is then presented in a simple and organized manner, interspersed with ‘Check Your Progress’ questions to test the student’s understanding of the topics covered. A Summary along with a list of Key Terms and a set of Questions and Exercises is provided at the end of each unit for effective recapitulation.

Self-Instructional Material 1

Nature and Scope UNIT 1 NATURE AND SCOPE OF of Business BUSINESS NOTES Structure 1.0 Introduction 1.1 Unit Objectives 1.2 Business, Trade and Commerce: An Overview 1.2.1 Objectives of a Business 1.3 Problems in Establishing a New Business 1.3.1 Factors to be Considered While Starting a Business Enterprise 1.3.2 Key Areas for Assessing the Feasibility of a New Venture 1.4 Social Responsibility of Business 1.4.1 History of Corporate Social Responsibility 1.4.2 Theories of Corporate Social Responsibility 1.4.3 Benefits of Corporate Social Responsibility 1.4.4 Challenges to Corporate Social Responsibility 1.5 Summary 1.6 Key Terms 1.7 Answers to ‘Check Your Progress’ 1.8 Questions and Exercises 1.9 Further Reading

1.0 INTRODUCTION

Business to a layman is the selling of goods or services to clients, customers or consumers with the purpose of earning some profit. However, there is much else that goes into business. The term business is used to mean trade, profession or occupation, dealings, and commercial activity of a commercial or industrial concern. Business has also evolved over the ages. From a simple barter system that was followed in ancient times, we now have e-commerce which is growing in leaps and bounds. Before deciding how to establish an operation, the prospective entrepreneur needs to identify the legal structure that will best suit the demands of the venture. Setting up of any business enterprise involves a lot of paperwork and legal formalities. This unit explains the factors that need to be considered while starting a new business establishment. You will learn various concepts related to corporate social responsibility, such as its governing principles, benefits and the challenges it faces.

1.1 UNIT OBJECTIVES

After going through this unit, you will be able to: • Explain the meaning of business and list its objectives • Identify the problems faced in establishing a new business • Discuss the concept of social responsibility of business

Self-Instructional Material 3 Nature and Scope of Business 1.2 BUSINESS, TRADE AND COMMERCE: AN OVERVIEW

NOTES What is business? The term business comes from the word ‘busyness’, or the state of being busy. Business is an economic activity with the object of earning an income, i.e., profit and thereby accumulating wealth. The economic activity must be regular and continuous. It involves (i) production of goods and services with a view to selling them at a profit or (ii) merely purchasing of goods and services to resell at a profit. In the old days, business was conceived merely in terms of gains. ‘The business of business is business.’ In those days, the exclusive objective of business was maximization of profit at any cost. Business began merely as an institution for the purpose of making money. So long as a man made money and kept himself out of jail he was considered successful. He felt no particular obligation and acknowledged no responsibility to the community. As he was the owner of the business, he thought he had the perfect right to do with it what he pleased. The modern business enterprise is a social and economic institution. It does not exist in a vacuum. Business, by itself, is not an end but a means to achieve an end – i.e., public welfare. According to Peter Drucker, the objective of business is to create a customer. The customer is the master and to serve him well is the only purpose of business. Business cannot survive without customers. Modern business aims at profit through service. Trade and Commerce There was a time when man lived in caves and jungles and subsisted on agriculture. In fact, the main source of food was agriculture and hunting. Man only knew how to kill animals for meat and grow his own limited food such as rice, wheat or maize. With passage of time, man being a social animal started interacting with others of his kind. He moved out of the cave and community life came to have more meaning. The need for giving, sharing and exchanging was felt. Despite the absence of currency, necessary goods or items were obtained in return for other goods. This exchange of one good for another was known as the barter system—a system based on mutual needs and understanding. This kind of exchange of valuable items between two people can be referred to as commerce. Whenever a farmer had excess crop, he would exchange that with another person who raised animals but needed crop, in exchange for animals. Such a commercial deal ensured that both the people involved in the exchange were satisfied. This form of trade continued till some sort of currency came to be used for purchasing things. A common medium of exchange became necessary because barter was not always possible. A person may not always really want what the other person has to offer. That is, the needs of both the people involved in the barter may not always be satisfied. For example, X has a cow to offer and he wants a bundle of rice that Y has to offer. But then the barter would be successful only if Y also wants the cow that X has to offer. Therefore, the need for a common medium of exchange arose. Initially, gold and silver coins were used. Later on, copper and bronze were also brought into use. But now, paper currency is widely employed all over the world. The commercial transaction between two people grew and developed to take the form of transactions between two communities and then between countries. Trade grew Self-Instructional and so did industry. Although some people still lived off agriculture, there were times 4 Material when the weather intervened and upset trade in agricultural produce. By the mid- Nature and Scope eighteenth century, the industrial revolution was already starting. of Business The development of commerce and the development of industry are both responsible for the current economic state of countries across the world. With the recent development of plastic money and now electronic money, the barter form of trade or NOTES commerce has been left far behind. Business as an Economic Activity Business is an economic activity. An economic activity involves the task of adjusting means to the ends or ends to the means. An economic activity may assume the form of production, consumption, distribution and exchange. Each business firm has a target to achieve and for that purpose it has some resources at its disposal. Sometimes the target has to be matched with given resources and sometimes the resources have to be matched with the given target. Either way, the function of the business firm is to achieve optimum result of economic activities. A business firm is basically a transformation unit; it transforms input into output. The objective of this activity is to earn maximum profit in the long run. It is a value added process—the value of output in excess of the value of input. Business decision-making is an economic process. Decision-making involves making a choice from a set of alternative courses of action. Rational choice is the root of all economic problems. The question of choice arises because resources are scarce. When input is the constraining factor, business firm’s decision variable is the output and when output is the constraining factor, firm’s decision variable is the input. 1.2.1 Objectives of a Business Anything that a person wants to achieve becomes his objective. For a student, the objective could be to do well in his exams while for a candidate, the objective would be to clear the interview. The objectives of a business would be to provide good quality products or services, to earn profits and to grow to a certain level within a certain period. It is commonly believed that most businesses have a single main objective which is to earn profits. This is not true. In its attempt to make profits, the business can not ignore the interests of its workers or employees, the opinions of its customers and the well-being of the society. This is because the business will only survive if the workers and customers are happy and content. Therefore, fair wages, quality products or services and concern for the environment and society are as essential as profit making. The objectives of a business could be classified as economic, social, human, national or global. • Economic Objectives Economic objectives would include the following: o Profit earning o Creation of customers o Regular innovations o Best possible use of resources

Self-Instructional Material 5 Nature and Scope • Social Objectives of Business Social objectives include the following: o Production and supply of quality goods and services NOTES o Adoption of fair trade practices o Contribution to the general welfare of the society • Human Objectives Human objectives include the following: o Economic well being of the employees o Social and psychological satisfaction of employees o Development of human resources o Well being of socially and economically backward people • National Objectives National objectives would include the following: o Creation of employment o Promotion of social justice o Production according to national priority o Contribute to the revenue of the country o Self-sufficiency and export promotion • Global Objectives Global objectives of a business would include: o Raising of general standard of living o Reducing disparities among nations o Making available globally competitive goods and services

1.3 PROBLEMS IN ESTABLISHING A NEW BUSINESS

One of the most important hindrances in setting up a new enterprise is lack of awareness about the various options available. The choice of an appropriate form of business undertaking depends upon: • Objectives and size of the business desired with reference to the scale of operations • Financial and capital resources available for investment • Nature of control • Supervision and management of the business enterprise Check Your Progress • Liability of the owners 1. Define a business • Transferability of the ownership interest and lifespan of the business firm. Ownership is a legal concept that bestows certain rights when an individual or a 2. List the economic group of individuals acquire legal title to assets for the purpose of controlling them and to objectives of business. enjoy the gains or profits that come from such possession and use. Business firms may be owned by private individuals or by the state (government). Business firms owned by individuals come under the private sector, while firms owned by the state are part of the Self-Instructional 6 Material public sector. Firms owned jointly by the private parties and the state constitute the joint Nature and Scope sector. of Business At the most general level, the choice to set up an enterprise involves setting up: (i) Either a profit or a non-profit venture NOTES (ii) Either a corporate or a non-corporate venture. Traditionally, non-profit organizations exist to provide services for a particular group of people with a specific need. 1.3.1 Factors to be Considered While Starting a Business Enterprise A new venture goes through three phases (i) pre-start-up (ii) start-up (iii) post start up. The pre-start up stage begins with an idea for the venture and ends when the doors are opened for business. The start-up stage commences with initiation of sales activity and delivery of products and services and ends when the business is firmly established and beyond short-term threats to survival. The post start-up stage lasts until the venture is terminated or the surviving organizational entity is no longer controlled by an entrepreneur. During the first two phases, five factors are critical (i) relative uniqueness of the product (ii) relative investment size at start-up (iii) expected growth of sales and/or profits as the venture moves through its start up phase (iv) availability of products during the pre-start- up and start-up phases (v) availability of costumers during the pre-start-up and the start- up phase. 1.3.2 Key Areas for Assessing the Feasibility of a New Venture After a new venture idea has been finalized, the entrepreneur has to consider the feasibility of the venture from the following perspectives:

Technical – Feasibility analysis of product/service

Market – Determination of market opportunities and risks Determination of feasibility of New Venture Idea Financial – Analysis of planned new financial feasibility and venture resources

Organizational – Analysis of organizational capabilities and personnel requirements

Competitive – Analysis of Competition

Fig. 1.1 Key Areas for Assessing the Feasibility of a New Venture

• Feasibility of idea o Would the product sell? o Is it legal? • Advantages that idea offers against competition o Advantages offered by product/service o Advantages already held by competing firms o Likely ways in which competitors may respond o Ways in which the advantage over competitors can be maintained

Self-Instructional Material 7 Nature and Scope • Decisions of the buyers pertaining to venture of Business o Likely customers of the product o Likely number of units to be sold and likely number of customers o Location of the customers and distribution channels required to supply to these NOTES customers • Marketing decisions regarding goods/services o Likely costs of marketing and sales o Likely share of market the product will capture o Possible retailers and other sellers o Price point and in comparison with competitors’ similar product o Likely location and how it will be identified o Best possible distribution channels (wholesale, retail or direct) o Ideal sales targets and ways to achieve them o Possibility of getting pre-orders • Decision regarding production of goods o To manufacture product or buy it or both o Study of raw material sources o Likely delivery time o Arrangement of adequate space for premises o Timely arrangement of equipment o Identifying possible problems with plant setup, clearances and insurance o Methods of quality control o Methods of service and handling o Methods to control waste, spoilage and scrap • Decisions related to staffing o Ensuring competence in each aspect of the business o Hiring and management of required manpower o Decide if advise of lawyers and bankers is required • Venture control decisions o Insuring all required written records are in place o Identifying the special controls that will be required • Decisions related to finance o Capital required to start the development of product o Capital required to set up operations o Working capital required o Sources for raising capital o Identifying the biggest risks in assumptions o Calculating return on equity and sales and how it stands up to competitors’ figures o Ways to pay back debts o Ensuring bank’s support Besides all these factors, ‘Laws of the land’ as they are commonly called, require to be strictly followed by an entrepreneur to avoid any future legal conflicts. This aspect is important at all stages of the development of an enterprise, right from the commencement of the venture. Thus, an entrepreneur has to be careful about obeying the legal formalities, procedures, policies and plans of the government. Some of the important laws and regulations, which are common to all types of enterprises, can be listed as follows:

Self-Instructional 8 Material • No Objection Certificate (NOC) from local body: Entrepreneurs have to Nature and Scope of Business obtain a No Objection Certificate from any local body, like the panchayat or municipality, while promoting a new venture. This is required for construction of industrial sheds and land utilization as well as for the benefit which may be given to the enterprise in the course of its operation by the government. NOTES • Registration of the unit in DIC: Small-scale units should be registered with the District Industries Centres functioning under the Directorate of Industries of the state. • Statutory licence or clearance: Except for industries coming under the public sector, all industrial undertakings are exempted from industrial licensing. The Industries Development and Regulation Act (IRDA), 1951, provides the basic framework for directing the flow of investments into different types of industries. In India, a number of administrative bodies in the government have been established for considering the proposal for the issue of industrial licence and a time limit for the same. However, after the announcement of the New Industrial Policy in July 1991, industrial licensing has been abolished for all projects except eighteen industries related to security and strategic concerns, social reasons, hazardous chemicals and overriding environmental reasons and items of elitist consumption. Thus, the process of liberalization has played a significant role in the abolition of industrial licensing for a large number of industrial items of manufacturing.

1.4 SOCIAL RESPONSIBILITY OF BUSINESS

The history of concern for the social and environmental aspect of business can be traced back centuries ago. For instance, commercial logging co-existed with legislation to protect forests about 5,000 years back. In around 1700 BC, in ancient Mesopotamia, King Hammurabi made death penalty for builders, innkeepers and farmers compulsory, if their act or negligence caused the death of, or put to inconvenience, the citizens. With the beginning of industrialization, the impact of business on the society and the environment took on a new form. Those who amassed great wealth in the late nineteenth and early twentieth centuries diverted it into philanthropic ventures. By the 1920s, discussions about the social responsibilities of business had led to what we now recognize as the beginnings of the modern CSR movement. In 1929, Wallace B. Donham, Check Your Progress the Dean of Harvard Business School, stated in an address: 3. State one of the Business started long centuries before the dawn of history, but business as we most important hindrances faced now know it, is new—new in its broadening scope, new in its social significance. while setting up a Business has not learned how to handle these changes, nor does it recognize the new enterprise. magnitude of its responsibilities for the future of civilization. 4. List the factors These words are true even in the present times. Even though the concerns about which affect the choice of an the role of business in society today are somewhat novel, ranging from dealing with appropriate form of security threats to Internet spam to violation of intellectual property, various other issues business raised are not very dissimilar from those that were prevalent in the 1920s. undertaking. 5. What are the three phases of a new venture?

Self-Instructional Material 9 Nature and Scope Meaning and Definition of Corporate Social Responsibility of Business Corporate social responsibility can be defined as a form of self-regulation practiced by businesses and this is integrated into the business model. It functions as an in-built NOTES mechanism that helps a business to monitor itself and ensure its compliance with law, ethical standards and international norms. It helps a business to embrace responsibility for its actions and encourage positive impact through its activities relating to protection of the environment and rights of consumers, employees, communities and stakeholders. The term became popular in the late 1960s and early 1970s after corporations came up with the concept of ‘stakeholder’, which means all of those parties on whom the activities of an organization have an impact. ISO 26000 is the recognized international standard for CSR. The scope of the term includes the following: • Corporate sustainability • Corporate citizenship • Corporate social investment • Business sustainability • Corporate governance The following list provides some known, easy-to-understand definitions of corporate social responsibility that are essential to develop a clear understanding of the term. • Focusing on the social, economic and stakeholder dimensions of CSR, the World Business Council for Sustainable Development, 1999 defines CSR as ‘The commitment of business to contribute to sustainable economic development, working with employees, their families, local community and society at large to improve their quality of life.’ • Moving further in 2000 the World Business Council for Sustainable Development added the dimension of Voluntariness and defined CSR as ‘Corporate social responsibility is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as the local community and society at large.’ • Philip Kotler and Nancy Lee (2005) define CSR as ‘A commitment to improve community well being through discretionary business practices and contributions of corporate resources.’ • The most commonly and widely accepted definition of CSR is that provided by World Bank that defines it as ‘CSR is the commitment of business to managing and improving the economic, environmental and social implications of its activities at the firm, local, regional and global levels.’ It introduced the element of companies’ responsibilities for development in poor nations.

Self-Instructional 10 Material Nature and Scope of Business

NOTES

Philanthropic

Fig. 1.2 Dimensions of Corporate Social Responsibility

1.4.1 History of Corporate Social Responsibility The term ‘corporate social responsibility’ is new, but the concept and its working existed well before the inception of the term, when visionaries like Carnegie, Rockefeller, Cadbury and Lever utilized company assets to improve the conditions of their workers. The responsibility of business towards the society and environment has evolved over the years and three important events are believed to have been the watershed moments for corporate social responsibility. These include the Industrial Revolution, the rise of the mid-twentieth-century welfare state and globalization. Each period has raised issues about responsible business practices and shaped the CSR as we see it today. The Industrial Revolution led to large scale migration of the rural poor, which facilitated the growth of urban centres where business flourished and provided employment to many migrants. This phenomenon was characterized by injuries, fatalities and inhuman living conditions. Amidst all this emerged the concept of responsible business. The mid-twentieth century era that has affected the CSR can be divided into two periods: (i) World War I and World War II and (ii) post-World War II era. The period before World War I witnessed the flourish of free trade, power of corporations and their self-interest. It also saw greater equality and companies getting engaged in promoting new capitalism, which was founded on the notion that a company should voluntarily take steps to portray itself and its activities as beneficial to society at large. The era of globalization has redefined business and its role in the world, and corporate social responsibility as a growing function of the business has not remained untouched. In this era of globalization, corporate organizations have realized the agenda of a shared CSR vision. Businesses have realized the benefits of strong community relationships and the notion moved dramatically from mere philanthropy as is evident through separating CSR from public relations and human resource department and opening exclusive offices with programs that are more sustainable.

Self-Instructional Material 11 Nature and Scope 1.4.2 Theories of Corporate Social Responsibility of Business The modern concept of corporate social responsibility can be traced back to mid 1800s, when industrialists like John H. Patterson of National Cash Register started the industrial NOTES welfare movement and philanthropists like John D. Rockefeller set up a charitable precedent. These activities are now being carried out by people like Bill Gates, more than 100 years later. However, no unifying theories of CSR exist and the first text related to corporate responsibility appeared in 1932 with the work of Berle and Means. Furthermore, Bernard Dempsy, in his article titled ‘The Roots of Business Responsibility’, published in the Harvard Business Review in 1949, laid out a rationale for responsible business practice. Without using the term CSR, Dempsey provided a foundation of the concept and underlined four concepts of justice: • Exchange • Distributive • General • Contributive In the same year, Donald K. David, Dean of the Harvard Graduate School of Business Administration published an article titled ‘Business Responsibilities in an Uncertain World’ in which he asserted that business leaders should get involved in activities for societal contribution, which are beyond the pursuit of business’s profit. Moving further, David identified four priorities in business obligations which are as follows: • Making business effective • Making good and healthy business organization • Operating in a respectful manner • Contributing to external community and organizations The Social Responsibilities of Business: Company & Community 1900 – 1960, written by Morrell Heald and published in 1970, took into account the theory of social responsibility and experiences of businessmen themselves. Focusing on the concept of ‘trusteeship’, Heald depicted the origin of the concept way before the two world wars and highlighted the role of philanthropists including Andrew Carnegie and Owen D. Young, who all moved beyond philanthropy to include substantive cooperation for a variety of community initiatives. However, it was Archie Carroll in the post-World War II period, who provided the most elaborative overview of CSR. He examined and compared scholarly contributions of the time and regarded Howard R. Bowen, author of Social Responsibilities of the Businessman as the father of corporate social responsibility. Caroll also presented the most accepted and established model of CSR where he describes it as a multi-layered concept that can be differentiated into four interrelated aspects: • Economic responsibilities • Legal responsibilities • Ethical responsibilities • Philanthropic responsibilities

Self-Instructional 12 Material The different responsibilities are seen as consecutive layers within a pyramid, Nature and Scope such that ‘true’ social responsibility requires the meeting of all four levels consecutively. of Business The model shown in Figure 1.3 is the most accepted and established.

NOTES

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E st con le rs re omic ofitab othe Re e pr h all spon B hic sibi on w lities ation found The

Fig. 1.3 Carroll’s CSR Pyramid

Source: http://www.csrquest.net/default.aspx?articleID=12770&heading= Other important concepts including social auditing, social issues management (SIM) and the stakeholder theory emerged in the 1970s and 1980s. The 1980s witnessed efforts to connect corporate social responsibility (as principles), corporate social responsiveness (as processes) and social issues management (as policies) or to link responsibility, responsiveness and business ethics. According to the stakeholder concept, an organization is to be taken as an amalgamation of stakeholders, and the purpose of the organization should be to manage the interests, needs and viewpoints of these stakeholders. However, stakeholder management is considered to be done by the managers of the organization. Thus, the role of managers is twofold: • Manage the corporation for the sake of stakeholders to ensure their rights and participation in decision making • Act as the stockholder’s agent to ensure the success of the firm and safeguard the long-term stakes of each group The stakeholder theory was formalized as a corporate decision-making framework through the work of R. Edward Freeman in the 1980s. During the same period, the concept of corporate conscience was developed by Kenneth E. Goodpaster at the Harvard Business School. According to Freeman, ‘stakeholders’ can be defined as ‘groups that are vital to the survival and success of the corporation’. In another new principle, which reflects a new trend in stakeholder theory, the consideration of the perspective of the stakeholders themselves and their activities is also important enough to be taken into the management of companies. Corporate social responsibility in India is deep-rooted and traces can be found as early as the Vedic period. However, the modern concept of CSR is relatively new and the institutionalized efforts can be found in the works of Tata and Birla groups of industries. Self-Instructional Material 13 Nature and Scope CSR in India has traversed through four phases. According to ‘Altered Images: of Business the 2001 State of Corporate Responsibility in India Poll’, a survey conducted by Tata Energy Research Institute (TERI), the evolution of CSR in India has followed a chronological order of four thinking approaches. These are as follows: NOTES • Ethical Model (1930–1950) • Statist Model (1950–1970s) • Liberal Model (1970s–1990s) • Stakeholder Model (1990s–Present) 1.4.3 Benefits of Corporate Social Responsibility CSR has evolved as an important activity in the global business community and is slowly becoming a mainstream activity. Various benefits of CSR can be documented; however, these can be easily categorized under company benefits, community benefits and environmental benefits. • Company benefits include: o Better financial performance o Less operating costs o Better brand image and reputation o Increased productivity • Community benefits include: o Contributions through charity o Volunteer programs by employees o Community development programs conducted by companies • Environmental benefits include: o Emphasis on the use of renewable resources of energy o Enhanced functionality of the product as well as durability o Combining environmental management tools with business plans Figure 1.4 depicts the important benefits of CSR.

Brand Differentiation

Benefits of Employee Corporate Social Consumer Retention Perspective Responsibility

Risk Management

Fig. 1.4 Benefits of CSR

Self-Instructional 14 Material 1. Brand Differentiation Nature and Scope of Business In the present competitive era, business organizations are always striving for a unique selling proposition to set themselves apart from their competitors. Brand differentiation has become extremely important in today’s world. This is mainly because product and/ NOTES or service differentiations have become harder to detect. CSR initiatives make it easier for corporate organizations to build a stronger brand, which is in accordance with key external stakeholders, i.e., customers, general public and the government. By incorporating social activities into their brand, companies make an effort to influence the buying decisions of potential customers and consumers. There are many organizations, which have stimulated emotions by incorporating CSR initiatives with a product brand and promoted brand differentiation, which ultimately led to a better reputation of the company and its brand. 2. Consumer Perspective Consumers are surely one of the most important stakeholders for a corporate. CSR as we have seen has emerged as a strong notion in the past few years and cannot remain aloof from the perspectives that a consumer develops. On a positive note, CSR activities help in building consumer trust on a range of company’s products and support it through brand differentiation. The same could go wrong if the consumers perceive that the business practices of a company are unethical and unacceptable. For example, after the report of the Centre for Science and Environment on use of pesticides in soft drinks, the sales of cola drinks Pepsi and Coke were severely affected for a long time. 3. Risk Management Risk refers to the possibility of suffering harm or loss. Managing and controlling risk are important to running a successful organization. This is because the reputation of any firm, which takes years to build, can be ruined in the shortest possible time through unethical and unacceptable business practices. It can also lead to unwanted attention from regulators, courts, governments and media. According to an article Human Rights – Is it any of your business?, published by Amnesty International in 2000, building a genuine culture of ‘doing the right thing’ within an organization can reduce or eliminate these risks. Responsible companies have long understood this fact towards their employees, but more recently they have accepted that the bounds of their responsibility should be extended to embrace the large environmental, social and economic aspects of the society. The failure to do so results in the risk of reputational damage to companies. CSR comprises four areas of risk, which includes supply chain, operational risks, product and societal expectations and broader human rights. These are explained as follows: • Supply chain: Including human rights abuses and pollution • Operational risks: Not conforming with regulations, unable to achieve employee satisfaction and dangerous operations • Product: Use of hazardous and toxic raw materials, wastage during production, and health and safety issues • Societal expectations: Does not cover what society expects from a business in the 21st century

Self-Instructional Material 15 Nature and Scope 4. Employee Retention of Business CSR is also being undertaken with an objective of retaining employees in an organization. This practice is increased at a global level and CSR activities are utilized as means to NOTES motivate employees through their involvement with the communities in numerous thematic areas. CSR boosts the employee morale in the organization and create a positive brand- centric corporate culture in the organization. By developing and implementing such initiatives, corporate organizations feel contented and proud, and this pride trickles down to their employees and leaving them more satisfied and consequently making them work for longer years. 1.4.4 Challenges to Corporate Social Responsibility Most corporations, especially multinational corporations (MNCs), have already adopted CSR policies. Previously, governments depended on legislations and regulations to ensure that social and environmental objectives in the business sector were achieved. However, reduction in government resources, combined with a distrust of regulations, led to the rise of voluntary and non-regulatory initiatives instead. (i) Limitations of jurisdictions: Under globalization, many corporations have outsourced their manufacturing processes to developing countries. In those countries, domestic legislations do not usually provide sufficient protection on labour, such as minimum wage or guidelines on health and safety in the workplace. (ii) No direct responsibility imposed on the purchasing firms: Even if the domestic law is well enforced, the purchasing MNCs are not legally responsible for any of the charges. Ultimately, it is the domestic factory or firm that will be held responsible. Since there are almost no punitive measures on the MNCs, the law and enforcement system fail to function here. (iii) Difficulties in auditing: In order to comply with higher standards of CSR, some firms have undergone active research and auditing on the firms they hired in their supply chain. Discrepancies between reality and audit results do exist. Taking Foxconn as example, after the several tragic incidents of workers’ suicides, Apple decided to investigate the working condition of those related factories. Its investigation report shows that there were no issues of overtime work, no child or forced labour, which is contrary to what the NGOs claim. Ironically, after the reassurance of good working conditions in the investigation report, the number of suicides has not stopped, which just shows that the conditions have not been improved. One very crucial difficulty in auditing is that the factory can always hide the bad things since they know what they look for. Workers could also be under pressure and not tell the truth. Since difficulties exist while carrying out active auditing, its effectiveness and reliability is therefore questionable. Ethical Consumerism The increase in popularity of ethical consumerism in the last 20 years can be connected with the rise of CSR. The term ‘ethical consumer’, now used universally, was initially made popular by the British magazine, Ethical Consumer, which was first published in 1989. Ethical consumerism is nothing but the intentional purchase of products and services made by a consumer according to ethics. It may refer to making choices by keeping in mind that minimum harm is done to the environment, humans and animals. Self-Instructional 16 Material Social Awareness Nature and Scope of Business Both shareholders and investors can resort to socially responsible investing to urge corporate organizations to behave responsibly and usher in change. The role of non- governmental organizations is also increasing, almost bringing them on par with the NOTES media and the internet by increasing their scrutiny and collective activism when faced with corporate behaviour. In the modern times, the traditional role and perception of CSR has been challenged and replaced by the community-conscious concept of creating shared value (CSV), and several companies are refining their collaboration with stakeholders accordingly. Corporate Greenwashing Greenwashing is a term used to denote the publicity material that is produced by public relations firms or green marketers. The material developed is deceptively used to promote an image that the aims and policies of an organization are environment-friendly – the aim may be to increase profits, gather political clout or manipulate popular opinion. The term ‘greenwashing’ was coined by Jay Westervelt, New York environmentalist, regarding the practice of the hospitality industry to promote the reuse of towels to ‘save the environment’. More than reducing energy consumption and waste generation, this increased the level of profit of the institutions. Thereby, he labelled this and other so-called environmentally conscientious acts to have a hidden purpose of profit increase as greenwashing.

1.5 SUMMARY

• Business is an economic activity with the object of earning an income, i.e., profit and thereby accumulating wealth. • Business firm is an economic unit. A business firm is basically a transformation unit; it transforms input into output. • Business decision-making is an economic process. • The objectives of a business would be to provide good quality products or services, to earn profits or to grow to a certain level within a certain period. • It is commonly believed that most businesses have just a single main objective which is to earn profits. • The objectives of a business could be economic, social, human, national or global. Check Your Progress • One of the most important hindrances of setting up a new enterprise is lack of 6. Define corporate social awareness of the various options available for setting up an enterprise. responsibility. • A new venture goes through three phases (i) Pre-start-up (ii) Start-up (iii) Post 7. Which is the start up. recognized international • Corporate social responsibility can be defined as a form of self-regulation practiced standard for CSR? by businesses and this is integrated into the business model. It functions as an in- 8. List the four areas built mechanism that helps a business to monitor itself and ensure its compliance of risk in CSR. with law, ethical standards and international norms. 9. Define the term greenwashing. • ISO 26000 is the recognized international standard for CSR. 10. Who coined the • No unifying theories of CSR exist and the first text related to corporate responsibility term greenwashing? appeared in 1932 with the work of Berle and Means. Self-Instructional Material 17 Nature and Scope • CSR has evolved as an important activity in the global business community and is of Business slowly becoming a mainstream activity. Various benefits of CSR can be documented; however, these can be easily categorized under company benefits, community benefits and environmental benefits. NOTES • Brand differentiation has become extremely important in today’s world. This is mainly because product and/or service differentiations have become harder to detect. • CSR comprises four areas of risk, which includes supply chain, operational risks, product and societal expectations and broader human rights. • CSR is also being undertaken with an objective of retaining employees in an organization. • Previously, governments depended on legislation and regulation to ensure that social and environmental objectives in the business sector were achieved. However, reduction in government resources, combined with a distrust of regulations, led to the rise of voluntary and non-regulatory initiatives instead. • Ethical consumerism is nothing but the intentional purchase of products and services made by a consumer according to ethics. It may refer to making choices by keeping in mind that minimum harm is done the environment, humans and animals. • In the modern times, the traditional role and perception of CSR has been challenged and replaced by the community-conscious concept of creating shared value (CSV), and several companies are refining their collaboration with stakeholders accordingly. • Greenwashing is a term used to denote the publicity material that is produced by public relations firms or green marketers. The material developed is deceptively used to promote an image that the aims and policies of an organization are environment-friendly – the aim may be to increase profits, gather political clout or manipulate popular opinion.

1.6 KEY TERMS

• Business firm: Business firm is an economic unit. A business firm is basically a transformation unit; it transforms input into output. • Corporate social responsibility: Corporate social responsibility can be defined as a form of self-regulation practiced by businesses and this is integrated into the business model. • Greenwashing: Greenwashing is a term used to denote the publicity material that is produced by public relations firms or green marketers.

1.7 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. Business firm is an economic unit. A business firm is basically a transformation unit; it transforms input into output. 2. Economic objectives would include the following: • Profit earning • Creation of customers Self-Instructional 18 Material • Regular innovations Nature and Scope • Best possible use of resources of Business 3. One of the most important hindrances of setting up a new enterprise is lack of awareness of the various options available for setting up an enterprise. NOTES 4. The choice of an appropriate form of business undertaking depends upon: • Objectives and size of the business desired with reference to the scale of operations • Financial and capital resources available for investment • Nature of control • Supervision and management of the business enterprise • Liability of the owners • Transferability of the ownership interest and lifespan of the business 5. A new venture goes through three phases (i) Pre-start-up (ii) Start-up (iii) Post start up. 6. Corporate social responsibility can be defined as a form of self-regulation practiced by businesses and this is integrated into the business model. 7. ISO 26000 is the recognized international standard for CSR. 8. CSR comprises four areas of risk: • Supply chain • Operational risks • Product • Societal expectations 9. Greenwashing is a term used to denote the publicity material that is produced by public relations firms or green marketers. 10. The term ‘greenwashing’ was coined by Jay Westervelt, a New York-based environmentalist.

1.8 QUESTIONS AND EXERCISES

Short-Answer Questions 1. What are the important laws and regulations that are common to all types of enterprises? 2. Write a short note on the history of corporate social responsibility. 3. What is corporate greenwashing? Long-Answer Questions 1. Why is business considered to be an economic activity? Discuss the objectives of a business. 2. Discuss the theories of corporate social responsibility. 3. What are the benefits of corporate social responsibility? 4. Discuss the various challenges to corporate social responsibility.

Self-Instructional Material 19 Nature and Scope of Business 1.9 FURTHER READING

Weston, J Fred, Kwang S. Chung and Susan E Hoag. 1990. Mergers, Restructuring NOTES and Corporate Control. New Jersey: Prentice Hall. Horne, James C. Van. 2002. Financial Management. New Jersey: Prentice Hall. Brealey, Richard A., Stewart C. Myers and Franklin Allen. 2008. Principles of Corporate Finance. New York: McGraw-Hill. Pandey, I. M. 2010. Financial Management. New Delhi: Vikas Publishing House. Muralidharan. 2009. Modern Banking: Theory and Practice. New Delhi: PHI Learning Private Ltd. Maheshwari, S. N. 1983. Banking Law and Practice. New Delhi: Kalyani Publishers. Gordon E. and K. Natrajan.1992. Banking: Theory, Law and Practice. Mumbai: Himalaya Publishing House. Sharma, K.C. 2007. Modern Banking in India. New Delhi: Deep and Deep Publications. Sharma and Gupta. 2003. Business Organisation and Management. India: Kalyani Publishers. Shukla, Madhukar. 2008. Understanding Organisations. New Delhi: PHI Learning Pvt. Ltd.

Self-Instructional 20 Material Forms of Business UNIT 2 FORMS OF BUSINESS Organization ORGANIZATION NOTES Structure 2.0 Introduction 2.1 Unit Objectives 2.2 Sole Trader 2.3 Partnership and Joint Company 2.3.1 Essential Characteristics of Partnership 2.3.2 Various Aspects of Partnership Firm 2.3.3 Joint Stock Companies 2.3.4 Forming a Company 2.3.5 Differences Between a Company and a Partnership 2.4 Cooperatives 2.4.1 Suitability of a Form of Organization 2.5 Summary 2.6 Key Terms 2.7 Answers to ‘Check Your Progress’ 2.8 Questions and Exercises 2.9 Further Reading

2.0 INTRODUCTION

A business enterprise can be owned and organized in several forms. Before starting a new business venture, one has to decide which form of business ownership would be most suitable. There are many forms of ownership prevalent in countries across the world. Each form has its own pros and cons depending on the government regulations, tax policies and the law applicable to the area where it is operating. Sole proprietorship is a business with a single owner. The owner has the option of running the business all by himself or employing people to run it for him. He is completely responsible for the business and has liability of the debts that may be incurred. Partnership is a business involving two or more people working together for a common goal of making profit. Each partner has unlimited liability of the debts sustained by the partnership. A cooperative business has members instead of shareholders. All the members share the power of making decisions. In this unit, you will learn in detail about the different forms of business ownership.

2.1 UNIT OBJECTIVES

After going through this unit, you will be able to: • Understand the concept of sole trader • Discuss the characteristic features of partnership firm and a company • Understand the meaning of cooperative organizations

Self-Instructional Material 21 Forms of Business Organization 2.2 SOLE TRADER

Sole proprietorship is the oldest and the simplest form of business organization. It has NOTES been in operation since the beginning of our civilization. A sole proprietor is simply a person who independently conducts an unincorporated business for profit. Sole proprietorships are quick and inexpensive ways to start a new venture since this form of organization requires no formalities other than complying with the laws affecting local licensing and registration of the name of the business. A sole proprietorship is a form of business organization that is run under the exclusive ownership, management and control of an individual. The individual brings his own or borrowed capital, uses his own skill and intelligence in the management of affairs, bears all the risks alone, enjoys all profits and suffers all losses. Thus, only one person is the sole owner, manager, financier, risk-bearer and controller — all rolled into one. The individual may run the business alone or may obtain the assistance of employees for running the routine activities of business. Features of Sole Proprietorship • Sole ownership • One-man control • Contribution of owned and/or borrowed capital • No sharing of profits or losses • No separate legal entity of the firm – proprietor and the firm are identical as entities • Unlimited liability • Freedom from government regulations Merits of Sole Proprietorship • It is simple and easy to form and easy to close down; there are few legal formalities in its formation or closure • Starting a sole proprietorship takes very little initial investment • Decision-making is prompt and consistent, which ensures smooth management • Matters of business can be kept confidential to safeguard business interests • Customer relationships are close and personal which reflect the increase in the volume of business and the ultimate success of the organization • Motivation and incentives are the highest as the owner keeps all profiles • Minimum governmental interference • Flexible business, as consumer demand changes according to the season, fashion or taste • Offers a person the opportunity for self-employment • Factors like creativity, pride, job security and profit are linked to performance Demerits of Sole Proprietorship • Personally liable to local laws/regulations, business/investment risks and bankruptcy

Self-Instructional • Limited ability to borrow from banks; difficulty in attracting capable managers 22 Material • Limited managerial and decision-making ability; owner’s capacity to look after Forms of Business Organization production, sales, advertising, purchasing and financing are constrained • No continuity of the business as with the death of owner the business closes down NOTES • The owner has to put in long hours of work, has personal responsibility and is under constant pressure to please consumers, employees and creditors An evaluation of the advantages and weaknesses of sole proprietorship suggests that one-man control of business is most efficient and profitable only if that one man has an indefinite capacity to manage everything. Unfortunately, such a person does not exist. However, the following are the circumstances under which the sole proprietorship form of business organization is considered to be very suitable: • Where capital requirements are small and the risk is not heavy • Where decision making has to be quick • Where the customers require personal attention • Where special regard has to be shown to the individual tastes and preferences of the customer • Where fashions change quickly • Where demand is temporary, seasonal and local Naturally, the sole proprietorship form of business organization is most suitable for professional services (such as doctors, dentists, accountants, lawyers and artists), household and personal services, such as barber shops, tailoring, dry-cleaners, bullion dealers, corner sweet shops and bakeries, small manufacturing activities, cottage industries, handicrafts, small retail store, repair shop, and so on.

2.3 PARTNERSHIP AND JOINT COMPANY

Partnership, as a form of business organization, came into existence to overcome the limitations of one-man business, limitations of financial resources, and managerial skill. According to Section 4 of the Partnership Act, 1932, partnership is ‘the relation between partners who have agreed to share the profits of a business carried on by all or any one of them acting for all.’ In the words of Professor Haney, ‘partnership is the relation existing between persons competent to make contracts, who have agreed to carry on a lawful business and with a common view to earn profits.’ The persons who have entered into partnership are individually called ‘partners’ and are collectively called a ‘firm’. The name under which they carry on the business is called the ‘firm’. The partners enter into an agreement to lay down the terms and conditions relating to partnership and the regulations governing its internal management and organization. This agreement is known as ‘Partnership Deed’. The agreement may be oral or in Check Your Progress writing. However, a regular partnership agreement in writing, duly signed by all partners, can ensure the smooth running of the partnership business. The partners contribute 1. Define sole proprietorship. capital and they share managerial responsibility and profits/losses as per the agreement. 2. List three features of sole proprietorship.

Self-Instructional Material 23 Forms of Business 2.3.1 Essential Characteristics of Partnership Organization The definition of partnership reveals certain characteristics of partnership. These are as follows: NOTES • Association of two or more persons: There must be at least two persons to form a partnership. Regarding the maximum number, Companies Act, 1956, provides that where the firm carries on banking business, the number of partners should not exceed ten and where the firm is carrying on any other business, the number of persons should not exceed 20. An association or a partnership firm having members more than this statutory limit must be registered as a company. If the minimum number of persons is reduced to one, the firm is automatically dissolved. • Agreement: Partnership can be formed only by a contract which may be express or implied. All the essential elements of a valid contract must be present in a partnership agreement (e.g., capacity of parties, free consent and legality of object). • Business: Partnership is formed to carry on some business. The term ‘business’ includes all forms of trades, occupations and professions. The idea behind the business is to secure gain. • Sharing of profits: The division of profits is an essential condition for the existence of partnership. The sharing of profits involves the sharing of losses as well. But sharing need not be equal. Partners can mutually agree to share profits in any way they like. Section 13(b), however, provides that the partners are entitled to share equally in the profits earned and shall contribute equally to the losses sustained by the firm, unless otherwise agreed. • Mutual agency: The partnership business may be carried on by all the partners or any of them acting for all. Each partner is the agent of the firm as well as other partners. He can bind the firm by his acts done in the usual course of business. Similarly, a partner may be bound by the act of the other partners. This is the most essential principle of partnership. • No separate legal existence: The partnership firm is a voluntary association of persons and it has no separate legal entity of its own. The partnership firm and partners are one and the same in the eyes of the law. • Unlimited liability: Each partner is liable jointly and severally for all debts and obligations of the firm to an unlimited extent. The creditors can recover their dues from the private property of any or all partners in case the firm’s assets are insufficient to meet the claims of the firm’s creditors. • Utmost good faith: Every partner should be just and faithful to other partners. They must disclose every information and present true accounts to one another. • Restriction on transfer of interest: A partner cannot transfer his rights or interests in a partnership firm to an outsider without the consent of other partners. 2.3.2 Various Aspects of Partnership Firm • Formation: Although a partnership is constituted by means of a contract between the partners, no legal formalities are required for its formation. An oral contract is sufficient to bring it into being. But it is advisable to reduce the agreement to writing, and prepare a properly drafted Deed of Partnership or Articles of Partnership laying down the terms and conditions of partnership and the rights, obligations and duties of the partners. Self-Instructional 24 Material Registration of a partnership firm is not compulsory under our law, nor is any Forms of Business penalty provided for non-registration. The law, however, introduces certain Organization disabilities which make registration necessary under some conditions. In fact, the law has effectively ensured the registration of firms without making it compulsory. The first disability is that an unregistered firm cannot file a suit or take other legal NOTES proceedings to enforce a right arising from a contract. Second, a partner cannot sue the firm or other partners arising under a contract or conferred by the Partnership Act. But, an outsider can sue an unregistered firm and its partners. • Finance: Normally, the capital of a partnership firm consists of the amounts contributed by the various partners. The capital contributions by all the partners need not be equal, and one or more may not put in any capital at all. This will happen where such partners bring in special skills and abilities. The initial capital may be augmented or more may be obtained for the expansion of business by borrowing on the security of the firm’s property and also on the strength of the private estates of partners. • Control: As partnership results from a contract, the control will depend upon its terms. Where all the partners take active part in the conduct of the partnership business, the control rests with all of them. All major decisions, as observed earlier, must be made by the unanimous consent of all the partners. There may, however, be some partners who do not take active part in the conduct of the business. They are known as sleeping or dormant or secret partners. In a word, control is ordinarily shared by the active or ostensible partners. • Management of affairs: In law, every partner has a right to take part in the conduct and management of the business of the firm. In practice, a partnership agreement provides for the division of work among the different partners according to their experience and knowledge. It is not unusual to have one of them as the senior partner who would be in the position of the chief executive exercising overall supervision. • Duration of partnership: The partners are at liberty to fix the duration of the partnership or make no mention about it. Where they agree to carry on business for a definite period of time, it is called a partnership for a fixed term. When the term is over, the partnership comes to an end; but if the business is continued after the expiry of the period originally fixed, the renewed partnership will become a partnership at will. Where a partnership is formed for a particular adventure, it is called particular partnership, which would presumably last until the business is finished. If the partners say nothing about the duration, or agree to carry on the business as long as they wish to do so, the partnership will be one at will. It can be dissolved at the will of any partner, on his giving notice. Where partners cannot agree on the dissolution of the firm, the court may, on application, order its dissolution. • Taxation: A partnership firm is liable to pay income tax and other taxes as an individual is liable to pay. But, there is a slight difference with regard to the rate of tax which depends on whether the firm is registered under the Income Tax Act or not. If it is so registered (apart from registration under the Partnership Act), the income will be divided among partners and each partner will be assessed separately. If the firm is not registered, the firm will be required to pay tax on its total profit as distinct from the income of the individual partners.

Self-Instructional Material 25 Forms of Business Types of Partners Organization The liabilities of the partners depend upon their mutual agreement. They can enter into partnership subject to any terms and conditions. Therefore, the following types of partners NOTES may be distinguished: 1. Active or actual partner: Actual partner means a person who is by agreement entitled to participate in the management of the partnership business. He is also called ostensible or working partner. He binds himself and other partners by his acts done in the usual course of business, as far as third parties are concerned. In case of his retirement from the firm, he has to give public notice of retirement. If he fails to give public notice, he continues to remain liable to outsiders for the acts of other partners. 2. Dormant or sleeping partner: A sleeping partner is one who does not take part in the management of the firm’s business. He is not known as a partner to the outside world. He invests capital and shares in the profits of the business. He is liable to outsiders for all the debts of the firm. A sleeping partner need not give public notice of his retirement. He is not liable for any act of the firm done after his retirement. 3. Nominal partner: A person who merely lends his name to the firm without taking part in its management is a nominal partner. He has no right to share the profits. He does not invest any capital and has no real interest in the business. However, he is liable to third parties for the acts of the firm, as if he is an actual partner of the firm. A nominal partner is known to the outside world as a partner, though internally he has no right to share profits or take part in management. 4. Partner in profits only: A ‘partner in profits’ is one who is entitled to share in the profits only and not in losses. He invests capital in the business but does not take part in management. However, he is liable to the third parties for the acts of the firm like any other partner. 5. Partner by estoppel or holding out: A partner by holding out is one who represents himself to be a partner in the firm, but in reality he is not so. If any person, by words spoken, written or by his conduct, represents himself or knowingly permits himself, to be represented as a partner in a firm, he is liable as a partner in that firm to anyone who has the faith of such representation given credit to the firm (Section 28). Merits of a Partnership Firm • Easy formation, as there are no formalities in entering into an agreement between the parties; the agreement need not be in writing if the firm is not registered • Better availability of finance as funds contributed by two or more partners; this ensures the credit-worthiness of a firm to borrow funds for the business • Pooling of resources and management skills lead to a firm’s success • All partners share the risk of the business • Flexibility in introducing changes in operations; quick decisions lead to quick actions with minimal legal formalities • Partners are motivated to improve efficiency through their joint efforts in management or supervision, which lead to enhanced profits

Self-Instructional 26 Material • The firm has a higher survival ratio than a sole proprietorship Forms of Business Organization • Better public relations with employees and customers enhance the goodwill of the firm Demerits of a Partnership Firm NOTES • Unlimited liability of a partner • Limited resources which hinder growth and expansion of the firm • Conflict or dissent amongst partners will lead to dissolution of the partnership • Death of a partner, incapacity or insolvency dissolves the firm • As interest in the firm cannot be transferred without the consensus of all the partners, this blocks investments • The lack of sufficient regulations and accountability leads to public distrust and erosion of confidence in the firm In short, partnership is an ideal form of organization for small-scale and medium- size business where there is limited market, limited risk or loss, and where limited capital and limited specialization in management is required. When the firm becomes large and partners cannot cope with the needs of expansion, the business had better be organized as a joint stock company. 2.3.3 Joint Stock Companies The sole proprietorship and partnership forms of business organizations proved incapable of meeting the challenges posed by the growing needs of modern industry and commerce. These forms of ownership suffered from certain drawbacks like limited financial and managerial resources, unlimited liability and fear of discontinuity. Therefore, it became necessary to have another form of organization to get over these limitations. The company form of organization, thus, came into existence. This form enables the entrepreneurs to get the necessary capital from the general public, retaining, at the same time, control and management in their own hands. As a matter of fact, most of the shortcomings of a partnership form of organization are overcome by organizing a business as a joint stock company with limited liabilities. Tracing the ever-increasing importance of the modern corporation in the industrial economy of the US, Thomas J. Adams states: ‘Perhaps no other institution has had a greater effect upon business development than the corporate form of business enterprise. Its unique characteristics have made possible the accumulation of large amounts of capital needed for large-scale activity under unified business management.’ As soon as our nation gained independence, it became apparent that single proprietorship and partnership forms of business would prove inadequate for building our industrial, commercial, banking and transportation facilities. This task was undertaken largely by corporations (companies), with such marked success that today the great bulk of business activity is centered on corporate enterprises. Modern corporations are not only effective vehicles for the use of business resources, but they also influence the fabric of modern life because of their size and economic importance.

Self-Instructional Material 27 Forms of Business 2.3.4 Formation of a Company Organization Lord Justice Lindley defines a company as follows: ‘A company is an association of many persons who contribute money or money’s NOTES worth to a common stock and employs it in some trade or business, and who share the profit and loss arising therefrom. The common stock so contributed is denoted in money and is the capital of the company. The persons who contribute it or to whom it belongs are members. The proportion of capital to which each member is entitled is his share. The shares are always transferable although the right to transfer is often more or less restricted’. According to Chief Justice Marshall, ‘A corporation is an artificial being, invisible, intangible and existing only in contemplation of the law. Being a mere creation of law, it possesses only the properties which the charter of its creation confers upon it, either expressly or as incidental to its very existence.’ Still another definition is given by Haney who observes that, ‘A company is an incorporated association, which is an artificial person created by law, having a separate entity, with a perpetual succession and a common seal.’ These definitions clearly bring out the characteristics of a company. A company is created by law. It comes into existence only when it is registered under the Act. It has a personality of its own which is distinct from the personality of its shareholders. The capital of the company is divided into transferable shares and the liability of the members is limited to the nominal value of the shares held. The persons who hold shares in the company are known as shareholders and they elect the directors who control and manage the affairs of the company. It is characterized by perpetual succession and a common seal. It continues to exist until it is wound up in accordance with the provisions of the Act. Characteristics of a Company The most distinguishing characteristics of a company are as follows: 1. Incorporated association: A company is created when it is registered under the Companies Act. It comes into being from the date mentioned in the certificate of incorporation. To form a public company, at least seven persons are required, and in the case of a private company, at least two persons are required. These persons will subscribe their names to the memorandum of association and also comply with other legal requirements of the Act in respect of registration to form and incorporate a company. 2. Artificial legal person: A company is an artificial person. Generally speaking, it is not a natural person. It exists in the eyes of the law and cannot act on its own. It has to act through a board of directors elected by the shareholders. The board of directors is the brain of the company, which is the body and the company can and does act only through them. 3. Separate legal entity: This means that a company has a legal entity distinct from and independent of its members. The creditors of the company can recover their money only from the company and the property of the company. They cannot sue individual members. Similarly, the company is not in any way liable for the individual debts of its members. The property of the company is to be used for the benefit of the company and not for the personal benefit of the shareholders. On

Self-Instructional 28 Material the same grounds, a member cannot claim any ownership rights in the assets of Forms of Business the company either individually or jointly during the existence of the company or Organization in its winding up. The separate legal entity of the company is also recognized by the Income Tax Act, where a company is required to pay income tax on its profits and when these profits are distributed to shareholders in the form of dividends, NOTES the shareholders have to pay income tax on their dividend income. This proves that a company and its shareholders are two separate entities. 4. Perpetual succession: A company has perpetual succession and is independent of the life of its members. Its existence is not affected in any way by the death, insolvency or exit of any shareholder. A company can be compared with a river which retains its identity though the parts which compose it are constantly changing. Perpetual succession, thus, means that in spite of a change in the membership of the company, its continuity is not affected. Perpetual succession lends stability and long life to a company, as compared to other forms of business organizations. 5. Limited liability: One of the important advantages of the company is that the liability of its members is limited. In the case of a company limited by shares, the liability of members is limited to the extent of the nominal value of shares held by them. If a shareholder has paid the full nominal value of shares held by him, his liability is nil. This means that a shareholder remains liable to pay the unpaid value of shares, if any. 6. Transferable shares: In a public company, the shares are freely transferable. The right to transfer shares is a statutory right and it cannot be taken away by a provision in the articles. 7. Common seal: A company is an artificial person. It cannot act on its own. It acts through natural persons who are known as directors. All contracts entered into by the directors must be under the common seal of the company. The common seal, with the name of the company engraved on it, is used as a substitute for its signature. No document issued by the company shall be binding on it unless it bears the common seal which is duly witnessed by at least two directors of the company. 8. Separate property: A company, being a legal person, is capable of owning, enjoying and disposing of property in its own name. The property of the company is to be used for the company’s business and not for the personal benefit of its shareholders. Members have no direct proprietary rights over the company’s property. 9. Capacity to sue and be sued: The company is a legal person and it can enforce its legal rights. Similarly, it can be sued for breach of its legal duties. A company is an artificial entity created by law for the purpose of carrying on any activity such as business, sports, research or charity. However, most companies are formed for the purpose of conducting business. In India, the Companies Act of 1956 sets down rules for the establishment of both public and private companies. The most commonly used corporate form is the limited company, unlimited companies being relatively uncommon. A company is formed by registering the Memorandum and Articles of Association with the State Registrar of Companies of the state in which the main office is to be located. The process of forming a company can be divided into four distinct stages—(i) promotion (ii) registration or incorporation (iii) capital subscription and (iv) commencement of business.

Self-Instructional Material 29 Forms of Business Promotion Organization This is the first stage in the formation of a company. Gerstenberg in his book, Financial Organization and Management of Business, has defined ‘promotion’ as, ‘the discovery NOTES of business opportunities and the subsequent organization of funds, property and managerial ability into a business concern for the purpose of making profits therefrom.’ First, the idea of carrying on a business which can be profitably undertaken is conceived either by a person or by a group of persons who are called promoters. After conceiving the idea, the promoters make detailed investigations to find out the weaknesses and strong points of the idea to determine the amount of capital required and to estimate the operating expenses and the probable income. When the promoter is satisfied that the idea, as originally conceived, can be put into practice profitably, he takes the necessary steps for assembling the proposition. These steps include securing the cooperation of the required number of persons who will associate themselves with the project and act as the first directors of the company to be floated, securing the necessary patents, acquisition of a suitable site for the factory, arrangements for machinery and equipment, tentative arrangements for personnel, and so on. After assembling the proposition, the promoters prepare a detailed financial plan showing therein the total cost of the project, sources of finance, and so on. They must also decide at this stage whether the company to be formed is to be a private company or a public company. The minimum number of members required to form a company is seven in the case of a public company and two in the case of a private company. They must also arrange in advance the success of the company floatation by finalizing contracts with the underwriters and the Issue Houses. Finally, they should get the necessary documents prepared such as the memorandum of association, articles of association, and the prospectus, and arrange for their publication. These documents are prepared with the help of legal experts and the promoters have to see that the particular requirements of the Act are incorporated therein. Registration or Incorporation This is the second stage of the formation of the company. In this stage, the company is registered with the Registrar of Companies under the Companies Act. Section 12 of the Act provides that to form a public company at least seven persons are required, and for a private company, at least two persons are required. These persons will subscribe their names to the memorandum of association and will also comply for registration to form and incorporate a company with or without limited liability. However, before registration, the promoters must take the following steps: • They must take a decision about whether the company proposed to be formed is to be a public company or a private company. • They must obtain the approval of the proposed name from the Registrar of Companies. To get this approval, an application has to be made in the prescribed form. The application should be filed with the prescribed fee and it will be better for the promoters to select and send three or four names for the company in the order of preference. • They must have the necessary documents prepared and printed. • They must prepare preliminary contracts and a prospectus or a statement in lieu of a prospectus.

Self-Instructional 30 Material Filing Documents with the Registrar Forms of Business Organization The following documents are to be filed with the Registrar of Companies of the state in which the registered office of the company is to be situated, along with an application for registration and necessary fees: NOTES • The memorandum of association of the company, which shall be printed, divided into paragraphs and signed by each subscriber who shall add his address, description and occupation in the presence of at least one witness who shall attest his signature. • The articles of association of the company, if any, shall also be duly signed by subscribers of the memorandum of association. A public company limited by shares may not have its own articles and in that case, Table A, the model set of articles, shall be applicable, but this fact must be specified in the memorandum. However, all other companies must prepare their articles which shall be filed with the Registrar along with the memorandum. [Sec 33(1)(b)] • The agreement, if any, which the company proposes to enter into with any individual for appointment as its managing or whole-time director or manager. • Notice of address of the registered office of the company must be given to the Registrar within thirty days of incorporation if it cannot be filed at the time of registration. • A list of persons who have given their consent to act as directors of the company must be filed with the Registrar. • The written consent of each proposed director signed by him, along with a written undertaking to take up and pay for qualification shares, if any, must be filed with the Registrar. • A declaration that all the requirements of this Act in respect of registration have been complied with. Registration of a Company The Registrar will examine the documents. He may, however, accept the declaration as sufficient evidence of compliance with the Act. If he is satisfied that all requirements of the Act in respect of registration have been complied with, he will register the company and place its name in the Register of Companies. A certificate of incorporation will be issued whereby the Registrar shall certify under his hand that the company is incorporated and in the case of a limited company, that the company is limited. The Registrar of Companies is also required to issue a Corporate Identity Number (CIN) to each company registered on or after 1 November, 2000. The certificate of incorporation is the birth certificate of a company. The company comes into existence from the date mentioned in the certificate of incorporation. Not only does the certificate create the company, the certificate is conclusive for all purposes. Capital Subscription A private company can commence business immediately on receipt of the certificate of incorporation. But a public company cannot commence business unless it obtains another certificate called ‘the certificate of commencement of business’ from the Registrar of Companies. For this purpose, a public company has to go through the ‘capital subscription stage’, and the ‘commencement of business stage’. Self-Instructional Material 31 Forms of Business Making necessary arrangements for raising capital: In the capital subscription Organization stage, the company makes necessary arrangements for raising capital for the company. The most common method of raising capital from the public is by inviting offers from the members of the public to subscribe for the shares or debentures through the issue of NOTES prospectus. The Securities and Exchange Board of India (SEBI), which was established by SEBI Act, 1992, regulates the issue of capital to the public. A public company raising capital from the public by the issue of shares or debentures, has to comply with the ‘Guidelines for Disclosure and Investor Protection, 2000’ issued by SEBI. Inviting public subscription: Where the directors of a public company wish to invite the public to subscribe for its shares, they will file a copy of the prospectus with the Registrar of Companies. On the advertised date, the prospectus will be issued to the public. No prospectus can be issued unless a copy of it has been filed with the Registrar. Prospective investors can obtain a copy of the prospectus either from the company’s registered office or its bankers. Investors are required to forward their applications for shares along with the application money to the company’s bankers mentioned in the prospectus. The bankers will then forward all applications to the company and the directors will consider the allotment of shares. If the subscribed capital is at least equal to the minimum subscription of 90 per cent of the capital issue, and other statutory conditions for the allotment of shares are fulfilled, the directors will pass a formal resolution of allotment of shares to the applicants. Allotment letters will be sent to those applicants who have been allotted shares in the company, whereas letters of regret will be sent to those who have been refused. A return with allotment details is filed with the Registrar. In due course of time, a register of members will be prepared and share certificates will be issued to shareholders in exchange of letters of allotment. If the company does not receive applications that cover the minimum subscription of 90 per cent of the issued amount within sixty days from the closure date of the issue, the company shall forthwith refund the entire amount received and no allotment can be made. Arranging capital privately: Sometimes, a public company may decide not to approach the general public for selling its shares as it may be in a position to obtain the required capital privately. In this situation, the company will file a statement in lieu of prospectus with the Registrar at least three days before the allotment of shares. It need not issue a prospectus. It may also be noted that the contents of a prospectus and a statement in lieu of a prospectus are more or less the same. Commencement of Business A private company can commence business immediately after obtaining the certificate of incorporation. But, a public company cannot commence business until it receives the certificate of commencement of business. Companies issuing the prospectus: A company which has issued a prospectus inviting the public to subscribe for its shares cannot commence any business or exercise any borrowing powers unless, (a) shares payable in cash have been allotted to an amount not less than the minimum subscription; (b) every director of the company had paid the company in cash, the application and allotment money on his shares in the same proportion as others; (c) no money is liable to be repaid to the applicants for failure to apply for, or to obtain, the permission for the shares or debentures to be dealt in on any recognized stock exchange; and (d) a declaration duly verified by one of the directors or the secretary that the above requirements have been complied with is filed with the Registrar. Companies not issuing the prospectus: Where a company with a share capital has Self-Instructional not issued a prospectus inviting the public to subscribe for its shares, it shall not commence 32 Material any business or exercise any borrowing power, unless (a) a statement in lieu of a prospectus Forms of Business is filed with the Registrar; (b) every director of the company has paid the company in Organization cash application and allotment money on his shares in the same proportion as others; (c) a declaration duly verified by one of the directors or the secretary that these requirements have been complied with, are all filed with the Registrar. If the company has not appointed NOTES a secretary, it can get the declaration signed by a secretary in whole-time practice. [Sec. 149(2)] When the company fulfils these conditions, the Registrar shall certify that it is entitled to commence business and that the certificate shall be conclusive evidence that the company is so entitled. [Sec. 149(3)] 2.3.5 Differences Between a Company and a Partnership The principal points of difference between a company and a partnership are as follows: 1. A company comes into existence only when it is registered under the provisions of the Companies Act. However, a partnership is created by an agreement between partners. The registration of a partnership firm under the Partnership Act is optional. 2. A private company must be constituted by at least two persons, and by at least seven in case of a public company. A partnership can be created by two persons. 3. In a public company, there is no limit on the maximum number of members, while in a private company the number of members shall be restricted to fifty excluding its present and past employees. In the case of a partnership carrying on a banking business, the maximum number of partners can be ten, and in the case of any other business, twenty. 4. A company has a separate legal entity distinct from the members who constitute it. A partnership, commonly called a firm, has no legal existence apart from its members. This means that the partners and the firm are one and the same. 5. In the case of a company, the property belongs to the company and not to its individual members, whereas the property of a partnership firm belongs to individual partners comprising the firm. 6. A shareholder may enter into a contract with a company, whereas a partner cannot enter into a contract with a firm. However, a partner can enter into a contract with other partners. 7. Creditors of the company are not the creditors of individual shareholders. They can proceed against the company alone. Creditors cannot hold the shareholders directly liable for their amounts. The creditors of a partnership firm are the creditors of individual partners and a decree obtained against a firm can be enforced against them. 8. A shareholder is not an agent of the company, whereas a partner is an agent of his firm in connection with partnership business. 9. The liability of partners is unlimited. The liability of shareholders is usually limited. However, the law does not prevent a company from rendering the liability of members unlimited. 10. Shares of a company are freely transferable. However, in the case of a private company, the articles restrict the rights of members to transfer their shares. In a partnership, a partner cannot transfer his share without the consent of his co- partners. Self-Instructional Material 33 Forms of Business 11. A company has perpetual succession. Death, insolvency or the exit of any Organization shareholder do not affect the existence of the company. It comes to an end only when it is liquidated according to the provisions of the Act. Unless otherwise provided, a partnership comes to an end when a partner dies or becomes insolvent. NOTES 12. In a company, the shareholders do not interfere in the affairs of the company directly. It is managed by a board of directors, who are elected by the shareholders. But, a partnership is managed by all partners or any of them acting for all. 13. Each partner is the agent of every other partner in all matters connected with the business of the partnership. Every partner has the authority to act on behalf of all and can, by his actions, bind all the partners of the firm. In a company, no shareholder is an agent of another shareholder. Neither can a shareholder bind other shareholders by his actions nor is he bound by the actions of other shareholders. 14. A company’s powers are defined by the memorandum. The articles contain the rules and regulations for internal management, and any changes in these documents can be made only by following the legal procedure laid down in the Companies Act. In the case of a partnership, the rules regarding management of the business of the firm and the powers of the firm are spelt out in the partnership deed which can be easily altered with the consent of all the partners. 15. A company is also subject to strict control by the Companies Act with regard to various matters such as maintenance of books of account, share capital, distribution of profit, and so on. There are no such statutory obligations in a partnership.

Exihibit 2.1

Steps to be taken to get a new company incorporated

z Select, in order of preference, at least one suitable name up to a maximum of six names, indicative of the main objects of the company

z Ensure that the name does not resemble the name of any other already registered company and also, does not violate the provisions of emblems and names (Prevention of Improper Use Act, 1950) by availing the services of checking name availability on the portal

z Apply to the concerned RoC to ascertain the availability of name in eForm1 A by logging in to the portal. A fee of Rs 500 has to be paid alongside and the digital signature of the applicant proposing the company has to be attached in the form. If the proposed name is not available, the user has to apply for a fresh name on the same application

z After the name approval, the applicant can apply for registration of the new company by filing the required forms (that is, Form 1, 18 and 32) within sixty days of name approval

z Arrange for the drafting of the memorandum and articles of association by the solicitors, vetting of the same by RoC and printing of the same

z Arrange for stamping of the memorandum and articles with the appropriate stamp duty

z Get the Memorandum and the Articles signed by at least two subscribers in his/her own hand, his/her father’s name, occupation, address and the number of shares subscribed for and witnessed by at least one person.

z Ensure that the memorandum and article are dated on a date after the date of stamping

z Log in to the portal available at the Ministry of Corporate Affairs site and fill the following forms and attach the mandatory documents listed in the eForm o Declaration of compliance - Form-1 o Notice of situation of registered office of the company - Form-18 o Particulars of the Directors, Manager or Secretary - Form-32

Self-Instructional 34 Material o Submit the eForms after attaching the digital signature, pay the requisite filing and Forms of Business registration fees and send the physical copy of Memorandum and Article of Organization Association to the RoC

z After a processing of the Form is complete and a Corporate Identity is generated, obtain the Certificate of Incorporation from RoC NOTES Additional steps to be taken for the formation of a Public Limited Company: To obtain a Commencement of Business Certificate after the incorporation of the company, the public company has to make the following compliance:

z File a declaration in eForm 20 and attach the statement in lieu of the prospectus(schedule III) or

z File a declaration in eForm 19 and attach the prospectus (Schedule II) to it

z Obtain the Certificate of Commencement of Business Additional steps to be taken for registration of a Part IX Company:

z The Part IX Company is required to file eForm 37 and eForm 39 apart from filing eForm 1, 18 and 32

z The company is required to file eForm 1 first and then the company can file all the other eForms (18, 32, 37 and 39) simultaneously or separately

2.4 COOPERATIVES

A cooperative enterprise, also called cooperative society, is an association of persons, usually of limited means, who have voluntarily joined together to achieve a common economic end through the formation of a democratically controlled business organization, making equitable contributions to the capital required and accepting a fair share of risks and benefits of the undertaking. The principle theory of a true cooperative organization is the elimination of profit and the provision of goods and services to members at a cost. As a form of organization, it is an enterprise ordinarily set up by ‘economically weak’ individuals to further their common economic and social interests, to eradicate capitalist exploitation, to eliminate middlemen and to bring the consumer and the producer together. Thus, a cooperative enterprise is established with the fundamental objective of organizing and rendering service for the organization and its members and not for making profits. In essence, cooperation is nothing but self-help made effective by organization. According to the Cooperative Societies Act, 1912, a cooperative organization is a society which has as its objectives the promotion of the interests of its members in accordance with the principles of cooperation. Check Your Progress 3. Who are known as Characteristics of Cooperative Organizations partners? • Voluntary association: The membership of the society is voluntary and open to 4. What is partnership deed? all persons having a common interest. Any person, irrespective of his caste, creed, 5. Who is a nominal religion, sex, and so on, can become a member of a cooperative society voluntarily partner? and can leave it any time at his own will. 6. Who is known as a • Equal voting rights: Members of the cooperative society have equal voting partner in profits only? rights in the management of its affairs. 7. List the four • Democratic management: Democracy is the rule of cooperatives. The distinct stages in management of a cooperative society is entrusted to a managing committee elected the process of formation of a by members on the basis of ‘one member – one vote’. The members frequently company. meet and give guidelines to its executives. Self-Instructional Material 35 Forms of Business • Service motive: A cooperative society is organized to render service to its Organization members and not to make profit. • Capital: A cooperative society raises capital from its members in the form of share capital. The other sources on which a society has to rely are loans, grants NOTES and assistance from the government and apex cooperative institutions. • Distribution of surplus: In a cooperative society, a fixed rate of return not exceeding 10 per cent, is fixed on capital subscribed by each member. One- fourth of the profit is to be transferred to general reserve as per law. In addition, a portion of profit not exceeding 10 per cent may be utilized for the general welfare of the locality in which the society is functioning. The residual may be distributed among members in the form of bonus on an agreed basis, but not on the basis of capital contributed by members. • Trading on cash basis: As a rule, cooperative societies conduct business on a cash basis and allow no credit. • Corporate status: A cooperative society is required to be registered under the Co-operative Societies Act. Hence, it enjoys a corporate status. After registration, a co-operative enterprise becomes a body corporate independent of its members. It is entirely distinct from its members. Thus, it is characterized by perpetual succession which is not affected by the entry or exit of members. • State control: Although voluntary in its basic character, cooperative societies are subject to considerable state control and supervision. A cooperative society has to submit annual reports and accounts to the Registrar of Cooperative Societies. The activities of the cooperative societies are subject to certain rules and regulations framed by the government. Classes of Cooperative Societies Cooperatives may be formed in any walk of life for mutual economic benefits. Cooperatives as a form of business organization may be classified as follows: • Producers’ cooperatives • Marketing cooperatives • Consumers’ cooperative societies • Housing cooperative societies • Cooperative farming societies • Cooperative credit societies • Multi-purpose cooperatives Formation of Cooperatives A cooperative society enjoys a separate legal entity and its registration is compulsory. It is required to be registered under the Cooperative Societies Act, 1912, or the State Cooperative Societies Act. In each state, there is a Registrar of Cooperative Societies who is in charge of cooperatives. In order to get a cooperative society registered, an application in the prescribed form is to be made to the Registrar of Cooperative Societies of the concerned state in which the society’s registered office is situated. Any ten adult persons may submit a joint application to form a cooperative society. The application must contain the following information:

Self-Instructional 36 Material • The name and address of the society Forms of Business Organization • The aims and objects of the society • The details of share capital • The names, addresses and liabilities of the members NOTES • Method of admission of new members • Two copies of the by-laws, that is, rules and regulations governing the internal functions of the society The Registrar will carefully scrutinize the application and when he is fully satisfied, he will enter the name of the society in his register and will issue a certificate of registration. Then the society will come into existence and acquire legal status. Advantages and Disadvantages of Cooperative Organizations Advantages • Ease of formation • Democratic management • Limited liability • Perpetual succession • Scope for internal financing • State assistance • Social desirability • Tax concessions Disadvantages • Limited resources • Dependence on external aid • Inefficient management • Lack of motivation • Lack of secrecy • Internal quarrels and rivalries • Excessive government control On the basis of this evaluation, it can be concluded that cooperatives are primarily suitable for small and medium-sized organizations and particularly for trading organizations. 2.4.1 Suitability of a Form of Organization Businesses are set up with the objective of making profits. They are established by one person or a group of persons in the private sector. In the public sector, they are set up by the government and other public bodies. A form of business organization started and run by only one person is called sole proprietorship. A form of business organization started by a group of persons can be Partnership or Joint stock company or a cooperative enterprise. The various forms of organizations refer to aspects such as ownership, distribution of profit, control and risk bearing. The different forms of business organizations such as sole proprietorship, partnership, joint companies and cooperative enterprise may be adopted for establishing a business. One form is more suitable than other for a particular Self-Instructional Material 37 Forms of Business enterprise. The form of business organization which is more suitable will depend on Organization factors like nature of business, objectives, scale of operations, capital requirement, legal issues, state control, and so on. Sole proprietorship and partnership firm can be categorized as non corporate and NOTES joint stock company and cooperative enterprise or a cooperative society can be categorized as corporate forms of ownership. The main difference between these two categories is that while a corporate form of business cannot be set up without registration, a non corporate form of business can be started without registration.

2.5 SUMMARY

• Sole proprietorship is the oldest and the simplest form of business organization. • A sole proprietorship is a form of business organization that is run under the exclusive ownership, management and control of an individual. The individual brings his own or borrowed capital, uses his own skill and intelligence in the management of the affairs, bears all the risks alone, enjoys all the profits and suffers all the losses. • Partnership as a form of business organization came into existence to overcome the limitations of one-man business, the limitations of financial resources, and managerial skill. • The persons who have entered into partnership are individually called partners and are collectively called a firm. The name under which they carry on the business is called the firm. • The partners enter into an agreement to lay down the terms and conditions relating to partnership and the regulations governing its internal management and organization. This agreement is known as Partnership Deed. • The liabilities of the partners depend upon their mutual agreement. They can enter into partnership subject to any terms and conditions. • The company form of organization enables the entrepreneurs to get the necessary capital from the general public, retaining, at the same time, control and management in their own hands. As a matter of fact, most of the shortcomings of a partnership form of organization are overcome by organizing a business as a joint stock company with limited liabilities. • A company is an artificial entity created by law for the purpose of carrying on any activity such as business, sports, research or charity. However, most companies Check Your Progress are formed for the purpose of conducting business. 8. Define a • In India, the Companies Act of 1956 sets down rules for the establishment of both cooperative public and private companies. enterprise. 9. State the principal • The process of forming a company can be divided into four distinct stages: objective of a (i) promotion (ii) registration or incorporation (iii) capital subscription and cooperative (iv) commencement of business. enterprise. 10. Classify • A private company can commence business immediately on receipt of the cooperatives as a certificate of incorporation. But a public company cannot commence business form of business unless it obtains another certificate called the certificate of commencement of organization. business from the Registrar of Companies.

Self-Instructional 38 Material • A cooperative enterprise, also called cooperative society, is an association of Forms of Business persons, usually of limited means, who have voluntarily joined together to achieve Organization a common economic end through the formation of a democratically controlled business organization, making equitable contributions to the capital required and accepting a fair share of risks and benefits of the undertaking. NOTES • The principle theory of a true cooperative organization is the elimination of profit and the provision of goods and services to members at a cost. • A cooperative enterprise is established with the fundamental objective of organizing and rendering service for the organization and its members and not for making profits. • Cooperatives as a form of business organization may be classified as follows: (i) Producers’ cooperatives (ii) Marketing cooperatives (iii) Consumers’ cooperative societies (iv) Housing cooperative societies (v) Cooperative farming societies (vi) Cooperative credit societies (vii) Multi-purpose cooperatives

2.6 KEY TERMS

• Sole proprietorship: A sole proprietorship is a form of business organization that is run under the exclusive ownership, management and control of an individual. • Partners: The persons who have entered into partnership are individually called partners. • Partnership deed: It is an agreement made by partners to lay down the terms and conditions relating to partnership and the regulations governing its internal management and organization. • Cooperative enterprise: A cooperative enterprise is an association of persons, usually of limited means, who have voluntarily joined together to achieve a common economic end through the formation of a democratically controlled business organization, making equitable contributions to the capital required and accepting a fair share of risks and benefits of the undertaking.

2.7 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. A sole proprietorship is a form of business organization that is run under the exclusive ownership, management and control of an individual. 2. Three features of sole proprietorship are: • Sole ownership • One-man control • Contribution of owned and/or borrowed capital 3. The persons who have entered into partnership are individually called partners.

Self-Instructional Material 39 Forms of Business 4. The partners enter into an agreement to lay down the terms and conditions relating Organization to partnership and the regulations governing its internal management and organization. This agreement is known as Partnership Deed. 5. A person who merely lends his name to the firm without taking part in its NOTES management is a nominal partner. 6. A partner in profits is one who is entitled to share in the profits only and not in losses. He invests capital in the business but does not take part in management. 7. The process of forming a company can be divided into four distinct stages—(i) promotion (ii) registration or incorporation (iii) capital subscription and (iv) commencement of business. 8. A cooperative enterprise, also called cooperative society, is an association of persons, usually of limited means, who have voluntarily joined together to achieve a common economic end through the formation of a democratically controlled business organization, making equitable contributions to the capital required and accepting a fair share of risks and benefits of the undertaking. 9. A cooperative enterprise is established with the fundamental objective of organizing and rendering service for the organization and its members and not for making profits. 10. Cooperatives as a form of business organization may be classified as follows: • Producers’ cooperatives • Marketing cooperatives • Consumers’ cooperative societies • Housing cooperative societies • Cooperative farming societies • Cooperative credit societies • Multi-purpose cooperatives

2.8 QUESTIONS AND EXERCISES

Short-Answer Questions 1. What are the merits of sole proprietorship? 2. Distinguish between active or actual partner and dormant or sleeping partner. 3. Write a short note on promotion stage of a company. 4. How are cooperatives formed? Long-Answer Questions 1. Discuss the essential characteristics of partnership. Also discuss the merits and demerits of a partnership firm. 2. What are the characteristics of a company? 3. Distinguish between a company and a partnership. 4. Explain the characteristics of cooperative organizations. Discuss its advantages and disadvantages.

Self-Instructional 40 Material Forms of Business 2.9 FURTHER READING Organization

Weston, J Fred, Kwang S. Chung and Susan E. 1990. Hoag. Mergers, Restructuring and Corporate Control. New Jersey: Prentice Hall. NOTES Horne, James C. Van. 2002. Financial Management. New Jersey: Prentice Hall. Brealey, Richard A., Stewart C. Myers and Franklin Allen. 2008. Principles of Corporate Finance. New York: McGraw-Hill. Pandey, I. M. 2010. Financial Management. New Delhi: Vikas Publishing House. Muralidharan. 2009. Modern Banking: Theory and Practice. New Delhi: PHI Learning Private Ltd. Maheshwari, S. N. 1983.Banking Law and Practice. New Delhi: Kalyani Publishers. Gordon E. and K. Natrajan.1992. Banking: Theory, Law and Practice. Mumbai: Himalaya Publishing House. Sharma, K.C. 2007. Modern Banking in India. New Delhi: Deep and Deep Publications.

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Public Enterprises and UNIT 3 PUBLIC ENTERPRISES AND their Rationale THEIR RATIONALE NOTES Structure 3.0 Introduction 3.1 Unit Objectives 3.2 Public Enterprises and their Rationale 3.2.1 Forms of Organization of Public Undertakings 3.2.2 Rationale for the Public Sector 3.3 Causes of Low Productivity and Inefficiency in Public Enterprises 3.3.1 Performance of Public Enterprises 3.4 Summary 3.5 Key Terms 3.6 Answers to ‘Check Your Progress’ 3.7 Questions and Exercises 3.8 Further Reading

3.0 INTRODUCTION

Business firms owned by private individuals fall in the private sector, while firms owned by the State are categorized as public sector. Firms owned jointly by private parties and the State (government) constitute joint sector. In this unit, you will be introduced to the concept of public sector enterprises. You will learn about the characteristic features of public sector enterprises, its advantages and disadvantages. The problems faced by the public sector enterprise have been discussed in detail in this unit.

3.1 UNIT OBJECTIVES

After going through this unit, you will be able to: • Identify the features of public sector enterprises and the differences between public the private sector • Discuss the various problems faced by a public sector enterprise and evaluate its performance

3.2 PUBLIC ENTERPRISES AND THEIR RATIONALE

On the basis of the number of members, a company may be either a private company or a public company. A public company means the following: • It is not a private company. • It has a minimum paid-up capital of ` 5 lakh or such higher paid-up capital, as may be prescribed. • It is a private company which is a subsidiary of a company that is not a private company. In other words, it is a subsidiary of a public company. Self-Instructional Material 43 Public Enterprises and This means that a public company may invite the general public for the subscription their Rationale of its shares or debentures. However, it is not obligatory for a public company to invite the public for this purpose if it is confident of raising the required capital privately. At the same time, a public company is free to invite or accept deposits from the public. Similarly, NOTES the limit of a maximum of fifty members as applicable to a private company does not apply to a public company. However, the minimum number of members required to form a public company is seven. At the same time, the articles need not contain a clause for restricting the right of members to transfer their shares. These are freely transferable. It should be noted that a public company must add the word ‘Limited’ at the end of its name. A private company refers to a company which has a minimum paid-up capital of ` 1 lakh or such higher paid-up capital as may be prescribed, and by its articles of association: • It restricts the right of the members to transfer shares, if any. • It limits the number of its members at fifty, excluding members who are or were in the employment of the company. • It prohibits any invitation to the public to subscribe for any share in, or debentures of, the company. • It prohibits any invitation or acceptance of deposits from persons other than its members, directors or their relatives. The minimum number required to form a private company is two. A private company shall add the words ‘Private Limited’ at the end of its name, and it may commence its business immediately after obtaining a certificate of incorporation. But it should be noted that a public company, after obtaining the certificate of incorporation, has to comply with certain formalities to obtain a certificate of commencement of business, only after which it is entitled to commence. Private companies are usually family concerns, since shares are generally held by members of the family. The basic point of a private company is that shareholders have the advantage of limited liability and its affairs remain secret to a considerable extent. The main points of distinction between a private company and a public company are as follows: • Minimum paid-up capital: A private company must have a minimum paid-up capital of ` 1 lakh, while a public company must have a minimum paid-up capital of ` 5 lakh at the time of incorporation. • Number of members: The number of members in a private company is two, while a public company must have at least seven. The maximum number of members in a private company cannot exceed fifty, excluding its present or past employees. In the case of a public company, there is no maximum limit on members. • Name of the company: In a private company, the words ‘Private Limited’ shall be added at the end of its name. In a public company, only the word ‘Limited’ shall be added at the end of its name. • Transfer of shares: In a private company, the articles restrict the right of members to transfer their shares, whereas in a public company, the shares are freely transferable. • Public subscription: A private company cannot invite the public to purchase its shares or debentures. A public company may do so. Self-Instructional 44 Material • Acceptance of public deposits: A private company, by its articles, prohibits Public Enterprises and any invitation or acceptance of deposits from persons other than its members, their Rationale directors or their relatives, whereas a public company can invite or accept deposits from the public. • Issue of prospectus: Unlike a public company, a private company is not expected NOTES to issue a prospectus or file a statement in lieu of prospectus with the Registrar before allotting shares. • Allotment of shares: A private company can proceed to allot shares even before the minimum capital is subscribed or paid. But a public company cannot allot shares without raising the minimum capital. • Issue of right shares: While making further issue of capital, a public company is required to first offer such further shares to its existing shareholders on a pro- rata basis. But a private company is not required to do so. • Issue of share warrants: A private company cannot issue share warrants while a public company can. • Commencement of business: A private company may commence its business immediately after obtaining a certificate of incorporation. A public company cannot commence its business until it is granted a certificate of commencement of business. • Holding of statutory meeting: A private company is not required to hold a statutory meeting, whereas a public company must do so after one month but within six months of obtaining the certificate of commencement of business. • Quorum for general meetings: Two members personally present form the quorum in a private company, but in a public company the number is five members. • Minimum number of directors: A private company shall have at least two directors, whereas a public company is required to have at least three directors. • Restriction on appointment of directors: In a public company, the directors must file with the Registrar their consent to act as such in writing. Similarly, they must sign the memorandum or enter into a contract for their qualification shares. At least two-thirds of the directors of a public company must retire by rotation. They cannot vote on a contract in which they are personally interested. These restrictions, however, do not apply to the directors of a private company. • Managerial remuneration: In a public company, the overall limit of managerial remuneration is 11 per cent of net profits. However, this restriction does not apply to private companies. • Index of members: A private company need not keep an index of members, whereas a public company is required to keep an index of members if the number of members exceeds fifty. 3.2.1 Forms of Organization of Public Undertakings The most preferred forms of organization and management of public enterprises in India are—(i) departmental undertakings (ii) public or statutory corporations (iii) mixed ownership corporations or government companies set up under the Companies Act. Departmental Undertakings This is the oldest form of organizing public sector undertakings. Under this form of organization, a public enterprise is run as a department of the government. A departmental Self-Instructional Material 45 Public Enterprises and enterprise is organized, financed and controlled in much the same way as any other their Rationale government department. It may be run either by the Central Government or by a state government. Some of the departmentally administered public enterprises in India are the Indian Railways, Post and Telegraph, All India Radio, Doordarshan, Chittaranjan NOTES Locomotive Works and the Integral Coach Factory. Characteristics • It is managed by a government department attached to the ministry, with a minister at the top responsible to the Parliament for its operation. • It is financed by annual appropriations from the treasury and the revenues are paid into the treasury. • It is subject to budget, accounting and audit controls applicable to other government activities. • It is manned by civil servants and their conditions of recruitment and service are the same as for other civil servants. • It possesses the sovereign immunity of the state and cannot be sued without government consent. Advantages • Full government control • Tool for economic and social objectives of the state • Accountability to the parliament • Proper use of public money • Source of government revenue Disadvantages • Excessive bureaucratic control • Lack of the flexibility needed in business operations • Lack of professional management • Low efficiency • Undesirable political pressure • Lack of necessary autonomy and presence of red-tapism This type of organization is very suitable for industries where secrecy and strict control are needed, for example, defence and strategic industries and post and telegraphs. Public or Statutory Corporations A public corporation may be defined as a body corporate created by the legislature under a special act which sets out its powers, purpose, duties and immunities. Simply stated, it is a company whose capital is wholly subscribed by the state and which is answerable to the parliament which creates it. It is clothed with the power of the government, but possesses the flexibility and initiative of private enterprises. Structurally, it is a joint stock company and it is managed by a Board of Directors appointed by the Government to which it is answerable. In India, there are a number of statutory corporations such as the State Bank of India, Life Insurance Corporation of India, ONGC, Food Corporation of India and the Central Warehousing Corporation. Self-Instructional 46 Material Characteristics Public Enterprises and their Rationale • It is owned by the state. • It is created by a Special Act of the Legislature with its powers and duties defined by the Act. NOTES • It is a body corporate and can sue and be sued, enter into contracts and acquire property in its own name. • It is ordinarily not subject to the budget, accounting and audit laws and procedures applicable to government departments. • It works primarily for service, and profit is only a secondary consideration with it. • Employees of public corporations are not civil servants and are not governed by government regulations with respect to conditions of service. • It enjoys internal autonomy and is free from parliamentary or political control in the internal routine management. It is, however, subject to ministerial control. Advantages • Internal autonomy • Flexibility and effectiveness of private enterprise • Stability • Public accountability and business management for public ends • Service-oriented outlook • Professional management Disadvantages • Elaborate and time-consuming formation through a special Act of the legislature • Rigid form of organization • Excessive parliamentary control • Lack of cost-consciousness In spite of some disadvantages, public corporations are popular in insurance, banking, transport and the trade sectors of the economy. Joint Sector The radical shift in government policy has brought the concept of the joint sector into sharp focus. It is nothing but a form of partnership between the public sector and the private sector. Although the Joint Sector concept was conceived by the authors of the Industrial Policy Resolution, 1956, it was really the brainchild of the Industrial Licensing Policy Enquiry Committee, popularly known as the Dutta Committee. Besides the public and the private sectors, there was a need for a new sector—a joint sector—for the harmonious industrial development of the economy. The joint sector is envisaged as something in between the public and the private sector and in which the state could actively participate in management, control and decision-making. It is claimed that the joint sector scheme has the advantages of both the public and the private sectors and at the same time avoids the evils of both sectors, and thus, fulfils the basic socio-economic objectives of

Self-Instructional Material 47 Public Enterprises and the country. Moreover, it offers an avenue of growth when all other gates to growth their Rationale seem to have been closed. The concept of a joint sector is basically an extension of the idea of mixed economy in which the public and private sector units are separate and function independently, but are nevertheless part of a national plan. It is a compromise NOTES between total nationalization and complete private autonomy. In the joint sector, the relationship between the representatives of the private and public sectors is much closer as they have to work together within the same unit. The joint sector was recommended for units where a large proportion of the cost of a new project was to be met by public financial institutions either directly or through their support. There are three different concepts of joint sector: First, financial institutions can exercise the right to convert debt into equity and appoint directors on company boards. Second, the government may appoint directors on company boards through the exercise of powers granted by the Monopolies and Restrictive Trade Practices Act to check malpractices. This need not involve share participation and must not be confused with the joint sector. The third form is the real joint sector where the government directly, or through its agencies, is a co-shareholder in an enterprise. The government, in this case, plays a promotional and entrepreneurial role and is an active majority partner. Features of the Joint Sector In a memorandum submitted to the government, JRD Tata suggested a slightly different definition of the joint sector. ‘A joint sector enterprise is intended to be a form of partnership between the private sector and the Government in which the State participation of capital will not be less than 26 per cent, the day-to-day management will normally be in the hands of the private sector partner, and control and supervision will be exercised by a board of directors on which government is adequately represented’. The Dutta Committee advocated conversion of some of the private sector units into joint sector enterprises as an important means of curbing the concentration of economic power in certain private groups. A number of new industrial projects had been established in the private sector with the help of funds provided by public financial institutions, but the latter had not asked for a voice in the management. It was strange that huge private industrial empires should be built with funds provided by public institutions without knowing how the money was actually spent. The Dutta Committee asked the government to enunciate a new industrial policy whereby this anomaly could be rectified. There was a change in the industrial policy without there being a change in the 1956 Policy Resolution. The government announced the new industrial policy in February 1970. The joint sector concept as suggested by the Dutta Committee, was accepted in principle. It was laid down that while sanctioning loans or subscribing to debentures, public financial institutions should in future have the option to convert them into equity within a specified period of time. Specific guidelines had been laid down. In case the aggregate loans granted were below ` 25 lakh, the financial institutions are not to insert any convertibility clause in the agreement. If the loans granted were between ` 25 lakh and ` 50 lakh, it is optional for the financial institutions to insert a convertibility clause in the agreement. Once convertibility was agreed to, the undertaking is required to appoint representatives of the lending institutions as directors on company board. It is not difficult to understand the logic behind the joint sector. The old concepts of exclusive private ownership and private profit do not fit in with today’s social values Self-Instructional and priorities. An open society requires an open corporate structure; the joint sector 48 Material provides this openness without taking away the advantages of private enterprise and Public Enterprises and their Rationale initiative. The joint sector is a departure from exclusive private ownership, but it should be welcomed in preference to outright nationalization. The joint sector experiment has been viewed with misgivings by many industrialists. NOTES It has been assailed as ‘nationalisation by the backdoor’. But others have welcomed it on the ground that it is preferable to wholesale nationalization of existing private undertakings. There is one serious objection to the joint sector. The concept is based on mutual trust and confidence, yet the idea originated because the private sector could not be trusted enough to grow on its own. Thus, conceived in mistrust, the marriage might be a disastrous failure. The joint sector was evolved to check the concentration of economic power of private groups. But, some think it is not necessary to check the concentration of economic power as the existing Monopolies and Restrictive Trade Practices Act was adequate for the purpose. 3.2.2 Rationale for the Public Sector 1. Socialist pattern of society: The public sector was meant to socialize the means of mass production and benefit the masses, as is typically the case in a socialistic pattern of society. The commanding heights of the economy – the core sector comprising investment, production, distribution and consumption – were State owned, so as to promote national development as opposed to considerations of private profit. In such a situation, the so-called public sector needs to expand rapidly, cover areas where the private sector is unwilling or unable to participate, and play a dominant role in shaping the economy. Some of these areas are power, communication, mass transportation, information and broadcasting, mines and defence production. Initially, the public sector took the lead in developing the basic and capital goods industries, laying the foundations for national growth unhindered by narrow considerations of profit as would arguably be seen in a laissez faire economy dominated by private enterprise, where motives of personal profit would presumably supersede national priorities. In time, however, some of these monolithic establishments exhausted their early dynamism and metamorphosed into complacent, inefficient, cash-strapped, overstaffed, overunionized islands of mediocrity that generated. 2. Socio-economic objectives: Reduction of inequalities of wealth and income is the most important socio-economic objective, going hand in hand with the need to eliminate poverty and establish an egalitarian society by redistributing wealth and earning potential equitably. Another important objective of a socialistic system is to help the underprivileged, realize their dormant potential by liberating them from economic serfdom and to give them all opportunity to attain social justice. Although rarely declared in so many words, the giant public sector organizations were also meant to serve this purpose by providing upliftment to these neglected sectors, by means of reserving a certain percentage of jobs for weaker sections of society including the physically handicapped. Nationalized banks rendered yeoman service by extending concessional loans under the ‘Differential Rates of Interest’ scheme, that allowed cheap finance to reach District Consultative Committee sponsored beneficiaries drawn from such sections of the local populace—something a purely profit-driven banking system would never dream of undertaking. Self-Instructional Material 49 Public Enterprises and 3. Balanced regional development: One of the major goals of planning is to try their Rationale and correct regional disparities by spreading the benefits of economic development as evenly as possible across the country. It is vital for humane as well as for security reasons to ensure that the fruits of prosperity percolate throughout the NOTES nation, for civil unrest is usually born of discontent with a system of wealth distribution that serves but to defeat the very purpose of adopting a socialistic type of governance. This is particularly true of the sensitive north and north- eastern states, many of which are economically underdeveloped, and hence, vulnerable to ideologies incompatible with our peaceful, non-violent, democratic system of governance run on socialist principles. Industrial development of these areas is a top priority; Bhilai, Rourkela and Durgapur are well-known examples, but more such success stories are needed, and quickly. 4. Need for rapid economic development: The need of the hour is rapid economic development. The private sector has neither the desire nor the resources to undertake the massive programme of industrialization. Hence, dependence on the private sector will only slow down the economic development. Expansion of public enterprise will speed up the rate of economic growth. 5. Pattern of resource allocation: The main reason for the expansion of the public sector lies in the pattern of resource allocation decided upon under the plans. In the first plan, the major emphasis was on agriculture, but in the second plan the emphasis was shifted to basic and capital goods industries. During the first plan period, the private sector was dominant in the field of industrial activities. But, with changed emphasis, it was inevitable that the public sector must grow not only absolutely, but also relatively to the private sector. 6. Building infrastructure: Infrastructure provides certain basic facilities for rapid economic growth. In the economic infrastructure, there are facilities like power, irrigation, transport and communication, banking and training. Social infrastructure includes education, health, sanitation, drinking water facilities, etc. The development of infrastructure is not possible through efforts of private individuals since its benefits go to society as a whole and not to individuals. It is, therefore, mainly the responsibility of the State. The infrastructure has accounted for 95.1 per cent of the public outlays in the first Plan and nearly 75 per cent in the subsequent plans.

Check Your Progress 3.3 CAUSES OF LOW PRODUCTIVITY AND 1. What is meant by a public company? INEFFICIENCY IN PUBLIC ENTERPRISES 2. Which are the three most preferred Public sector or public enterprises include all governmental activities including public, forms of organization of industrial and commercial enterprises. Public enterprise occupies a strategic and crucial public position in the Indian economy. It is no exaggeration to say that the economy would sink undertakings? or swim depending upon the efficiency with which these enterprises operate. 3. Which is the oldest form of organizing India is still primarily an agricultural country and the distribution of income depends public sector mainly on the distribution of agricultural property. Although there have been some attempts undertakings? to distribute land to the peasants, land remains unequally distributed and there is evidence 4. Define a public that the range of income inequality has been reduced. The tax system continues to be corporation. regressive, direct taxes are rarely levied on land and high urban income taxes are marked by evasion. The pre-tax income distribution figures sum up the failure to establish a Self-Instructional 50 Material more equitable distribution of income. In 1960, the bottom 10 per cent of families accounted Public Enterprises and their Rationale for less than one per cent of all income, while the top 10 per cent accounted for over one-third. This income distribution is less equitable than in industrialized capitalist countries. Public enterprises are expected to be the principal agents for rapid economic and NOTES social transformation by developing infrastructure and the core sector and by closing the gaps in the industrial structure. Its dominant position in the financial field is intended to control and guide the private sector, wherever necessary. Lastly, the economic growth through public enterprise will ensure social justice. In developing countries, public enterprises are largely a necessity and not a matter of choice. In India, though the Congress government was clearly committed to expanding the public sector, it did not go into areas where private enterprise was operating. Nationalization of the existing enterprises has been generally resorted to where the public interest was involved or where it was imperative to put the industry on sound footing and regulation and control were not found sufficiently effective. The vast majority of public enterprises is in areas which were hitherto untouched or unexplored by the private sector. In the Industrial Policy Statement of 1956, it was emphasized that public enterprise was designed to control the ‘commanding heights’ of the economy. But in recent years, the trends toward increasing liberalization are very much in evidence in India and one gets the impression that private sector is designed to play an important role in the economy in the coming era. Public sector in the industrial field has expanded rapidly since Independence. In 1951, there were only five non-departmental public undertakings with an investment of ` 29 crore. On 31 March 2004, the number of public enterprises had risen to 230 with the total capital employed therein amounting to ` 586,140 crore. Public sector units generally are of four kinds: • National monopolies like railways that have downward sloping unit cost curves. These are hard to assess, being monopolies. • Entrepreneurial ventures that, at the start and for many years thereafter are monopolies or near monopolies. These are generally large units with sophisticated technologies and long gestation periods that produce basic products. Many of the Indian public sector manufacturing units are of this type. • Sick units in the private sector that have been taken over to maintain employment etc. • Units taken over or formed to acquire the ‘commanding heights’ or for other ideological reasons. The State Trading Corporation is a case in point. Evolution of the Public Sector The entry of the public sector in a big way in the economic sphere is a post-independence development. Prior to 1947, public sector investment was limited to the railways, the post and telegraphs department, the ordinance factories and a few state-managed factories like the quinine factories and salt factories. It was the Industrial Policy Resolution of the Government of India in 1948 which brought the public sector into the limelight. It declares Self-Instructional Material 51 Public Enterprises and that a dynamic national policy must be directed to a continuous increase in production by their Rationale all possible means, side-by-side with measures to secure its equitable distribution. The problem of state participation in industry and the conditions in which private enterprise should be allowed to operate must be judged in this context. Since then the expansion of NOTES the public sector has been very rapid. The idea that in the economic development of the country the state enterprises would play a predominant role took root with the adoption of a socialist pattern of society in the second Plan. The growth of public enterprises in India has taken place in two ways—(a) by nationalizing existing enterprises and (b) by starting new enterprises. The State Bank of India, LIC, Air India and nationalization of 20 banks are included in the first category, while the Hindustan Steel Ltd. and the Fertilizer Corporation of India fall in the second category. The enormous growth of public sector investments has taken place against a political and ideological background which is peculiar to Indian political development. The objectives of establishing new enterprises and reasons for nationalizing some existing ones are varied and often different from case to case and from time to time. Perhaps, the only generalization possible in this regard is that public enterprise for us is more a matter of necessity than of choice. It is not so much the ideology as the compulsion of the situation which has led to the growth of public enterprise in India. A brief statement about the need and role of public enterprise in India is contained in the statement of former Prime Minister Indira Gandhi where it is stated that a public sector is advocated for three reasons—to gain control of the commanding heights of the economy: to promote critical development in terms of social gain or strategic value rather than primarily on considerations of profit; and to provide commercial surpluses with which to finance further economic development. 3.3.1 Performance of Public Enterprises The evaluation of the performance of the public sector is rather difficult. Public enterprises should be evaluated in terms of social cost-benefits rather than commercial profitability alone. Performance of the public sector can be assessed on the following grounds: • The share of the public sector in the net domestic product has been steadily increasing. The public sector accounts for one-fourth of the total income of the economy. The compound rate of annual growth of the public sector was 6 per cent whereas that of the private sector was only 2.8 per cent. • If we evaluate the relative efficiency of investment in the public enterprises against the performance of private enterprises, we find that private enterprises are, on an average, 2.5 times more profitable than public enterprises. For every hundred rupees invested, the private enterprise yields a return of ` 11.40, while the same amount in the public enterprise yields only ` 4.70. We must not forget that public enterprises are mostly concentrated in basic, core and heavy industries where the rate of return is very low and also in sick enterprises taken over by the government, such as the National Textile Corporation and Coal India Limited. Self-Instructional 52 Material The economic efficiency of a public sector industry should be considered in Public Enterprises and their Rationale terms of the transformation of the industrial structure, modernization, higher labour productivity on a countrywide scale. The fact is that a higher proportion of the value produced by the public sector industries is realized outside this sector, and it is therefore, very difficult to estimate the efficiency NOTES of public sector enterprises in terms of costs and profitability. B.H. Dholakia advocates the adoption of the total factor productivity criterion to judge the efficiency of public sector enterprises. The criterion examines the contribution made by the enterprise to the country’s net national product in terms of rent, wages and salaries, interest and profit. Adopting this criterion, Dholakia finds that over the period 1967–68 to 1975–76, the overall economic efficiency of the public enterprises increased at a rate of 2.44 percentage points per annum, whereas that of private sector enterprises could increase by only 0.59 percentage points per annum. • Public sector has played an important role in capital formation. The share of the public sector in the total gross fixed capital formation in the country was 41 per cent during the First and Second Plans and 49 per cent during the Third Plan. It was reduced to 42 per cent in the Fourth Plan and 40 per cent in the Fifth Plan. But, it again rose to 47 per cent in the Sixth Plan and 48 per cent in the Seventh Plan. It should be pointed out that investment in the private sector producing luxury goods should be evaluated lower than similar types of investment in the public sector which is engaged in the production of basic goods and infrastructural services to the economy. Considering this, capital formation in the public sector is very significant for a developing economy like India. • In India, the organized sector is very small as it provides 10 per cent of the total employment in the economy and about 90 per cent is provided by the unorganized sector. The workers employed in the public sector constitute only 7 per cent of the total labour force in the country and those employed in the organized private sector are 3 per cent. The number of persons employed in the public sector enterprises stood at 23.05 lakh as on 31 March 1991. The public sector is a model employer which provides the workers better wages and other facilities compared to the private sector. The public sector enterprises have also spent huge amounts for the development of townships around industries. • Foreign exchange earnings of public enterprises have been substantial and they have also helped in saving foreign exchange through their efforts at import substitution. Capital goods and industrial machinery which were imported about three decades ago are now being manufactured in the country itself. This has saved valuable foreign exchange. Public sector export earnings went up from ` 2143 crore in 1980–81 to ` 6366 crore in 1989–90. In addition to actual exports by manufacturing units, foreign exchange is also earned from services rendered by air corporations and shipping companies. • The value of sales of public sector enterprises is an indicator of their contribution to the flow of goods and services in the economy. The total turnover of public enterprises amounts to ` 5,86,140 crore in 2003–04. Public enterprises contribute to national exchequer in the form of interest on

government loans, income tax and excise duty. In 1990–91, Central Self-Instructional Material 53 Public Enterprises and Government units generated about ` 11,372 crore of resources; it contributed their Rationale about ` 1,400 crore towards tax and ` 4,100 crore towards interest. As far as the net profit after tax is concerned, the position was unsatisfactory up to 1980–81. However, the situation improved and the public sector made NOTES impressive profits. In 1981–82, the net profit after tax was ` 445 crore which went up to ` 3,789 crore in 1989–90 and ` 53,168 crore in 2003–04. Shortcomings of the public sector It is a fact that public sector enterprises contributed less to industrial progress than what was expected of them. These enterprises suffer from a number of shortcomings such as over-capitalization, underutilization of plant, bureaucratic and irresponsible management, political interference and wrong personnel policies and overstaffing. Underutilization of installed capacity is an important cause for the low level profitability in public sector enterprises. In 1988–89, nearly 40 per cent of public enterprises showed capacity utilization of less than 75 per cent and 20 per cent enterprises worked at even lower than 50 per cent rate of capacity utilization. Unutilized capacities mean higher overhead charges which reduce the rate of profit. There is overregulation of government undertakings which is not good for any business enterprise. Problems of the Public Sector The public sector faces the following problems: 1. Massive losses: A review of the working of public sector enterprises shows that either their profits are extremely low or that they are incurring losses. State government enterprises like State Electricity Boards (SEBs) and State Road Transport are the major loss makers. The losses incurred by SEBs rose from ` 4117 crore in 1991–92 to ` 24063 crore in 2001–02. The main causes of losses include power supplied at a price of 240 paise which is lower than that of production, and distribution cost of 350 paise per unit. The losses of State Road Transport undertakings were of the order of ` 1282 crores in 1997–98. As far as the Central Government is concerned, the public sector enterprises have shown a net profit of ` 26045 crore in 2001–02 as against a loss of ` 203 crore in 1980-81. This shows an overall improvement where 50 per cent of the total profit is contributed by petroleum enterprises only by raising the price of oil. 2. Overcapitalization: Public sector projects are usually criticized for overcapitalization, or in other words, input-output ratio obtained in many projects is unfavourable. The enterprises like Heavy Engineering Corporation, Hindustan Aeronautics, Fertilizers Corporations are found to be overcapitalized. The causes leading to overcapitalization can be traced to inadequate planning, delays and avoidable expenditure during construction, surplus machine capacity, together with the compulsion to purchase imported equipment on a non-competitive basis, expensive turn-key contracts, bad location of projects, the provision of housing and other amenities on liberal scale. 3. Capacity utilization: During 2001–02, 110 units (or 52 per cent) of all producing units had recorded capacity utilization of more than 75 per cent. On the other hand, 38 public sector enterprises operated in the capacity utilization range of

Self-Instructional 54 Material 50–75 per cent, and 64 functioned below 50 per cent utilization of rated capacity. Public Enterprises and This is certainly not an optimum situation. their Rationale 4. No manpower planning: In most public enterprises, manpower is in excess of actual requirements. There is poor manpower planning as a result of which more employees are recruited than required. It is because of the excess manpower NOTES that most of the public sector enterprises incur losses. 5. Price policy: Price policy of the public sector undertakings are not solely guided by profit maximization principle. Prices of public sector enterprises are controlled by the government. Most of the public enterprises produce products which are used as inputs for other sectors of the economy. It is not wise to keep the prices of steel, coal, oil and fertilizers very high in view of the overall growth of the economy. In many cases, as a result of public pressures, prices are kept low even when the costs are increasing. This, in turn, affects commercial profitability. 6. Inefficient management: Public sectors are mostly managed by bureaucrats, and bureaucratic management is proverbially inefficient and cannot run an organization in a business-like manner. An unfortunate practice has developed to appoint bureaucrats as chairman, managing director and managers of public enterprises. They do not have the capacity and expertise to run industrial enterprises. Unless these public enterprises are run by professional managers, their performance will not improve.

3.4 SUMMARY

• The minimum number of members required to form a public company is seven. • Private companies are usually family concerns, since shares are generally held by members of the family. The basic point of a private company is that shareholders have the advantage of limited liability and its affairs remain secret to a considerable extent. • The most preferred forms of organization and management of public enterprises in India are: (i) departmental undertakings; (ii) public or statutory corporations; and (iii) mixed ownership corporations or government companies set up under the Companies Act. • Departmental undertaking is the oldest form of organizing public sector undertakings. • A departmental enterprise is organized, financed and controlled in much the same way as any other government department. It may be run either by the Central Government or by a state government. • Some of the departmentally administered public enterprises in India are the Indian Check Your Progress Railways, Post and Telegraph, All India Radio, Doordarshan, Chittaranjan Locomotive Works and the Integral Coach Factory. 5. List the four kinds of public sector • A public corporation may be defined as a body corporate created by the legislature units. under a special act which sets out its powers, purpose, duties and immunities. 6. What are the two ways in which the • India, there are a number of statutory corporations such as the State Bank of growth of public India, Life Insurance Corporation of India, ONGC, Food Corporation of India and enterprises has the Central Warehousing Corporation. taken place?

Self-Instructional Material 55 Public Enterprises and • The joint sector is envisaged as something in between the public and the private their Rationale sector and in which the state could actively participate in management, control and decision-making. • It is claimed that the joint sector scheme has the advantages of both the public NOTES and the private sectors and at the same time avoids the evils of both sectors, and thus, fulfils the basic socio-economic objectives of the country. • The joint sector experiment has been viewed with misgivings by many industrialists. It has been assailed as ‘nationalisation by the backdoor’. But others have welcomed it on the ground that it is preferable to wholesale nationalization of existing private undertakings. • Public enterprises are expected to be the principal agents for rapid economic and social transformation by developing infrastructure and the core sector and by closing the gaps in the industrial structure. • Its dominant position in the financial field is intended to control and guide the private sector, wherever necessary. Lastly, the economic growth through public enterprise will ensure social justice. • In 1951, there were only five non-departmental public undertakings with an investment of ` 29 crore. On 31 March 2004, the number of public enterprises had risen to 230 with the total capital employed therein amounting to ` 586,140 crore. • The Industrial Policy Resolution of the Government of India in 1948 which brought the public sector into the limelight. • The growth of public enterprises in India has taken place in two ways: (a) by nationalizing existing enterprises and (b) by starting new enterprises. • It is a fact that public sector enterprises contributed less to industrial progress than what was expected of them. These enterprises suffer from a number of shortcomings such as over-capitalization, underutilization of plant, bureaucratic and irresponsible management, political interference and wrong personnel policies and overstaffing. • Underutilization of installed capacity is an important cause for the low level profitability in public sector enterprises.

3.5 KEY TERMS

• Departmental enterprise: A departmental enterprise is organized, financed and controlled in much the same way as any other government department. • Public corporation: A public corporation may be defined as a body corporate created by the legislature under a special act which sets out its powers, purpose, duties and immunities. • Joint sector: The joint sector is envisaged as something in between the public and the private sector and in which the state could actively participate in management, control and decision-making.

Self-Instructional 56 Material Public Enterprises and 3.6 ANSWERS TO ‘CHECK YOUR PROGRESS’ their Rationale

1. A public company means the following: • It is not a private company. NOTES • It has a minimum paid-up capital of ` 5 lakh or such higher paid-up capital, as may be prescribed. • It is a private company which is a subsidiary of a company that is not a private company. In other words, it is a subsidiary of a public company. 2. The most preferred forms of organization and management of public enterprises in India are— (i) departmental undertakings (ii) public or statutory corporations and (iii) mixed ownership corporations or government companies set up under the Companies Act. 3. Departmental undertaking is the oldest form of organizing public sector undertakings. 4. A public corporation may be defined as a body corporate created by the legislature under a special act which sets out its powers, purpose, duties and immunities. 5. Public sector units generally are of four kinds: • National monopolies like railways that have downward sloping unit cost curves. • Entrepreneurial ventures that at the start and for many years thereafter are monopolies or near monopolies. • Sick units in the private sector that have been taken over to maintain employment. • Units taken over or formed to acquire the ‘commanding heights’ or for other ideological reasons. 6. The growth of public enterprises in India has taken place in two ways— (a) by nationalizing existing enterprises and (b) by starting new enterprises.

3.7 QUESTIONS AND EXERCISES

Short-Answer Questions 1. What are the characteristics of departmental undertakings? 2. Write a short note on the advantages and disadvantages of departmental undertakings. 3. State the features of the joint sector. 4. What are the shortcomings of a public sector enterprise? Long-Answer Questions 1. Distinguish between a public and a private company. 2. What are the characteristics of a public or statutory corporation? Discuss its advantages and disadvantages. 3. Discuss the rationale for existence of the public sector. 4. What are the problems faced by the public sector?

Self-Instructional Material 57 Public Enterprises and their Rationale 3.8 FURTHER READING

Weston, J Fred, Kwang S. Chung and Susan E. 1990. Hoag. Mergers, Restructuring NOTES and Corporate Control. New Jersey: Prentice Hall. Horne, James C. Van. 2002. Financial Management. New Jersey: Prentice Hall. Brealey, Richard A., Stewart C. Myers and Franklin Allen. 2008. Principles of Corporate Finance. New York: McGraw-Hill. Pandey, I. M. 2010. Financial Management. New Delhi: Vikas Publishing House. Muralidharan. 2009. Modern Banking: Theory and Practice. New Delhi: PHI Learning Private Ltd. Maheshwari, S. N. 1983.Banking Law and Practice. New Delhi: Kalyani Publishers. Gordon E. and K. Natrajan.1992. Banking: Theory, Law and Practice. Mumbai: Himalaya Publishing House. Sharma, K.C. 2007. Modern Banking in India. New Delhi: Deep and Deep Publications.

Self-Instructional 58 Material Home Trade Transactions UNIT 4 HOME TRADE TRANSACTIONS

Structure NOTES 4.0 Introduction 4.1 Unit Objectives 4.2 Different Forms of Trade 4.3 Documents of Trade 4.3.1 Importance of Trade Documents 4.3.2 Types of Trade Documents 4.4 Trade Documents Used in International Trade 4.4.1 Cash Discount and Trade Discount 4.5 Summary 4.6 Key Terms 4.7 Answers to ‘Check Your Progress’ 4.8 Questions and Exercises 4.9 Further Reading

4.0 INTRODUCTION

Trade, also called goods exchange economy, is to transfer the ownership of goods from one person or entity to another by getting a product or service in exchange from the buyer. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. Trade is essential for satisfying human wants. It is done not only for earning profit but also to provide service to the consumers. Trade means buying and selling of goods. Traders purchase goods to sell to other traders and consumers at a profit. They act as an intermediary between producers and consumers and earn profit from buying and selling operations in the course of exchange. Development of commerce has given us a good standard of living. Commerce refers to all those activities which are necessary to bring goods and services from the place of their origin to the place of their consumption. It includes trade and aids to trade. The aids to trade consist of services such as transport, banking, insurance, warehousing, advertising and communication. In ordinary language, the term commerce means the exchange of goods and services for value. In this unit, we will learn about different types of trade and the documents used in home trade.

4.1 UNIT OBJECTIVES

After going through this unit, you will be able to: • Define trade • Discuss the different forms of trade • Identify the documents required for home and international trade

4.2 DIFFERENT FORMS OF TRADE

Trade is an important social activity because the society needs uninterrupted supply of Self-Instructional goods that are forever increasing and changing. Trade originated with human Material 59 Home Trade Transactions communication in prehistoric times. Trading was the main facility of prehistoric people, who bartered goods and services from each other before the innovation of modern day currency. Trade will continue as long as human life exists on the Earth. Therefore, we can say that trade is a very important social activity. NOTES The two terms ‘commerce’ and ‘trade’ are interrelated. They do not mean the same thing. Commerce has a much wider connotation and significance than trade. While trade refers to buying and selling alone, commerce is concerned with not merely buying and selling but also facilitates a smooth flow of goods and services from the producer to the consumer with the help of aids to trade. Trade can be divided into two types: • Internal or home or domestic trade • External or foreign or international trade

Trade

Home Foreign Trade Trade

Wholesale Retail Import Export Entrepot Trade Trade Trade Trade Trade

Fig. 4.1 Different Forms of Trade

1. Internal Trade or Home Trade Internal trade is also known as home trade. It is conducted within the geographical and political boundaries of a country. It can be at local level, regional level or national level. Internal trade can be further divided into the following two groups: • Wholesale trade: It involves buying in large quantities from producers or manufacturers and selling in bulk to the retailers for resale to consumers. The wholesaler is basically a link between manufacturer and retailer. Wholesalers occupy prominent position since manufacturers as well as retailers both are dependent upon them. Wholesalers act as an intermediary between producers and retailers. • Retail trade: It involves buying in smaller quantity from the wholesalers and selling in very small quantities to the consumers for personal use. Retailers are the last link in the chain of distribution. They establish a link between wholesalers and consumers. There are small as well as large retailers. Small scale retailers include hawkers, peddlers, general shops, etc. Retailers need smaller capital than the wholesaler. They usually carry out their trade on cash basis. They do not specialize in any commodity and usually carry a large variety of goods in their stock and their activities are generally confined to a particular locality where they have their shops.

Self-Instructional 60 Material Small-scale Retail Trade Home Trade Transactions There are varieties of retailers engaged in small scale retail trading. They can be classified as: • Itinerant retailing NOTES • Fixed shop retailing Itinerant Retailing Itinerant retailing is a type of small-scale retail trade in which retailers move around and sell a variety of items directly to the consumers. They do not have a fixed shop where they can sell. You must have seen them distributing newspapers early in the morning, selling peanuts, bangles, toys, etc. in buses and trains, selling fruits and vegetables in different localities using a cart, selling ice cream, namkeens, etc. on a cycle, selling rice, earthen pots or even carpets by using a cart. You can also see them on pavements selling their goods. In towns and cities we come across different type of itinerant retailers. There are traders who sell their articles on fixed days at different market places. In villages these market places are called ‘Haat’ and in towns or cities they are called ‘weekly bazaars’. The itinerant retailing also includes people selling articles from door to door. In most cases, the price of items is not fixed and mostly settled through bargaining. In most cases the products sold are not branded: Fixed Shop Retailing Here the retailers sell goods and services from a fixed place known as ‘shop’. These shops are usually located at market places or commercial areas or near residential localities. These shops normally deal with a limited variety of goods. The goods are stored as well as displayed in the shops. On the basis of the type of goods which the fixed shops deal in, we can classify this form of retailing as under. • General store or variety store • Single line store • Specialty store General store or Variety store General stores, as the name suggests, deals with a variety of items of general use. They sell products mostly required by people for their daily use. For example, in a variety store you can find different items on toiletry, hosiery, biscuits and snacks items, grocery, cosmetics, gift items and stationery. Normally these retailers make direct sale by cash only. However, for their regular customers, these retailers may give discounts, provide credit facility and also deliver goods at the customer’s house free of charge. Single line store Single line stores deal with a specific line of goods. You must have seen medicine shops, bookshops, toy shops, ready-made garment shops, etc. These are all single line stores. They sell goods of different sizes, brands, designs, styles and quality of the same product line.

Self-Instructional Material 61 Home Trade Transactions Specialty Store Specialty stores deal with products of specific brand or company. All varieties of any particular brand or manufacturers are made available in these stores. You must have seen stores, like Woodland shoe shops where products starting from shoe to apparel NOTES produced by Woodland are made available to the customers. Large-Scale Retail Trade Large scale retail trade is a type of trade in which either single type of goods or a variety of goods are made available to a large number of consumers in a big shop under a single roof or may be made available at the convenience of customers. Features of Large-scale Retail Trade The following are some of the common features of large-scale retail trade: • Deals in a variety of goods of daily need and makes these goods available to the customers at their convenience • Purchases goods in bulk directly from the manufacturers, thus avoiding middlemen in the process of purchase of goods • Provides service to a large number of customers • Size of the shops/stores is comparatively bigger than the local retail shops/stores • Requires huge capital investment to start and run the business • Generally sells goods to the customers on cash basis In India, generally we find the following types of large-scale retailing business: • Departmental store • Multiple shops • Super bazar You will read in detail about these in Unit 5.

4.3 DOCUMENTS OF TRADE

Trade documents are also known as business documents. These are written records that provide the details of the transaction between the buyer and the seller. 4.3.1 Importance of Trade Documents Trade documents are important for the following reasons: • Provides written record of transactions that have taken place: These documents help the system to be organized and also accountable. The written records also help in noting the progress of society. Revenue could also be collected through these papers. Check Your Progress • Helps to maintain books of accounts: The profit or loss made by any 1. What is trade? organization could be traced only with proper documentation. By maintaining 2. What are the two these, the firm could analyse its growth or the areas where it needs to grow. different types of trade? • Helps to assess the rate of tax and revenue: The documents help the custom and income tax authorities to assess the total assets of any institution for taxation

Self-Instructional 62 Material purpose. These help to keep a check on both tax evasion and tax avoidance. That Home Trade Transactions is why governments are keen to make stringent laws in this regard. • Helps the government to publish statistics regarding business activities: The documents give an idea about the rate of growth in a particular society. Whether the investment is proper or not, whether the direction in which the NOTES business is moving is correct or not, whether it is a sick or healthy unit can be determined. Contents of Trade Documents A trade document may have the following features or information: • Date of issue: This gives the date of ascertainment of any delivery or reception of income. • Date of transactions: When a particular transaction is effectuated gives the authority to note the date of the completion of transaction and continuing of process. • Nature of transactions (goods): The goods which are sold or purchased have to be determined by this. • Name of the parties: This is very important in order to maintain the list of the customers of a particular organization. It also helps to trace many things later in course of business. • Amount of transactions: This is very integral and important as we see that the transactions amount is what determines the value of the business deal as many calculations are based on this. • Terms and conditions of transaction: This fixes the future course of action for the whole transaction, that is, how the matter will be solved in case of any dispute or how the division of the profit will be done is all decided through determining the terms at early level of the dealings. • Serial number: Mainly used for in-house purpose of the business organization, it helps to maintain the outgoing and incoming stuff. 4.3.2 Types of Trade Documents According to the types of trade, different documents are used. Documents Used in Home Trade

1. Letter of Enquiry Letter of enquiry is a document sent by the buyer to the seller to find about the goods required, their availability, their prices, quantity and the terms of payment. The buyer can send a number of letters to various sellers to find the best goods at lower prices. Enquiry letter is also known as prospecting letter or letter of interest. The key purpose of this letter is to ask or find out about something. This is an official business document which is sent to both inside and outside the organizations, to individuals and to government departments. For example, if a person sends out an enquiry letter to an office to find out if they have any job vacancies even if they have not advertised it in the newspaper. This way once he/she gets feedback of the enquiry letter, he/she sends out an actual resumé to the HR department of that particular company officially for the available post. As enquiry means to question something so an individual also sends enquiry Self-Instructional Material 63 Home Trade Transactions letter to a business if he/she wants to find out about their products and services and other discount offers on special occasions. Businesses write enquiry letters among each other to see if they can work together or if they have a deal for some transaction. When a company wants to hire another NOTES company for a large scale construction or development, they write enquiry letter to that company to ask for their products, services and charges. Government agencies send enquiry letters to other departments or private businesses to clarify misunderstandings. When a department wants to increase its production or start a new project, they first send an enquiry letter to the finance department to check if they can grant finances for the project. Once the financial department agrees to pay for the project, they are provided with a proper project proposal and its expenses. Students also send out enquiry letters to find out if the school or college is offering seats to new applicants or going to start a new course which may interest them. When a well-known college or university offers a new course, thousands of applicants apply for admission but it is not possible to have all of them. That is why these institutes sometimes do not publish the news that they are offering a new course because they do not want to disappoint the students. This is why students send enquiry letters to colleges or universities even if these institutions have not offered anything. General Guidelines to Write an Enquiry Letter • Be patient in writing the letter and just use an appropriate tone. By sending out an enquiry letter one can ask for the time and consideration of the addressee. Therefore one has to be courteous with the words. • There is no need to send out an enquiry letter if you can find out the issues by other means like telephone or website. • There is no need to tell the full story and the letter should start with just an introduction of the queries that one has. After that in the second paragraph one can concisely explain the purpose of the enquiry and all the questions that one has in their mind. • In the third paragraph explain the nature of answers or response that one is expecting from the reader and possible ways to give the feedback like email or face to face meeting. If the questions are confidential or they involve a secret incident, mention that all the information should not be shared with anyone. • Close the letter with an appropriate greeting like ‘Regards’ or ‘Sincerely’. Format of a Letter of Enquiry Follow this format in writing a letter of enquiry: • In the first paragraph, identify yourself and, if appropriate, your position, and your institution or firm. • In the second paragraph, briefly explain why you are writing and how you will use the requested information. Offer to keep the response confidential if such an offer seems reasonable. • List the specific information you need. You can phrase your requests as questions or as a list of specific items of information. In either case, make each item clear and discrete. • Conclude your letter by offering your reader some incentive for responding. Self-Instructional 64 Material 2. Quotation Home Trade Transactions Quotation is sent by the seller to the buyer in reply of the letter of enquiry. It provides all the relevant information required by the buyer which has been mentioned in the letter of enquiry. It shows the types of goods, their brands, their respective prices, the terms of NOTES delivery, the terms of payment, etc. This letter requests a quotation on some required products by a company. The product requirements are given while requesting for each unit product’s sale price. A prompt reply is requested due to the urgency of the matter. A projected acquisition target is also given to envisage the volume of business from this collaboration. The quotation letter should begin with the address of the purchaser and with the routine etiquettes you should mention the name and quantity of goods which is required. After which one should mention the requirement of the quotations to be offered by the seller. A sample could be as given below:

A.B Srinivas 2000 Hedge Street Bengaluru, India

4th September 2010.

Subject: Business letter for quotation.

Dear Mr. Parikh,

I am writing this letter in order to inform you that I am planning to upgrade my computer system. I request you to send me a detailed quotation regarding the requirements for up gradation of my computer system.

Here is the list of items I would like to upgrade:

Graphic card of 2GB RAM 2GB HDD capacity of 500GB

I have a kind request for you to guide me in selecting the latest upgrades and branded company. The price range and the quality should be according to my satisfaction. Kindly send me the quotation of the following items and get in touch with me as soon as possible.

Yours Faithfully,

A.B Srinivas

3. Catalogue Catalogue could be defined as a book of reference, including a description and, if possible, an illustration of products and other pertinent data, such as instructions for their use and care. Sometimes, instead of sending a quotation, the seller may send a catalogue to the buyers containing detailed and classified information of the various types of goods offered for sale. It is similar to quotation but prices are not quoted in it. It can be used as an advertisement medium. Catalogs are used to group the various code groups. Code groups contain the various codes, where codes are used to define various tasks, activities, object parts, causes and damages.

Self-Instructional Material 65 Home Trade Transactions Catalogue Retailing: This is a type of non-store retailing in which the retailers offer merchandise in a catalogue, which includes ordering instructions and customer orders by mail. Catalogue marketing is a form of direct marketing where the seller prepares NOTES catalogues of merchandise or products and sells directly to the customer. The catalogues are generally in printed form but can also be distributed in the form of CDs. To avoid printing and distribution costs, the catalogues are being increasingly made available online. Products from various companies or vendors may be combined into a single catalogue to provide a one shop point for customers looking out for a particular type of product. Example: Avon is a good example of a company successfully leveraging this channel to sell its range of cosmetics. 4. Purchase Order Purchase order is sent by the buyer to the seller to place an order for buying the goods on the basis of a quotation. It states the type, brand, quantity and price of the goods (as given in the quotation) as well as the terms of delivery, the terms of payment, the expected delivery date and the address to which the goods are to be sent. Purchase order is a document prepared by a buyer to a seller containing the details of order with description of goods, price, terms of delivery, terms of payment and other terms and conditions mutually agreed by the buyer and the seller prior to issue of such document. Pro forma Invoice is nothing but a commitment of sale by a seller as binding agreement with buyer with the terms and conditions of sale agreement. Usually, purchase order is sent after collecting a pro forma invoice from seller. Commercial invoice is prepared by seller based on the purchase order issued by the buyer. Normally, commercial invoice is issued at the time of shipment. Commercial invoice contains details of buyer, seller, order number, details of product, quantity, price, terms of delivery, terms of payment and other details of contract as mutually agreed by buyer and seller. In a nutshell, major difference between a purchase order and commercial invoice is that a purchase order is issued by buyer where an invoice is prepared by the seller. Purchase order is an offer of contract of sale where invoice is a document of confirmation of sale. Purchase order can be one document covering all parts of shipments. However, invoice is prepared under each shipment separately. After completion of enquiry procedures between buyer and seller about the details of product and after satisfaction of quality, price and terms and conditions, the seller sends a pro forma invoice to the buyer. Based on such pro forma invoice, buyer releases a purchase order to confirmation the purchase of goods. Purchase order contains the details of product, quantity, price, payment terms, delivery terms and other terms and conditions of purchase contract as mutually agreed between buyer and seller. Normally purchase order is prepared by buyer on the basis of pro forma invoice sent by seller to buyer. After acceptance of purchase order by seller, the purchase contract comes into existence. Purchase order is prepared on the basis of mutual agreement between buyer and seller. Some of the contents of purchase order are product specification, price, terms of delivery, terms of payment, mode of transport, validity of shipment etc. Since the seller has to supply his goods on the basis of purchase order, all terms and conditions to supply goods are mentioned in a purchase order.

Self-Instructional 66 Material Since purchase order is prepared by buyers, obviously it is signed by them. However, Home Trade Transactions in most cases, buyer sends purchase order to seller and requests him/her to sign and send back to buyer as a proof of acceptance of such purchase order. Purchase order can be amended before the actual shipment, but with mutual understanding between NOTES buyer and seller. If there are any amendments in purchase order, a revised purchase order has to be sent to seller with such amendments. 5. Invoice

It is sent by the seller to the buyer to inform the buyer about the amount due on the goods supplied, stating also the type, quantity, price and terms of payment. It is used for the goods sold on credit. It is a very important document used for accounting entries. Invoices are used as a record of products/services purchased by a customer. All payment related transactions are contained in an invoice including the products or services purchased and the balance (opening and closing) on the subscription. Other transactions like refunds applicable to the subscription are also shown in the invoice. From a retailer’s point of view, invoice is the prime document in business. The contents of an invoice are as given below: (i) Consigner/seller: Details of the party who consigns the goods is mentioned in this column. The name and complete address of consignor to be mentioned with country name. (ii) Consignee: Details of the party to whom the consignment is shipped is mentioned in this column. Normally, details of the overseas buyer are mentioned. In some cases, when Letter of Credit is involved, the bank name is mentioned as consignee starting with ‘To the order of…’ If the cargo is resold at destination to a third party, the column can be mentioned as ‘To Order’. (iii) Buyer: In some cases consignee may not be the actual buyer, then the details of the buyer other than the consignee is mentioned. (iv) Invoice number and date: This number is the serial number of sale transaction used by a seller. This reference number is quoted at many occasions including authorities to identify the consignment for future reference. This is the reference number against the said sale used internally by the buyer in all future reference and files in office also. (v) Buyer’s order number and date: The purchase order number of overseas buyer is mentioned here. If the shipment is under Letter of Credit, the LC number and date is mentioned. (vi) Other reference if any: You can mention any other reference number to be declared related to the said shipment. (vii) ‘Pre carriage by’: The term ‘Pre carriage by’ means the mode of movement of cargo to port of loading by the shipper. The Pre carriage can be ‘By road’, ‘By Rail’ ‘By air’ or ‘By sea’.

Self-Instructional Material 67 Home Trade Transactions (viii) Place of receipt: Place of receipt of goods by carrier after completing export customs procedures. If you (exporter) are situated far from load port, the cargo can be customs cleared at nearest Container Freight station and move to port of loading. If you are completing customs procedures near NOTES the load port, the column ‘place of receipt’ and ‘port of loading’ will be the same. (ix) ‘Port of loading’: You can mention the port of loading of goods. It can be airport or sea port of place where you load your goods to aircraft or vessel. (x) Place of discharge: This is the port where your goods are unloaded from the aircraft or ship to deliver to the buyer’s place. The port of discharge column should be filled up carefully. If you handle documentation for different shipments at a time, there are chances to get interchanged. Shipping Bill is prepared on the basis of Invoice to file with customs clearance procedures. Bill of Lading is prepared on the basis of customs clearance completed shipping bill. Once Bill of Lading is released with the change of port of discharge, the cargo will reach the destination mentioned on ‘the port of discharge’ in the Invoice. (xi) Place of delivery: Once goods are unloaded at the port of discharge by ship or aircraft, the cargo is moved to the said location. This is the place where importer files customs documents for import and take delivery of cargo. In other words, responsibility of carrier to deliver the goods is up to this place. The importer has to move the goods from place of delivery to final destination of goods at his cost. (xii) Terms of delivery and terms of payment: As explained before, the terms of delivery are those terms which are agreed by both seller and the buyer. Terms of Payment also as explained earlier like LC, DA, DP, etc. (xiii) Marks and number: The details of ‘marking’ have to be on the parcels to be sold and also the number mentioned on the parcel. Suppose one has 10 packages to be exported. This should be labeled or marked as 1, 2, 3,….10 serial numbered on each parcel and complete address of consignee and seller address should be written under respective heads. Here, write marks and numbers as, ‘01 – 10’ ‘As addressed’ in the column of ‘marks and numbers’. The proper marking and labeling is very important. (xiv) Number and kind of packages: In this column, one needs to mention the total number of packages in the particular shipment. (xv) Description of goods: The description details of goods are mentioned in this column. (xvi) Quantity: Number of quantity against which you are selling. Say, if one is selling the product per piece and have packed 10 pieces in one package and there are in total 10 packages then it means that there are 100 pieces to be sold. The mention in ‘quantity’ column should be as 100 pieces. If goods are sold on per kg basis, it should be mentioned as ‘100kgs’ in ‘quantity’ column. (xvii)Rate: In the column ‘rate’, one has to mention the unit selling price of goods. Say, rate per piece, rate per kg. etc. If one sells at USD 10 per piece, one can mention USD 10.00. (xviii)Amount: The amount of goods is mentioned here. As per the above example, one should mention USD 1000.00

Self-Instructional 68 Material (xix) Total: If one does not have further items to be included, it could be mentioned Home Trade Transactions as the total amount of invoice. Say as per above example: USD 1000.00. (xx)Amount in words: Please note that the amount in words should match the amount in figures mentioned. (xxi) Declaration: While declaring and signing the invoice means, one should NOTES state all information given in invoice to be true. The words of declaration mentioned in the invoice may differ from country to country based on their respective law. (xxii) Authorized signatory, rubber stamp and date: Means, the person signs on invoice with rubber stamp of the firm. Authorized signatory means, the person to who the exporter authorizes to sign invoice on behalf of the exporter. 6. Advice Note Advice note is sent by the seller to the buyer to inform the buyer that the goods have been dispatched. It shows the quantity of the goods and the date of dispatch. A payment advice note contains the incoming payment details required for allocating and clearing the relevant open item. Payment advice note headers contain the payment amount, payment date and other information about the payment. The advice items contain information on the paid items; the amount, different reason codes. They also contain information used for identification purposes such as document number, reference number, billing document number, customer reference number and so on. A payment advice note can be created in several ways: • You can enter handwritten advice notes manually. • When processing bank statements, check deposit lists or lockbox data, you can have the system create a payment advice note with the detailed information automatically. This may be necessary if the program cannot clear open items immediately due to differences. • When manually processing open items for incoming payments, you can create an advice note to record the current processing status of the items. • Payment advice notes can be imported into the SAP R/3 System using EDI. Payment advice notes are used during payment clearing to search for and allocate open items automatically. Instead of having to enter selection criteria and then process the open items, all you have to do is specify the payment advice note number. The system uses the payment advice note to propose items for clearing, including any necessary difference. 7. Delivery Note Delivery note is sent by the seller to the buyer along with the goods to confirm the delivery of goods. It is sent through the delivery van driver and the buyer has to sign on it after the goods are received in good condition. The Delivery Note Voucher is used for recording goods delivered to a customer. A Delivery Note is made when a shipment is shipped from the company’s warehouse. A copy of the Delivery Note is usually sent with the transporter. The Delivery Note contains the list of Items that are sent in the shipment and updates the inventory. The entry of the Delivery Note is very similar to a Purchase Receipt.

Self-Instructional Material 69 Home Trade Transactions A sample of the delivery note for a vehicle could be as: Delivery Note of Vehicle (Scooter/ Bike) for Seller

DELIVERY NOTE NOTES I ______have this day taken delivery of a Scooter/ Bike / Vehicle ______registered at ______bearing its Registration No. ______, Chassis No. ______and Engine No. ______Model ______from ______son of ______, Resident of ______today i.e. on ______at ______and as well have received the original documents and R.C. Now, I am responsible for the challan/accident and any other cases from today onwards & I will get the said vehicle transferred in my name within 10 days and shall bear all the expenses incidental thereto.

Time: ______Date: ______

Yours Faithfully,

Signature______Name: ______Son of ______Resident of ______

8. Consignment Note Consignment note is similar to the delivery note. It is sent by the seller to the buyer when the goods are delivered through hired vehicles. It is a formal instruction to the transport firm to deliver the goods to the customer. It is to be signed by the buyer for ensuring the right delivery of goods. The consignment note contains all the details about the shipment and accompanies the shipment throughout its journey. Complete the consignment notes clearly and accurately, particularly the sender and recipient name and address. 9. Debit Note Debit note is prepared by the seller and sent to the buyer who has been undercharged on an invoice. It is an additional invoice sent to the buyer to pay the short amount. It informs the buyer that his account is debited, increasing the amount that he owes. Reasons for issuing a debit note • If there has been an undercharge on an invoice • If some charges like delivery, packing, loading, etc. have not been included in the invoice. A debit note or debit memorandum (memo) is a commercial document issued by a buyer to a seller as a means of formally requesting a credit note. A seller might also issue a debit note instead of an invoice in order to adjust upwards the amount of an invoice already issued (as if the invoice is recorded in wrong value). Debit notes are generally used in business-to-business transactions. Such transactions often involve an extension of credit, meaning that a vendor would send a shipment of goods to a company before the goods have been paid for. Although real goods are changing hands, until an actual invoice is issued, real money is not. Rather, debits and credits are being logged in an accounting system to keep track of inventories shipped and payments owed. Debit notes are generally used in business-to-business transactions. Such

Self-Instructional transactions often involve an extension of credit, meaning that a vendor would send a 70 Material shipment of goods to a company before the goods have been paid for. Although real Home Trade Transactions goods are changing hands, until an actual invoice is issued, real money is not. Rather, debits and credits are being logged in an accounting system to keep track of inventories shipped and payments owed. NOTES 10. Credit Note It is prepared by the seller and sent to the buyer who has been overcharged on an invoice. The credit note is normally printed in red to distinguish it from other documents. It is sent to the buyer to deduct the overcharged amount in the invoice. It informs the buyer that his account is credited, decreasing the amount that he owes. Reasons for issuing a credit note • If there has been an overcharge on an invoice. • If damaged goods have been returned by the buyer. • If the goods are short delivered to the buyer. • If the buyer has returned gift vouchers or coupons to the seller. A transaction that reduces Amounts Receivable from a customer is a credit memo. For e.g. the customer could return damaged goods. A debit memo is a transaction that reduces Amounts Payable to a vendor as damaged goods are sent back to the vendor. 11. Credit Memo Credit memo request is a sales document used in complaints processing to request a credit memo for a customer. If the price calculated for the customer is too high, for example, because the wrong scale prices were used or a discount was forgotten, you can create a credit memo request. The credit memo request is blocked for further processing so that it can be checked. If the request is approved, you can remove the block. The system uses the credit memo request to create a credit memo. One can use credit memos in Sales and Distribution (SD) for assigning credit memo requests to the open invoices and in Financial Accounting (FI) for assigning credit memos and payments to the open invoices and carry out clearing with them. If one uses both Financial Accounting (FI) and Sales and Distribution (SD), there is a 1:1 relationship between the credit memo request and the credit memo item posted in Financial Accounting (FI). As soon as the bill the credit memo request together with other sales orders, or distribute the items of one credit memo request to several billing documents, the assignment is no longer valid and the system will not process it. For credit memos, credit memo requests, and payments, one has the following assignment options: • Assignment to a single invoice • Assignment of a partial amount to an invoice • Assignment to several invoices When one uses post credit memos, the payment programme processes them automatically. If the credit memo is specifically related to a particular open invoice item, the payment programme automatically attempts to offset the credit memo against the open item. If it is not possible to completely offset the credit memo against an invoice, you can post a debit memo to the vendor, who is to reimburse the amount. Then you can apply a multilevel dunning program.

Self-Instructional Material 71 Home Trade Transactions Debit memo request is a sales document used in complaints processing to request a debit memo for a customer. If the prices calculated for the customer were too low, for example, calculated with the wrong scaled prices, one can create a debit memo request. The debit memo request can be blocked so that it can be checked. When it has been NOTES approved, you can remove the block. It is like a standard order. The system uses the debit memo request to create a debit memo. As mentioned above, creating a credit or debit memo request enables one to create credit or debit memos based on a complaint. For this create a sales document with the order type for a credit or debit memo request. You can create the debit or credit memo requests in the following ways: • Without reference to an order • With reference to an existing order In all cases, specify the value or quantity that should be in the credit or debit memo 12. Cheque/Draft (Mode of Payment) A payment system is a mechanism that facilitates transfer of value between a payer and a beneficiary by which the payer discharges the payment obligations to the beneficiary. Payment system enables two-way flow of payments in exchange of goods and services in the economy. Payment systems comprises of instruments through which payments can be made, rules, regulations and procedures that guide these payments, institutions which facilitate payment mechanisms and legal systems etc. that are established to facilitate transfer of funds between different participant institutions. Payment systems are used by individuals, banks, companies, governments, etc. to make payments to one another. In other words, anybody who has to make a payment to anyone can use one or the other form of payment system to make such a payment. Customer can make payments by issuing paper based instruments like cheques, demand drafts, payment orders, etc or by advising bank to debit his account and originate an electronic payment like ECS, NEFT/EFT, and RTGS. The process of cheque payment starts when payers give personal cheques to the beneficiary. In order to get the actual payment of funds, the receiver of the cheque has to present the cheque to the issuing bank. If the cheque is not crossed and is payable to bearer he can receive payment at the issuing bank counters, otherwise he has to deposit the cheque in his bank account. Another mode of making payments is by having a letter of credit transmitted to the beneficiary’s banker who releases payments on fulfillment of certain conditions laid down in the LC. The cheque or draft should be sent by the buyer to the seller in the given period to settle the due amount mentioned in the invoice. Nowadays the traditional payment method is replaced by the online payment using cash cards. Demand drafts are used when one person wants to send or transfer money (remit) to another person who is in another city. The person wanting to send money, deposits cash in a bank or issue a cheque in favour of the issuing bank, which issues him a demand draft. The demand draft is sent to the person who is to receive the money. The receiver gives it to the branch/bank where he holds an account and receives the payment. They are valid for 6 months. Banks normally charge a commission for issuing demand drafts.

Self-Instructional 72 Material Electronic Payments and Remittances: Home Trade Transactions Electronic Clearing Services (ECS): They are available for receiving or making payments. ECS for receipt is ECS (Credit). ECS for payment is ECS is ECS (Debit). The scheme is operational in 64 cities. NOTES • ECS (Credit): Electronic Clearing Service for credit is a mode of payment by an institution and receipt by individuals for interest, dividend, salary, pension, etc. A large number of investors, share holders, employees, ex-employees can receive their dues electronically directly into their accounts on due dates without using paper cheques/instruments. • ECS (Debit): Electronic Clearing Service for debit has been introduced so that bank customers can make small value repetitive payments such as electricity bills, telephone bills, loan installments, insurance premia, club fees, etc. The process operates on the basis of ‘large number of small debits and one consolidated credit’ from users to the service provider. The system provides the convenience of paperless payment on due dates by direct debit to the customer’s account. NEFT/EFT (National Electronic Funds Transfer/Electronic Funds Transfer): This electronic mode of remittance of funds is available with over 18,500 bank branches. The amount sent from the sender’s bank branch is credited to the receiver’s bank branch on the same day or at the most the next day. This facility saves the effort of sending a demand draft through post and the inherent delay in reaching the money to the receiver. Banks may charge commission for using NEFT/EFT. RTGS (Real Time Gross Settlement) System: The RTGS system facilitates instant transfer of money from one account to another across cities. This is basically a large value remittance system where funds are required to be transferred quickly. While all the above payment and remittance systems are settled between banks on a net basis, RTGS is settled on a gross basis which means that each transaction is settled independently. This facility is useful to banks for their funds management, for companies to transfer large amounts for individuals who require urgent payments. 13. Receipt It is issued by the seller to the buyer as a proof of the money received. When the payment is made by cheque, it is not necessary to issue a receipt since the cheque serves as a proof of payment. 14. Statement of Account Bank statement or account statement is a summary of financial transactions which have occurred over a given period on a bank account held by a person or business with a financial institution. Bank statements are typically printed on one or several pieces of paper and either mailed directly to the account holder’s address, or kept at the financial institution’s local branch for pick-up. Certain ATMs offer the possibility to print, at any time, a condensed version of a bank statement. In recent years there has been a shift towards paperless, electronic statements. It is sent by the seller to the buyer showing the summary of the transactions between the buyer and the seller for a particular period of time. It shows the amount of goods purchased, the returns made, the payments, cash discounts, details of the credit note, debit note and the amount due. With the introduction of online banking, bank statements (also known as electronic statements or e-statements) can be viewed Self-Instructional Material 73 Home Trade Transactions online. Due to identity theft concerns, an electronic statement may not be seen as a dangerous alternative against physical theft as it does not contain tangible personal information, and does not require extra safety measures of disposal such as shredding. However, an electronic statement can be easier to obtain than a physical one through NOTES computer fraud, data interception and/or theft of storage media.

4.4 TRADE DOCUMENTS USED IN INTERNATIONAL TRADE

When trading internationally, the right paperwork is crucial. Missing or inaccurate documents can increase risks, lead to delays and extra costs, or even prevent a deal from being completed. Whether you are importing or exporting, you need to understand what paperwork is required. Even if you use a freight forwarder or an agent, it’s still up to you to make sure the right documentation is available. One should have the right documentation while engaging in international trade. Thorough, accurate paperwork minimizes the risk of problems and delays. • There should be a clear written contract between buyer and seller, including details of exactly where goods will be delivered. • Specific documents may be needed to get the goods through customs and to work out the right duty and tax charges. There may be requirements both for the country the goods are being exported from and the country they are being imported into. • Documentation is needed to cover the transport of the goods and insurance during the journey. • The right paperwork can be an important part of the payment mechanism. Following are the documents important for international trade: 1. Indent or order The order for the goods placed by the importer to the exporter or his agent is known as indent. It shows the nature of products, quantity, shipping mark, etc. 2. Bill of lading Bill of lading is an important document used in foreign trade when the goods are sent through ships. It contains the details of the goods, details of the consignor and the ship which carries the goods. Bill of lading is a document of title to the goods. This means that the holder is entitled to claim the goods from the shipping authority when the ship reaches its destination. 3. Airway bill (Air consignment note) Airway bill is similar to bill of lading but it is used only when the goods are sent by air. It is issued by the aircraft authority as an evidence of the contract of carriage between the Check Your Progress exporter and the carrier. It is not a document of title to the goods. 3. What are trade documents? 4. Consular invoice 4. What is a letter of Consular invoice is issued by the consul (foreign ambassador) of the importing country enquiry? resident in the exporting country. It is issued for the purpose of reducing the falsification 5. What is a purchase order? on the price of goods with the intention of evading the duty.

Self-Instructional 74 Material 5. Certificate of insurance Home Trade Transactions Certificate of insurance is issued by an insurance company. In order to reduce the chance of risk, the goods must be insured with the insurance company. This certificate is enclosed with the goods if the goods have been insured properly. NOTES 6. Shipping note (Dock receipt) When the goods are delivered to the docks, they are accompanied by a shipping note formally requesting the port authorities to handle them. This document furnishes the details of the goods, ship and the destination port. A copy of the note is signed by the port authority and retained by the exporter as a proof of delivery to the port; it is then referred to as dock receipt. 7. Mate’s receipt A receipt signed by the mate (captain or his agent of the ship) to say the cargo (goods) has been received on board in good condition after examining the goods. 8. Certificate of origin It is a document stating the name of the country that produced the specified goods which are ready to export. It is often required before the importation of goods. Certificate of origin can be used to prevent the evasion of duty on goods. 9. Letter of credit Letter of credit is a document issued by the importer’s bank to the exporter giving a guarantee of payment to the exporter. It can also be the source of repayment of the transaction meaning that the exporter will get paid with the redemption of the letter of credit. 10. Customs declaration form This is the document issued by the customs authority in order to examine the concerned goods easily for calculating duties therein. It is to be filled by both the exporter and the importer respectively and furnishes the details of the goods. 4.4.1 Cash Discount and Trade Discount

Trade discount Trade discount is discount allowed to the buyers who make bulk purchases from the seller. It is also known as quantity discount. For example, if the buyer purchases more than 100 units he will be given a 5 per cent discount on price. Cash discount Cash discount is a discount allowed to the buyers those who make the payment on time for their purchases. It is allowed by the seller to motivate the buyers to pay the dues in the given credit period of time. Eg:- If the buyer pays within 10 days he will be given a 6 per cent discount.

Self-Instructional Material 75 Home Trade Transactions Table 4.1 Difference between Cash Discount and Trade Discount

CASH DISCOUNT TRADE DISCOUNT 1. This is a deduction off the invoice 1. This is a deduction off the list NOTES price of goods purchased on price of goods purchased. credit. 2. This is given to encourage bulk 2. This is given to encourage prompt purchases. payment. 3. The rate of trade discount depends 3. The rate of cash discount depends on the quantity purchased. on the period of credit allowed. 4. Buyer is entitled to the trade 4. The buyer loses the cash discount discount even if he fails to pay if he fails to pay within the given within the given period. period. 5. It does not appear in the ledger 5. It is treated as an expense in the accounts. ledger accounts.

E & OE (Errors and Omissions Excepted) E & OE stands for the Errors and Omissions Excepted. It tells that if an error is made or something is omitted from the trade documents, the seller reserves the right to correct the mistakes.

4.5 SUMMARY

• Trade is an important social activity because the society needs uninterrupted supply of goods that are forever increasing and changing. Trade originated with human communication in prehistoric times. • Trade can be divided into two types—Internal or Home or Domestic trade and External or Foreign or International trade. • Wholesale Trade involves buying in large quantities from producers or manufacturers and selling in bulk to the retailers for resale to consumers. • Retail Trade involves buying in smaller quantity from the wholesalers and selling in very small quantities to the consumers for personal use. Retailers are the last link in the chain of distribution. • Itinerant retailing is a type of small-scale retail trade in which retailers move around and sell a variety of items directly to the consumers. They do not have a fixed shop where they can sell. • General stores, as the name suggests, deals with a variety of items of general use. They sell products mostly required by people for their daily use. • Single line stores deal with a specific line of goods. • Trade documents are also known as business documents. These are written records Check Your Progress that provide the details of the transaction between the buyer and the seller. 6. What is Bill of • Letter of enquiry is a document sent by the buyer to the seller to find about the Lading? goods required, their availability, their prices, quantity and the terms of payment. 7. What is certificate of insurance and The buyer can send a number of letters to various sellers to find best goods at why is it issued? lower prices.

Self-Instructional 76 Material • Quotation is sent by the seller to the buyer in reply of the letter of enquiry. It Home Trade Transactions provides all the relevant information required by the buyer which has been mentioned in the letter of enquiry. It shows the types of goods, their brands, their respective prices, the terms of delivery, the terms of payment, etc. • Catalogue could be defined as a book of reference, including a description and, if NOTES possible, an illustration of products and other pertinent data, such as instructions for their use and care. • Purchase order is sent by the buyer to the seller to place an order for buying the goods on the basis of a quotation. It states the type, brand, quantity and price of the goods (as given in the quotation) as well as the terms of delivery, the terms of payment, the expected delivery date and the address to which the goods are to be sent. • Advice note is sent by the seller to the buyer to inform the buyer that the goods have been dispatched. It shows the quantity of the goods and the date of dispatch. • Delivery note is sent by the seller to the buyer along with the goods to confirm the delivery of goods. It is sent through the delivery van driver and the buyer has to sign on it after the goods are received in good condition. • Debit note is prepared by the seller and sent to the buyer who has been undercharged on an invoice. It is an additional invoice sent to the buyer to pay the short amount. It informs the buyer that his account is debited, increasing the amount that he owes. • Credit memo request is a sales document used in complaints processing to request a credit memo for a customer.

4.6 KEY TERMS

• Credit note: It is prepared by the seller and sent to the buyer who has been overcharged on an invoice. The credit note is normally printed in red to distinguish it from other documents. • Credit memo request: It is a sales document used in complaints processing to request a credit memo for a customer. • RTGS: This system facilitates instant transfer of money from one account to another across cities. • Consular invoice: It is issued by the consul (Foreign ambassador) of the importing country resident in the exporting country. • E & OE: It stands for Errors and Omissions Excepted and tells that if an error is made or something is omitted from the trade documents, the seller reserves the right to correct the mistakes.

4.7 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. Trade, also called goods exchange economy, is to transfer the ownership of goods from one person or entity to another by getting a product or service in exchange from the buyer. Trade is sometimes loosely called commerce or financial transaction or barter. Trade means buying and selling of goods.

Self-Instructional Material 77 Home Trade Transactions 2. The two types of trade are (1) Internal trade and (2) External trade. 3. Trade documents are also known as business documents. These are written records that provide the details of the transaction between the buyer and the seller. NOTES 4. It is a document sent by the buyer to the seller to find about the goods required, their availability, their prices, quantity and the terms of payment. The buyer can send a number of letters to various sellers to find best goods at lower prices. 5. Purchase order is a document prepared by a buyer to a seller containing the details of order with description of goods, price, terms of delivery, terms of payment and other terms and conditions mutually agreed by buyer and seller prior to issue of such document. 6. Bill of lading is an important document used in foreign trade when the goods are sent through the ships. It contains the details of the goods, details of the consignor and the ship which carries the goods. 7. Certificate of insurance is issued by an insurance company. In order to reduce the chance of risk, the goods must be insured with the insurance company. This certificate is enclosed with the goods if the goods have been insured properly.

4.8 QUESTIONS AND EXERCISES

Short-Answer Questions 1. Define trade and state its importance. 2. What are the different forms of trade? 3. State the difference between wholesale and retail trade. 4. What is Itinerant retailing? 5. What are the features of large-scale retail trade? 6. What are trade documents important? 7. State the importance of a purchase order. 8. What documents are important for international trade? Long-Answer Questions 1. Differentiate between home trade and international trade. 2. Discuss fixed shop retailing. 3. Write a detailed account on different types of trade documents. 4. Write a short note on letter of enquiry. What is its format? 5. What are the contents of a purchase order? 6. What is a catalogue and how are they used? 7. Distinguish between cash discount and trade discount. 8. How are payments done in trading? Describe the process in detail.

Self-Instructional 78 Material Home Trade Transactions 4.9 FURTHER READING

Weston, J Fred, Kwang S. Chung and Susan E. 1990. Hoag. Mergers, Restructuring and Corporate Control. New Jersey: Prentice Hall. NOTES Horne, James C. Van. 2002. Financial Management. New Jersey: Prentice Hall. Brealey, Richard A., Stewart C. Myers and Franklin Allen. 2008. Principles of Corporate Finance. New York: McGraw-Hill. Pandey, I. M. 2010. Financial Management. New Delhi: Vikas Publishing House. Muralidharan. 2009. Modern Banking: Theory and Practice. New Delhi: PHI Learning Private Ltd. Maheshwari, S. N. 1983.Banking Law and Practice. New Delhi: Kalyani Publishers. Gordon E. and K. Natrajan.1992. Banking: Theory, Law and Practice. Mumbai: Himalaya Publishing House. Sharma, K.C. 2007. Modern Banking in India. New Delhi: Deep and Deep Publications.

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Wholesale and UNIT 5 WHOLESALE AND RETAIL Retail Trade TRADE NOTES Structure 5.0 Introduction 5.1 Unit Objectives 5.2 Retail Trade 5.2.1 Functions of a Retailer; 5.2.2 Retailing Principles 5.2.3 Retailing in India; 5.2.4 Retail Market Prospects in India 5.2.5 Retailing Across the Globe 5.3 Wholesalers 5.4 Organization of Wholesale and Retail Trade 5.4.1 Process of Organizing a Retail Firm 5.5 Departmental Stores 5.5.1 Multiple Shops; 5.5.2 Super Market 5.6 Mercantile Agents and Their Functions 5.7 Summary 5.8 Key Terms 5.9 Answers to ‘Check Your Progress’ 5.10 Questions and Exercises 5.11 Further Reading

5.0 INTRODUCTION

The liberalized financial and political environment in India has prompted a large number of entrants into the country’s rapidly growing retail industry during the past few years. Without doubt, the retail industry in India is in the throes of radical restructuring. The fundamental drivers of change are the increasing per capita income, growing gross domestic product (GDP) and the availability of consumer finance and, therefore, these changes are irreversible. Retailing in the general sense consists of business activities that are involved in buying and selling of goods and services to final consumers. At present, retailing in India is at crossroads. On the one side, retail sales are reaching new heights year after year and on the other side, traditional Indian retailers (kirana stores) face numerous challenges. In this unit, the principles and various functions of retailing are discussed. The functions of wholesalers and mercantile agents are also discussed in this unit.

5.1 UNIT OBJECTIVES

After going through this unit, you will be able to: • Explain the concept of retail trade • Understand the role of wholesalers in the distribution channel • Describe the organization of wholesale and retail trade • Understand what are departmental stores, multiple shops and supermarkets • Discuss the types and duties of a mercantile agent

Self-Instructional Material 81 Wholesale and Retail Trade 5.2 RETAIL TRADE

To understand the role of retail format in an economy and its significance, let us first NOTES try to understand what retail actually is. Retailing consists of selling merchandise from a permanent location (a retail store) in small quantities directly to consumers. These consumers may be individual buyers or corporate buyers. A retailer purchases goods or merchandise in bulk directly from a manufacturer or a wholeseller and then sells the merchandise in small quantities to consumers. The place where he sells the merchandise directly to the consumer is known as retail shop or store. The shops may be located in residential areas, colony streets or community centres or in modern shopping arcades/malls. In fact, any organization selling merchandise to final consumers–whether a producer, a wholesaler or a retailer–is doing retail business. It does not take into account how the merchandise is being sold. While on the other hand, retail format is a blend of product range, pricing and marketing. Whether a format will be suitable for a retailer does not depend upon market practice but upon retailer’s budget, merchandise and the need of the locality. A good format draws more footfalls and provides the retailer a platform to succeed and earn name and fame. Origin of Retailing in India Although retailing is here to stay as an inseparable part of our lives, it was not always so. We know that in the bygone era, man grew just enough to meet his basic needs. However, things began to change once he improved his methods of cultivation and found that he had some left even after satisfying the needs of his family, animals and keeping aside stock for a rainy day. It was this leftover surplus that he decided to trade or barter for items that could meet his additional requirements. One thing led to another; some people with large tracts of land began to produce more with the objective of selling and making money, while others continued to grow. This led to division of labour in spheres other than food, such as tools, jewellery, crockery and more. With the coming up of central markets where producers gathered regularly to exchange goods, informal markets became formal, finally resulting in permanent shops which required to be well stocked. This was the beginning of the Retail Trade. There were also peddlers or traders who sold their goods by moving from place to place. It was this selling of goods from a regular market that came to be called retailing. Some permanent shopkeepers decided to store their extra stock in another market place which could probably be managed by a member of the family. This was the earliest form of a retail chain. The major boost to the retail industry came during the 19th century. The breakaway from the traditional style of trading was possible with improved telegraph and rail communications and logistics. At the beginning of the Industrial Revolution departmental and discount stores were in a nascent stage. Increased industrial development gave an impetus to growth of retailing. The pioneer traveling salesman or peddlers had many names - hawkers, chapmen etc. Mostly of New England origin in the colonial era, they moved from farm to farm with their

Self-Instructional 82 Material trunks on their backs. When roads became better, they traveled in wagons. The goods Wholesale and Retail Trade they sold comprised combs, pins, knives, woolens, books, in exchange for farm products, which they usually resold at a profit in stores or markets in towns. It was in the early 1830s that the organized retail format, the Departmental Stores made its presence, followed by chain stores, discount stores, variety stores, mail order, concept NOTES stores and the like. Tracing the evolution of retail in India, it can be seen that the earliest system of retail included haats, melas and mandis. The caste system can be taken as the earliest record regarding retailers. The people who were involved in trade were categorized into the vysya caste system. The term baniya today is synonymous with the shopkeeper, but refers to the people who would sit under the banyan tree and sell their wares. Retail in India has evolved through three phases, the traditional formats, the established formats and the emerging formats. The traditional formats are haats, melas, mandis, etc: the established formats are kirana, pan beedi, public distribution systems, departmental stores, etc; and the emerging formats are multiplexes, malls, etc. Contemporary retail chains that dominate India are Public Distribution System (PDS), Post Offices, and Khadi & Village Industries (KVIC) stores, which are organised by the government. On the unorganised side, Kirana and pan beedi store formats outnumber other formats. The PDS is the single largest retail chain existing in the country. It ensures availability of essential commodities like wheat, rice, sugar, edible oils and kerosene to the consumers, through a network of outlets or Fair Price Shops (FPS). There is a network of about 4.61 lakh PDS retail outlets in the country. PDS is operated under the joint responsibility of the Central and State Governments. The Central Government bears the responsibility of procurement, storage, transportation and bulk allocation of food grains, rice and wheat at subsidized prices, while the responsibility of distribution to consumers through FPSs rests with the State Governments. The public distribution of grains in India has its origin in the rationing system introduced by the British during World War II. The system was started in 1939 in Bombay and was subsequently extended to other cities and towns. By 1946, as many as 771 cities/towns were covered under this system of public distribution. After the war this system was abolished only to be reintroduced after Independence in 1950 in the face of renewed inflationary pressures on the economy. However, the system catered chiefly to urban needs, so much so that it almost became redundant in 1956, oil. The number of ration shops also increased from 18,000 in 1957 to 51,000 in 1961. By the time the second Five-Year Plan ended, the PDS had become a system that provided social safety, offered reasonably priced foodgrains to ensure greater reach to the common man, and kept a check on the speculative tendencies in the market. In the 40 years of its functioning, the PDS has been effective in preventing famines in India. When the First Five-Year plan ended, with foodgrain becoming easily available, it was then that the PDS came back, offering additional essential commodities like sugar, cooking coal, and kerosene.

Self-Instructional Material 83 Wholesale and Retail Trade Rural Traditional Government Modern Approach Approach Approach Approach

NOTES Shopping malls, super bazaar, hypermarkets,

PDS stores, khadi outlets, cooperative stores Mom and Pop ‘kirana’ t

Weekly bazaars, rural fairs (melas)

Entertainment Convenience Subsidized Self-service Sources Stores Stores Stores

Fig. 5.1 Origin of Retailing in India

Ancient Retailing The business of retail flourished in the past because some people had surplus of one item and shortage of another item and vice versa. According to the records, the earliest traders were the Cretens who sailed the Mediterranean and started the retailing business with the people of Sparta. They continued for roughly 2000 years and distributed goods to Egypt and Babylonia. Carthage, Sidon and Tyre used to be the main trading centres. Later on this group was ultimately taken over by the Romans. The Romans set up a very sophisticated form of retailing, in the major commercial areas especially urban one. The concepts of shops (outlets) in fact originated in Rome. The ancient ruins even confirm that first of all departments store originated in Rome but with the fall of Roman Empire, retailing disintegrated and spread to the remaining part of the world.

5.2.1 Functions of a Retailer Retailing is the last stage in a channel of distribution, which consists of all the trades and people involved in the physical movement and transfer of ownership of goods and services from manufacturer to the final consumer as shown in Figure 5.2.

Manufacturer Final Wholesaler Retailer Consumer

Fig. 5.2 Channel of Distribution

Self-Instructional 84 Material If we analyse the distribution process, we find that the retailer plays a key role Wholesale and Retail Trade as the contact between manufacturers, wholesalers and the final consumers. Retailers are the gatekeepers to the market for all other members of the sales distribution process, while on the other hand wholesaling is an intermediate stage in the distribution channel during which merchandise (both goods and services) are sold to business customers NOTES but not to final consumers. Business customers here are wholesalers, exporters and retailers who buy for resale or to run their business. One thing to be noted, in this regard, is that wholesaling excludes producers and farmers because their task is to produce goods. Therefore, the best way of understanding the relationship between wholesalers and retailers is to look at it from the manufacturer’s point of view, which provides a clear picture of the sales distribution process. With liberalization, privatization and globalization (LPG) and the borderless economies, the distance between the manufacturer and its ultimate consumer has increased. In today’s world, many products are produced in one country but are sold in another country. Most of the manufacturers do not prefer to sell their merchandise directly to the consumers, but instead, like intermediaries, such as retailers, wholesalers, agents and commission brokers to make their merchandise available to the consumer. Further, sometimes, it has been observed that manufacturers dealing in variety of goods provide their merchandise to more than one intermediary (wholesalers). Retailers buy these merchandises from more than one wholesaler in bulk and offer in small quantities to consumers. This phenomenon in the world of retailing is termed as sorting process, as shown in Figure 5.3.

Manufacturer Manufacturer Manufacturer Manufacturer Manufacturer Manufacturer Brand ‘A’ Brand ‘B’ Brand ‘C’ Brand ‘D’ Brand ‘E’ Brand ‘F’

Wholesaler ‘X’ Wholesaler ‘Y’ Wholesaler ‘Z’

Retailer

Brand ‘E’ Consumer Brand ‘A’ Brand ‘B’ Consumer Consumer Brand ‘F’ Consumer Brand ‘D’ Brand ‘C’ Consumer Consumer

Fig. 5.3 Sorting Process and the Retailer’s Role

The benefit of the sorting process is that according to the variety of merchandise and business complexity, it can be changed into different shapes, consequently, a manufacturer becomes more effective and ultimately consumers find this comfortable and convenient as they get different goods and services under one roof and in as much quantity as they need. Otherwise, it becomes difficult for the consumer to visit from one store to another to collect the assortment of goods and services that he needs. Further, wholesalers enjoy selling the goods and services in bulk rather than attending Self-Instructional Material 85 Wholesale and individual consumers, as their invested amount is more and, therefore, want quick Retail Trade return on their investments. The retailer serves the manufacturer by providing his goods and services to the consumers and creates a channel of information where customers’ feedback, their NOTES expectations and points of dissatisfaction, if any, are shared with the manufacturer. From the customer’s point of view, the retailer’s main function is to provide merchandise in the right quality, quantity, price, time, and at the right place. This objective is achieved through different perspectives. • Identifying consumer demands: The first task that a retailer has to perform is to identify the consumer needs and wants. The retailer does not provide raw materials, but offers finished goods and services in a ready to use form that consumers want. For this, from time-to-time, the retailer gathers information about the consumers’ liking, disliking, taste and preferences. • Managing merchandise: The second task that a retailer performs is the management of merchandise. The retailer performs the function of storing the merchandise and sells the amount required by the customer. • Adjusting timing as per consumers convenience: The retailer creates time utility by keeping the store open and ready for sale according to consumers’ convenience. The new trend in retailing to longer trade hours reflects the socio- cultural changes where over one in ten people work outside normal hours resulting in changing trading hours and panacea for small retailers against the cheaper prices of the super stores and other retail chains. By being available at a location that has easy access and convenient to shop, retailer creates place utility. Finally, when selected and bought by customers, retailers create ownership utility. In short, retailers are not only the final link between the consumers and the manufacturers but a vital part of modern business world. In the absence of retailing, one can easily imaging how tedious and costly it would have been for a consumer to approach manufacturers for various things every time he wanted them. Retailers do not only sell things in small quantities but also make their shopping convenient and less risky. Retailers have floor staff to answer the consumers’ queries regarding how to use a product effectively and safely, guide them what to buy according to their individual preferences and budget and give demonstration or display products so that the consumers should have a feel of the merchandise before buying. The successful retailer focuses its activities on meeting these objectives through effective marketing. 5.2.2 Retailing Principles

In order to be sound and effective, a retail organization must be governed by the following basic principles: 1. Clear definition of objectives and policies: According to this principle of retail organization, each employee must understand the objectives and policies of the store. If the objectives are not clearly defined, employees in the retail organization shall not be in a position to understand what is expected from them and in what type of activities the organization engage itself.

Self-Instructional 86 Material 2. Duties and responsibilities: According to this principle, the duties and Wholesale and Retail Trade responsibilities of each and every employee, working at various levels in the retail store should be clearly defined. The line of authority must be clear from the highest to the lowest positions. All the employees must be well informed of NOTES their respective positions, responsibilities in the retail organization and the persons to whom they are answerable and who reports to them. 3. Unity of command: According to this principle, one employee working at the junior level should be responsible to one direct supervisor. The purpose is to avoid any conflict regarding responsibilities of the employees receiving orders from more than one supervisor. 4. Supervision and control: According to this principle, even after delegating the authority, the supervisor will still be responsible for a manager’s or an employee’s mistakes. He cannot avoid the responsibility of the mistake made by his juniors. 5. Interest in employees: According to this principle, the retail organization should show continuous interest in its employees, such as job promotion, employees’ participation in management, internal promotion, efforts/job recommendation, job enrichment, induction, and so on, and thus improve employee’s morale and efficiency. 6. Monitoring of human resources: According to this principle, issues related to employees like attendance, employee turnover, punctuality and absenteeism should be regularly monitored otherwise they could create problems for the retail organization. 7. Rule of simplicity: According to this principle, simplicity in all sorts of operations is must for running a retail organization properly. 8. Responsibility and authority: According to this principle, assigning duties without any authority will not work in a retail organization. Therefore, responsibilities should be associated with proper authority. An employee who is responsible for achieving some of the retail organization’s objectives needs the power to achieve them. 9. Division of labour: According to this principle, in order to achieve organizational objectives, the work should be divided among the subordinates properly. It means dividing the retail organization’s work in various departments; into various components and then assigning the same to each employee of the organization. It enables the management to fix up the responsibilities on each employee concerned. 5.2.3 Retailing in India India is known as the ‘nation of shops’. After agriculture, retailing is the second largest employer in India. Approximately, over 12 million shops exist in various parts of the country. These shops are totally unorganized, independent, owned-managed outlets. Further, the rising per capita income and the fast emerging middle-class has made India the favourable destination for retailing. New malls are coming up in the urban parts of the country. Franchisee outlets are mushrooming. More and more Self-Instructional Material 87 Wholesale and business houses are venturing into the retail industry. New retail formats are emerging Retail Trade and even changing the traditional face of jewellery shops, furniture shops, bookstores and pharmacy shops. People are spending their major portion of income on food and clothing. The share was 72.8 per cent in 2006, worth approximately `9861.4 billion; NOTES while non-food and clothing sales was worth `3476.8 billion and this trend is expected to continue in the years to come. The Indian retail industry is broadly divided into two segments: • Organized retailing • Unorganized retailing The unorganized retailing comprises of ‘mom and pop’ stores or ‘kirana’ stores. These are very small shops located near the residential areas, popularly known as ‘baniya shops’. The unique sellingproposition (USP) of these stores is the location advantage. These shop owners, in order to retain their customers, can even go to their customers’ houses to get orders. Trading hours are flexible and the retailer to the consumer ratio is very low due to the presence of several ‘kirana’ stores in the locality. Credit facility varies from store to store and customer to customer. The customers’ reliability and relation with the shopkeeper is enough to avail credit facility. Branding is not the criterion to attract the customers, as the latter prefer low-priced products. Further, retailer’s suggestion and recommendation regarding any product or service plays a significant role in the customer’s purchase decision. Traditionally, retailers procure merchandise from wholesalers in bulk and sell in small quantities to the final consumers. Characteristics of Retailing Retailing is different from other forms of business in the following ways: • It offers direct interaction with customers/end customers. • Sales volume is comparatively large in quantities but less in monetary value as compared to exporting/manufacturing. • Customer service plays a vital role in the success of the retail business. • Sales promotions are offered at this point only. • In almost all countries, retail outlets are more popular than any other form of business. • Location and layout are critical factors in retail business. • It offers employment opportunities to all age groups irrespective of age and gender, qualification or religion 5.2.4 Retail Market Prospects in India

In India, the traditional forms of independently owned small business and cooperatives have lost their earlier charms. Though the arrival of organized retail in India is a bit late, but it is increasing by leaps and bounds. In 2005, the retail industry in India which amounted to `10,000 billion is expected to cross `20,000 billion by 2010 in which the organized sector will cross `1,250 million. Organized retailing in India is mainly present in the metro cities. However, few players are now eyeing Tier II and Tier III cities to explore the opportunities. The growth in Indian organized retail sector Self-Instructional 88 Material is mainly because of shift in consumer behaviour. This change has come due to the Wholesale and Retail Trade following reasons: • Rapidly increasing income level • Change in lifestyles NOTES • Favourable pattern of geography • Retail offering one-roof shopping experience • Increase in the number of nuclear families • Improved purchasing power of Indian middle class • Presence of domestic and foreign players • Effect of liberalization, privatization and globalization (LPG) • Mass inflow of FDI in Indian retail sectors • Emergence of new business sectors like ICT, engineering firms, outsourcing Opportunities in Retailing Retail industry is one of the largest contributors to Indian gross domestic product (GDP). The study at the Tata Strategic Management Group (TSMG) indicates that over the next decade, the Indian retail industry is likely to grow at a compounded annual growth rate (CAGR) of 5.5 per cent (at constant prices) to US$ 374 billion (`16,77,000 crore) in 2015. The organized retail market is expected to grow much faster, at a CAGR of 21.8 per cent to US$ 55 billion (` 2,46,000 crore) in the same time frame. The success story of Wal-Mart in small and remote areas of the US has further tempted Indian retailers to focus on smaller towns and rural parts of the country. It presents a tremendous opportunity for Indian retail industry (especially the organized retail) to grow and prosper. 5.2.5 Retailing Across the Globe

Since 2005, Indian retail industry has been hot sector of the Indian economy. The rapidly increasing middle class is catching the eyes of big players like Birla, Reliance, Wal-Mart, Bharti, and so on. The modern retail industry in Brazil, Russia, India and China (BRICs) is seen as having the maximum potential on growth worldwide. It grew by almost 30per cent in India and 13per cent in China and Russia last year. As the developed markets are becoming mature, retailers are eyeing new growth opportunities in the upcoming economies. According to A.T Kearney report, 2007, India held the 1st position successively for two years. In this landmark report, the growth prospects of thirty leading economies are considered. The ranking criteria have four broad categories: • Country risk • Market attractiveness • Market saturation and • Time pressure for a new entrant to start retail business

Self-Instructional Material 89 Wholesale and The report has ranked India on the top in terms of market saturation and time Retail Trade pressure as compared to Russia and China. India has got an aggregated score of 92, (First) followed by Russia at 89 (Second) and China with 86 (Third). NOTES 5.3 WHOLESALERS

Wholesalers and distributors are also known as merchants. They usually buy products from producers and take ownership or title of goods. The rationale for their existence is their cost-effective operation in buying goods in large quantities and reselling them in smaller, yet sizeable lots. Distributors act as intermediaries between manufacturers, wholesalers and retailers. While distributors purchase products for resale to wholesale and retail outlets, wholesalers market or sell merchandise to a retailer. In both cases, they do not sell directly to the consumer. Both wholesalers and distributors buy products from producers (often, from several producers) in large quantities, take title to it, and resell the merchandise. They generally specialize by type of product, industry or markets. There are two types of wholesalers: • Full service wholesalers • Limited service merchant wholesalers A full service wholesaler offers the widest possible range of functions. The main functions of the wholesalers are stock holding and sub-distribution. They provide warehousing and storage facilities and sometimes they take part in the marketing of product. Examples are a general merchandiser who offers a wide mix (unrelated), limited depth of products or a limited line merchandiser who offers only few products but an extensive assortment. Full service wholesalers also perform functions like promotion, collection of accounts receivables and provision of market feedback. They also provide credit and transportation to their customers, in general. Limited service merchant wholesalers only provide some functions. They buy products either from producers or full service wholesalers in bulk, break the bulk and resell the goods (mostly) to retailers in assortments needed by them. Like the full service wholesalers, they may perform some of the different wholesaling functions Check Your Progress that are part of the distribution process. 1. Define retailing. Examples of limited service merchant wholesalers are cash and carry 2. What is the role of a retailer in the wholesalers, who provide warehousing and storage but do not offer credit, customers retail business? pay and use their own transportation to take their purchases away; dop shippers or 3. What are the desk jobbers, they take title of the product, negotiate sales and even take the title of functions of a the item, but do not take possession. Goods or items are shipped by the manufacturer retailer from a directly. customer’s viewpoint? Benefits of a Retailer to the Wholesaler 4. Mention the two segments in the 1. Reducing transaction complexity: This concept can be better understood Indian retail industry. with an example. Let us take five companies and ten customers. If each and 5. What is a ‘kirana’ every customer makes at least one transaction per month with each of the store? companies, then he would have made five transactions per month and a total of ten customers will amount to a total number of 50 transactions. Each company Self-Instructional 90 Material has to deal with a minimum of 10 transactions per month. In reality, the number Wholesale and of customers will run into millions of customers. Thus, a company has to put Retail Trade aside its production and dedicate all its efforts in completing these million transactions effectively. In case of a credit transaction, a single transaction runs throughout the year. In case of a retailer, all the five companies make five NOTES transactions with the retailer and the ten customers make ten transactions with the company. Thus, the total number of transactions is fifteen only which is far better than the fifty transactions. From the point of a producer, without a retailer, he has to deal with ten customers, thus making ten transactions. On the other hand, if a retailer is there, each company has to make one transaction only. 2. Improves production efficiency: The transaction/exchange with a customer is exclusively taken care of by the retailer, reducing the burden on the part of the producer. Hence, a producer can take care of production exclusively; increasing the production efficiency, through his specialization in production. If a producer cannot specialize in production, then he cannot achieve the economies of scale, thus increasing the cost to the customer. 3. Economy and efficiency in exchanging: A producer will use a retailer when he believes that the retailer can perform the function more economically and efficiently than he can. A retailer is specialized in customer transaction management, thereby creating better exchanges with the customer, in terms of economy and quality. 4. Match supply and demand: Forecasting a demand for his goods, a manufacturer will produce the goods and supply to the retailer. A customer comes to a retailer with a demand for the required goods or services. A retailer understands the need of the customer and provides him with the required products or services, thus matching the demand with the supply. 5. Support to small suppliers: For small suppliers, retailers can provide assistance by transporting, storing, advertising and pre-paying for products. 6. Feedback: Retailers communicate both with manufacturers and wholesalers. Manufacturers and wholesalers are informed by their retailers with regard to sales forecasts, delivery delays, customer complaints, defective items, inventory turnover and more. Many goods and services have been modified due to retailer’s feedback. This allows the manufacturer to reach more customers, reduce costs, improve cash flows, increase sales more rapidly, and focus on his area of expertise.

5.4 ORGANIZATION OF WHOLESALE AND

RETAIL TRADE Check Your Progress 6. Who act as Retail organization enables the store to assign responsibilities, resources, policies and intermediaries rewards so that it can satisfy customers demands and the requirements of its target between market. Essential factors that must be considered while planning and assessing a manufacturers, wholesalers and retail organization are: retailers? 7. Which are the two types of wholesalers?

Self-Instructional Material 91 Wholesale and • From the Management Point of View Retail Trade o Is it possible to get the right employee for the right job? o Are HR policies clearly defined? NOTES o Are the levels of organization properly developed? o Are there proper arrangements for employee’s supervision and control? o Is there a need to motivate employees? o Is absenteeism an issue of concern? o Are the employees trained under position rotation system? o Is the store flexible enough to adapt to changes in customer preferences? o Are the duties of store employees working at different levels clearly defined? o Are the organization’s objectives clearly defined to all employees? • From the Employees’ Point of View o Is the employee turnover rate satisfactory? o Is the remuneration competitive enough? o Are employees welcome to participate in the decision making process? o Is the authority-responsibility relation properly balanced? o Are employees rewarded for showing good performance? o Is there partiality towards any employee? o What is the promotional policy? o Are employees promoted at regular intervals from within? o Is the job description properly laid down? • From Marketing Point of View o Does the store have adequate staff to attend to customers and to provide customer service? o Are changes in customers’ demands, likes and dislikes, and innovations properly addressed? o Are chain stores effectively maintained? o Is there a mechanism to understand the specific needs of branch stores? o Are employees knowledgeable and properly trained? o Is the complaint handling department properly maintained? 5.4.1 Process of Organizing a Retail Firm Retailing today is one of the most competitive industries in India. Some retailers pursue the strategy of providing better customer service, while others try to make shopping more pleasant by investing money in providing entertainment. The strategy that a retailer adopts is dependent on the performance of his subordinates. The process of organizing is nothing but developing an organizational chart, creating designations and assigning various tasks that will be performed on behalf of a retailer.

Self-Instructional 92 Material The process of organizing a retail firm basically has the five following steps: Wholesale and Retail Trade

Determination of tasks to be performed in a retail distribution channel

NOTES

Division of tasks among channel members and customers

Grouping the retailer’s tasks into responsibilities

Classification of jobs

Developing an organizational chart

As a policy matter, a retailer cannot survive unless its retail organization satisfies the needs and wants of the customers. In retailing a retailer, can compete with competitors only if the needs of customers are fulfilled. No one will give you credit and acknowledge how effectively the management and employees needs are being met. Thus, an organization structure that adopts the policy of central buying in order to cut costs but ignores the specific requirements of its various chain stores would be a fatal decision in the long run. This practice is normally common in newly-born retail stores but ultimately retailers will have to understand that individual attention should be given to buying, pricing, wrapping and displaying merchandise considering geographical and cultural differences. There are many ways of organizing to perform these functions and focus on customers, employees and management requirements. The process of setting up a retail organization is divided into five steps. These are discussed as follows: 1. Tasks to be performed: The general tasks in a retail organization vary from organization to organization and size to size but there are some common retail activities that are usually applicable to all sorts of retail distribution channels. • Arranging and buying merchandise for the retailer • Receiving merchandise and checking for its quality • Determining prices i.e. price setting/labelling • Marketing the merchandise • Inventory management and control including stores • Classifying merchandise and window displays • Store maintenance • Customer research and development cell • Customer complaint handling • Customer contact (e.g. personal selling, advertising) • HR management Self-Instructional Material 93 Wholesale and • Facilitating shopping (e.g. short check out queue, convenient site) Retail Trade • Customer billing section • Management of receipt and date recording • Payment operations (e.g. cash, credit.) NOTES • Gift wrapping • Coordination between various activities • Returning damaged, rejected or unsold goods to vendors • Sales forecasting and budgeting • Repairs and after sales service The effectiveness of above mentioned activities is necessary for successful retailing to occur. Yes, retailer can give preference to various activities but cannot get rid of any one. 2. Division of tasks among channel members and customers: Although the above mentioned various activities take place in a retail channel, the retailer is not supposed to accomplish all the tasks. Some of these activities are usually performed by the manufacturer or wholesaler, professional, customer or retailer itself. Table 5.1 shows the activities that are performed by different parties of the retail chain. Table 5.1 Division of Retail Activities Manufacturer or Wholesaler Manufacturer/wholesaler functions include pricing merchandise, inventory control, display layout preparation, research, sales forecasting, checking quality of incoming inventory, etc.

Professional Professional can take up these activities: site arrangement, R&D, advertising agency, warehousing, legal matters, credit maintenance, computer service provider, lift maintenance, etc. Customer Customer is responsible for: acceptance of delivery, bill payment, self service, selecting merchandise, product replacement (do it yourself). Retailer Retailer is normally responsible for buying merchandise and coordinating between various activities.

Note: If the store’s size is small, then most of the activities can be performed by him.

This is a list of possible activities that are normally performed in a retail chain. But an activity should be performed only if it is as per the needs of the target market. For example, free home delivery should not be provided unless required by the majority of the customers. In luxury and cosmetic retailing, customers would like to take their ornaments, cosmetic items with them but in case of grocery, they would require home delivery. Once a facility/activity is provided, it should be done with proper competence. For instance, customer follow-up and complaint handling activities may require a dedicated staff that could understand customer’s feelings and has soft communication skills. In case of some retail store, this activity can be handled by retailer itself but when the store grows in terms of size and volume of merchandise, it requires separate staff for both personal and telephonic customer care.

Self-Instructional 94 Material 3. Grouping tasks into responsibilities: After considering and finalising Wholesale and various retail activities, necessary to be performed in a store, the retailer groups these Retail Trade activities into job profile that will be handled by a particular employee/group of employees. To make retailing successful, various activities must be defined and properly grouped. Table 5.2 gives you an idea of how a retailer does task grouping NOTES and assigns tasks to jobs. Table 5.2 Grouping Tasks into Responsibilities Arranging and displaying merchandise, registering customers’ Floor Staff reactions, collecting customers’ views, gift wrapping, guide to customers Receiving inventory, checking for its quality, keeping record of issue Inventory Staff and receipt, inventory storage, returning inventory to vendors, making inventory. Management of receipts, ledger maintenance, providing poly Cashier bags/packaging materials, bills issue, maintaining data related to credit/card purchasing Inventory repairs, alterations and setting, attending queries, Customer Care complaints handling, R&D, follow up Staff Recruitment, training and development, sales forecasting, budgeting, HR staff pricing, coordination between various activities Cleaning store, washing floor, repairing shelves, racks and cabins Janitorial staff

Note: In order to avoid the problems of role conflict, a retailer should use the rule of ‘specialization’. According to the rule of specialization, each employee should be responsible for definite range of functions as per his expertise and depth of knowledge. Specialization results in role clarity, reduced training costs, greater efficiency and increased output. Specialization further results in right person doing the right job. After grouping the activities, job descriptions should be prepared. A job description, as the name implies, outlines the title of a job, objectives and expectations from a job in terms of duties and responsibilities. Job description further helps the HR department in recruitment, selection, supervision and assigning pay scales to each job title. 4. Classification of jobs: After grouping tasks into jobs, the next step in setting up a retail organization is to classify the jobs under functional, product, geographical, or a combination classification system. Under functional classification, jobs are divided in terms of various retail functions, like sales promotion, customer care, inventory management and store operations. Under products classification, jobs are divided on the basis of nature of goods and services. Thus, a retail store recruits different employees for apparel, vegetables and fruits, furniture, electronics, grocery, food and so on. Product classification is based on the concept that employees’ requirement in terms of experience, age, look, qualification varies from product to product. Under geographical classification, jobs are classified according to spread of the organization in various cities and states. Therefore, job locations are assigned in such a way that to the extent possible the employee should work in or near his home town. This benefits the organization too as the person is aware about the locality, its preferences and buying behaviour. For example, if recruitment is done by head office

Self-Instructional Material 95 Wholesale and and two shortlisted selected candidates belong to Garhwal, a hilly area then these two Retail Trade candidates should be offered a job at a store which is closest to Garhwal region. Under combination classification system, stores use more than one classification. NOTES For example, if a branch retail store of luxury items like jewellery, gold, diamond and platinum recruits its own staff for selling goods, but acquires employees for each product line from head office and controlled by head office, then it will be a combination of functional, geographical and product formats. 5. Developing an organizational chart: This is the last step of organizing a retail firm. For the purpose of understanding the concept, various organizational patterns are given as under: A. Organizational Pattern in Retailing by Function

Managing Director

Inventory HR Sales Store Security Manager Manager Promotion Operations In charge Manager Manager

B. Organizational Pattern in Retailing by Product

Store Director

Men’s Kids Furniture Sports Ladies Outwear Manager Manager Manager Outwear Manager Manager

C. Organizational Pattern in Retailing by Geography

Managing Director

Manager Manager Manager Manager Manager North South Central East Indian West Indian Indian Indian Operations Indian Operations Operations Operations Operations

Self-Instructional 96 Material D. Mixed Organizational Pattern Wholesale and Retail Trade As the name implies, these types of organizational patterns involve two or more organizational patterns. Thus, they have the features of various organizational patterns. These are used when the store is expanded in terms of branches, NOTES customers and variety of merchandise.

Managing Director

Inventory HR Sales Store Security Manager Manager Promotion Operations In charge Manager Manager

Manager Manager North Indian South Indian Manager Manager Operations Operations North Indian South Indian Operations Operations Manager Manager North Indian South Indian Manager Manager Manager Manager Operations Operations North Indian South Indian North Indian South Indian Operations Operations Operations Operations

Sports Furniture Manager Manager

Organizatonal Structures Applied by Small and Independent Retail Stores It has been observed that, in India, most of the small, independent and unorganized retailers usually use simple patterns consisting only of two or three levels of employees. There are few employees with hardly any specialization and no branch outlets. But this does not mean that fewer activities must be performed. In India, some independent stores are very big in size and have few decades of retailing tradition. The small independent retailers normally have long working hours and most of the supervision is done directly by the retail owner. Merchandising staff is involved with the buying and selling of goods and services, sales promotion, displays and advertisement. As such they have no separate marketing or advertisement departments. Staff has experience of working in several departments and performs varied duties. Figure 5.4 shows the organization of a furniture store. It shows how a furniture store owner has divided the store into five different departments on the basis of varied furniture. In Figure 5.5, a beauty product store is organized on the pattern of product differentiation with staff normally committed for selected activities. All product categories get due attention and some sort of expertise is developed. This expertise plays a vital role since different skills are necessary to buy and sell each type of furniture. Similarly, Figure 5.6 represents the organization structure of a local kiryana store while Figure 5.7 represents the organizational structure of an electronic appliances store.

Self-Instructional Material 97 Wholesale and Retail Trade Store Owner

NOTES Office Bedroom Living room Dining room Kitchen Furniture Furniture Furniture Furniture Furniture Staff Staff Staff Staff Staff

Fig. 5.4 Organizational Structure of a Furniture Store

Store Owner (Manager)

Herbal Bridal Cosmetic Jewellery Staff Products Staff Products Staff Products Staff

Fig. 5.5 Organizational Structure of a Beauty Products Store

Store Owner (Manager)

Dry Fruits Staff Grocery Staff Ghee and Oil Pickles and Jams Staff Staff

Fig. 5.6 Organizational Structure of a Kiryana Store

Store Owner (Manager)

Radio, TV, Air Conditioners Washing Machines Computer Staff VCD and DVD and Coolers and Kitchen Staff Staff Appliances Staff

Fig. 5.7 Organizational Structure of an Electronic Appliances Store

5.5 DEPARTMENTAL STORES Check Your Progress A traditional departmental store is a large retail outlet that offers a large variety and 8. State the rule of specialization. deep assortment and is organized into separate departments for the purpose of sale, 9. Define job display and promotion, customer service and control. Each department sells unique description. products and has its own sales, accounts, packaging and security staff. This type of

Self-Instructional 98 Material format is popular not only in India, but is well appreciated in many parts of the world. Wholesale and Retail Trade To be defined as a department store, usually it needs to fulfill the following conditions: • It must employ a minimum of 50 people as store staff • Most of the goods sold relate to FMCG and items of daily use NOTES • It should have proper balance between home furniture, consumer electronics, apparel and food • All the departments should generate a balanced contribution towards sales. For instance, not more than 80 per cent of annual sales can come from a single product line

Department Stores at a Glance • Big Bazaar • C3 Cost, (Comfort and Convenience) • Food World • Marks and Spencer • More….. – An Aditya Birla Group Venture • Pantaloons • Reliance Fresh • Shopper’s Stop • Six to Ten • Spencer’s • Spinach • Vishal Mega Mart • Gokul Mega Mart • Pocket Friendly Mega Mart In India, apparel and furnishing are two common categories found in most department stores. The major India department stores like Ebony, Shopper’s Stop, Westside, Music World, Globus and Lifestyle deal in women’s, men’s and kids’ clothing as well as furniture, jewellery, kitchenware and furnishings.

Traditional Department Stores A traditional department store offers several product lines – typically clothing, household goods, jewellery and home furnishings. Each department within the store has a separate line, managed by specialist buyers or merchandises and offer mid-to high quality products. Features: Size : 20,000 – 40,000 sq. ft Pricing : Moderate to above average Customer service : High level Product category : General Ownership structure : Corporate chain Pricing Strategy : Competitive Keeping pace with technology : Yes

Self-Instructional Material 99 Wholesale and 5.5.1 Multiple Shops Retail Trade This term refers to retail organizations that have a central operational headquarters and a collection of branch stores under common ownership. Most of the retail chain NOTES stores are corporate/company owned and controlled. The term most should not be confused with all because some of the retail chains are family owned businesses. The function of defining and implementing a strategy is centralized. Most of the chains have a well-defined management philosophy and overall strategies with similar formats, uniform image and identity, and methods of operations in all their stores. The biggest advantage of operating a chain store is the ability to reduce costs through economies of scale. By purchasing in large quantities, the big chains can buy at reduced costs, thereby gaining the ability to pass on the lower costs to their customers. The large volumes also allow these retailers to negotiate with suppliers for a lower product cost. Due to their size, chains have the advantage of using information technology more efficiently than smaller retailers. Many large chains, such as future group, RPG can monitor instantly what is currently selling and what remains in inventory. Technology allows chains to link directly with suppliers and have merchandise shipped when it falls below a given level. Retail chains can hire and train the best and brightest minds in retail business and have specialists for each functional area within the business. Chain store operations also have some disadvantages. The biggest drawback is the cost associated with running a large operation. As the chain’s size increases, so do its financial commitments. Furthermore, big chains take time in responding to environmental changes due to bureaucracy. Another disadvantage is the difficulty in tailoring the product assortment to different geographic areas. To take advantage of economies of scale, chains often purchase the same products for all their stores. The advantages and disadvantages are summarised as follows: Advantages • Economies of scale • Bargaining power • Efficiency and cost-effectiveness through technology • Organized and systematic – has a management philosophy and policy • Long-range planning Disadvantages • Low flexibility • High investment costs and risk • Limited independence among personnel • Slow response or change to environmental demands • Low customization 5.5.2 Super Market A supermarket is a departmentalized grocery store with a wide range of dairy products and household items such as soft and hard drinks (wherever allowed to be sold), household cleaning products, shampoos, soaps, clothes, medicines and plastic items.

Self-Instructional 100 Material A supermarket offers a large retail facility with a huge range of merchandise under Wholesale and the same roof. The products are offered at low prices by shrinking margins. Retail Trade Supermarkets usually rely on high inventory turnover and are built either near a residential area or on the outskirts of the city. Customers in supermarkets use ‘trolleys’ or ‘baskets’ for collecting their desired products and pay for the same at the checkout NOTES counters (billing sections) located near the exits. However, conventional supermarkets are facing intense competition from the traditional, cost-effective and consumer savvy ‘kirana’ stores and other types of food outlets. Supermarkets, in India, are one of the fast growing segments but so far there is no standard criterion for a supermarket format. Even many traditional ‘kirana’ stores are refurbishing their shops/retail outlets and advertising themselves as supermarkets. They use the Every Day Low pricing (EDLP) selling policy to build store traffic and provide a one-stop shopping.

Supermarket at a Glance A conventional supermarket is relatively large, low-priced, low-margin, high- volume, self-service operation designed to serve variety needs for food and household items. Other benefits include convenient shopping hours and space for parking. Features: Location : Near/edge of town Size : Large Product range : Vast range, deep and broad Pricing policy : Low pricing Selling theme : Every Day low Pricing (EDLP) Target market : Mass Atmosphere : Busy and well organized Service level : self service

5.6 MERCANTILE AGENTS AND THEIR FUNCTIONS

The term, agency, is used to connote the relation that exists where one person has an authority or capacity to create legal relations between a person occupying the position of principal and third parties. The relation of agency arises whenever one person called the agent, has authority to act on behalf of another called the principal and consents to act. The contract of agency may be in writing under seal (i.e, a power of attorney) or it may be a simple writing or it may be an oral agreement.

An agent is a person employed to do any act for another or to represent another Check Your Progress in dealings with third persons. The person for whom such act is done or who is so represented is called a principal. Any person who is of age according to the law to 10. Define a departmental store. which he is subject to and is of sound mind can employ an agent. 11. What do multiple Agents are usually of two kinds: shops refer to? Mercantile 12. Define a • supermarket. • Non-mercantile

Self-Instructional Material 101 Wholesale and The following are the different kinds of mercantile agents: Retail Trade • Broker: A broker is a mercantile agent who has been appointed to negotiate and enter into a contract for sale or purchase of goods while the possession and control of the goods is with his principal. NOTES • Factor: A factor is a mercantile agent who has the authority to sell or dispose goods which are in his possession. • Auctioneer: An auctioneer is a mercantile agent who sells goods by way of public offer to the highest bidder for the principal. • Del credere: A Del credere mercantile agent is one who establishes contract between his principal and a third party. Here, the mercantile agent also guarantees to the principal the performance of the contract by the third party. A Del credere is not liable to the third party for an act of default by the principal. • Commission mercantile agent: A commission mercantile agent is one who is appointed by his principal to purchase goods in the market on behalf of the principal for which a commission is charged by the agent. Commission agents are of two kinds: o Kuchhaarhatya: He is similar to a broker. He brings the buyer and the seller together so that they can negotiate and then collects a brokerage from the contract made. o PakkaArhatya: Sells or purchases goods in his name without disclosing the name of the principal The duties of a mercantile agent are: • Duty to act according to directions or customs of trade [Sec. 211 of Sales of Goods Act]: The mercantile agent is the one who is responsible to act as per the direction of the principal. But he cannot act of his own even on certain terms which could be associated to common prudence. Hence, he has a duty to act according to the directions of the trade in which he is entrusted with the responsibility of the concerned work. • Duty to act with reasonable care and skill [Sec. 212 of Sales of Goods Act]: As far as any work is concerned, the mercantile agent in no matter be deviated with the due care and skill which is linked with his work. This ordinarily means the due care and attention should be paid for the work to be completed. • Duty to render accounts [Sec. 213 of Sales of Goods Act]: This is accountability of the agent towards his principal and his work. He has to honestly maintain the book of accounts with every sale and have to submit to his principal. This helps two ways; one being clear with the superior and second is to be clear with tax authorities. • Duty to communicate with the principal and obtain his instructions [Sec. 214 of Sales of Goods Act]: This primarily means the instructions to be received by the superior and to act on it as the agent is having no authority to conclude the contracts. • Duty to obtain principal’s consent in personal dealings [Sec. 215 of Sales of Goods Act]: While any agent is also making some personal dealings on his own behalf with the customers he need to acquaint the principal for this. Not only this but also a formal permission is required to be taken from the same for any dealing in name of business. Self-Instructional 102 Material • Duty to disclose all material circumstances [Sec. 216 of Sales of Goods Wholesale and Act]: The agent is bound to disclose all the relevant aspect of his dealing to his Retail Trade boss and to the customers as well. This makes him accountable to both the parties he is having duties to answer. The agent is actually also representing the repute of the principal and also giving an account of the material in market. If NOTES he makes any wrong deliberations he is not only losing the repo with the principal but also he is making his goods not having sale in market. • Duty to remit sums [Sec. 217 and Sec. 218 of Sales of Goods Act]: The sums he own to the principal should be remitted to him only, as it is seen that actually it is the agent gaining on behalf of the principal. Hence, it is his utter duty to give the money back to his legal holder. • Duty to protect and preserve the interest continued to him [Sec. 219 of Sales of Goods Act]: Same as stated before the repute of the goods and that of his principal are within the hands of the mercantile agent. His acts should not harm the overall work of the business confided in him. He should not only preserve the very interest of the work assigned to him but also protect the very reputation of the goods in market. Here, the goods are representing his principal. • Duty not to delegate [Sec. 190 of Sales of Goods Act]: In no circumstances did the work assigned to any agent should be further delegated, which means that the work associated or entrusted to one person should remain with that person only. In case if it is further delegated this would hamper the very business ethics and quality.

5.7 SUMMARY

• Retailing consists of selling merchandise from a permanent location (a retail store) in small quantities directly to consumers. • A retailer purchases goods or merchandise in bulk directly from a manufacturer or a whole seller and then sells the merchandise in small quantities to consumers. • The place where he sells the merchandise directly to the consumer is known as retail shop or store. • Retailing is the last stage in a channel of distribution, which consists of all the trades and people involved in the physical movement and transfer of ownership of goods and services from manufacturer to the final consumer. • Retailer plays a key role as the contact between manufacturers, wholesalers and the final consumers. Retailers are the gatekeepers to the market for all other members of the sales distribution process. • The benefit of sorting process is that according to the variety of merchandise and business complexity, it can be changed into different shapes, consequently, a manufacturer becomes more effective and ultimately consumers find this Check Your Progress comfortable and convenient as they get different goods and services under one 13. What are the two roof and in as much quantity as they need. kinds of agents? • The retailer serves the manufacturer by providing his goods and services to the 14. Who is a broker? 15. Define a consumers and creates a channel of information where customers’ feedback, commission their expectations and points of dissatisfaction, if any, are shared with the mercantile agent. manufacturer. Self-Instructional Material 103 Wholesale and • From the customer’s point of view, the retailer’s main function is to provide Retail Trade merchandise in the right quality, quantity, price, time, and at the right place. • In short, retailers are not only the final link between the consumers and the manufacturers but a vital part of modern business world. NOTES • The Indian retail industry is broadly divided into two segments: (i) Organized retailing (ii) Unorganized retailing • The unorganized retailing comprises of ‘mom and pop’ stores or ‘kirana’ stores. These are very small shops located near the residential areas, popularly known as ‘baniya shops’. The unique selling proposition (USP) of these stores is the location advantage. • In India, the traditional forms of independently owned small business and cooperatives have lost their earlier charms. • Organized retailing in India is mainly present in the metro cities. However, few players are now eyeing Tier II and Tier III cities to explore the opportunities. • The report has ranked India on the top in terms of market saturation and time pressure as compared to Russia and China. • Wholesalers and distributors buy products from producers (often, from several producers) in large quantities, take title to it, and resell the merchandise. They do not sell directly to the consumer. • There are two types of wholesalers: (i) Full service wholesalers (ii) Limited service merchant wholesalers • Retail organization enables the store to assign responsibilities, resources, policies and rewards so that it can satisfy customers demands and the requirements of its target market. • Some retailers pursue the strategy of providing better customer service, while others try to make shopping more pleasant by investing money in their entertainment. The strategy that a retailer adopts is dependent on the performance of his subordinates. The process of organizing is nothing but developing an organizational chart, creating designation and assigning various tasks that will be performed on behalf of a retailer. • In order to avoid the problems of role conflict, a retailer should use the rule of specialization. According to the rule of specialization, each employee should be responsible for definite range of functions as per his expertise and depth of knowledge. • After grouping tasks into jobs, the next step in setting up a retail organization is to classify the jobs under functional, product, geographical, or a combination classification system. • A traditional department store is a large retail outlet that offers a large variety and deep assortment and is organized into separate departments for the purpose of sale, display and promotion, customer service and control. • The term, multiple shops, refers to retail organizations that have a central operational headquarters and a collection of branch stores under common

Self-Instructional 104 Material ownership. Most of the retail chain stores are corporate/company owned and Wholesale and controlled. Retail Trade • A supermarket is a departmentalized grocery store with a wide range of dairy products and household items such as soft and hard drinks (wherever allowed to be sold), household cleaning products, shampoos, soaps, clothes, medicines NOTES and plastic items. • Agents are usually of two kinds: o Mercantile o Non-mercantile • The different kinds of mercantile agents are— broker, factor, auctioneer, Del credere, and commission mercantile agents.

5.8 KEY TERMS

• Retailing: Retailing consists of selling merchandise from a permanent location (a retail store) in small quantities directly to consumers. • Wholesalers: Wholesalers buy products from producers (often, from several producers) in large quantities, take title to it, and resell the merchandise to the retailer; they do not sell directly to the consumer. • Department store: A traditional department store is a large retail outlet that offers a large variety and deep assortment and is organized into separate departments for the purpose of sale, display and promotion, customer service and control. • Multiple shops: The term, multiple shops, refers to retail organizations that have a central operational headquarters and a collection of branch stores under common ownership. • Supermarket: A supermarket is a departmentalized grocery store with a wide range of dairy products and household items such as soft and hard drinks (wherever allowed to be sold), household cleaning products, shampoos, soaps, clothes, medicines and plastic items. • Agent: An agent is a person employed to do any act for another or to represent another in dealings with third persons.

5.9 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. Retailing consists of selling merchandise from a permanent location (a retail store) in small quantities directly to consumers. 2. The retailer plays a key role as the contact between manufacturers, wholesalers and the final consumers. Retailers are the gatekeepers to the market for all other members of the sales distribution process. 3. From the customer’s point of view, the retailer’s main function is to provide merchandise in the right quality, quantity, price, time, and at the right place. 4. The Indian retail industry is broadly divided into two segments: • Organized retailing • Unorganized retailing Self-Instructional Material 105 Wholesale and 5. Kirana stores are very small shops located near the residential areas, popularly Retail Trade known as baniya shops. The unique selling proposition (USP) of these stores is the location advantage. 6. Distributors act as intermediaries between manufacturers, wholesalers and NOTES retailers. 7. There are two types of wholesalers: • Full service wholesalers • Limited service merchant wholesalers 8. According to the rule of specialization, each employee should be responsible for definite range of functions as per his expertise and depth of knowledge. 9. A job description, as the name implies, outlines the title of a job, objectives and expectations from a job in terms of duties and responsibilities. 10. A traditional department store is a large retail outlet that offers a large variety and deep assortment and is organized into separate departments for the purpose of sale, display and promotion, customer service and control. 11. The term, multiple shops, refers to retail organizations that have a central operational headquarters and a collection of branch stores under common ownership. 12. A supermarket is a departmentalized grocery store with a wide range of dairy products and household items such as soft and hard drinks (wherever allowed to be sold), household cleaning products, shampoos, soaps, clothes, medicines and plastic items. 13. The two kinds of agents are— mercantile and non-mercantile. 14. A broker is a mercantile agent who has been appointed to negotiate and enter into a contract for sale or purchase of goods while the possession and control of the goods is with his principal. 15. A commission mercantile agent is one who is appointed by his principal to purchase goods in the market on behalf of the principal for which a commission is charged by the agent.

5.10 QUESTIONS AND EXERCISES

Short-Answer Questions 1. What are the ways in which retailing is different from other forms of business? 2. Write a short note on retail market prospects in India. 3. Write a short note on retailing across the globe. 4. Distinguish between full service wholesalers and limited service merchant wholesaler. 5. What are the advantages and disadvantages of multiple shops? Long-Answer Questions 1. Discuss the concept of retail trade. What are the functions of a retailer? 2. What are the basic principles of retail business? Self-Instructional 106 Material 3. Discuss the steps involved in the process of setting up a retail organization. Wholesale and Retail Trade 4. Explain the duties of a mercantile agent.

5.11 FURTHER READING NOTES

Weston, J Fred, Kwang S. Chung and Susan E. 1990. Hoag. Mergers, Restructuring and Corporate Control. New Jersey: Prentice Hall. Horne, James C. Van. 2002. Financial Management. New Jersey: Prentice Hall. Brealey, Richard A., Stewart C. Myers and Franklin Allen. 2008. Principles of Corporate Finance. New York: McGraw-Hill. Pandey, I. M. 2010. Financial Management. New Delhi: Vikas Publishing House. Muralidharan. 2009. Modern Banking: Theory and Practice. New Delhi: PHI Learning Private Ltd. Maheshwari, S. N. 1983.Banking Law and Practice. New Delhi: Kalyani Publishers. Gordon E. and K. Natrajan.1992. Banking: Theory, Law and Practice. Mumbai: Himalaya Publishing House. Sharma, K.C. 2007. Modern Banking in India. New Delhi: Deep and Deep Publications.

Self-Instructional Material 107

Banking and UNIT 6 BANKING AND INSURANCE Insurance Sectors SECTORS NOTES Structure 6.0 Introduction 6.1 Unit Objectives 6.2 Banking Sector 6.3 Commercial Banks 6.3.1 Functions of Commercial Banks and the Services Rendered by Them 6.3.2 General Structure and Methods of Commercial Banking 6.3.3 Earning Assets of a Bank 6.4 Systems of Banking 6.5 Investment Banking and Mixed Banking 6.6 Universal Banking 6.7 Merchant Banking 6.8 Virtual Banking 6.9 Green Banking 6.10 Central Banking 6.10.1 Functions of a Central Bank; 6.10.2 Secondary Reserve Requirements 6.10.3 As Banker and Advisor of the State; 6.10.4 Recent Trends in Central Banking 6.11 Insurance Sector 6.11.1 Insurance Transaction 6.12 Summary 6.13 Key Terms 6.14 Answers to ‘Check Your Progress’ 6.15 Questions and Exercises 6.16 Further Reading

6.0 INTRODUCTION

Banking had traditionally remained a protected industry in many economies, especially emerging economies. Regulated deposit and lending rates and restrictions of competition enabled comfortable spreads. There existed only a very limited pressure on banking institutions to come out of this quiescent and protected world. A variety of developments have compelled banks to change the old ways of doing business. These include, among others, advancements in information technology, increased emphasis on shareholder value, the problems of South-East Asian economies, the recessionary trends in the Japanese economy, the financial sector problems encountered in Latin American economies and more recently, in some Central European economies, pressures of disintermediation arising from a liberalized market place, macroeconomic pressures and banking crises in 1990s. All these have provided graphic evidence of how a weak banking sector can undermine confidence in macroeconomic policies. It is, therefore, no longer possible for developing economies to delay the introduction of structural reforms, stricter prudential and supervisory norms, greater transparency and increased accountability, not only to ensure the stability of the financial system, but also to enhance competitiveness. A well-developed and evolved insurance sector is a boon for economic development of a country. It provides long-term funds for infrastructure development and concurrently strengthens the risk-taking ability of the country. India’s rapid rate of economic growth over the past decade has been one of the most significant developments in the global Self-Instructional Material 109 Banking and economy. In this unit, you will study about the functions of banking and insurance sector Insurance Sectors in detail. Monetary policy, systems of banking, mechanism of credit creation along with the components of insurance policy have also been touched upon.

NOTES 6.1 UNIT OBJECTIVES

After going through this unit, you will be able to: • Discuss the functions of the banking and insurance sectors • Analyse the general structure and methods of commercial banking • Describe the mechanism of credit creation • Analyse the systems of banking • Discuss the functions of central bank • Define monetary policy and discuss its instruments • Define insurance from the viewpoint of the individual and the society • Categorize the components of the insurance policy

6.2 BANKING SECTOR

India is considered among the top economies in the world, with tremendous potential for its banking sector to flourish. The last decade witnessed a significant upsurge in transactions through ATMs, as well as internet and mobile banking. The country’s banking industry looks set for greater transformation. With the Indian Parliament passing the Banking Laws (Amendment) Bill in 2012, the landscape of the sector has duly changed. The bill allows the Reserve Bank of India (RBI) to make final guidelines on issuing new licenses, which could lead to a greater number of banks in the country. The style of operation is also slowly evolving with the integration of modern technology into the banking industry. In the next 5-10 years, the sector is expected to create up to two million new jobs driven by the efforts of the RBI and the Government of India to expand financial services into rural areas. Two new banks have already received licenses from the government, and the RBI’s new norms will offer incentives to banks to spot bad loans and take necessary recourse to curb the practices of rogue borrowers. Market size The size of banking assets in India totalled US$ 1.8 trillion in the financial year 2013 and is expected to touch US$ 28.5 trillion in the financial year 2025. Bank deposits have grown at a compound annual growth rate (CAGR) of 21.2 per cent over the financial year 06-13. In 2013, total deposits were US$ 1,274.3 billion. The revenue of Indian banks increased from US$ 11.8 billion to US$ 46.9 billion over the period 2001-2010. Profit after tax also reached US$ 12 billion from US$ 1.4 billion in the period. Credit to housing sector grew at a CAGR of 11.1 per cent during the period 2008- 13. Total banking sector credit is anticipated to grow at a CAGR of 18.1 per cent (in terms of INR) to reach US$ 2.4 trillion by 2017.

Self-Instructional 110 Material In 2014, private sector lenders experienced significant growth in credit cards and Banking and personal loan businesses. ICICI Bank saw 141.6 per cent growth in personal loan Insurance Sectors disbursement in 2014, as per a report by Emkay Global Financial Services. The bank also experienced healthy growth of 20.8 per cent in credit card dues, according to the report. Axis Bank’s personal loan business also grew 49.8 per cent, with its credit card NOTES business expanding by 31.1 per cent. Investments HDFC Bank and state-owned United Bank of India plan to tap the equity markets to raise funds to enhance capital base and lending. HDFC Bank plans to raise ` 10,000 crore (US$ 1.66 billion) while the board of Kolkata-based United Bank will seek approval for raising about ` 1,300 crore (US$ 216.47 million) by selling shares to increase its capital base. Export-Import Bank of India (Exim Bank) will increase its focus on supporting project exports from India to South Asia, Africa and Latin America, as per Mr Yaduvendra Mathur, Chairman and MD, Exim Bank. The bank has moved up the value chain by supporting project exports so that India earns foreign exchange. In 2012-13, Exim Bank had lent support to 85 project export contracts valued at ` 24,255 crore (US$ 4.03 billion) secured by 47 companies in 23 countries. IndusInd Bank will soon begin its asset reconstruction business. The private- sector lender plans to partner asset reconstruction companies (ARCs) for this venture. ‘I think our new initiative, which is going to launch in the next two months, is about asset reconstruction. We will do asset reconstruction within the bank but in tie-ups with ARCs. The business plan is ready. We believe a huge stock of assets is coming into the ARCs as a business area that we need to look at and we will exploit,’ as per Mr Romesh Sobti, CEO and MD, IndusInd Bank. Jammu and Kashmir (J&K) Bank plans to increase its presence outside India. The bank is looking to establish branches in London and Dubai to enhance its relationship with current customers who have business interests in West Asia and Europe. ‘We have a number of business relationships in these countries and it makes sense for us to have a presence there,’ as per Mr Mushtaq Ahmad, Chairman and CEO, J&K Bank. Government Initiatives The RBI has announced a few measures in its bi-monthly monetary policy on 3 June 2014 which includes an increase in the foreign exchange remittance limit to US$ 125,000 from the previous limit of US$ 75,000. State Bank of India (SBI) has announced a one-year rural fellowship programme ‘SBI Youth for India (SBI YFI)’ for 2014 to draft the country’s youth to become change agents in the country’s rural regions. The programme is for young professionals who are keen to lead the change for a better India. The RBI has simplified the rules for credit to exporters. Exporters can now receive long-term advance credit from banks for up to 10 years to service their contracts. Exporters have to have a satisfactory record of three years to receive payments from banks, who can adjust the payments against future exports. The RBI has enabled overseas investors, including foreign portfolio investors (FPIs) and non-resident Indians (NRIs), to invest up to 26 per cent in insurance and related activities through the automatic route. Self-Instructional Material 111 Banking and Insurance Sectors 6.3 COMMERCIAL BANKS

Commercial banks are organized on a joint stock company system, primarily for the NOTES purpose of earning a profit. They can be either of the branch banking type, as seen in most of the countries, with a large network of branches, or of the unit banking type, as seen mainly in the USA, where a bank’s operations are confined to a single office or to a few branches within a strictly limited area. Although, the commercial banks attract deposits of all kinds—current, savings and fixed—their resources are chiefly drawn from current deposits which are repayable on demand. So, they attach much importance to the liquidity of their investments and as such they specialize in satisfying the short- term credit needs of business rather than the long-term. 6.3.1 Functions of Commercial Banks and the Services Rendered by Them The two essential functions of a commercial bank may best be summarized as the borrowing and the lending of money. They borrow money by taking all kinds of deposits. Deposits may be received on current account whereby the banker incurs the obligation to repay the money on demand. Interest is not payable on current account deposits. When deposits are received on savings bank account as well, the bank undertakes the obligation to repay them on demand. Interest is usually allowed on savings bank deposits although there are usually restrictions on the total amount that can be withdrawn and/or the number of times withdrawals are allowed during a defined period. When deposits are received on fixed deposit accounts, the banker incurs the obligation to repay the money together with an agreed rate of interest after the expiry of a fixed period. When deposits are received on deposit accounts, the banker undertakes to repay the customer together with an agreed rate of interest in return for the right to demand from him an agreed period of notice for withdrawals. In addition, a new banking account, which is similar to savings bank account, known as flexi bank account has been introduced by banks. Thus, a commercial bank mobilizes the savings of the society. This money is then provided to those who are in need of it by granting overdrafts or fixed loans or by discounting bills of exchange or promissory notes. In short, the primary function of a commercial bank is that of a broker and a dealer in money. By discharging this function efficiently and effectively, a commercial bank renders a very valuable service to the community by increasing the productive capacity of the country and thereby accelerating the pace of economic development. It gathers the small savings of the people, thus reducing the quantity of idle money to the lowest limits. Then, it combines these small holdings in amounts large enough to be profitably employed in those enterprises where they are most called for and most needed. Here it makes capital effective and gives industry the benefits of capital, both of which otherwise would have remained idle. For instance, take the practice of discounting bills of exchange. By converting future claims into present money, the commercial bank bridges the time element between the sale and the actual payment of money. This will enable the seller to carry on his business without any hindrance; and the buyer will get enough time to realize the money. Thus, a commercial bank receives deposits which it has to repay according to its promise and makes them available to those who are really in need of them. The bank is actually distributing its deposits between the borrowers and its own vaults. Herein, lies the most delicate of the functions of a commercial bank.

Self-Instructional 112 Material Besides these two main functions, a commercial bank performs a variety of other Banking and functions which may broadly be grouped under two main heads, viz., the agency services Insurance Sectors and the general utility services.

1. Agency Services NOTES A commercial bank provides a range of investment services. Customers can arrange for dividends to be sent to their bank and paid directly into their bank accounts, or for the bank to detach coupons from bearer bonds and present them for payment and to act upon announcements in the press of drawn bonds, coupons payable, etc. Orders for the purchase or sale of stock exchange securities are executed through the banks’ brokers who will also give their opinions on securities or lists of securities. Similarly, banks will make applications on behalf of their customers for allotments arising from new capital issues, pay calls as they fall due and ultimately obtain share certificates or other documents of title. On certain agreed terms, the banks will allow their names to appear on approved prospectuses or other documents as bankers for the issue of new capital; they will receive applications and carry out other instructions. A commercial bank undertakes the payment of subscriptions, premiums, rent, etc., on behalf of its customers. Similarly, it collects cheques, bills of exchange, promissory notes, etc., on behalf of its customers. It also acts as a correspondent or representative of its customers, other banks and financial corporations. Most of the commercial banks have an ‘Executor and Trustee Department’. Some may have affiliated companies to deal with this branch of business. They aim to provide a complete range of trustee, executor or advisory services for a small charge. The business of banks acting as trustees, executors, administrators, etc., has continuously expanded with considerable usefulness to their customers. By appointing a bank as an executor or trustee of his/her will, the customer secures the advantage of continuity, avoiding to have made changes, impartiality in dealing with beneficiaries and in the exercise of discretions and the legal and specialized knowledge pertaining to executor and trustee services. When a person dies without making a will, the next-of-kin can employ the bank to act as administrator and to deal with the estate in accordance with the rules relating to intestacies. Alternatively, if a testator makes a will but fails to appoint an executor, or if an executor is unable or unwilling to act, the bank can usually undertake the administration with the consent of the persons who are immediately concerned. Banks will act solely or jointly with others in these matters, as also in the case of trustee for stocks, shares, funds, properties or other investments. Under a declaration of trust, a bank undertakes the supervision of investments and distribution of income; a customer’s investments can be transferred into the bank’s name or control, thus enabling it to act immediately upon a notice of rights issue, allotment letters, etc. Alternatively, where it is not desired to appoint the bank as nominee, these services may still be carried out by appointing the bank as attorney. Where business is included in an estate or trust, a bank will provide for its management for a limited period, pending its sale to the best advantage as a going concern or transfer to a beneficiary. Private companies wishing to set up pension funds may appoint a bank as custodian, trustee and investment advisor, while retaining the administration of the scheme in the hands of the management of the fund. Most banks will undertake the preparation of income tax returns on behalf of their customers and claim for the recovery of overpaid tax. They also assist the customers

Self-Instructional Material 113 Banking and in checking the assessments. In addition to the usual claims involving personal allowances Insurance Sectors and reliefs, claims are prepared on behalf of residents abroad, minors, charities, etc. 2. General Utility Services NOTES These services are those in which the bank’s position is not that of an agent for his customer. They include the issue of credit instruments like letters of credit and travellers’ cheques, the acceptance of bills of exchange, the safe custody of valuables and documents, the transaction of foreign exchange business, acting as a referee as to the respectability and financial standing of customers, providing specialized advisory service to customers, etc. • Banker’s Drafts and Letters of Credit By selling drafts or orders and by issuing letters of credit, circular notes, travellers’ cheques, etc., a commercial bank is discharging a very important function. A banker’s draft is an order, addressed by one office of a bank to any other of its branches or by any one bank to another, to pay a specified sum to the person concerned. A ‘letter of credit’ is a document issued by a banker, authorizing some other bank to whom it is addressed, to honour the cheques of a person named in the document, to the extent of a stated amount in the letter and charge the same to the account of the grantor of the letter of credit. A letter of credit includes a promise by the issuing banker to accept all bills of exchange to the limit of credit. When the promise to accept is conditional on the receipt of documents of title to goods, it is called a ‘documentary letter of credit’. When the promise is unconditional, it is called a ‘clean letter of credit’. Letters of credit may again be classified as revocable and irrevocable. A ‘revocable letter of credit’ is one which can be cancelled at any time by the issuing banker. But the banker will still be liable for bills negotiated before cancellation. An ‘irrevocable letter of credit’ is one which cannot be cancelled before the expiry of the period of its currency. ‘Circular letters of credit’ are generally intended for travellers who may require money in different countries. They may be divided into ‘travellers letter of credit’ and ‘guarantee letters of credit’. A ‘travellers letter of credit’ carries the instruction of the issuing bank to its foreign agents to honour the beneficiary’s drafts, cheques, etc., to a stated amount which it undertakes to meet on presentation. While issuing a ‘guarantee letter of credit’, the bank secures a guarantee for reimbursement at an agreed rate of interest, or it may insist on sufficient security for the grant of credit. There is yet another type which is known as ‘revolving credit’. Here the letter is so worded that the amount of credit available automatically reverts to the original amount after the bills negotiated under them are duly honoured. • Circular Notes, Travellers Cheques, Circular Cheques Circular notes are cheques on the issuing banker for certain round sums in his own currency. On the reverse side of the circular note is a letter addressed to the agents specifying the name of the holder and referring to a letter of indication in his hands, containing the specimen signature of the holder. The note will not be honoured unless the letter of indication is presented. Travellers’ cheques are documents similar to circular notes with the exception that they are not accompanied by any letter of indication. Circular cheques are issued by banks in certain countries to their agents abroad. These agents sell them to intending visitors to the country of the issuing bank.

Self-Instructional 114 Material • Safe Custody of Valuables Banking and Insurance Sectors Another important service rendered by a modern commercial bank is that of keeping in safe custody valuables such as negotiable securities, jewellery, documents of title, wills, deed-boxes, etc. Some branches are also equipped with specially constructed strong NOTES rooms, each containing a large number of private steel safes of various sizes. These may be used for a small fee. Each user is provided with the key of an individual safe and thus not only obtains protection of his/her valuables but also retains full personal control over them. The safes are accessible at any time during banking hours, and often longer. • Night Safes For shopkeepers and other customers who handle large sums of money after banking hours, ‘night safes’ are available at many banks. Night safe takes the form of a small metal door on the outside wall of the bank, accessible from the street, behind which there is a chute connecting with the bank’s strong room. Customers who require this service are provided with a leather wallet, which they lock before placing in the chute. The wallet is opened by the customer when he calls at the bank the next day to get the contents credited to his account. • Referee as to the Respectability and Financial Status of the Customer Another function of great value, both to banks and businessmen, is that of the bank acting as a referee as to the respectability and financial status of the customer. o Bank Giro Among the services introduced by a modern commercial bank during the last quarter of a century or so, the ‘bank giro’ and ‘credit cards’ deserve special mention. The ‘bank giro’ is a system by which a bank customer with many payments to make, instead of drawing a cheque for each item, may simply instruct his bank to transfer to the bank accounts of his creditors the amount due from him. He writes one cheque debiting his account with the total amount. Credit advices containing the name of each creditor with the name of his bank and branch will be cleared through the ‘credit clearing’ of the clearing house, which operates in a similar way as for the clearing of cheques. Even non-customers of a bank may make use of this facility for a small charge. A direct debiting service is also operated by some banks. This service is designed to assist organizations which receive large number of payments on a regular basis. A creditor is thereby enabled, with the prior approval of the debtor, to claim any money due to him direct from the debtor’s bank account. To some organizations, for example, insurance companies, which receive, say, six equal sums on six dates in a year, the scheme is only an extension of the standing order facility but for the public utilities and traders which send out invoices for valuable amounts at differing times, the scheme is an entirely new one. o Credit Cards A credit card is basically a payment mechanism which allows the holder of the card to make purchases without any immediate cash payment. Credit limit is fixed by the issuing bank and the limit is determined by the financial history as well as the type of card. Users are issued with a card on production of which their signatures are accepted on invoices in merchant establishments participating in the scheme. The issuing bank makes the payment to the merchant establishment selling the relevant goods or services. The Self-Instructional Material 115 Banking and holder to whom the card is issued, in turn, reimburses the bank on receipt of the billing Insurance Sectors statement. Generally it is not necessary to reimburse the bank with the entire amount on the billing statement. After making payment of the minimum amount due every month, the balance could be staggered over a period. Of course, outstanding balance plus any NOTES overdue will attract service charge at a certain rate. Also, users are generally required to pay a regular subscription for the use of the service. Different types of cards are available. The benefits attached to the card vary according to the type of the card. Often, the bank which issues the card will be a member of a payments brand. For instance, VISA is a payments brand with global payments system. Its cards are accepted at numerous locations (about 23 million merchant establishments) all over the world. All establishments displaying VISA logo accept VISA cards for all transactions. Of course, VISA itself does not offer cards or financial services; it only advances new payment products and technologies on behalf of its members. On every card transaction conducted, the merchant establishment will give a commission which will be shared by the issuing bank and the acquirer bank (i.e., the bank which approaches the merchant establishment for its acceptance of the card). If it is a branded card, a part of the commission will go to the payments brand. For instance, if it is a VISA card, a part of the commission will go to VISA. Suppose Bank ‘A’ has convinced merchant establishment ‘X’ to accept VISA cards. This means that all VISA cards will be accepted by establishment ‘X’. In case establishment ‘X’ accepts the VISA card issued by Bank ‘B’, then the commission will be shared by Bank ‘A’, Bank ‘B’ and VISA. Establishment ‘X’ will collect the amount due to it from Bank ‘A’ and Bank ‘A’ will collect the amount from Bank ‘B’ (the bank which has issued the card). Bank ‘B’ will collect the amount from the card holder. The entire transaction is routed via VISA. o Kisan Credit Cards and Laghu Udyami Credit Cards A Kisan Credit Card (used to be designated as ‘green card’ by some banks) issued by Indian banks, aimed at providing adequate and timely support from the banking system to the farmers for their cultivation needs including purchase of inputs in a flexible and cost effective manner. More specifically, kisan credit cards will facilitate farmers in the purchase of agricultural inputs such as seeds, fertilizers and pesticides and to draw cash for other production and ancillary needs as many times as they wish. Unlike the usual credit cards, kisan credit cards are issued based on the landholding of agriculturists. As such, the provision of one-by-six scheme (i.e., the provision requiring the holder of a credit card to furnish income tax return) is not applicable to holders of kisan credit cards. The credit extended in the case of a kisan credit card would be revolving cash credit and provides for any number of drawals and repayments within the limit. The quantum of limit is based on operational landholding, the cropping pattern and scales of finance approved for the area. The cards are valid for three years and subject to an annual review. Encouraged by the kisan credit card scheme, Laghu Udyami Credit Cards have been introduced in India for providing simplified and borrower-friendly credit facilities to retail traders, artisans, professionals and self-employed persons, small industrial units and small businessmen including those in the tiny sector. o Debit Cards The main difference between credit cards and debit cards lies in the words ‘credit’ and Self-Instructional ‘debit’. In case of a credit card, the card holder makes the cash payment at the end of 116 Material the month. On other hand, in the case of a debit card, it runs down ones deposit account Banking and the moment the sale is made. In other words, while using a debit card, one is using ones Insurance Sectors own money in the bank account. Thus, while making a payment to a merchant establishment by using a debit card, it assumes the form of a transaction between the establishment and ones bank account. Debit cards are more readily accepted by merchant NOTES establishments since they get instant payment. Debit cards free the card holder from carrying cash for his/her purchases. Although debit cards are convenient in one sense, the card holder has to be extremely careful with the card. If the card is lost or is stolen, the entire balance in the bank account could be emptied with a single purchase by an unscrupulous person. o ATM Cards An ATM (Automatic Teller Machine) Card is a variation of a debit card which one can use in a cash machine by punching in ones PIN (Personal Identification Number) for making cash withdrawals from ones bank account. ATM cards have the advantage over debit cards in that a person other than the card holder will not be able to use it for cash withdrawals because of the secrecy surrounding the card holder’s Personal Identification Number (PIN). Also, most banks limit the amount of cash that can be withdrawn on any single day. o Budget Accounts Some banks are opening budget accounts for credit-worthy customers. The bank guarantees to pay, for a specific charge, certain types of annual bills (e.g., fuel bills, rates, etc.,) promptly as they become due, while repayments are spread over a twelve- monthly period from the customer’s account. All these money transmission services have contributed to the developments in computerised book-keeping which the banks in most countries have already introduced. o EFT (Electronic Funds Transfer) Service Another important service which is of comparatively recent origin is the Electronic Funds Transfer (EFT) service. This is a service under which funds are transferred electronically over the telephone, either nationally or internationally. International funds transfers from applicant to beneficiary are made in as little as a few seconds. The international network known as ‘SWIFT’ (Society for Worldwide Interbank Financial Telecommunications), an organization promoted by banks and financial institutions around the world, is utilized to facilitate the speedy transfer of funds across international destinations without any paper work and expeditious efficiency. SWIFT is the largest network in the world which has around 4,800 users in 130 countries. This is a path breaking technology that will ultimately pave the way for paperless banking. In addition to the service which it renders to individual customers, it will go a long way in curing the corporate sector’s headaches of cash management in multiple locations. • Overseas Trading Services Recognition of overseas trade has encouraged modern commercial banks to set up branches specializing in the finance of foreign trade. Banks in some countries have taken interest in export houses and factoring organizations. Assisted by banks affiliated to them in overseas territories, they are able to provide a comprehensive network of services for foreign banking business, and many transactions can be carried through Self-Instructional Material 117 Banking and from the start to finish by a home bank or subsidiary. In places where banks are not Insurance Sectors directly represented by such affiliated undertakings, they have working arrangements with correspondents so that the banks are in a position to undertake foreign banking business in any part of the world. NOTES The banks provide more than just a means for the settlement of debts between traders, both at home and abroad for the goods they buy and sell. They are also providers of credit and enable the company to release the capital which would otherwise be tied up in the goods exported. An outline of some of the services provided by banks for overseas traders is given. For centuries, the bill of exchange has been one of the chief means of settlement in trade. Its function is to enable a seller or exporter of goods to obtain cash as soon as possible after the dispatch of goods, and yet enable the buyer or importer to defer payment until the goods reach him or later. There are many ways in which trade may be financed with bills of exchange. Two common ways are: ο The exporter will draw a bill of exchange on the importer, or, by arrangement between the parties, on the importer’s bank, for the amount of the exporter’s invoice for the goods. Shipping documents (usually the invoice, marine insurance policy and the ‘bill of lading’ which is the shipowner’s receipt for the goods) which will convey title to the goods are attached to the bill of exchange. The exporter will sell (‘negotiate’ in technical terms) the bill with the documents to a local banker. The receipt of the documents of title along with the bill means that, in effect, goods are in possession. Thus, the bank will be willing to pay the exporter practically the full amount of his invoice and bill. The bank will immediately forward the bill and the documents to its banking correspondents or agents in the importer’s country to be presented to the importer, or the importer’s bank as the case may be, for payment if the bill is payable on demand , or for acceptance if the bill is a ‘term bill’. o The importer’s bank, at its request, will arrange for its banking correspondents or agents in the exporter’s country to accept a term bill drawn on them by the exporter, and to be accompanied by shipping documents mentioned above. (Such an arrangement is an example of ‘opening credit’ which is mentioned below). When the bill is accepted, it will be returned to the exporter who can either keep it until the period of the bill expires and then claim payment from the accepting bank, or, as is more likely in practice, sell the bill to his own or other banks. The accepting bank, upon accepting the bill, will detach the shipping documents and send them to the importer’s bank. If a bill is payable on demand (i.e., a ‘demand bill’), the importer, or his bank on his behalf if the bill is drawn on that bank, has to pay the whole amount when the bill is presented. If the bill is drawn payable at a later date (i.e., a ‘time bill’ or a ‘term bill’), for example three months after presentation, it is, upon presentation, accepted by the importer if it is drawn on him, or by his bank on his behalf if it is drawn on it by special arrangement. But the importer is not called upon to pay until the three months are up. Usually, the arrangement between the buyer and the seller will be that the shipping documents which accompany the bill are to be detached upon payment or acceptance of the bill by the importer or by a bank on his behalf. The documents thus become available to the buyer so that he can take delivery of the goods when the ship arrives, resell them Self-Instructional 118 Material in the ordinary way; and from the proceeds recoup himself or his bank, or make funds Banking and available to meet the bill when it matures. Insurance Sectors An overseas buyer may arrange through his bank in the home country to open a documentary credit in favour of the seller. This is an undertaking that the bank will honour drafts drawn in accordance with the terms of credit, if accompanied by stipulated NOTES shipping documents, insurance policies, etc., and presented not later than the date of expiry of the credit. The terms usually cover the nature, price and quantity of the goods, the method of shipment, the documents to be attached and the date by which shipment must be effected. The creditor may undertake payment of a demand draft or acceptance of a term draft. It may be expressed in home currency or in foreign currency, this depending on the condition of sale. It may be either revocable or irrevocable. The former may be cancelled at any time but the latter cannot be cancelled without the consent of both the parties. Therefore, an irrevocable credit provides much greater protection to the exporter. If, for instance, a foreign importer has no account with an Indian bank, he will open the credit with his local bank. The exporter may, however, prefer to receive a corresponding advice that the credit is opened from an Indian bank. Consequently, it is usual for the foreign bank to instruct its Indian banking correspondent to advise the credit to the exporter. As an additional safeguard, an Indian exporter may require his bank not only to advice but also to undertake responsibility by adding its confirmation. This is known as ‘confirmed credit’. Having received the advice on shipment of the goods, the exporter must lodge the documents within the time allowed by the credit. If the documents are in order as stipulated in the credit, the exporter will receive immediate payment if it provides for sight payment. If it calls for a bill drawn payable after sight, the bank will accept the bill which will then be available for discount. If, for any reason, the exporter is unable to present the document he must request the importer to instruct the relevant bank to extend or amend the credit. In case where it is not possible to arrange a documentary credit and the arrangement is for payment to be made only when the goods have been sold, a bank can usually undertake the dispatch of the shipping documents and arrange the goods to be warehoused and insured in the name of a correspondent bank, pending delivery of the goods in part or in whole to the exporter’s agent against payment. The correspondent bank will then remit proceeds of sales as and when they are made by the agent. Exporters who are dealing with first-class agents may be prepared to ship their goods on open account. In such cases, the exporter usually sends the documents directly by air mail to the consignee, who acts as his agent for the sale of the goods. Remittances, in order to avoid the inconveniences of collection, may be by a cheque for an Indian bank or by a telegraphic transfer. • Information and Other Services As part of their comprehensive banking services, many banks act as a major source of information on overseas trade in all its aspects. Some banks produce regular bulletins on trade and economic conditions at home and abroad, and special reports on commodities and markets. In some cases, they invite enquiries from those wishing to extend their foreign trade, and are able through their correspondents to furnish the names of reputable and interested dealers of goods and commodities and to advise on the appointment of suitable agents. For businessmen travelling abroad, letters of introduction indicating the purpose of journey undertaken can be issued addressed to banking correspondents in the various centres it is proposed to visit. In this way, it is often possible to establish new Self-Instructional Material 119 Banking and avenues of business. On request, banks obtain confidential opinions on the financial Insurance Sectors standing of companies, firms or individuals at home or overseas for customers for the purpose of business. Commercial banks furnish advice and information of trade, outside its scope. If it NOTES is desired to set up a subsidiary or branch overseas(or, for an overseas company to set up in the home country) they provide detailed information on local legal requirements on company formation, tax requirements, exchange control and insurance, helping to establish contact with local banking organizations. To sum up, the services rendered by a modern commercial bank is of inestimable value. It constitutes the very life blood of an advanced economic society. In the words of Walter Leaf: ‘The banker is the universal arbiter of the world’s economy.’ 6.3.2 General Structure and Methods of Commercial Banking Just as in the case of any other commercial enterprise, the commercial banks strive to earn a profit. But is profitability everything which a bank should pay attention to? Can we justify a commercial bank in employing its funds in a risky manner in anticipation of windfall profits? The answer is definitely in the negative. A commercial bank is a custodian of others’ surplus funds. Therefore, while earning a profit, the bank should never forget the fact that it is doing business with the funds of others, which it acquires because of its credit. It has been seen that these funds (deposits) are either repayable on demand or after the expiry of a fixed period. In either case, the bank must be ready to meet the liabilities whenever necessary. In other words, it means that the bank has many outstanding contracts for the future delivery of money. In case of failure, it will suffer in its credit which is the very basic foundation on which its business stands. Not only will it feel the shock of such a failure, but it will also be transmitted to the other links of the banking system, thereby precipitating nation-wide bank failures. Hence, a commercial bank should always bear in mind that it is the guardian of a very delicate mechanism which paves the way for future economic development and which, if disturbed, will create monetary disequilibrium with all the evil effects incidental thereto. Obviously, a commercial bank should take the necessary precautions to keep its assets as liquid as possible. Now the question arises as to what exactly is meant by the term ‘liquidity.’ By ‘liquidity’ one means the capacity to produce cash on demand. No doubt, the most liquid asset is cash in the vaults of a bank. It is necessary for a bank to keep a certain percentage of the deposits in the form of liquid cash as reserve, either in its own vaults or with his bank, generally the Central Bank. But such liquid cash does not earn anything and as such it is purely idle money, intended to provide the necessary liquidity Check Your Progress by meeting the immediate withdrawals of deposits. As a rule, successful banking is 1. Why were Laghu dependent on the capacity of these reserves to meet the immediate requirements. When Udyami Credi liquidity is provided by the cash reserves as above, a bank should invest its excess Cards introduced? money in some assets which are liquid in nature and at the same time which could earn 2. What are the two an income. main functions of commercial banks? ‘Liquid assets’ may be explained briefly. These are those assets which can be 3. What are the main turned into cash quickly and without loss, to meet the claims of the customers. But if an differences between asset is to be turned into cash quickly, it must be shiftable in nature. In other words, the credit and debit liquidity of an asset depends on the question of shifting it to the central bank or to others cards? willing to supply cash in exchange for it. For example, if a bank holds a first class bill of

Self-Instructional 120 Material exchange, among its other assets, which satisfies the eligibility rules of the central bank, Banking and it can be rediscounted with the central bank when the bank is short of funds. Again, a Insurance Sectors government security satisfies the quality of an ideal liquid asset since it is in great demand in the stock exchange and as such shiftable. But it is important to remember that liquidity implies not only shiftability but also shiftability without loss. To take an example, the NOTES ordinary shares of an industrial enterprise may be shiftable but only at a discount. Here shiftability is possible only at a loss and hence it cannot be considered as an ideal banking asset. The conclusion that one arrives at from the above analysis is that commercial banks, while employing their funds, should pay regard both for profitability and liquidity. Liquidity in its turn is dependent on shiftability without loss. An important point to be remembered in this connection is that liquidity should not be sacrificed at the altar of profitability. At the same time no less important is it to remember that to maintain excessive liquidity is to sacrifice earnings, without which banking operations cannot be carried on successfully. An efficient and effective commercial bank would, therefore, follow a via media between liquidity and profitability while employing its funds and selecting its assets. Employment of Funds by Commercial Banks Generally, following are the important items seen on the assets side of the Balance Sheet of a commercial bank: • Cash in hand • Money at call and short notice • Bills discounted • Investments • Loans and advances The first item appearing on the asset side of a commercial bank’s balance sheet is ‘cash in hand’, including cash reserve at the central bank and demand deposits with other banks. This is the most liquid of all assets. From the point of view of profitability, a banker is tempted to minimize his cash holdings, while from the point of view of liquidity, he is tempted to maximize his cash holdings. To maintain more reserves than what is necessary is to impair the profits. The English bankers usually maintain a cash ratio of 8 per cent, while in India, a higher cash ratio is desirable owing to the undeveloped and unpredictable nature of the money market. A banker is generally guided by experience in deciding what proportion of his deposits in cash will enable him to meet all demands readily. In addition to the minimum requirements indicated by experience, a wise banker must necessarily allow for unpredictable needs. In this connection, certain important considerations influencing the cash reserves of a banker may be pointed out. In the first place, if the customers are highly banking-minded, the need for liquid cash will be small because in that case, depositors will seldom demand the payment of cash and will content themselves with the transfer of rights which the bank can do by mere book entries. Secondly, the banking habits of the customers and the business conditions of the locality will have an important bearing on the cash reserves. Certain businesses carried on by the depositors may make heavy occasional demands for cash which the banker will have to meet with adequate provision of liquid cash. Thirdly, it is also dependent on the reserves kept by other banks of the locality. If certain banks are keeping higher amounts of cash reserves, other banks will be compelled to increase their Self-Instructional Material 121 Banking and cash ratio in their bid for popularity. Further, the nature of the accounts and the size of Insurance Sectors average deposits also influence cash reserves. For instance, if the accounts are of a fluctuating nature, a higher cash reserve may be required. So also the cash reserves of a bank having only a few large deposits will be generally large because of the chances NOTES of heavy withdrawals. On the other hand, if the bank has a large number of small sized deposits, the danger of large withdrawals by any individual customer will be less and hence it need not maintain a large amount of liquid cash. Again, the presence of a bankers’ clearing house greatly reduces the need for liquid cash to be kept by a bank because it has only to provide for the difference between the cheques drawn on it and the cheques drawn by it on other banks. Even this difference is settled by mere book entries by the clearing house. Lastly, the bank has to take into account probable receipts of cash by it and probable demands upon it, in the near future. Thus, the ratio of liquid cash to deposits which a banker should maintain is dependent upon a number of considerations. It varies from place to place and from bank to bank. Therefore, it is not possible to lay down any hard and fast rule regarding the exact cash reserve ratio which a bank should maintain. It has to give due consideration to the various factors discussed above and has to come to a conclusion as to the amount of liquid cash which it should maintain. In this connection, it may be pointed out that commercial banks, in most countries, are statutorily required to maintain a minimum reserve of liquid cash. 6.3.3 Earning Assets of a Bank The cash reserves of a bank may be strengthened by a judicious selection of certain earning liquid assets. Among these ‘Money at Call and Short Notice’ stands first. This item represents largely the amounts lent to the discount market and/or to stock exchange which are recoverable either on demand or on serving a short notice. This constitutes the second line of defence. This asset has an advantage over ‘Cash Reserves’, the first line of defence of a commercial bank in so far as it satisfies, to a certain extent, both the attributes of a sound banking asset, viz., profitability as well as liquidity. It is liquid in the sense that it is recoverable at call or short notice; it is profitable in the sense that it earns interest. ‘Bills discounted’ is also considered as a highly earning liquid asset and is included among the ‘money market assets.’ It is considered to liquidate itself automatically out of the sale of the goods covered by such a bill (i.e., a first class bill of exchange is considered to be a self liquidating paper). Again, it is readily shiftable to the central bank (by rediscounting it with the central bank) without much loss because of the very short length of life of such a bill. As a matter of fact, a bill of exchange is generally of three months duration and as such the loss involved in rediscounting it will not be very great, even when it is not shifted. All this indicates that ‘bills discounted’ is one of the most earning liquid assets, satisfying both the qualities of an ideal banking asset. It is not unusual for a commercial bank to invest its funds in stock exchange securities like government securities, semi-government securities, industrial securities, etc. These are represented by the term ‘investments’. They enable the bank to obtain more earning than that afforded by ‘Loans at Call and Short Notice’ or ‘Bills Discounted’, although they are less liquid. Here the bank gives importance not only to the safety of the investment but also to the possibility of easy conversion into cash without loss. The principles that influence a bank in rating these securities while selecting them are the safety of capital, easy marketability, stability of price and stability of income. The bank Self-Instructional 122 Material should always bear in mind that in buying these securities it is not its primary object to Banking and gain by a possible rise in the prices of these securities. Consideration should be given to Insurance Sectors this factor only if it is satisfied with the safety and stability of capital. Generally commercial banks prefer government securities to the shares and stocks of joint stock companies. The reasons are manifold. Firstly, the repayment of capital is ensured because this NOTES depends on the creditworthiness of the whole nation, whereas in the case of an ordinary stock exchange security, safety of capital is entirely dependent on the creditworthiness of a single institution. Secondly, the yield from a government security is steady and reasonable. Thirdly, they are easily saleable without causing a glut in their market prices, whereas in the case of ordinary industrial securities, sale of a large block of shares is likely to depress their prices. The item ‘Loans and Advances’ comes next in the order of liquidity. For all practical purposes they are not shiftable. Of course, this is the most profitable of a bank’s assets, and a bank’s earnings are mainly derived from these assets. As a rule, a commercial bank will lend only for short-term commercial purposes. It is not considered to be its duty to provide long-term loans for investment purposes. Such loans are provided by specialized agencies such as industrial banks. The reason advanced in support of this view is that in the case of long-term loans, the bank will find it difficult to realize them when emergencies arise. For example, in the case of a mortgage, the mortgaged property may cover the loan with a safe margin. But when the bank needs liquid cash most, it may find it difficult to convert the mortgaged property into liquid cash. Herein, lies the meaning of the oft-quoted statement ‘the art of banking lies in knowing the difference between a mortgage and a bill of exchange.’ In the case of a bill of exchange, it is of a self liquidating character and offers an ideal security for a bank’s investment for reasons already explained. Certain general principles may be laid down which should guide a commercial bank when it is making loans and advances. Before granting a secured loan, it should carefully consider the margin of safety offered by the security, possibility of fluctuations in its vale and possibility of shiftability. In case of an unsecured loan, its repayment entirely depends on the credit of the borrower. As such, the cardinal principles which the bank should consider are ‘character’, ‘capacity’ and ‘capital’ (usually referred to as the three Cs) of the borrower. In either case the bank should aim at spreading these loans as widely as possible over many industries and localities. It is also advisable for a bank to advance moderate amounts to a large number of customers than advance large amounts to a small number of customers. In addition to the above items, certain other items also appear on the assets side of a bank balance sheet, viz., ‘Acceptances and Endorsements as per Contra’ and ‘Furniture, Premises, etc’. Among these items, the item ‘Acceptances and Endorsements as per Contra’ refers to the amounts due from the customers on whose behalf the bank has accepted bills of exchange. These amounts are due from the customers and hence they are considered as assets. In a certain sense, this item represents a liability of the bank also since the liability to honour these obligations will fall upon the bank if the customers fail to meet them on the due dates. The other items such as furniture, premises, etc., are not important from the point of view of the investment portfolio of a bank as they are the least liquid of all the assets. Further, they are not intended for conversion into cash to meet an emergency.

Self-Instructional Material 123 Banking and Self-Liquidating Paper Theory vs Anticipated Income Theory Insurance Sectors Traditional banking theory favoured by the conservative bankers holds that the earning assets of a bank should be limited to short-term self liquidating productive loans. These NOTES include self liquidating commercial papers or short-term loans intended to provide the current working capital, which in itself is of a self liquidating nature. The merit of the ‘self liquidating theory’ of commercial bank loans is derived from the fact that such loans are considered to liquidate themselves automatically out of the sale of goods covered by such a transaction. For instance, look at the case of a bill of exchange, a typical example of a self liquidating paper, drawn for the purpose of purchasing raw materials. The bill is covered by a genuine commercial transaction. And a bank is justified in giving a loan against such a paper because such self liquidating papers automatically provide the bank with liquidity through loan repayments. Not only that but they are also shiftable to the central bank in times of emergencies since the central bank, being the lender of the last resort, is willing to rediscount such self liquidating papers. The loss avoiding aspect of liquidity is also present here because of the very short periods for which these loans are given. Moreover, they protect the business world against inflation because of their elastic nature to correspond with trade demands. Their volume increases as production increases and decrease as production decreases. No wonder the traditional bankers heavily favoured the claims of self liquidating theorists. The validity of the self liquidating theory, however, has been challenged by certain modern writers. They are contend that the transaction covered by a self liquidating paper does not by itself always guarantee the liquidity of the loan, especially when there is an abnormal fall in the prices of those commodities covered by the transaction. It is said that customers’ loans to provide their current working capital are not a safe and reliable source of bank liquidity. The contention that self liquidating commercial loans provide protection against inflation has also been challenged by the critics. They argue that during boom periods, when the business conditions are prosperous, the borrowers increase their loans by offering more and more self liquidating papers. As full employment is reached, the prices increase because of the increase in the money supply as compared to the output, introducing inflationary tendencies in the economy. They conclude by saying that the theory of self liquidating loans has fallen out of date. And as an alternative, they advocate a new theory of bank liquidity, viz., ‘Anticipated Income Theory of Liquidity.’ The origin of this theory lies in the extension of term loans by the commercial banks of the USA for financing long-term capital needs of industry. The loans are granted on the specific condition on the part of the borrower to conduct the financial and other affairs in such a manner as agreed upon between him and the bank. The loans are to be liquidated out of the anticipated earnings of the borrowing enterprise. Whatever be the merits of such a theory, a point may be said in favour of the traditional theory of commercial bank assets. When a bank provides short-term self liquidating productive loans, it is fairly easy for the bank to gauge the liquid position of its customer because of the short length covered by such loans. In the case of long-term loans granted on the basis of anticipated incomes of such loans, the question involved is not one of gauging the current liquidity position of the borrower, but the future earning capacity of the borrower. This depends on the correct assessment of a number of factors which may go wrong. Due to this, conservative bankers still find favour with the view that it is always good commercial banking to make short-term self liquidating productive loans.

Self-Instructional 124 Material Mechanism of Credit Creation Banking and Insurance Sectors From the previous analysis, it is clear that commercial banks always try to maintain their holdings of idle cash to the lowest extent possible. In their attempt to achieve this end, they unwittingly increase the total amount of money in circulation in the community. It, NOTES however, does not mean that they increase the total amount of legal tender currency which is an exclusive prerogative of the central bank. When it is said that a banker is lending money, he is actually lending money in the deposit credit with a right to the borrower to draw cheques against it. For instance, let us take the case of a loan granted to a customer. Instead of paying away the whole loan in the form of liquid cash, the bank will place the amount to the credit of the borrower. Thus, the borrower acquires a claim against the bank, just as a sum of money deposited by him with the bank creates a claim against the bank. Assuming the borrower draws cheques in favour of other people, they pay these cheques into their own banks for collection, and their deposits go up. Here one may agree with Hartley Withers in that ‘every loan creates a deposit’. Again, by purchasing securities or any other banking assets also a bank is adding to the total supply of money. When the bank buys securities, it pays for them by its own cheque. This cheque, like a currency note issued by the central bank, is an IOU (I Owe You) of the bank issuing it. And this is accepted by the seller of the securities because of his faith in the ability of the bank to produce cash on demand. The seller deposits this cheque in the very same bank or with any other bank where he has an account, thereby creating additional deposit money. Thus, the commercial banks as a system can and do increase the total amount of money in circulation by increasing the purchasing power of the people through the deposit money created by them. A close analytical study of the mechanism of banking will simplify matters more. Let us take the case of a community where there is only one bank and where the people are highly banking minded so that all transactions are settled by means of cheques. Further, let us assume that that total amount of legal tender currency in circulation is `10,000 and the bank knows by experience that 10 per cent of its deposits as cash reserves is sufficient to meet the demands of its customers. Since there is only one bank in the community, people will deposit all their money in this particular bank. The balance sheet of the bank would then be: Liabilities ` Assets ` Deposits 10,000 Cash in Hand 10,000 According to our assumption, the bank need maintain a cash reserve of only 10 per cent of the deposits and can safely lend the balance amount of `9,000 to those who are in need of funds. The bank will place this amount to the credit of the borrowers, giving them the right to operate their accounts with cheques. Their deposits will consequently go up by this amount. The balance sheet of the bank, then, would be: Liabilities ` Assets ` Deposits (original) 10,000 Cash in Hand 10,000 Deposits (i.e. credit Balance of borrowers) 9,000 Loans to clients 9,000 19,000 19,000 These deposits, now standing to the credit of the borrowers are, as we know, claims against the bank. As such they command a purchasing power and hence they Self-Instructional Material 125 Banking and may be considered as good as money. Suppose the borrowers draw cheques in favour Insurance Sectors of their creditors. The payees of these cheques will not require liquid cash over the counter since they are highly banking minded, according to our supposition. On the other hand, they will deposit these cheques with our supposed single bank for collection. Here NOTES what happens is merely a transfer of the credit balance of the borrowers to the credit of the accounts of the payees of their cheques. In short, although the total amount of legal tender currency in circulation is only to the order of `10,000, our bank, through the process of creating additional deposit money, has brought into effective circulation an additional amount of ` 9,000, thereby raising the total supply of money from `10,000– 19,000. The power of the bank to increase the amount of money in circulation does not come to an end here. It can further increase the supply of money. As shown in the above balance sheet, the amount of the deposits of the bank is now `19,000. The assumption is that the bank should maintain a cash reserve ratio of only 10 per cent. To maintain this, the bank only needs to provide an additional amount of `900 over and above the amount of `1,000 which it already maintains. Even then there is a balance of `8,100 in the vaults of the bank which it can lend without undergoing any risk. Now the balance sheet position would be:

Liabilities ` Assets ` Deposits (original) 10,000 Cash in Hand 10,000 Deposits (deposited by the Payees of the cheques issued by the first borrowers 9,000 Loans to Clients. Deposits (credit balance of 9,000 Subsequent borrowers) 8,100 8,100 17,100 27,100 27,100 Here the bank has to keep an additional cash reserve of `810. The total cash reserves increase to `2,710. Still there is a balance of loanable funds with the bank, amounting to `7,290. Thus, the bank can go on increasing the creation of additional money. However, there are questions that crop up. Is it possible for the bank to increase credit without any limit? Is the power of the bank to increase the supply of deposit money unlimited? The answer is definitely in the negative. Limitations on the Creation of Credit The power of commercial banks to create credit is limited mainly by the cash reserves which they have to hold against their deposits and the total amount of legal tender currency issued by the central bank. Every bank has to meet the demands of its customers to pay cash over the counter. So a working reserve of liquid cash is always necessary for a bank. Of course, if the people are highly banking minded, a lower cash reserve will be sufficient. But in the case of a community where the habits are not well developed, a higher cash reserve will be essential. In either case, a cash reserve is necessary. This acts as a brake on the power of the banks to create credit. To revert to the previous illustration, our supposed bank can go on creating further and further credit money till it finds that it has no more liquid cash to maintain the 10 per cent cash reserve ratio. In other words, it is in a position to supply more and more credit up to an additional amount of `90,000. If it wants to expand credit still further, either there should be an additional supply of liquid cash, which entirely is the sole prerogative of the central bank, or the cash ratio should be lowered which can be done only at its own peril. Moreover, a Self-Instructional 126 Material minimum cash reserve ratio is prescribed by law in most countries. Thus, a bank’s Banking and power to create credit is limited by two factors, viz., the cash reserve ratio and the total Insurance Sectors amount of legal tender currency. So far the analysis was confined to a community where there is only one bank. This is not a realistic assumption. But admittedly, the multiplicity of banks will not make NOTES any material alteration in the mechanism of credit creation and the limitations on it. The banking system, taken as a whole, will be conducting its operations on the very same lines. The only difference is that if any bank tries in an isolated manner to expand credit more than the other banks, it will lose cash to other banks. So in the case of a network of branches, each bank will have to keep in step with the others whenever it is creating credit. In conclusion, commercial banks can increase the total amount of money in circulation through the process of credit creation. In the words of Sayers, ‘Bankers are not merely purveyors of money, but also, in an important sense, manufacturers of money.’ The Clearing House System In the previous example of a supposed single bank, it was seen that no cash is actually paid out of the bank even when cheques are drawn on it and even when the drawer and payee are different persons. On the other hand, since everybody maintains an account with the bank, the transfer is effected by a mere book entry, i.e., by debiting the account of the drawer and crediting the account of the payee. But the case would be different where there are a number of different banks having different customers. Let us begin with two banks, say, Bank A and Bank B. Everyday the customers of Bank A will be receiving cheques drawn on Bank B by its customers. The customers of Bank A will deposit these cheques with their bank for collection. The customers of Bank B will also be receiving cheques drawn on Bank A by its customers which they will deposit with their bank, Bank B, for collection. The simplest method for the banks is to send their peons to the respective drawee bank and to collect cash over the counter. This method, no doubt, appears very simple. But at the same time, it is very cumbersome and expensive. Both the banks will have to keep a large amount of legal tender currency to meet the cheques drawn on each. This affects the profit earning capacity of both the banks and hence their efficiency. At the end of the day, each bank would find that it had paid a certain amount of cash to the other and had received a certain amount of cash from the other. So, it would be much better if the accounts between these two banks were settled as at the end of each working day on the principle of setting off a debt which one owes to another by a claim against him and paying the difference in cash. Where there are many banks, business will be easily facilitated if this principle is extended so that the cross obligations are set off through a central organization. ‘Clearing house’ is such a central organization. A clearing house may be defined as an organization of various banks constituted for the purpose of offsetting inter-bank indebtedness arising from the transfer of deposits by a customer of a particular bank to another bank. The mechanism of offsetting inter-bank indebtedness through a clearing house operates as follows. Officials representing various banks meet at a common place, the clearing house, everyday. Each representative then delivers cheques to the others and other claims which his bank holds against them. So he also receives the claims from the others which their respective banks hold against his bank. Cheques and other documents Self-Instructional Material 127 Banking and dishonoured will be returned to the representative of the respective bank. The various Insurance Sectors amounts of receipts and deliveries are added up and a balance is struck therein. The final settlement is effected by the supervisor of the clearing house by transferring the balance kept at the central bank by these various clearing banks. NOTES The advantages which a clearing house confers on society are manifold. It prevents the waste and cost involved in collecting each and every cheque and claim which a bank holds against another across the counter with all the danger of loss in transit incumbent upon it. Great economy is also achieved in the employment of liquid cash by settling the difference by simple transfer of credit from one account to another, thereby minimizing the necessity of holding large idle cash balances.

6.4 SYSTEMS OF BANKING

With the full-fledged development of banking institutions, various systems of commercial banks like ‘unit banking’, ‘branch banking’, ‘group banking’ otherwise known as ‘holding company banking’ and ‘chain banking’ have come into vogue. The typical commercial bank functioning in most countries is of the branch banking type. Under this system, banking is conducted by institutions with head offices in large cities operating numerous branches throughout the country. In contrast to this, under the unit banking system, banking tends to be localized, each maintaining a single office. In exceptional cases, it may also have branches, but within a strictly limited area. In addition to these systems, there are group banking and chain banking systems. Under the former system, which is also known as holding company banking system, a certain number of banks combine together through the ownership of stock by holding companies. Under the latter, chains of banks are formed by the common stock ownership without any intervention of holding companies or by interlocking directorates. Group Banking and Chain Banking Group banking and chain banking systems are commonly found in the USA. Their origin may either be attributed to the attempt to achieve the advantages of large scale operations or to satisfy the desire for power. Whatever it may be, as compared to the other systems of banking such as unit banking and branch banking, these systems cannot be considered as worthy of adoption. It is true that in the USA, they are subjected to a number of governmental regulations ranging from statutory prohibition to start certain types of holding companies to special investigation and control by the authorities concerned. According to the holding company banking system, a group of banks are brought under one centralized management and this centralized management exerts control over all the units. Although each bank has got a separate entity in itself, its affairs are controlled by a holding company. It is not uncommon for such a holding company to be affiliated with larger banks, in which case the policies of the whole group are influenced by that bank. This system of banking has been used, besides for the purpose of unifying the management, for bringing into closer relations banking corporations and other trading corporations. This is because the holding companies may include not only banking corporations but also non-banking corporations as their subsidiaries in certain cases. The supporters of holding company banking system point out certain merits of the system. They say that in the case of holding company banking system, it is not necessary to maintain large amounts of cash reserve by each and every bank of the system because such reserves can be centralized in one of the bigger members of the group. This member Self-Instructional 128 Material of the group will be willing to help other banks in the group whenever required although Banking and there is no legal obligation for any member of the group to help another. Further, all the Insurance Sectors members of the group can participate in loans given to large borrowers who, in the absence of such a group, would look elsewhere for accommodation. Finally, economies of large scale operations can be achieved by cutting down operating costs, by purchasing NOTES supplies in bulk and by improving the efficiency of management. As against these, certain disadvantages may also be pointed out. It is definitely undesirable to tie up banking corporations with non-banking corporations. Under group banking system, a banking corporation as well as a non-banking corporation may be subsidiaries of the same holding company and the holding company, in its effort to secure more profits, may overlook sound banking principles, thus landing the banking corporation in danger. The banking crisis of the USA during the early thirties stands as a testimony to this danger. Of course, in the USA, the law now protects the banks from this serious disadvantage by prohibiting bank holding companies to own the voting shares of non-banking corporations. It is also illegal, in that country, for any bank to make loans or to purchase the securities of a holding company of which it is a subsidiary, or any other subsidiary, of the same holding company. Another disadvantage of this system of banking is that it may lead to monopolies, thereby restraining healthy competition among banks, which is highly necessary for a balanced development of banking. Chain banking involving stock ownership in a number of banks by one or a number of individuals and interlocking directorates closely resembles group banking. The main difference between these systems lies in the fact that in the case of group banking the affairs of the group are controlled by a holding company whereas in the case of chain banking there is no such intervention from any central organization. Without much needless repetition, it may be pointed out that the advantages of the chain banking system are more or less similar to those of group banking system and they arise from the economies of large scale operations, centralization of reserves, parallel management, etc. So, the disadvantages may also be said to arise from mismanagement and exploitation. Unit Banking and Branch Banking Group banking and chain banking systems, which have been referred to, are generally found in the USA only. More important systems of banking are the unit banking and branch banking. The USA and England may be taken as the typical countries which follow the systems of unit banking and branch banking, respectively. For instance, in England most part of the banking business is in the hands of four major banks which are popularly known as ‘the Big Four’, viz., the Midland, the Lloyds, the Barclays and the National Westminster. The branches of these banks extend to all parts of England. In addition to England, countries like Canada, South Africa, Australia, India, etc., follow branch banking system. In contrast to this is the banking system of the USA, which is predominantly a localized one. In the USA, unit banks are generally linked together by the ‘correspondent bank’ system. Under the correspondent bank system, the country banks deposit money with the city banks and the city banks with the reserve city banks. This arrangement helps each bank to make remittances through the correspondent. Advantages and Disadvantages of Branch Banking and Unit Banking The advantages of branch banking, which are the objections raised by the advocates of branch banking against unit banking, may be summarized as follows:

Self-Instructional Material 129 Banking and • Branch banks as compared to unit banks can provide better facilities to their Insurance Sectors customers because of the comparatively limited number of customers per banking office and because of the efficiency achieved through large scale operations. • It is not necessary for any particular branch to maintain large amounts of idle NOTES cash reserves. Whenever any help is required by any branch the resources of the other branches can be transferred to that particular branch. Of course, a unit bank can draw on the correspondent banks, but in the case of branch banking the help will readily be forthcoming since it is in the interest of the bank as a whole. • Management can be made more efficient by proper staff selection, training and appointment of the right person in the right place. This advantage arises as a corollary to the economies achieved through large-scale operations. • Industrial and geographical diversification of loan risks is possible in the case of branch banking. Because of this even when a branch suffers a loss through the decline of the industries in that locality, the profits earned by the other branches will make up that loss. Whereas in the case of unit banks, those units situated in the depressed areas may undergo heavy losses which might be followed by a crop of bank failures. • Branch banks increase the mobility of capital which brings uniformity of interest rates. In order to take advantage of the increased interest rates prevailing in any locality, banks under branch banking generally transfer the deposits from the branches situated in those localities where demand for money is relatively low (and consequently interest rates less) to those branches situated in those localities where the demand for money is relatively high (and consequently interest rates higher). In both these localities the supply of money is thus brought into equilibrium with the demand and hence the interest rates tend to uniformity over the whole area served by branch banks. • Remittance facilities can be provided to the customers cheaply because inter- office indebtedness can be more easily adjusted than inter-bank indebtedness. • Clearing of cheques is comparatively easy since cheques deposited at a branch can be sent to the office in the city where there is a clearing house and then can be cleared in the customary way. But in the case of unit banks clearing involves greater complications and greater expenses. • Finally, it is said that branch banks give their customers the service of more powerful and solvent banks. A branch has not only the assets of a particular office behind it but the assets of all the offices of the bank. Now, one may turn the attention to the objections to branch banking which are generally raised by the unit bankers in support of the unit banking system. These may be summarized as follows: • The branch manager will have to get the permission of the Head Office, which, being totally ignorant of the borrowers, may require the branch to cover each and every loan by collateral securities, thus refusing to lend on the personal security of the borrowers even when they are desirable borrowers. In this respect, the unit banker is at an advantageous position because he will have personal knowledge of the borrowers and can easily decide which of them are desirable. • Since the branch managers have to refer each and every loan to the Head Office, delay and red taspism are but natural. The unit banker, on the other hand, can use his discretion and can arrive at quick decisions. Self-Instructional 130 Material • Branch managers are transferred too frequently and so they are liable to be Banking and unsympathetic with local needs. Insurance Sectors • The failure of a bank with a large number of branches spread all over the country will have wide repercussions throughout the country. On the other hand, the failure of a unit bank will not have generally such countrywide NOTES effects since they carry on purely localized business. • It is difficult to exert a very effective control over all the branches when a bank grows beyond the optimum size. Consequently, mismanagement on a large-scale is more likely under branch banking than under unit banking. As a result, expenses are likely to mount high, having an adverse effect on profits. • Finally, it is said that market conditions are so localized that unit banking is more suitable. No doubt, these objections contain an element of truth. But they hardly constitute a very serious criticism on branch banking and cannot be considered as absolutely valid. For instance, the charge of red tapism and delay in the case of branch banking is not a very serious one as it can easily be remedied by the use of telephone or by giving the branch managers the discretion to lend up to fixed amounts. Therefore, efficiency in management and effectiveness in control can also be maintained by keeping the number of branches within limits and not allowing the bank to grow beyond the optimum. Again, some of the objections raised against branch banking may be considered as its advantages, when viewed from another angle, like the example of the objection on the remoteness of the Head Office. This will enable the branch manager to refuse a loan without straining his personal relationship with the customer by shifting the responsibility of loan refusal to the shoulders of the Head Office. Further, against the objection that branch banking retards local economic development by insisting on collateral securities against loans, it may be stated that it is always better to be on the safe side by following a careful loan policy, and an ideal banker should never underrate the importance of securing advances with proper collateral securities. In conclusion, advantages weigh heavily with branch banking. That is why countries find increasing favour with branch banking system of banking. Even in the USA, which is known as the home of unit banking, branch banking is permitted by law to a certain extent. Eighteen states permit state wide branch banking, while seventeen states permit limited area branch banking. Only the remaining states specifically prohibit branch banking. Among the leading banks of that country, the Bank of America has branches throughout the State of California.

6.5 INVESTMENT BANKING AND MIXED BANKING

Investment banks are organizations which assist business corporations and governmental Check Your Progress bodies to raise funds for long-term capital requirements through the sale of shares, stocks. bonds, etc. These banks, unlike commercial banks, act primarily as middlemen 4. What items are seen on the asset side of between business corporations and investors. Generally, they purchase the entire issue a balance sheet? of new securities of the business corporations or of governmental bodies and re-issue 5. What is the them for public subscription at a higher price. Sometimes, they may act as agents on duration of a bill of commission basis, but as a rule they underwrite the issue of securities. exchange? 6. What are the Investment banks are classified as ‘originators’, ‘underwriters’ and ‘retailers.’ various systems of As originators, they bring out new issues of securities; as underwriters they underwrite banking? the issues; and as retailers they retail the securities to individual and institutional investors. Frequently, a single institution may act in all these capacities. Self-Instructional Material 131 Banking and The operative technique of the investment bankers may be briefly stated as follows. Insurance Sectors The originator enters into all the preliminary negotiations with the issuing corporation. Ordinarily, he requires detailed reports regarding the origin and history of the issuing corporation, the nature of its products, the condition of plant and machinery and other NOTES assets, its capital structure, the intention of the new issue, etc., authenticated by the opinions of expert technicians and professional accountants together with an attorney’s report regarding the legality of the issue. On finding the details satisfactory, the originator enters into an agreement with the issuing authority undertaking to bring out the new issue. If the issue is a large one, the originator calls upon the other investment bankers to join him in forming an ‘Underwriting Syndicate’. The next step is to invite the smaller retailers to join with the underwriting syndicate in order to form a selling group. Finally, the securities are offered for public subscription. Simultaneously, the originator adopts a method to avoid any possible glut in the market prices of these securities. Owing to the psychological reaction of the early buyers, they may, out of their nervousness, offer the securities for sale at very low prices in the market. In order to counter any such reaction, the originator leaves an ‘open order’ to repurchase these securities at a price slightly below the price at which they are offered to the public. However, if the market for these securities becomes very weak, this ‘open order’ may boomerang upon the originator himself resulting ultimately in the repossession of the securities previously sold to the public. But such cases are not frequent. An investment banker, thus, performs a highly useful service to the business world by providing the necessary capital for long-term capital needs of industry. He has been aptly termed as the entrepreneur of entrepreneurs.The investing public is also benefited by the activities of the investment banker. This is because of the independent and comprehensive analysis which he makes in order to gauge the desirability of the securities which he proposes to underwrite. Of course, instances are not wanting where unscrupulous investment bankers have cheated the public, thereby damaging the goodwill of the entire investment banking system. However, it is gratifying to note that many countries have already enacted protective legislations providing for the prosecution of dishonest security dealers. The origin of ‘mixed banking’ lies in the extension of the operations of the investment banker to the commercial banking field. The danger of this fatal combination of investment banking with commercial banking is unequivocally demonstrated by the crop of bank failures during the past. The imperative necessity of the commercial banks to keep their assets as liquid as possible, the chances of commercial banks employing their funds (which are mostly repayable on demand or on short notice) to underwrite the shares and stocks of concerns in which they are directly interested—all this tends to show the evils of mixed banking. Recognising the incompatibility of mixing investment banking with commercial banking, most of the countries have enacted suitable legislations accepting the principle of bifurcation of these two systems of banking. However, the recent trend towards ‘Universal Banking’, which is elaborated further later in the next section, could be considered as an extension of mixed banking in one sense. Of course, universal banking recognizes the necessity for the relevant institutions to have enough capacity to deal with new types of risks and for putting in place appropriate risk mitigation mechanism.

6.6 UNIVERSAL BANKING

There is no universally accepted definition of ‘Universal Banking.’ A universal bank refers to a bank which offers a wide variety of financial services beyond the strict Self-Instructional traditional boundaries of a commercial bank. According to the traditional description of a 132 Material commercial bank, it confines itself to the core business of accepting deposits and providing Banking and working capital finance to industry, trade, commerce and agriculture. If this could be Insurance Sectors considered as one extreme, universal banking is the other extreme. It would not be an exaggeration to state that a universal bank is a ‘financial services supermarket’, since universal banking is a combination of commercial banking, investment banking and various NOTES other activities including insurance. A universal bank offers this entire range of financial services within the bank or through subsidiaries. Most countries permit universal banking although it is most common in European countries. Universal banking is set to dominate world financial scene. It is set to take off in a major way in the global market. It may be mentioned in this connection that in the USA, the Glass-Steagall Act which had imposed severe restrictions on commercial banks in extending their activities and which had put up barriers between commercial banks, investment banks and insurance companies has been scrapped, thus enabling possible mergers and acquisitions in this field, resulting in universal banking in a big way. Universal banking has its own advantages while one cannot deny the fact that it has its own disadvantages also. The main advantage arises from the resultant increase in economic efficiency in the form of lower cost, higher output and better products. One of the main disadvantages of universal banking is that as the establishments carrying out universal banking activities grow in size, which is a natural development, any failure of the system will have very extensive harmful effects in the entire economy. Secondly, by virtue of the sheer size of universal banks, they are most likely to acquire monopoly power in the market with all the resultant undesirable consequences for economic efficiency. Further, there is a possibility of conflict of interests while carrying out diverse financial services. As a matter of fact, the enactment of the Glass-Steagall Act in the USA was mainly intended to counter this. Of course, the Act has since been scrapped. It is important to remember that before embarking upon universal banking, there should be enough capacities in the concerned institutions to deal with new types of risks, viz., market risk, credit risk, etc. Hence, there is the need for putting in place appropriate risk mitigation mechanism.

6.7 MERCHANT BANKING

The term ‘merchant bank’ is widely and loosely used today, being applied sometimes to banks which are not merchants and sometimes to merchants who are not banks, and sometimes to houses which are neither merchants nor banks. Although the term escapes a precise definition, a ‘merchant bank’ may be considered as an institution which centres its operations on all or most of the following activities: • Corporate financial advice, on such diverse matters as new share and bond issues, capital reconstructions, mergers and acquisitions; • The taking of deposits and money market operations, including foreign exchange dealings; • Medium term lending and syndication of loans; • Acceptance credit and all forms of export finance; • The holding and dealing in quoted and unquoted investments and • Fund management on behalf of clients, most typically pension funds, unit trusts, investment trusts, and wealthy individuals.

Self-Instructional Material 133 Banking and Traditionally, the main business of merchant banks has been concerned with Insurance Sectors acceptance credit for the financing of international trade and the raising of loans for overseas borrowers by new capital issues. Recently they have extended their interests over domestic financing, particularly as to advising on amalgamations and take-overs NOTES and to investment management and hire purchase and leasing finances. They also play an important part in the international short-term capital market. Some of the important British merchant banking groups add further variety to their range of services, and these include insurance broking, commodity dealing, and even advertising. But these services are normally carried out by subsidiary companies which are separate from the merchant bank itself. According to the predominant kind of business transacted, some of the merchant banks in the UK are known as ‘accepting houses’, while they and many others may be described as ‘issuing houses’. But, as observed earlier, the term ‘merchant banks’ cannot be confined to the accepting houses and the issuing houses alone. Since the early 1970s many of the London clearing banks have embarked upon merchant banking activities. A noticeable trend recently has been the emergence, within the powerful clearing bank groups, of merchant banking subsidiaries as serious competitors to the more traditional operators.

6.8 VIRTUAL BANKING

The practice of banking has undergone significant transformation in the 1990s. While banks are striving to strengthen customer relationships and move towards ‘relationship banking’, customers are increasingly moving away from the confines of traditional branch banking and are seeking the convenience of remote electronic banking services. And even within the broad spectrum of electronic banking, the aspect of banking which has gained currency is virtual banking. Broadly speaking, ‘virtual banking’ denotes the provision of banking and related services through extensive use of information technology without direct recourse to the bank by the customer. The origin of virtual banking in the developed countries can be traced back to the seventies with the installation of Automated Teller Machines (ATMs). Subsequently, driven by the competitive market environment as various technological and customer pressures, other types of virtual banking services have grown in prominence throughout the world. It is possible to delineate the principal types of virtual banking services. These include Automated Teller Machines (ATMs), Shared ATM Networks Electronic Funds Transfer at Point of Sale (EFTPoS), Smart Cards, Stored—Value Cards, Phone Banking, and more recently, internet and internet banking. The salient features of these services are the overwhelming reliance on information technology and the absence of physical bank branches to deliver these services to the customers. Three evolutionary phases of virtual banking services, which represent the impact that particular application has achieved within the industry have been described in the literature. These include: • The inception phase, where technology behind the application is in its infancy and a substantial amount of investment is required so as to make the application widely available commercially. • The growth phase, where the application is increasingly available to the customers and the technology behind the application is widely available.

Self-Instructional 134 Material • The maturity phase, wherein the application is in widespread use and Banking and institutions not offering such applications are likely to be at a competitive Insurance Sectors disadvantage. The financial benefits of virtual banking are manifold. First, virtual banking has the advantage of having a lower cost of handling a transaction via the virtual resource NOTES compared to the cost of handling the transaction via the branch. Second, the increased speed of response to customer requirements under virtual banking vis-à-vis branch banking can enhance customer satisfaction and, circumstances remaining the same, can lead to higher profits via handling a large number of customer accounts. It also implies the possibility of access to a greater number of potential customers for the bank without the concomitant costs of physically opening branches. Third, the lower cost of operating branch network along with reduced staff costs leads to cost efficiency under virtual banking. Fourth, virtual banking allows the possibility of improved quality and an enlarged range of services being available to the customer more rapidly and accurately at his convenience.

6.9 GREEN BANKING

Green IT (or green computing) refers to environmentally sustainable computing which is relatively more environment-friendly. IT is becoming relevant to the banking sector. Green computing is also defined as the study and practice of designing, manufacturing, using, and disposing of computers, servers, and associated sub-systems and monitors, printers, storage devices, and networking and communication systems – efficiently and effectively with minimal or no impact on the environment. Modern IT systems rely upon a complicated mix of people, networks and hardware, and then, a green computing initiative must cover all of these areas as well. The other aspect of green IT comprises using the IT services to reduce environmental impact of other industries. The goals of green computing are to maximize energy efficiency during the product’s lifetime and promote recyclability or biodegradability of defunct products and factory waste. The benefits accruing from practising principles associated with green IT would be : (i) reduced energy costs both through lower usage and more efficient operations of equipment; (ii) streamlined IT processes to reduce cost inefficiencies and reduce environmental impact; (iii) enable a more mobile and agile workforce for flexible and remote working, further reducing carbon emissions from unnecessary travel; (iv) organizations of all sizes can benefit by reducing operation costs and equipment costs. The concept of ‘Green Banking’ is becoming popular as more citizens look for ways in which they can help the environment. While, green banking encompasses a wide variety of banking services, many banks are promoting their online banking services as a form of green banking. The environment and the banking industry can both benefit if more customers start to use online banking services that are available. Benefits of online banking include less paperwork and less driving to bank branch offices by bank customers, which will have a positive impact on the environment. Interestingly, online banking services can also increase the efficiency and profitability of a bank. A bank can lower its costs from paper overload and bulk mailing fees if more of its customers use online banking. Green banking also reduces the expenditure of branch banking.

Self-Instructional Material 135 Banking and Insurance Sectors 6.10 CENTRAL BANKING

Although the origin of central banking dates back to 1894, when the ‘the Governor and NOTES the Company of the Bank of England’, the present day Bank of England, was established, the art of central banking assumed new dimensions only during the 20th century. Central banking is in fact essentially a 20th century phenomenon. The earlier institutions were, by and large, banks of issue with the sole or principal right of note issue. Modern central banking techniques were unknown to them. They were not very different from other existing institutions doing banking business except for the special relations which they had with their respective governments. It was only through a process of trial and error that they come to occupy the pivotal and strategic status which they enjoy in the present day monetary and banking structure. Even at the beginning of the 20th century, many countries were still without central banks. The First World War and the consequent chaotic monetary conditions brought home to these countries the imperative necessity of establishing a centralized institution capable of creating and maintaining equilibrium in the monetary sphere. The International Financial Conference held at Brussels in September 1920 pointed out the urgency of establishing a central bank in those countries which had not yet established a central bank. This conference resolved that in countries where there is no central bank of issue, one should be established. The Genoa Conference, in the spring of 1922, also emphasized the importance of a central bank as an agency to correct the financial disequilibrium and to promote international cooperation in the monetary world. There was a welcome reception to these advices throughout the world. The next three decades saw many countries equipping themselves with central banks. In 1900, there were only 18 central banks whereas now there are 172. These central banks have drawn their statutes in such a manner as to give novel meanings to central banks, of course, drawing inspiration from the experiences of the older central banks. The dynamic changes in the economic organism of each country raised the status of its central bank from the position of a bank of issue to that of a leader and symbol of economic development. Thus, the importance of central banking institutions has gained universal recognition and they now occupy a unique position in the economic map of every civilized country. It took nearly three centuries for the ‘art of central banking’ to attain the present day importance. Nevertheless, it would not be correct to say that central banking has attained its full growth. Indications are that the role of central banks is continually expanding. In the words of De Kock, ‘central banks have developed their own code of rules and practices, which can be described as ‘the art of central banking’ but which, in a changing world, is still in the process of evolution and subject to periodical adjustment’. 6.10.1 Functions of a Central Bank It is difficult to lay down any hard and fast rule regarding the functions of a central bank. The powers, the range of functions and the organizational set up of central banks vary from country to country. On the one hand, one sees the state-owned and state-controlled Bank of England which follows the centralized system of central banking. At the other extreme, there is the American system of Federal Reserve Banks owned by the Member Banks and coordinated by the Federal Reserve Board, following the decentralized system of central banking. However, a careful study into the operative techniques of the various central banks would enable us to draw certain broad conclusions as to the general functions of a central bank. Self-Instructional 136 Material One of the earliest of the functions to be discharged by a central bank is that of Banking and acting as a bank of issue. In addition, it is a controller of currency; a bankers’ bank and Insurance Sectors lender of the last resort, an agent, advisor and banker to the government, a custodian of the nation’s metallic reserves, etc. In this connection, the observations made by the Governor of the Bank of England before the Royal Commission on Indian Currency NOTES (1926) are highly illuminating. According to him, a central bank should have the sole right of note issue. It should be the sole channel for the output and intake of legal tender currency. It should be the holder of all government balances, the holder of the reserves of the other banks in the country. It should be the agent, so to speak, through which the financial operations, at home and abroad, of the government would be performed. It should further be the duty of a central bank to effect. As far as it could, suitable contraction and expansion, in addition to aiming generally at stability, and to maintain that stability within as well as without. Whenever necessary, it should be the ultimate source from which emergency credit might be obtained in the form of discounting of approved bills or advances on approved bills or advances on short-term securities, or government paper. The nature of these functions points out one basic fact, namely, that central banking is entirely different from commercial or other branches of banking and that its main aim is to serve in the public interest and not to secure profits. The functions of a central bank and the obligations resting upon it are of a very special character calling for skill, experience and judgment of a kind different from those which must be possessed by commercial and other branches of banks. It is true that no banker can neglect the rules of prudence and safety; but the object of a commercial banker is to make a profit. The situation of a central bank is such that it must often undertake operations which are not only profitable, but also result in losses. Its aim must be the economic welfare of the country. 1. Monopoly of Note Issue An important function of a central bank is the issue of legal tender currency. The main reasons for the concentration of note issue in a central bank may be found in the necessity of bringing about uniformity in the note circulation of a country and of avoiding the anomaly of over-issue by many banks established with the primary motive of securing profits. Further, the monopoly enjoined by a bank, which has close connections with the state, confers on the notes a distinctive prestige. These notes are capable of commanding public confidence. Above all, the very basis of monetary management is closely correlated with the capacity of a central bank to vary the total amount of legal tender currency according to the requirements of the productive sectors of the economy. Thus, it invariably follows that a central bank, which is endowed with the necessary powers of monetary management, must be equipped with the monopoly of note issue. However, as an issuer of currency, the role of the central bank in the future could be made complicated if not redundant, by the evolution of money substitute or digital money. Whether national currency itself will continue to be as important as it is now is another issue. In this connection, it is relevant to note that ‘euro’ has heralded the era of regional currencies. Note Issue and the State The separation of note issue from the hands of the state has been advocated mainly because of the danger of over-issue. According to Kisch and Elkin, ‘if the government itself has the right of note issue, either alone or in association with one or more banks, political considerations and pecuniary needs of the state rather than considerations of a Self-Instructional Material 137 Banking and sound monetary economy are likely sooner or later to become the determining factor.’ Insurance Sectors Again, ‘a state issue is likely to be unduly inelastic if the government of the day keeps to the paths of financial virtues, but all too elastic if the government finding itself in pecuniary difficulties is unable to resist the attractions of the printing press.’ Therefore, instead of NOTES the state monopolizing the note issue, it would be better if that right is entrusted with the central bank, subject to the overall supervision of the state. This would facilitate the function of the central bank in the field of monetary management. It is true that the state can bring pressure upon the central bank for an over-issue. But the resistance which is usually offered by the central bank against unsound monetary and financial policies on the part of the state is at least one advantage in favour of the central bank being the issuer of notes. Principles of Note Issue There are two different schools of thought regarding the principle of note issue, viz., the currency principle and the banking principle. According to the currency principle, the amount of legal tender currency should be limited to the gold reserves kept by a central bank. This assumes full convertibility of currency. The main advocates of this principle were Sir Robert Peel, Lord Overstone and Colonel Torrens of England. The Peel’s Act of 1844 in England was the outcome of this principle. The supporters of this principle hold that currency, under such a system, will expand and contract in the same manner as it would have expanded or contracted had metallic money been in circulation. Thus, the currency principle assures maximum safety for the currency. Nevertheless, it lacks elasticity. The supply of currency is absolutely tied down to the supply of gold, irrespective of the demands of trade and industry. Further, the principle does not take the power of the banks to create credit into account. In short, the currency principle may seem simple and intelligible to those who ignore the existence of credit, and the domestic demand which makes a larger circulation desirable at some periods than others. Against this is the view held by the advocates of the banking principle. According to them, there is no need to keep a hundred per cent reserves against the notes issued. Such a system would impair the productive capacity of the nation by making note issue inelastic. However, the supporters of this principle insist that the quality of notes should be maintained by assuring convertibility of notes. The great merit of this principle is that note issue, under this system, will correspond with the requirements of trade and industry. In other words, it will provide the country with an elastic currency, adequate in volume to the changing needs of the people. Further, guarantee as to convertibility will act as a regulator of note issue. The danger of over-issue is minimized to almost nil because notes which are in excess of the requirements of trade and industry will be returned to the bank of issue for conversion. In this connection, an important defect of this principle may be pointed out. For assuring convertibility of notes, the bank of issue must keep at least a small percentage of the total notes issued as reserves. If the over-issue exceeds these reserves, the bank of issue will find it impossible to convert the excess notes which are returned. An example may make the point more clear. Suppose the total amount of note issue is `10,000 and gold reserves worth `100 is kept by the bank of issue. According to our foregoing argument, any over-issue of notes will be returned to the bank of issue for conversion. Let us assume that the bank of issue has issued additional notes, in excess of the requirements of trade and industry, to the order of `150. Naturally, notes amounting to `150 will be returned to the bank of issue for conversion. At this stage the issuing bank is confronted with the problem of conversion. Its reserves amount to only `100 whereas notes returned for conversion Self-Instructional 138 Material amount to `150. Thus, the danger of over-issue will make the system of note issue Banking and inconvertible followed by loss of public confidence and monetary instability. Insurance Sectors In conclusion, it may be observed that both these principles are not worthy of adoption as they are. It is necessary to provide elasticity to the notes in circulation without affecting adversely public confidence. In a certain sense, banking principle assures NOTES elasticity and currency principle assures public confidence. At the same time, the former exposes the note issue to the serious risk of monetary instability and the latter makes it inelastic. Systems of Note Issue By coordinating the advantages of the banking principle and the currency principle, various systems of note issue have been evolved by different countries, such as the partial fiduciary system, maximum fiduciary system, proportionate reserve system, minimum reserve system and foreign exchange reserve system. Under the partial fiduciary system, a fixed amount is laid down by law which need only be covered by government securities. Notes issued above this amount must be fully backed by gold. England was the first country to adopt this system under the Peel’s Act of 1844. The declared purpose of the Act was ‘to cause our mixed circulation of coins and bank notes to expand and contract, as it would have expanded and contracted under similar circumstances had it consisted exclusively of coins.’ The purpose of fixing the fiduciary issue, i.e., the amount of notes to be covered by government securities only, was to economise that amount of gold without impairing the convertibility of notes. The fiduciary issue was arrived at with regard to the smallest amount which would always remain in circulation. This method was subjected to severe criticism. According to the critics, the system was not capable of satisfying the needs of trade and industry, and as such it lacked elasticity. On the other hand, the supporters of the system contended that it was capable of commanding public confidence by ensuring full convertibility of notes and avoiding the danger of over-issue. The inelastic nature of the system was clearly evidenced by subsequent events. In 1928, the Treasury was given the power to increase the fiduciary issue, which it still retains subject to its notification to the Parliament. In other words, under this system (maximum fiduciary system), a flexible maximum is laid down up to which notes may be issued without gold cover. Thus, the system ensures elasticity and makes the supply of money coincide with the requirements of trade and industry instead of tying it to the supply of gold. However, the system is criticized on the ground that it facilitates inflation and exposes the currency to the danger of monetary instability. Another system of note issue was prevalent in the USA between 1866 and 1913. According to this system, each National Bank was authorized to deposit bonds of the Federal Government having ‘circulation privilege’, and then issue notes in its own name upon the security of the deposited bonds. The system, no doubt, assured the safety of bank notes but it lacked elasticity. The inelastic nature of the system was clearly evidenced by the panic of 1907, when people found it difficult to obtain sufficient quantity of circulating medium. Consequently, it was abandoned in 1913 in favour of the proportionate reserve system. Under the proportionate reserve system, the central bank is obliged to keep a percentage of the total note issue in gold. The remainder should be covered by sound collateral securities. This system was first introduced in Germany, which provided for a minimum reserve of one-third of the notes in circulation. The remainder was to be Self-Instructional Material 139 Banking and covered by discounted paper having a maturity of not more than three months. Provision Insurance Sectors was also made for additional issue, in excess of the limits so fixed, subject to certain restrictions. This system was adopted in the USA in 1913 with minor modifications. Under the Federal Reserve Act of 1913, the Federal Reserve Banks were required to NOTES maintain gold reserves equal to 40 per cent of the face value of all federal reserve notes in circulation. In 1934, the Gold Reserve Act provided for the maintenance of reserves in gold certificates. These requirements were modified by the Act of 1945, which reduced the gold certificates reserve requirements from 40 per cent to 25 per cent. This system has the great advantage of elasticity. It ensures an adequate supply of currency to meet the trade demands of the country without any awkward rigidity. The provision to cover the uncovered portion by collateral securities like discounted paper and government obligations facilitates the central bank to expand the note issue in accordance with the volume of business activities. Further, the minimum reserve requirement provides a limiting factor against over-issue. It is also capable of commanding public confidence. The system has become very popular because of its added merits, especially in those countries where new central banks have been established during the beginning of 20th century. In this connection, it may be pointed out that the Hilton Young Commission recommended the suitability of this system for India. However, the system is not wholly devoid of disadvantages. Locking up gold reserves has often been pointed out as a shortcoming of this system. At the same time, full convertibility is not guaranteed because of the insufficiency of reserves to redeem all the notes. As such reserves will not be available for conversion. An extension of the above method may be found in the system of allowing the central bank to cover its note issue by foreign securities with or without a minimum percentage of gold reserves against notes and making the notes a first charge on all assets of the central bank. This system gives more freedom to the central bank. Reserve Requirements and Currency Regulation The necessity and purpose of any rigid reserve requirements against note issue under the present day circumstances have been questioned by many authorities. Do they in any way increase the confidence of the public in the currency? Or, do they in any way add to the security of the currency? The purpose of covering the note issue by gold reserves is often stated as the desire on the part of the currency authorities to sustain public confidence in the domestic currency. However, it would not be correct to say that under the present day circumstances, people’s faith in the currency is wholly dependent on the gold reserves kept against it. The bankruptcy of a modern central bank is almost impossible because the government of the country is close behind the bank to help it whenever necessary. As early as 1870, Walter Bagehot observed in connection with the stability of the Bank of England, ‘… neither the Bank nor the Banking Department have ever had an idea of being “put into liquidation”; most men would think as soon of ‘winding up’ the English nation’. These remarks hold good even in the case of other central banks. The bankruptcy of a modern central bank is never likely except in the event of the bankruptcy of the national government itself. This popular belief of the people has been amply demonstrated by past experiences. For instance, the Bank of England transferred its entire gold holdings to the Exchange Equalisation Account at the outbreak of the World War. However, this did not precipitate loss of public confidence in the currency. Although the provision still remains that note issue over above the fiduciary limit must be fully backed by gold Self-Instructional 140 Material reserves, the limit of fiduciary is altered from time to time so as to make it equal to the Banking and needs of the nation. Thus, today the Bank of England issues notes without any gold Insurance Sectors backing or, at best, with negligible gold backing. The limit of fiduciary which remained at 80 million pounds sterling at the outbreak of the War (1939) was increased to 2,325 million pounds sterling in 1961. The fact that the Bank holds only a trifling amount of gold NOTES has not affected adversely the soundness of pound sterling. The reduction of reserve requirements of the Federal Reserve Banks in the USA, a country which possesses the largest stock of gold, from 40 per cent to 25 per cent in 1945 is another case in point. The changes made in the Reserve Bank of India Act may also be pointed out in this context. The Amendment Act of 1956 provided for the revaluation of gold and a shift from the proportionate reserve system to the minimum reserve system of note issue. Another argument in favour of maintaining rigid reserve requirements is that such requirements will act as a brake on any inflationary over expansion of currency by the central bank. However, the success of a central bank in controlling inflationary pressures in the economy is mainly dependent on the overall monetary policy pursued by it rather than on the statutory gold reserves which it has to maintain. This is especially true from the point of view of the increasing popularity of bank credit. Moreover, if gold reserve requirements are rigidly fixed, the central bank will find it difficult to expand currency when it may do good to the nation as a whole. Further, the bank will find it difficult to discharge efficiently its function as a lender of the last resort. 2. Monetary Policy At the very outset, it may be made clear that this is sometimes referred to as ‘control of credit’. In the subsequent paragraphs, the term ‘monetary policy’ is used so that the credit control function of the central bank is viewed from a broader perspective. The function of instituting appropriate monetary policy measures is closely connected with the function of currency regulation. Needless to say, this function assumed importance with the growing popularity of bank credit and other forms of credit. In an earlier chapter, the power of the banks to alter the total amount of money in circulation through the mechanism of credit creation has been examined. Thus, the total amount of money in circulation has a relationship with the creation of credit. Of course, bankers are not the only persons having the power to create credit, although bank credit still occupies the most significant part in this sphere. There are other forms of credit. Businessmen and industrial enterprises can acquire goods and services without paying for them immediately. Such factors, no doubt, loosen the control of the central bank over credit money. However, a central bank does not refrain from its attempts to create orderly monetary conditions in the economy by implementing appropriate monetary policies. These attempts can further be reinforced by appropriate fiscal policies on the part of the state, and control of investment. In addition, exchange control measures can add their contribution towards the goal of establishing equilibrium in the realm of monetary Check Your Progress activities. 7. How are investment Objectives banks classified? 8. What is the main It is generally believed that ideally central banks should have the overwhelming objective advantage of of price stability. It is true that in practice central banks are responsible for a number of universal banking? objectives such as currency stability, financial stability, growth in employment and income, 9. State the types of virtual banking etc., in addition to price stability. In most cases, the primary objectives of a central bank services. are legally and institutionally defined. At the same time, the fact should be appreciated that it may not be possible to catalogue specifically all the objectives in the statute of a Self-Instructional Material 141 Banking and central bank. They usually evolve through traditions and tacit understanding between Insurance Sectors the government, central bank and other major institutions in the economy. Current thinking indicates that considerations of financial stability are assuming primary importance in monetary policy. It is important to remember in this connection NOTES that price stability is closely associated with financial stability. The economic crises in many emerging economies during the recent past appear to be closely associated with financial instability. According to the World Bank Annual Report, 2002, the loss of US $1 trillion in banking crises in the 1980s and 1990s is equal to the total flow of official development assistance to developing countries from 1950s to the present date. Instruments of Monetary Policy A central bank has at its disposal various instruments of monetary policy. Briefly, they are: • ‘Bank Rate Policy’, involving the alteration of discount rate so as to influence the market rate of interest, which plays a crucial role in the creation of credit. • ‘Open Market Operations’, involving the purchase and sale of securities in the open market so as to influence the total amount of money in circulation. • ‘Variable Reserve System’, involving the variation of the minimum reserves, which the banks are required to maintain with the central bank, so as to influence the power of banks to create credit. • ‘Selective Credit Controls’, involving directional controls so as to influence the flow of credit into particular channels. • ‘Credit Rationing’, involving the shortening the currency of bills eligible for rediscount and the limiting of the amount made available to banks so as to allocate funds among financially sound credit aspirants in accordance with a definite plan. • ‘Moral Suasion’, involving friendly persuasion and advice so as to influence the lending policy of banks. • ‘Direct Action’, involving coercive measures against particular banks so as to penalize recalcitrant units of the banking system. Practical Difficulties The adoption of the above mentioned methods cannot always be expected to produce the desired results. A variety of reasons may be pointed out for such ineffectiveness: • It is comparatively difficult for a central bank to arrest a fall in prices because no action can effectively restrain people from diminishing their investments. Control of inflationary tendencies is comparatively easier because the central bank can, by increasing the rate of interest or otherwise limiting the power of the banks to create more credit, make credit costly and discourage businessmen from expanding their volume of business. • The policies of the central bank will prove effective only if such policies are adopted in sufficiently earlier stages. If delayed, inflation or deflation is likely to gather momentum. In actual practice, it may take some time for the central bank to know exactly the market currents. Economic phenomena take some time to declare themselves and to be translated into statistics that reach the central bank’s desk. The counter measures, in turn, take some time to develop, and by the time they become effective, the original disturbance may be very deeply seated. Self-Instructional 142 Material • Even if we assume that the central bank gets correct information of the market Banking and trends at the right moment, a time lag is inevitable between the setting in of Insurance Sectors imbalance and the correcting of the disequilibrium. Added to this, there is another difficulty. By the time the policies of the central bank manifest themselves, market trends which existed at the time of instituting such policies may have yielded to NOTES entirely new and diametrically opposite trends. Or, a policy of expansion or contraction may be continued so long that it may ultimately result in a boom or a slump. An example may make the point more clear. Let us suppose that the existing market conditions are deflationary. The central bank will try to counteract this by adopting a policy of monetary expansion. More money will be injected into the economy. However, if the central bank is not careful enough to apply the brake at the correct moment, the expansionary policies will lead to a boom. The boom that followed the expansionary policies adopted by the authorities in the USA in 1927 is often pointed out as an example of this danger. Thus, the timing of the policies is one practical difficulty in making them effective. As observed by Crowther, ‘it is not an exaggeration to say that most of the energies of the central bankers in recent years have been consumed, not in resisting those natural economic tendencies that produce booms and slumps, but in counteracting the belated effect of their own previous policy’. • The success of the policies of a central bank depends, to a large extent, on a correct diagnosis of the market forces which, in turn, is dependent on a number of factors. If the dose of inflation intended to counteract mild deflationary tendencies becomes too strong, it will defeat the purpose of the central bank’s policy. The ultimate result will be inflation. Conversely, a mild dose of inflation to counteract severe slump may not produce the desired results. Apart from the above principal difficulties, the central bank may find it necessary to ‘swim against market currents’ in implementing its policies. For instance, a central bank may have to adopt a policy of monetary contraction when the market conditions are apparently quite bright because of boom conditions. Popular opinion, on the other hand, may be against the central bank following such policies. The government, which wants to remain popular, may also object to such policies. Here, the central bank requires much courage to brave all the oppositions and to take resolute action in the long-term interest. Difficulties may also arise because of forms of credit other than bank credit. It may be admitted that in the sphere of bank credit, the influence of the central bank, by and large, will be effective. But bank credit is not the only form of credit which is capable of altering the effective purchasing power. There are other forms of productive, commercial and financial credit like book credit, mortgage bonds, etc. One cannot deny the power of persons and corporations to acquire goods and services without paying for them immediately. This loosens the control of the central bank over the total volume of credit. Another important point to be mentioned in this connection is that even in the sphere of bank credit, the control of the central bank will not be perfect unless the banks are willing to realize their responsibility in maintaining orderly monetary conditions and to appreciate the policies of the central bank in this direction. Above all, as remarked by De Kock, ‘The personal element in credit control is generally a difficult force to contend with… . The controller of credit is constantly

Self-Instructional Material 143 Banking and confronted with the action, reaction and interaction of human factors which cannot Insurance Sectors always be accurately determined or completely neutralized.’ To sum up, the central bank is encountered with innumerable difficulties in its function of implementing appropriate monetary policies. Nevertheless, a modern central NOTES bank can never keep aloof from its responsibility in creating and maintaining orderly monetary conditions in the economy and stabilizing the general business situation. The methods by which a central bank strives to discharge this responsibility are discussed in the following sections. Bank Rate Policy Bank Rate is the rate at which the central bank rediscounts certain defined bills and other eligible papers. The Bank Rate Policy has been defined as ‘the varying of the terms and of the conditions, in the broadest sense, under which the market may have temporary access to the central bank through short-term assets or through secured advances.’ The central bank of a country is the ultimate source of cash, and is therefore considered as the lender of the last resort and the banker’s bank. In this capacity, it has to meet the genuine requirements of the banks in times of emergencies. A central bank will be willing to extend rediscount facilities to the banks, provided they offer short-term assets which are considered eligible for rediscount by the central bank. A central bank extends such a facility only at a price. This is technically known as the ‘bank rate’ or ‘discount rate’. In countries where active and well developed money markets exist, there will be a close relationship between the bank rate and the market rates. Since banks find it possible to get money in times of emergencies only at a price, viz., the bank rate, they will not be willing to charge a much different discount rate or interest rate to their constituents. As such, a variation in the bank rate will generally be followed by a corresponding variation in the market rates also. In general, the bank rate will be higher than the market rate. The relationship between the bank rate and the market rate endows the central bank with the power to influence the credit creation of banks. In the simplest terms, a high bank rate is likely to decrease the total amount of money in circulation, and a low rate to increase the total amount of money in circulation. Thus, whenever the central bank deems it necessary to decrease the total amount of money in circulation, it will increase the bank rate. This will be followed by an increase in the market rates. Higher market rates will discourage borrowing, resulting in a reduction of bank credit. Under gold standard, a variation in the bank rate will readjust the internal cost- price structure and will correct any disequilibrium in the balance of payments by curbing the movement of gold into and out of the country. Although the results of variations in the bank rate seem so simple apparently, it should not be construed that such variations will always produce the desired results. The limitations are discussed subsequently. • Mechanism of Bank Rate Policy The principle underlying the theory of Bank Rate policy is that a change in the Bank Rate will be followed by a corresponding change in the market rates. Let us assume that inflationary conditions are existing in the economy. Here the central bank intervenes and raises the Bank Rate. This, as indicated earlier, will increase the cost of borrowing for the banks. Consequently, the market rates will go up. The increased market rates will Self-Instructional 144 Material discourage businessmen from borrowing money. This will check business activity, and Banking and unemployment will ensue. The demand for goods and services decreases because of Insurance Sectors the decreased purchasing power of the people. This, in turn, will affect the producers adversely. Further reduction in productive activities and further unemployment will be the result. As demand decreases, prices will ultimately come down. Thus an increase in NOTES the Bank Rate will be followed by a diminution in the total amount of money in circulation, reduction in money incomes and prices, and a general slowing down of the economic activities. Conversely, a decrease in the Bank Rate will be followed by a reduction in the market rates. This, in turn, will be accompanied by increased borrowing, increased money incomes, increased prices and expanded business activities. • Bank Rate Policy Under Gold Standard The theory underlying Bank Rate policy is especially applicable under the gold standard system. When there is an adverse balance of payments followed by loss of gold from a country owing to maladjustment between imports and exports or by an excessive flow of capital owing to lower money rates prevailing in that country, the central bank can check this by increasing the Bank Rate. We have already traced the internal effects of such an increase and come to the conclusion that this will ultimately lead to a reduction in prices. Lower prices will induce foreigners to purchase goods from that country, while relatively higher prices in foreign centres will discourage imports. This will help the country to develop a favourable balance of trade. Further, higher money rates will attract foreign capital. In short, an increase in the Bank Rate will help the country to correct any adverse balance of payments through an inflow of gold. However, a continued inflow of gold will disturb the equilibrium in the balance of payments. When a country receives too much of gold, it will accelerate the power of banks to increase the total amount of money in circulation. Business activities will be stimulated, followed by an increase in the internal cost-price levels and will result in an adverse balance of payments. Therefore, whenever the central bank finds that boom conditions are developing in the economy, it has to apply the brakes and lower the Bank Rate. Thus, by varying the Bank Rate constantly, upwards or downwards, the central bank can maintain equilibrium in the balance of payments. • Short-term Rates vis-à-vis Long-term Rates In our earlier analysis, we have seen that the principle underlying the theory of Bank Rate policy is that investment is influenced by changes in the rate of interest. There is consensus of opinion regarding this basic fact. However, there are two lines of thought as to whether changes in the rate of interest influence short-term investments or long- term investments. According to Hawtrey, economic activity is mostly influenced by short-term rates of interest, whereas according to Lord Keynes economic activity is mainly influenced by long-term rates of interest. Hawtrey holds that any change in the Bank Rate influences the willingness of the middlemen and wholesale dealers to hold stocks of finished and partly finished goods because these stocks are financed through short-term loans. For instance, an increase in the Bank Rate will discourage the wholesale dealers to hold stocks. Hence they will reduce their stocks by placing fewer orders with the producers. The producers, in turn, will reduce production. This will have the effect of reducing the volume of employment of the factors of production. The money incomes of the people and consequently their Self-Instructional Material 145 Banking and purchasing power will contract. Contraction of the purchasing power of the final Insurance Sectors consumers will affect the wholesalers adversely. Thus, the vicious cycle of increase in short-term rates, decreased orders, decreased production and consequent unemployment, lesser purchasing power of final consumers and decreased demand will be set in motion. NOTES Added to this is the general tendency to postpone purchases in the expectation of a further fall in prices. The cumulative effect of all this is accentuated by a depression in the capital goods industries owing to lesser orders from the producers. Conversely, a fall in the Bank Rate will be followed by the readiness of the wholesalers to hold more stocks. This, in turn, will set in motion a chain of reactions beginning with increased orders, expanded output, increased employment, increased money incomes and increased sales. Ultimately, it will lead to expanding production and rising prices. The above view has been criticized mainly on the ground that it gives undue importance to changes in interest rates, which is only one of the factors in the total cost of holding stocks. In order to study the attitude of middlemen and wholesalers, it is necessary to take into account other costs as well. According to Lord Keynes, the demand for working capital is not so sensitive to changes in the short-term rates. He holds that economic situation is affected through long-term rates of interest and the volume of fixed capital goods. At this stage, it may be noted that short-term and long- term rates are not unrelated. Variations in Bank Rate, therefore, influence not only the short-term rates but also the long-term rates. A rise or fall in the short-term rates will ultimately lead to a rise or fall in the long-term rates and vice versa. This point may be illustrated. Assuming that the long-term rates remain the same while short-term rates increase, people will prefer to invest in short-term securities. Demand for short-term securities will go up and the demand for long-term securities will come down. This will naturally result in a fall in the prices of long-term securities. In other words, the yield on long-term securities will go up. For instance, let us assume that the market value of a long-term security worth `10,000 carrying interest rate of 8 per cent comes down to `8,000. Although the market value comes down to ` 8,000, still any prospective purchaser will get `800 as interest. Thus, for all practical purposes, it could be considered that the security worth 8,000 yields income of `800. That is, any prospective purchaser will get an effective yield of 10 per cent. In other words, there is an increase in the long-term rates. This increase in the long-term rates will affect the investment market. If investors find the prospects of profits to be the same, investments in capital goods will decline. This will be followed by a decline in the capital goods industries, causing unemployment. The vicious cycle of lower money incomes, lesser purchasing power, decreased demand and decreased production leading to further unemployment will be set in motion. Ultimately, it will result in a fall in prices. In conclusion, it may be stated that both these views hold good in a certain sense. Both short-term rates and long-term rates influence the general economic situation. In any case, they are closely inter-related. Limitations of Bank Rate Policy Suspension of gold standard, restrictions on capital movements and other artificial restrictions have greatly reduced the importance of Bank Rate policy in correcting automatically any disequilibrium in the balance of payments. It’s importance as a regulator of internal cost-price structure has also dwindled. The reasons are manifold. Self-Instructional 146 Material As mentioned earlier, the efficacy of Bank Rate policy depends, to a great extent, Banking and on its power to influence the market rates. This presupposes the existence of a highly Insurance Sectors organized money market. Unfortunately, most of the countries do not have organized money markets. The multiplicity of market rates makes the success of the Bank Rate policy doubtful. These market rates seldom respond to Bank Rate changes. The absence NOTES of any kind of conventional relationship between the central bank and other components of the money market further adds to the ineffectiveness of Bank Rate policy. If cooperation can be established between the central bank and the other components of the money market, somewhat on the lines of the traditional conventions by the English banks, changes in the Bank Rate can be made more effective. In addition, the necessity of the banks to approach the central bank for rediscount is an important factor in determining the effectiveness of the Bank Rate policy. It is through these discounts that the central bank tries to synchronise a change in the Bank Rate. But if the banks have ample liquid resources at their disposal, there is no need for them to approach the central bank. Even in the United Kingdom with a highly organized money market and traditional conventions observed by the banks, the market rates sometimes fail to follow the Bank Rate owing to the highly liquid state of the money market. The increase in the volume of money resulting from the revaluation of gold during the post-war years, net favourable balance of payments and the direct and indirect creation of bank credit for government and other purposes have substantially increased the liquidity of the money market in almost every country. Another important factor which is considered essential for the successful operation of the Bank Rate policy is the elasticity in the economic structure. Prices, wages, production and trade must respond to changes in the Bank Rate. Businessmen must work on narrow margins so that they react very sensitively to the slightest changes in costs and profit basis. The world-wide suspension of gold standard, government control over prices, wages, etc and artificial exchange restrictions have considerably limited the situation just mentioned. The psychological reactions to a change in the Bank Rate should also be taken into account in this connection. During a depression, businessmen may feel so gloomy that they will not be prepared to embark upon new ventures even if there is a considerable fall in the interest rates. Similarly, during a boom period businessmen may feel so assured of future profits that they will not be prepared to curtail their business activities in spite of a considerable rise in the interest rates. Conclusion The limitations discussed above have caused a decline in the importance of the Bank Rate policy. Even in England it has lost much of its old significance. Commercial banks are now ready to grant commercial credit on open account and bank advances on current account. This has greatly reduced the popularity of bills of exchange. Further, Treasury Bills and other short-term government securities have displaced bills of exchange for short-term investments. However, it would not be correct to say that this instrument of monetary policy has gone completely out of use. It is true that it is often used in conjunction with other instruments of monetary policy as well as suitable fiscal policy and investment control. In fact, there has been a recent revival of this instrument in many countries. • Open Market Operations ‘Open market operations’ implies the sales and purchases of government securities. In a broader sense, ‘open market operations’ may be said to cover sales and purchases of Self-Instructional Material 147 Banking and equities, and gold and foreign exchange, besides government securities. In countries Insurance Sectors where the market for government securities is limited or where the supply of government securities is inadequate, open market operations may also include operations in government-guaranteed securities and municipal or other securities. But in most countries, NOTES these operations are confined to the sales and purchases of government securities. It was only after the 1930s that the employment of open market operations as an instrument of monetary policy came to receive attention in countries outside the UK and the USA. It has been found that open market operations are better suited to influence the market trends directly. In the case of the policy of bank rate, the central bank has to wait for the market to react. Its efficiency depends on its indirect influence in the market trends through changes in money rates. Whereas, open market operations have direct and immediate effect on the volume of money and credit as well as on money and interest rates generally. Thus, open market operations are even considered to be superior to the policy of bank rate. However, for achieving effective results, both policy of bank rate policy and open market operations are often used in conjunction. Bank rate changes or open market operations independently may not produce the desired results. In this connection, two divergent views may be pointed out. Hawtrey holds that open market operations should be employed in conjunction with the bank rate policy to bring about the desired results. On the other hand, Lord Keynes holds that open market operations need not be supplemented by bank rate policy to achieve the desired results. According to him, open market operations may be employed independently, provided they are supplemented by suitable fiscal policies. Nevertheless, open market operations are generally employed to prepare the ground for a change in the bank rate. In addition, they are employed for creating and maintaining cheap money conditions on grounds of public policy or as a means of absorbing excess liquid cash or for raising the necessary funds to finance the developmental activities of the state or for avoiding disturbances in the money market as a result of movements of government funds or for offsetting the inflow and outflow of gold or for insulating the internal credit structure from sudden and temporary changes in the balance of payments or for avoiding undue fluctuations in the prices and yields of government securities. Thus, open market operations have come to be adopted as a principal instrument of monetary policy and also as an independent method. • Mechanism of Open Market Operations Open market operations influence the market trends by varying the total amount of money in circulation and the power of the banks to create more credit. Purchases or sales of securities in the open market will be followed by a decrease or increase, respectively, of the total amount of money in circulation. The cash reserves of the banks, on which the very superstructure of credit stands, will correspondingly contract or respond. The point may be illustrated. Suppose, the central bank purchases securities through open market operations. This will have the effect of injecting more money into circulation. Sellers of the securities will deposit the sale proceeds in their banks, thereby increasing the cash reserves of these banks. Thus, purchases of securities by the central bank will be followed by an increase in the legal tender currency and an increase in the power of banks to create more credit. Conversely sales of securities will be followed by absorption of excess money in circulation. The deposits of banks will decrease because the purchasers generally Self-Instructional 148 Material effect payments by withdrawing their deposits. If the purchasers are the banks, they will Banking and issue cheques drawn on their accounts with the central bank. In either case, the result Insurance Sectors will be a decline in the cash reserves of the banks. Ultimately, the total amount of legal tender currency as well as the power of the banks to create more credit will contract. These operations may be combined with the bank rate policy. Excess liquidity in NOTES the money market may be absorbed by carrying out open market operations. Now if the central bank increases the bank rate, the money market rates will readily respond. This is mainly owing to the fact that banks will find it possible to increase loans and advances only by approaching the central bank for financial accommodation since their excess cash reserves are depleted. This accommodation can be obtained from the central bank only at a price. Naturally, banks will have to increase their lending rates. Limitations of Open Market Operations The success of open market operations depends on the existence of a broad and well developed market for government securities and the maintenance of a relatively stable cash reserve ratio. Except for a few well developed money markets, the absence of these conditions has, by and large, limited the significance of open market operations. The market for government securities in certain countries is so small that large scale of purchases/sales by the central bank would have the effect of causing wide fluctuations in their prices. Further, the total amount of money in circulation and the cash reserves of banks may not always respond to the purchases/sales of securities owing to certain disturbing factors. For example, there are chances for the withdrawal of currency for hoarding purposes when the central bank endeavours to increase the total amount of money in circulation by purchasing securities. Conversely, release of currency from hoards may neutralize the policy of the central bank to withdraw money from circulation by selling securities. It is equally necessary to take into consideration the reactions of the businessmen while the central bank is employing open market operations in order to increase the total amount of money in circulation and thereby to revive the general business situation. They may feel so gloomy about the future courses of prices and profits that they may not be willing to expand their business activities. Sometimes it is not only a case of unwillingness to borrow on the part of the businessmen, but also of unwillingness to lend on the part of banks. Thus, owing to the risks involved, there may be either a lack of borrowers as such or lack of borrowers who are creditworthy applicants and require credit for purposes which is acceptable to banks under the prevailing circumstances. Another limitation may arise from the fact that banks may neutralize the contraction of credit by making use of the rediscounting facilities afforded by the central bank. Conclusion In spite of the above limitations, open market operations find a place in the armoury of monetary policy. It is true that these operations are employed mainly in countries like the USA and the UK which have broad and active markets in short-term and long-term government securities. However, other countries also employ such operations, although their efficacy has remained limited. An attempt may be made in this connection to highlight the measures which may overcome the limitations of open market operations. The first task of any central bank for the successful implementation of open market operations is the development of a sufficiently well-developed and an active Self-Instructional Material 149 Banking and money and capital markets so that these operations can be carried on without wide price Insurance Sectors fluctuations in the securities. Further, the central bank should be fully equipped with sufficient securities of different maturity with which it can carry on its operations. The legal setting for the conduct of open market operations should also be made favourable. NOTES As observed by the Board of Governors of the Federal Reserve System, the central bank should be given a relatively free hand in all matters pertaining to monetary policy. It appears equally necessary to grant the central bank the power to deal in securities other than government securities when the latter do not constitute a very sensitive part of the financial structure. Variable Reserve Ratio The limited efficacy of the traditional instruments of monetary policy has induced the central banks to explore the possibility of adopting new methods. ‘Variable Reserve Ratio’ has been the outcome of such a tendency. Under this method, the central bank is given the power to vary the minimum cash reserves to be kept by the banks with the central bank. This method was first suggested by the Federal Reserve Board in its annual report for 1916. It was introduced in the USA in 1933 and was given a permanent status by the Banking Act of 1935. It has been laid down in the Act that the Board of Governors of the Federal Reserve System might, by regulation, change the requirement as to the reserves to be maintained against demand or time liabilities or both by member banks. The system has been later adopted in several other countries including India. Objectives Reserve requirements were originally sought to be enforced upon the commercial banks with the main objective of imparting liquidity to them. However, the modern conception is that reserve requirements of banks serve primarily not as a means of preserving their liquidity but as a medium through which contractionist or expansionist pressure can be exerted on the credit situation. Thus, the main objective of variable reserve ratio is to endow the central bank with an additional weapon in order to prevent injurious credit expansion or contraction by varying the reserves required to be maintained by the banks with the central bank. As stated by the Board of Governors of the Federal Reserve System, ‘it is far better to sterilize part of these superfluous reserves while they are still unused than to withdraw the foundation of the structure’. It was further stated that the principal effect of the increased reserve requirements was not to restrict the current availability of money, but rather to limit the potential expansion of credit which might ultimately be based upon the reserves held by the banks. • Criticisms Although variable reserve ratio has found increasing favour with many central banks, it has been criticized on certain grounds. The first criticism levelled against this method is that its effect on the smaller banks with fewer resources will be adverse as compared to bigger banks with large resources. To remedy this defect, the American Technological Mission to Cuba recommended that, in fixing the reserve ratios of banks, the central bank may be authorized to make adjustments in order to enable the smaller banks some degree of expansion of credit. In the American banking system, different banks are treated differently for the Self-Instructional 150 Material purpose of fixing reserve ratio. This will certainly help to increase the flexibility. But it Banking and may give rise to the possibility of discriminatory treatment. Moreover, when a central Insurance Sectors bank increases the reserve requirements, the intention is obviously to discourage the banks from increasing their credit creation. As such, there is no justification in allowing certain banks to create more credit on the ground that they are small banks or comparatively NOTES newer banks. Another method may be suggested by which relief can be given to smaller banks. The increase in reserve requirements may be on the basis of any future increase in deposits. It has been observed that if the emphasis is on arresting further expansion in bank credit, the logical approach should be that only growth in deposits shall be subject to higher reserve requirements. Another criticism is that the method lacks flexibility, in the sense that it cannot be employed in correcting small or localized situations of credit stringency or superfluity. This complaint can be effectively remedied by classifying banks area-wise as in the USA and fixing separate reserve ratios for each group of banks. It is also pointed out that an increase in reserve ratio may cause a depressing effect on the securities market. When the central bank increases the reserve ratio of banks, they may try to replenish their cash reserves by selling securities included in their asset portfolio in the market. This may cause a glut in the market prices of securities. But, as pointed out by the Open Market Committee of the Federal Reserve System, variable reserve ratio may be supplemented by open market purchases. Although apparently the integration of the two policies may appear paradoxical, it can be made complementary. The observations of the Open Market Committee referred to above are pertinent in this connection. It said, ‘Open market purchases will be designed to maintain security prices and relieve local stringencies in the reserves of member banks rather than increase the total volume of reserves. Member banks may tend, in such circumstances, to restrict their sales of securities to just what will be necessary to adjust their reserve position to the changed requirements.’ Further, the difference in the reserve ratios to be kept against time and demand liabilities has been pointed out as not justifiable and that one flat rate is desirable. Admittedly, it is not the intention of the central bank to ensure the liquidity of the banks while requiring them to keep cash reserves with it. The aim is to check the multiple credit expansion of the banks. As such, there appears to be little justification for making any distinction between the ratios of cash reserves to be kept against time and demand liabilities of banks. On the other hand, a uniform rate will only increase the control of the central bank in this regard. The method has also been criticized on the ground that high reserve requirements will impair the profit earning capacity of the banks. In reply to this criticism, it may be stated that most of the central banks provide for the payment of interest on the reserves when they exceed a certain percentage of the deposits of the respective banks. The method has been further criticized on the grounds that it confers wide powers upon the central bank. This does not constitute a valid criticism because the central bank, as the nucleus of a nation’s financial system, is often vested with wide powers. As such, there is not much sense in arguing that a central bank should not be given such powers on the ground that, if abused, such powers will cause untold damage. It is the duty of the central bank to feel the pulse of the market and act appropriately. No doubt, variable reserve ratio method is very powerful which may do more harm, if applied carelessly. The remedy does not lie in abandoning the method, but in devising ways and means for its successful employment. As suggested by Lord Keynes, the ratio might be Self-Instructional Material 151 Banking and varied with due notice and in small degrees. The possibility of any undesirable psychological Insurance Sectors reactions may be guarded against sufficiently earlier by giving explanatory statements as to the purpose of such variation. It has been correctly argued that the nature and extent of the market may often NOTES limit the success of variable reserve ratio. Truly, if the banks are in the habit of maintaining large and flexible cash ratio, they may transfer a part of their excess reserves to the central bank whenever the latter increases the reserve ratio. Thus, the potential credit creating capacity of the banks will not be much affected. To a certain extent, this limitation may be remedied by fixing a high cash ratio. 6.10.2 Secondary Reserve Requirements In the earlier discussions, it has been noticed that banks can alter the total amount of credit money by altering their reserve base through sales of government securities and other liquid assets included in their asset portfolio, when the central bank employs bank rate policy, open market operations or variable reserve ratio. In order to restrict this power of banks, the Board of Governors of the Federal Reserve System stated in the annual report of 1945 that the central bank should be given the power to require the banks to maintain minimum holdings of short-term government securities and other liquid assets. The method has been adopted in many countries. In some countries, it served as a valuable anti-inflationary measure by making the bank rate policy more effective. In some other countries it facilitated deficit financing by the state. However, in general, it could be made to play an important function in the overall monetary policy under conditions of exceptional inflationary pressures. It strengthens the effects of variable reserve ratio system. A difficult problem that may be encountered when secondary reserve ratios are provided is that of fixing the level of the ratio. Before fixing the level, the position of the bank should be taken into careful consideration. In any case, it should be fixed at a sufficiently high level. Otherwise, the power of banks for multiple credit expansion will not be affected much. Another point to be noted in this connection is that in case variable reserve ratio and secondary reserve ratios are employed in unison, it would be advisable not to increase both ratios simultaneously except in extreme cases. Conclusion The power of the central bank to vary the reserve requirements of banks is considered as a very useful addition to the armoury of monetary policy. The method has been characterized by some as a ‘battery of the most improved type’ that a central bank can add to its armoury. It is particularly useful in countries with undeveloped money markets where the bank rate policy and open market operations have only limited efficacy. It may be noted that the bank rate policy, open market operations and variable reserve ratio (with or without secondary reserve ratios) are closely related instruments of monetary policy. In the final analysis, the effect of all these instruments is on the reserve base. Open market operations and variable reserve ratio affect that base directly, while the bank rate policy affects it indirectly through the cost of reserves. At times, the use of one method rather than another may be necessary. This is explained by the fact that each has a different impact. However, for achieving effective results, all these instruments should be used together. In this connection, the fact cannot be overlooked that high reserve requirements create distortions in the financial system. Hence, even the abolition of reserve requirements Self-Instructional 152 Material is demanded by some quarters on the plea that with capital adequacy and prudential Banking and norms now in place in many countries, reserve requirements are no longer necessary. Insurance Sectors They point out that the market environment has induced many central banks to focus more on interest rates rather than bank reserves to influence liquidity. As a matter of fact, many countries have now no reserve requirements. And in those countries which NOTES still have reserve requirements, the minimum deposit at the central bank has fallen to such low levels that it is no longer considered to be an active monetary policy instrument. Qualitative Instruments of Monetary Policy The instruments discussed above are intended to control the quantity of the total amount of bank credit by causing variations in the amount of available reserves. These methods do not control the distribution of bank credit in particular directions. In other words, they do not strive to control the quality of bank credit. This objective is achieved by employing certain other instruments like credit rationing, selective credit controls, direct action and moral suasion. Credit Rationing Credit rationing is employed by central banks as a temporary expedient or an abnormal measure dictated by special circumstances, or as a part of a comprehensive scheme of national economic planning. Under this method, the central bank rations credit by limiting the amount available to each applicant and restricting rediscounts of short-term bills. This instrument of monetary policy is mainly employed by authoritarian states to facilitate intensive and extensive economic planning. In the former USSR, it used to be considered as an important technique of monetary policy. By employing this method, the State Bank of the USSR used to allocate funds among financially sound credit aspirants in accordance with a definite plan. Although it is mainly employed by authoritarian states, credit rationing in one form or another is adopted by several other countries during times of exceptionally difficult and critical conditions. According to Wagemann, in more primitive economic conditions, the setting of credit quotas is the only decisive method which the central bank has in order to prevent excessive credit demands on the part of business. Credit rationing was employed by the Bank of England towards the end of the eighteenth century. During 1924–26, the Reischsbank of Germany adopted this method. In 1931, the Reischsbank fixed credit quotas ‘to prevent the collapse of the large banks’. The Bank of Mexico is another central bank which employed credit rationing as an important weapon for regulating credit. The Bank of France is yet another central bank which laid down a rediscount ceiling for each commercial bank in 1949. However, credit rationing is not considered an instrument of monetary policy to be used under normal circumstances. It should be used only under highly exceptional Check Your Progress circumstances. For instance, the President of the Reischsbank described credit rationing 10. State three as an extremely imperfect and undesirable form of action for a bank of issue. His instruments of justification for the employment of the instrument by the Reischsbank during 1924–26 monetary policy. was that ‘extraordinary situations call for extraordinary remedies and cannot always be 11. What is the relation between bank rate mastered by the theoretical rules evolved for normal conditions’. and market rate? Direct Action—Moral Suasion—Publicity 12. When was the variable reserve Direct action implies the coercive measures taken by a central bank against individual ratio first units of the banking system. Direct action has derived its designation from the fact that introduced? it implies direct dealings with individual banks, whereas the bank rate policy is applied Self-Instructional Material 153 Banking and generally and objectively to all institutions which have to borrow from the central bank, Insurance Sectors and whereas open market operations are characterized by their impersonal application as well as their repercussions on banks and the money market generally. The importance of this method increased considerably during the post war years. Many countries NOTES conferred upon their respective central banks specific statutory power to have a direct control over the banks. Selective credit controls are sometimes considered as one form of direct action. To a great extent, direct action is effective in controlling the quality of bank credit. However, it should be noted that any drastic action is likely to create an unfavourable psychological reaction. Moral suasion, as opposed to direct action, does not contemplate any coercive measures. It implies the friendly persuasion by the central bank. Many quarters have expressed doubts about the efficacy of this instrument of monetary policy. According to Clark, ‘persuasion as a means of credit control has not been successful. The efficacy of warnings as an instrument of credit control has been very slight. At times they no doubt has created a restraining influence, the forces making for expansion have proved too powerful for warnings without any teeth in them to be effective.’ On the other hand, according to Burgess, ‘the Reserve Bank may at times exercise an important influence on the general credit situation through the informal suggestions which they make to bankers… . The informal influence which they exercise in this way may at times prove more important than their formal action under law.’ No doubt, the success of this instrument depends on the relationship existing between the central bank and the commercial banks. However, in spite of the limitations, many central banks endeavour to exercise their moral influence over the links of the banking system. Publicity is often employed by the central banks to educate the banks about the money market trends. As an instrument of monetary policy, much can not be said about the efficacy of publicity. Generally, central banks regard it as a matter of duty rather than an instrument of monetary policy to publish weekly statements, monthly and other periodical reviews and annual reports dealing with credit and business conditions. Of course, there are certain writers who place a great deal of value and importance on publicity. According to Burgess, ‘the statements of views of officials have sometimes constituted an instrument of policy fully as effective as specific action and they may well prove in the long run as important a factor making for financial stability.’ Selective Credit Controls The traditional instruments of monetary policy, which are employed to restrict the total quantity of credit, are not effective in controlling the quality of credit and channelizing its flow into those lines where they are most called for and most needed. This point has induced many central banks to make a shift in their credit policies in favour of selective credit controls. Selective credit controls imply direct restraint on certain types of bank lending. They restrict credit from flowing into particular channels which are considered as undesirable or less essential. They are also employed to attain the positive object of diverting bank credit into desirable channels. In developing economies, they are primarily intended to prevent the anti-social use of credit, which is associated with the speculative hoarding of strategic commodities, and to push down the prices or to check any unwarranted increase in their prices. A distinction may be made between qualitative controls like credit rationing, direct action and moral suasion and selective credit controls. The former affect only the supply Self-Instructional 154 Material side of the money market, whereas the latter mainly affect the demand side and exercise Banking and a restraining influence on the demands of potential borrowers. Insurance Sectors Selective credit controls owe their origin to the crisis of the 1920s in the US stock market. The stock market boom which culminated in a crash was largely a product of bank credit expansion. The Securities Exchange Act of 1934, therefore, endowed the NOTES Federal Reserve Board with the authority to impose margin requirements on credit against stock exchange securities (other than government securities), extended by banks as well as brokers and dealers in securities. Again, during the war period, the Board was authorized to regulate consumer credit. This was intended to restrict non-essential expenditure and to divert funds to government borrowing. The authority was suspended in 1952. In 1950, the Board of Governors was given a temporary authority to regulate real estate credit, which continued till September 1952. In UK, selective credit controls are mainly employed through Treasury requests, generally conveyed through the Governor of the Bank of England. Behind these requests are the unused statutory powers of the Treasury for issuing directions on bank credit. However, the high sense of responsibility shown by the English banks made it unnecessary for the Treasury to use this statutory authority. Through these requests, the banks were directed, from time to time, not to make advances for hire purchase or speculative holding of commodities, to give priority to production for export or for the displacement of imports, etc. Although there has been a relaxation of credit curbs, selective credit controls are retained in principle. In addition to the USA and the UK, most of the other central banks are endowed with this instrument of monetary policy. Limitations of Selective Controls Although increasing use of selective credit controls is made by many countries, there are certain limitations to this instrument which should be reckoned with. In the first place, bank credit is not the only form of credit available to the borrowers. In addition to banks, there are other institutions which extend loan facilities. Therefore, unless these institutions are also brought under the control of the central bank, the success of the control measures will remain limited. For instance, in Australia, selective controls are imposed on hire purchase financing companies and private lenders. The relationship between the central bank and the commercial banks is an important factor determining the success of selective controls. If the banks are conscious of their responsibilities, the task of the central bank in implementing the control measures will be much smoothened. The high sense of national responsibility evinced by the English banks is a case in point. On the other hand, in Australia the controls are looked upon by the trading banks as an undue interference in their working. A further limitation arises from the fact that traders may get the necessary bank credit in the non-controlled sector and divert these funds to the controlled sector. The extent of the area of operation is yet another factor determining the efficacy of the control measures. Selective controls can be made a really powerful instrument only by extending them over all the sectors. However, such wide operations are possible only in a totalitarian state. It has been correctly observed that ‘if we want to extend the scope of selective controls, we must be prepared to wander away from a free private enterprise economy right into the straight jacket economy of a highly socialist state’. Above all, it should be remembered that the success of selective credit controls in arresting inflationary pressures in the economy does not only depend on the selective Self-Instructional Material 155 Banking and controls on bank credit but also on certain other factors such as aggregate and individual Insurance Sectors demand and supply. When there is an increase in the price of a commodity owing to its scarcity, selective credit controls cannot be expected to bring about spectacular results.

NOTES Conclusion In spite of the limitations enumerated above, the importance of selective credit can not be ruled out absolutely. There could be occasions when short lived restrictions are more appropriate and then selective restrictions on bank credit will be preferable to a general raising of interest rates. Again, when an exceptionally unusual situation develops, directional control of lending is justifiable; their disadvantages are of the kind which warrant early relaxation rather than complete avoidance. The American experience has clearly demonstrated the efficacy of this instrument in controlling speculative credit and mitigating the swings of business cycle. As observed by Dr John Mathai, ‘restricting money where non-essentials are concerned and releasing money where essentials are concerned is a wise policy of the central bank’. While supporting the flow of credit in desirable directions, it is the duty of the central bank to ensure that bank credit does not flow in certain undesirable directions. It has been rightly observed that before administering therapy to all parts of the ‘body economic’, the particular ailing part should be selected for administration of local therapy. 6.10.3 As Banker and Advisor of the State Acting as banker, agent and advisor of the state is an important function of the central banks. As the banker to the state, the central bank conducts the banking accounts of government departments, boards and enterprises. Providing the government with short- term loans and advances is an important banking service rendered by the central bank. This enables the government to meet its current financial obligations in anticipation of its revenue. For instance, in India, the Reserve Bank of India is authorized to make ‘ways and means advances’ to the central and state governments, which are repayable within three months from the date of making such advances. In this connection, it should be remembered that at times such loans and advances may become a powerful source of inflation. During the times of crisis, they may lead to serious inflation as had happened in the case of France, Germany and elsewhere in Europe during and after the First World War (1914–18). The reason is that such loans and advances bring about not only a direct increase in the quantity of money in circulation, but also an increase in the cash reserves of commercial banks. This, in turn, facilitates multiple credit expansion by banks. However, if they are given only to meet temporary monetary stringency, till the receipt of income from taxation or from public loans, they need not necessarily result in inflation. In addition, the central bank is rendering a very useful service to the government by providing the latter with the necessary foreign exchange required to meet the external debt service or the purchases of goods and other disbursements abroad, or by buying any surplus foreign exchange which may accrue to the government from foreign loans or from other sources. Further, the central bank is often entrusted with the management of public debt and the issue of new loans and Treasury Bills on behalf of the government. In this regard, current thinking is for separation of public debt operations from the central bank on the ground that such operations might be in conflict with the monetary policy operations.

Self-Instructional 156 Material By acting as an advisor to the state, the central bank discharges another important Banking and service. The role of the central bank as an advisor to the state is endowed with much Insurance Sectors significance because of the pivotal status which it enjoys in the monetary map of the country. Thus, it is in a position to judge the general financial situation of the country and render appropriate advices to the government. Most central banks have separate NOTES departments to study the market trends and to formulate suitable policies in conformity with the changing circumstances. In conclusion, it may be observed that as banker to the state, the central bank usually operates more as a legal agent than actually performing all the functions. To the extent that a central bank provides overdrafts to the state, it is in a way going beyond mere central banking functions. The thrust of financial sector reforms world-wide has been to distance the central banks from the governments in terms of providing accommodation finance. In any case, the role of a central bank as a banker to the state is likely to diminish rather than increase with redefined and somewhat reduced role of government in the economy. As Bankers’ Bank and Lender of Last Resort As the sole authority of note issue and as banker to the state, the central bank stands in a privileged position in the money market. This has made the commercial banks to recognize the supremacy of the central bank and to consider it as their bank. The central bank, in turn, recognizes its duty to help the banks in times of emergencies by extending financial accommodation. In most countries, the banks entrust their surplus funds with their respective central banks. In addition, there are also statutory provisions for the maintenance of minimum reserves with the central banks. The principle of statutory centralization of minimum reserves was first introduced in the USA. Subsequently, this was adopted by many other countries. The principle of flexible minimum reserves was also adopted by many central banks, as a monetary policy instrument. The centralization of cash reserves in the central banks has its own advantages. Such reserves facilitate the settlement of the clearance difference between banks. Further, the central bank can employ such reserves in the most effective manner during periods of seasonal and local monetary stringency. In addition, flexible minimum reserves can be used as an instrument of monetary policy. Of course, of late, the importance of this instrument has dwindled in importance. The role of the central bank as a bankers’ bank is certainly an important one. It has to be noted in this connection that the role of banks in financial intermediation is becoming less and less important. To that extent, the role of a central bank would diminish. But the management of overall liquidity in the system will, in all probabilities, continue to be critical for the economy with the consequent continued significance of a central bank and its operations through banks. As Lender of the Last Resort In its role as a bankers’ bank, the central bank extends financial facilities to commercial banks in times of emergencies. The essential duty of a central bank as the lender of last resort is to make good shortage of cash among the competing banks. In fact, this is the most important duty of the central bank in its capacity as the bankers’ bank. The central bank extends financial accommodation mainly through rediscounts of first class bills of exchange, government securities and such other eligible papers. As observed by De Kock, ‘The central bank’s function of lender of last resort developed Self-Instructional Material 157 Banking and out of the rediscount function and was primarily associated with the latter. It implied the Insurance Sectors assumption of the responsibility of meeting, directly or indirectly, all reasonable demands for accommodation from commercial banks, discount houses and other credit institutions, subject to certain terms and conditions which constitute the discount rate policy of the NOTES central banks’. In a broader sense, the term ‘rediscounts’ implies all forms of central form accommodation to the approved credit institutions in general and to the commercial banks in particular. Originally the eligibility rules of the central banks were very stringent. Before the First World War, certain central banks like the Bank of England were normally following a policy of restricting rediscounting facilities to short-term trade bills. During the war and the post-war periods, the central banks were compelled to relax their eligibility rules and to extend rediscounting facilities against Treasury Bills, and loans against government securities. The decline in the volume of bills of exchange further induced the central banks to widen their eligibility rules. Thus, the Board of Governors of the Federal Reserve System, in 1937, made finance paper, construction loans and consumers’ paper eligible for rediscount. Many other central banks also adopted a policy towards widening of the scope of the eligibility rules by enlarging the type of permissible operations and lengthening the maturities of the papers. An example may be found in the Philippines Central Bank Act. According to it the central bank of Philippines is authorized to sell, purchase or rediscount paper having maturities up to 180 days in the case of commercial loans and up to 270 days in the case of production or processing loans. Further, the bank is authorized to grant extraordinary advances against the security of any kind of ‘acceptable assets’. Such widening of the eligibility rules has been made in the central banking legislations of India, New Zealand, Guatemala, Dominican Republic and such other countries. The function of rediscount is considered a very important function of the central bank because it increases the elasticity and liquidity of the entire credit structure. Generally speaking, rediscounting facilities promotes economy in the use of cash by credit institutions individually and collectively to conduct their business with smaller cash reserves than if they were to depend only on their own resources and on such money market facilities as were available. The full acceptance of this responsibility by the central bank works, other things being equal, in the direction of encouraging the banks to maintain relatively stable cash ratio. This is of great importance to the central bank in performing its general function of implementing monetary policies. As Central Bank of Clearance Being the holder of the cash balances of banks, the central bank is qualified to act as a bank of central clearance. The Bank of England was the first central bank to act as a bank of central clearance. The plan adopted was to offset inter-bank indebtedness by effecting transfers in the accounts kept by the various banks with the Bank of England. Since then, many central banks have adopted the function of central clearance. The main advantage of central clearance is that it minimizes the necessity of banks to hold large cash reserves. As Regulator of Banks The statutes of most central banks contain the necessary provisions concerning the regulatory role of the respective central bank over the banks. There is a difference of opinion as to whether the central bank should be entrusted with this function. It is argued that regulatory and supervisory functions over the banks will affect adversely the Self-Instructional 158 Material independence of the central bank. As far as this point is concerned, although no final Banking and view has yet emerged, it has to be recognized that the central bank’s capacity to ensure Insurance Sectors financial stability will be ensured if regulation of banks is taken out of its jurisdiction.

As Custodian of Nation’s Reserves NOTES The central bank of a country is generally entrusted with the custody of the nation’s reserves. This function is derived from the role of the central bank as the sole authority for note issue. The reserves are, in the main, kept in the form of gold or silver or both. Not infrequently, the central bank is also considered as the custodian of foreign exchange reserves. 6.10.4 Recent Trends in Central Banking

Transparency in Monetary Policy A contemporary trend in central banking is to make the monetary policy transparent, as far as possible and feasible, on the ground that such transparency results in a reduction in the market’s uncertainty about the monetary authority’s reaction function. Additionally, greater transparency will, in all probabilities, improve the financial markets’ understanding of the conduct of monetary policy and thus reduce uncertainty. The limits to transparency are also recognized since publishing detailed results of the central bank’s economic projections is likely to eliminate an element of surprise, which is useful on occasions with respect to the central bank’s operations in financial markets. Central banks increasingly realize that their traditional ‘command and control approach’ is not effective under the present day circumstances. During the 1950s and 1960s, it was still possible for central banks, especially in more industrially advanced countries, to use moral suasion, to enforce interest rate ceilings and use credit rationing to successfully implement controls over the rate of growth of credit and monetary aggregates. In Japan, this was the case up to the late 1980s. But those days are gone. In a market driven world, ‘control’ has been superseded by ‘influence’. The modern central bank has to make use of the few instruments which it can still directly control to convince the market, with its immense deep pockets, of both the intention and capacity to achieve stated objectives. It is the realization of this fact that has driven the central banks to become much more transparent over the course of recent years. Admittedly, there is now increasing transparency on the long run strategic objectives. It may not be feasible for central banks to disclose their tactical considerations because some manoeuvrability in influencing the market is necessary. However, in many cases, information is revealed to the market with a time lag. The central banks attempt to gather estimates of market expectations through surveys. In short, a process of openness is initiated by most central banks. Increasing emphasis is placed on the quantity and quality of data dissemination, viz., adequate, timely and reliable information in a standardized form. Recent experience indicates that this process of transparency has been widened, deepened and intensified. The process has become relatively more articulate, consultative and participative with external orientation. The stance of monetary policy and rationale are communicated to the public in a variety of ways. For instance, In India, the Governor of the Reserve Bank of India makes an annual monetary policy statement and a mid-term review. In general, the rationale of monetary measures is given through press releases and also statements Self-Instructional Material 159 Banking and made by high ranking officials of the central bank. The setting up of a Monetary Policy Insurance Sectors Committee in the UK is another instance of this process of transparency. The deliberations of the Committee leading to monetary policy actions are disclosed. There are many other central banks which disseminate the minutes of major policy decisions in order to NOTES help gain credibility and in building a reputation of the central bank in achieving the objectives of monetary policy. State and the Central Bank Most of the earlier central banks were originally established as private shareholders’ institutions, thus maintaining their political independence. During the First World War and post-war period, the general opinion was against any kind of state interference with the central banks. The Brussels Conference in 1929 adopted that, ‘banks and especially banks of issue should be freed from political pressure and should be conducted solely in the lines of prudent finance’. The theory underlying this concept of independence of central banks was largely based on the point that absolute state control would pave the way for mismanagement of currency and credit. According to Kisch and Elkin, ‘The network of financial and commercial life is so intricate, and the decisions of the bank on important points have such widespread results that all interests are not affected in the same way. If the government has a controlling influence over the bank, there are obvious ways by which the more powerful interests in the country can try to enforce their wishes. The road is open for political intrigue, and there can be no safeguard that the policy of the bank will be carried on without bias as national interests require.’ It is further maintained in some quarters that if the central bank is brought under the control of the state, it becomes ‘fatally easy’ for the latter to abuse its powers by reducing the central bank to a mere mechanism for issuing notes, which will ultimately lead to currency depreciation and monetary chaos. The disastrous financial policies pursued by certain governments of central Europe during the war and the post-war period are pointed out to illustrate the evils of the subordination of the central bank to the state. Further, it is essential that the working of the central bank should be unbiased and continuous. But if the bank is under state control, continuity of policy cannot be guaranteed with changing governments, nor can freedom from political bias in the administration be assured. However, the trend since the late 1940s has been towards state control of central banks. There has been an almost universal recognition that the state should necessarily exercise a considerable measure of control over the central bank, whether or not the state owns the central bank. The observations made by the Governor of the Bank of England regarding the relationship between the state and the central bank deserve special mention in this connection. According to him, ‘it is of utmost importance that the bank and the policy of the government should at all times be in harmony—in as complete harmony as possible’. He further contended, ‘although the central bank has a right to offer advice, it is always subject to the supreme authority of the government’. The nationalization of the older central banks and the establishment of new central banks as state-owned institutions during the last five decades reflects the trend for the state to own the central bank. The National Bank in Copenhagen, the Reserve Bank of New Zealand and the Bank of Italy were nationalized in 1936. The Bank of Canada was nationalized in 1938, the Central Bank of Bolivia in 1939, the Bank of England in 1946 and the Reserve Bank of India in 1949. New central banks established between 1939 and 1945 were all state-owned banks. By 1949 as many as 30 out of 57 central banks on independent countries became completely state-owned as against 10 in 1931, 15 in 1939 and 19 in 1945. Self-Instructional 160 Material Even in the USA, which is considered as a country with an independent central Banking and banking system, it would be incorrect to say that the central banking system is entirely Insurance Sectors an independent one. All central banking operations are under the control of the Board of Governors of the Federal Reserve System. The Board consists of seven members appointed by the President of the USA, with the approval of the Senate. Further, the NOTES Board of Directors of the Federal Reserve Banks along with two other members is chosen by the Board of Governors. In other words, for all practical purposes, the American central banking system is administered by people appointed by the government. Thus, most of the central banks are either owned by the state or are controlled by the state through the appointment of a Governor or Board. The statutes of these central banks lay down express provisions governing the relation between the central bank and the state. In some cases, they expressly subordinate the central bank to the government and in others they empower the state to give legally binding directions or require the central bank to issue directions only after consultation with the state. One basic fact may be noted here. The state exercises considerable measure of control over the central bank, whether or not the former owns the latter. Many reasons can be pointed out for this trend in central banking. In the first place, the increase in government borrowing during the post-war years made it imperative for the state to adopt suitable fiscal policies. An independent monetary policy pursued by the central bank may sometimes defeat the policies of the state. A coordination of the policies of the central bank and the state has thus become inevitable. Another factor has been the post-war trend towards economic planning. For facilitating economic development, the state often finds it necessary to have adequate control over the central bank as otherwise the latter may fail to fall in line with the policies of the state. In certain other cases, state control over the central bank has been the result of political ideology. To summarise, it may be observed that the point involved in defining the relation between the state and the central bank is neither ‘absolute subordination’ nor ‘absolute independence’. Nevertheless, it has been the opinion on the part of many governments that the central banks possessing large and important powers should be controlled by the state so that a proper coordination and integration of the currency, credit and monetary policy of the central bank with the government’s financial and economic policy might be secured. An important point to be noted in this context is that although state control over central banks has been accelerated during the second half of the 20th century, recent trend is giving some sort of ‘independence’ to the central banks. It is true that the term ‘independence’ used in the connection could be somewhat misleading. In a democratic set up, no government agency, including the central bank, can be wholly independent of the government. As far as ‘independence’ in the exercise of powers is concerned (this is what the majority have in mind as to the meaning of ‘independence’), the trend today is for the central banks to exercise these powers without too much interference or guidance from the state. The objective is to insulate the central bank from short-term political influence and to ensure a consistent pursuit of medium term objectives. In conclusion, it may be stated that it is possible to argue that in the case of developing economies there is a need for strong presence of public sector and that private ownership of central banks should not be considered. However, another line of thought is advanced by Dr Anand Chandavarkar (1996), an eminent economist, who favours a serious consideration of some diversification of ownership of central banks, especially in developing economies. According to him, ‘A crucial but little discussed Self-Instructional Material 161 Banking and element in the professionalisation of central banks in developing countries is the weakness Insurance Sectors of hands-on market contracts and the tendency to equate expertise too uncritically with academic credentials and analytic skills to the neglect of market-based judgmental skills, insights and on-the-job experience. The market orientation and market discipline of central NOTES banks in developing countries would only be enhanced if they were to be partially privatized and listed on the stock exchange, an overlooked option which merits serious consideration’. Central Bank and Economic Development The role of the central bank in financing economic development is a matter of acute controversy. The advocates of orthodox central banking ideas hold that it is not the function of a central bank to finance economic development. They fear that such financing would ultimately lead to monetary disequilibrium. According to them, the primary responsibility of the central bank is the maintenance of monetary and exchange stability. In contrast to the view held by orthodox central bankers is the view that due consideration should be given to the role of central banks in financing economic development. In fact, the statutes of many central banks specifically recognize this role. In 1937, the Board of Governors of the Federal Reserve System in the USA stressed the inadequacy of mere price stability or exchange stability as an objective of central banking policy. The Board observed that the maximum sustainable utilization of the nation’s resources rather than mere price stability or exchange stability should be the goal of public policy. In conformity with this view, many central banks had been called upon to provide direct finance to carry out the developmental activities of the state. There had also been a widening of the eligibility rules. In addition, many central banks had been authorized to extend direct or indirect industrial and agricultural credit. For instance, in the USA, under the Federal Reserve Act of 1934, the Federal Reserve Banks were allowed to discount or buy from any bank, trust company, mortgage company, credit corporation for industry or other financing institutions obligations maturing within five years entered into for the purpose of advances to commercial and industrial enterprises. In exceptional circumstances, they were also authorized to make direct working capital advances to established private enterprises. Even in England, the home of conservative central banking ideas, there had been considerable departure from the traditional principles. Instances could be found in the setting up of the Bankers Industrial Development Company in 1950 under the auspices of the Bank of England and in the extension of direct financial assistance to certain industrial enterprises. The association of the Bank of England with the Credit for Industry Limited, a specialized institution for financing small and medium sized industries, was another instance. India was also not lagging behind. Briefly, the Reserve Bank of India had extended substantial financial and organizational help to the special agencies catering to the needs of industry, trade and agriculture. The intention behind this wave of discarding orthodox central banking ideas had been the desire on the respective central banks to help the money market to tide over temporary difficulties, the need to finance the growing expenditure of government departments by means other than an appeal to the capital market and to provide funds to branches of the economic system which were not in a position to obtain them through the usual channels.

Self-Instructional 162 Material At this juncture, it would not be out of place to examine the dangers and difficulties Banking and involved in extending the activities of a central bank far beyond the traditional boundaries. Insurance Sectors In the first place, it is maintained that an increase in the total currency issued by the central bank does not in and of itself initiate processes of economic expansions. Money is only one of the factors on which economic growth depends. Besides, there are NOTES other and more important factors such as the will and ability of the entrepreneurs, availability of other factors of production, capital formation, effective demand, total volume of production, etc. Therefore, a policy of the central bank to inject more money into circulation need not foster economic growth. On the other hand, an indiscriminate creation of money will create inflationary tendencies in the economy and impair economic development. This point is countered by arguing that financing of economic growth could be tempered by an appropriate monetary policy intended to stimulate private initiative and to keep the volume of money within appropriate limits. Further, it is pointed out that there is nothing inherent in central bank financing economic development to lead inevitably to inflation. The proponents of this line of argument say that everything will depend on the terms of overall financing of the economic development and on the extent to which it depends on planned savings and taxation. They further maintain that abuse is no argument against use, and the point that some central banks have in the past overstepped the limits under the pressure of the government does not invalidate the proposition that central bank financing of economic development may be usefully undertaken without the dangers of inflation. There is a further argument that the central bank, being the controller of the money market, should not take part in the financing of ordinary industrial and commercial activities. This may blur its vision as an impartial observer and affect adversely its monetary policy functions. In conclusion, it may be stated that the central banks, especially those in emerging economies, would do well to promote the process of accelerated economic growth by infusing efficiency and effectiveness in financial intermediation and stability in the financial system. Admittedly, ensuring availability of credit for all productive purposes is necessary for accelerating economic growth and this could be ensured through the pre-condition of efficiency and stability in the financial system. After the onset of East Asian crisis in mid-1997, there has been an increasing realization that proper development of the financial system cannot be regarded as ancillary or an adjunct to the development of the real sector; but it is a pre-condition of growth. There has also been an increasing realization during the recent past that an efficient and well functioning financial system contributes to economic growth by raising the level of savings and investment and the productivity of capital. It is true that credit availability to the small and medium industries sector in many countries is lagging behind. But recent thinking in central banking circles indicates that recourse to the same instruments or same methods through which direct financing was undertaken during the past is not appropriate since they had proved to be more harmful than beneficial in the context of economic development. In continuation of this line of thinking, contemporary central bankers hold the view that central banks should give adequate support for the development of technological infrastructure or financial structure or funding of research and training in this sector and should be catalyst for the development of new type of financial institutions; but they should not become the conduit for resources for financial intermediaries.

Self-Instructional Material 163 Banking and With Particular Reference to Developing Economies Insurance Sectors The observations made above are relevant to developing economies as well. In addition to it, since the objectives which the central banks have to strive for in developing economies NOTES being varied and numerous and more complex in nature, special attention has to be given to both policies and techniques applied. The conventional and established tools should be applied only on a selective basis. It should not be taken for granted that the same technology tried and found successful in a different financial climate will yield the same results. Much more attention will have to be paid to the general economic policy. Central banks should find ways to influence such policies and obtain the necessary help for their being able to do so. It is not surprising, therefore, that central banks in developing countries have fashioned tools of policy and control to suit their particular purpose and have branched out into new areas of activity which, though not sanctified by the practices of their arch- types in the developed economies, are nevertheless of relevance in their immediate situation. The conclusions arrived at the International Seminar on Central Banking and Development sometime back, are pertinent even today. In the discussions, there was a consensus that, with all the refinements of theory and statistical and other data available, there could be no precise rules and techniques in central banking. Central banking thus remains an art to be preferred by practice. It is neither feasible nor possible for all central banks to use the traditional instruments of monetary policy, and there is room for adaptation and innovation. An important task of a central bank in a developing economy is to give advice to the government, sharing the latter’s concern with economic development. The central bank should also be continuously in dialogue with the other factors of the economy to contribute to the realisation of the objective of development with stability. Thus, it should endeavour to build up lines of communication with the government on one hand and other sectors of the economy on the other. There is also need for improving the scope of public intelligence and technical documentation. Appropriate measures should be taken to infuse efficiency and effectiveness in financial intermediation and stability in the financial system, bearing in mind that such efficiency, effectiveness and stability are pre-conditions to ensure availability of credit for all productive purposes. As observed by AI Kral, Advisor to the Central Bank of Trinidad and Tobago, ‘the central banks must not feel themselves bound by the established practices and must try to introduce such new instruments and methods of banking that would be basically sound and assist their countries in economic growth. Central banks in developing countries shall not be shy of innovations. Besides transplanting the known techniques from other Check Your Progress countries, they should cooperate in devising new tools in banking and new methods of 13. When is credit their application’. He even advocated the establishment of a permanent organization of rationing employed central banks in developing economies. Such an organization may assist in fostering the by central banks? most advanced knowledge of the principles of policy. According to him, ‘there is no need 14. Define the term ‘rediscount’ under for each country to obtain the experience desired at the price of ones own mistakes central banking. which may have been costly to somebody else before, and whose repeating can easily 15. Which was the first be avoided.’ bank to act as a bank of central clearance?

Self-Instructional 164 Material Banking and 6.11 INSURANCE SECTOR Insurance Sectors

The insurance industry of India consists of 52 insurance companies, of which 24 are in life insurance business and 28 are non-life insurers. Among the life insurers, Life Insurance NOTES Corporation (LIC) is the sole public sector company. Apart from that, among the non- life insurers there are six public sector insurers. In addition to these, there is sole national re-insurer, namely, General Insurance Corporation of India. Other stakeholders in Indian Insurance market include Agents (Individual and Corporate), Brokers, Surveyors and Third Party Administrators servicing Health Insurance claims. Out of 28 non-life insurance companies, 5 private sector insurers are registered to underwrite policies exclusively in Health, Personal Accident and Travel insurance segments. They are Star Health and Allied Insurance Company Ltd, Apollo Munich Health Insurance Company Ltd, Max Bupa Health Insurance Company Ltd, Religare Health Insurance Company Ltd and Cigna TTK Health Insurance Company Ltd. There are two more specialised insurers belonging to public sector, namely, Export Credit Guarantee Corporation of India for Credit Insurance and Agriculture Insurance Company Ltd for Crop Insurance. Insurance penetration of India i.e. Premium collected by Indian insurers is 3.96% of GDP in FY 2012-13. Per capita premium underwritten i.e. insurance density in India during FY 2012-13 is US$ 53.2. 6.11.1 Insurance Transaction Insurance is a contract. One party, namely, the insurer, contracts with another, the policyholder, to perform a particular service. The nature of insurance transaction can be represented by the following triangle: At the apex of this triangle there is the risk insured against. The insured— policyholder—is the person or company entering into the insurance contract and the insurer is the insurance company which has contracted with the insured to provide cover for the risk insured against. Let us delve briefly into a few important concepts associated with insurance: An indemnity is a sum paid by A to B by way of compensation for a particular loss suffered by B. from the perspective of the insured. Subrogation has its purpose in compelling the ultimate payment of a debt by the party who, in Equity and good conscience, should pay it. This subrogation is an equitable device used to prevent injustice. The principle according to which two or more insurers each liable for an insured loss ought to indulge in the payment of that loss. Having paid its share of a loss, an insurer may be entitled to equitable contribution—a legal right to recover part of the payment from another insurer whose policy was also applicable. Insurable interest exists when an insured person derives a financial or other kind of advantage from the continuous existence of the insured object (or in the context of living persons, their continued survival). A person has an insurable interest in something when loss-of or damage-to that thing would cause the person to suffer a financial loss or other kind of loss. Referral of a dispute to an impartial third party chosen by the parties in the dispute who agree in advance to abide by the arbitrator’s award issued after a hearing at which both parties have a chance to be heard. As per the law, a proximate cause is an event sufficiently related to a legally recognizable injury to be held to be the cause of that injury.

Self-Instructional Material 165 Banking and Looking at this triangle from the perspective of the insured one could say that: Insurance Sectors • The insured knows the nature of the risk. • The insured has to describe the risk to the insurer. At this stage insured could NOTES more properly be termed the proposer as he, she or the firm is at the point of describing the risk to the insurer in order to obtain insurance. • The proposer will look for acceptable protection. He may have a particular form of insurance cover in mind or want a special clause included or even excluded. The proposer knows, or should know, what he wants, and will go into the market place in an effort to satisfy his needs. • Price is an important determinant in selecting an insurer. The proposer will also, of course, be concerned with service and security, but price will be extremely important. From the perspective of the insurer: • It will be told about the risk by the proposer; • In many cases the insurer will not rely on this source of information alone but will make its own inquiries. This may imply using skilled risk surveyors to look at proposals and make physical inspection or doctors to carry out medical examination for a life or permanent health insurance proposal; • The insurer will decide on the level of cover which it is prepared to offer to the proposer; • Finally, the insurer will have to determine the price to be charged for the cover it is willing to offer. This price will have to reflect a number of relevant factors. The triangle is not the whole story. At the ‘insured’ end of the triangle, there is the intermediary. The intermediary—the agent or broker—will assist insured or proposer at various stages in the transaction of insurance. For any large industrial insured, the use of a broker is almost essential as the role, he performs, is of crucial importance. At the insurer’s side of the triangle, there is the reinsurer who essentially offers the same kind of protection to the insurer as the insurer offered to the insured. Publicity Insurers have a service to offer and this must be marketed in such a way as to attract consumers or potential consumers. Marketing plays a vital role in the transaction of insurance today. At some point, the potential consumer has to be provided with an idea of the product being offered. This has always represented something of a problem for insurers. They are in the business of providing a service and cannot offer the proposer the opportunity to see and touch the product. There is no possibility of testing the product. There may thus be a certain ambiguity about the insurance product and the marketing message may not always be clear. Proposal Form The proposal form is the most common and important mechanism by which the insurer receives information about the risks to be insured. In most classes of insurance a proposal form is completed by the proposer and submitted to the insurer. These forms may be requested from an insurer direct or could be provided by a broker or agent. In the past the proposal form also acted as a form of advertising and there is still some element of Self-Instructional 166 Material this at present, though, advertising is much more sophisticated now and as such importance Banking and of proposal form as a means of advertising is significantly reduced. Insurance Sectors There are two broad categories of insurance covers: life and non-life. Life insurance is inclusive of endowment policy, money back and pension which we shall briefly discuss. NOTES An endowment policy is a life insurance contract that ensures a lump sum after a stipulated period (on its ‘maturity’) or on death. Usually the maturities are ten, fifteen or twenty years up to a certain age limit. Some policies also pay out in emergencies of critical illness. Non-life insurance includes property, life and health insurance. Unlike endowment plans, in the case of money back policies, the policy holder gets periodic ‘survivance payments’ during the term of the policy and a lump sum amount on surviving its term. In case of death during the term of the policy, the beneficiary receives the full sum assured, without any deductions for the amounts paid till date, and no further premiums are required to be paid. A pension is a contract for a fixed sum to be paid regularly to a person, typically following retirement from service. Non-life insurance policies include insurance on property, liability and health. General features of proposal forms are briefly stated below: (a) For personal life and non-life insurance (i) There are certain common questions which are not necessarily specific to any class of business; (ii) The name and address of the proposer, occupation and age; (iii) Details of past claims and history of past insurance covers including the names of insurers and particulars of refusal to insure or cancellation of existing insurance; (iv) The period of time over which insurance is required; (v) The basis upon which the premium will be calculated. In property insurance, it will be the value of the building or contents. In life insurance, it will be the sum assured, the age of the proposer and the type of policy required. (b) For business insurance (i) The name of the proposer would be the corporate or business name; (ii) The business address is required as are the addresses of the various locations from which the company operates, and for which it may require insurance cover; (iii) An exact description of the trade, business or profession carried on by the proposer is required; (iv) The basis upon which the premium is to be calculated is asked for. In the liability form, it would be the wage roll and/or turnover. The premium is calculated using this wage or turnover figure; (v) A question concerning the period of cover is also asked. Insurance Policy The proposer or potential insured has now made a proposal to an insurer. When the insurer accepts this proposal, the terms are agreed and the premium is to be paid, or there is an agreement to pay the premium that may fall due later in terms of the agreement. It is worth pointing out that the contract of insurance is subject to all normal laws of contract and that the contract exists irrespective of the nomination and assignment of actual policy document. The policy is only the evidence of the contract; it is not the contract itself. Self-Instructional Material 167 Banking and The Components of Policy Insurance Sectors With the passage of time, it became less and less practical and standard policy documents were pre-printed. These policies had blank spaces where the individual details of the NOTES insured were to be inserted. This narrative form of policy eventually gave way to what is known as the scheduled policy of the present. Heading Each policy will have a heading which includes the name of the insurer, the address and the company logo. Preamble At the very beginning of each policy there is a wording which is referred as ‘preamble’. In essence, three points are covered in preambles which may vary a little from policy to policy: • The proposal made by the insured is stated as being the basis of the contract and incorporated in it. It has the effect of making the proposal part of the contract even though it is not actually reproduced and printed with the policy document. It means that the insured has to be particularly careful when completing the proposal form as it will eventually become part of the contract. • The preamble also makes a mention of the premium. Clearly, there can only be a valid contract when the insured has paid the premium or, if the policy is prepared ahead of the premium having been paid, has agreed to pay it, as and when required. • The preamble also states that the insurer will provide the cover detailed in the policy. Signature Under the preamble, or close to it, will be the signature of an official from the company— an authorized signatory. Operative Clause The most important section of the policy is the part where the actual cover provided is outlined. The wording begins with the words, ‘The company will...’ and then goes on to say exactly what the company is promising to do. This is the cover under the policy. Exceptions There is a list of exceptions to the cover under the policy. When an exception is applied, a claim is not payable. Policy Schedule The schedule is the place where the policy is made personal to the insured. The policy schedule includes information on: • The insured; • The address of the insured; • The nature of business/profession; • The period of insurance; Self-Instructional 168 Material • The amount of premiums; Banking and Insurance Sectors • The limit of liability/sum insured; • The policy number; • Reference to any special exclusions, conditions or aspects of cover. NOTES Definitions Definitions of the terms used in the policy are listed in a separate section of the policy in an attempt at making the policy simpler to read and understand. Conditions All policies contain a list of conditions. They appear in different parts of the policies but convey similar points. Common conditions will include: • That the insured will comply with all terms of the policy; • That the insured will notify the insurer of any changes in the risk; • That the claim be notified within a certain time and the procedure to be followed; • The effect of fraud is to be clarified; • That the insured will take all reasonable care to minimize the risk of loss or damage or of incurring liability. In other words, the existence of a policy of insurance is not to be regarded as a mandate for carelessness; • There may also be a condition about arbitration. The arbitration condition relates to the amount to be paid under a claim and not liability for the claim itself. In other words, the insurer agrees that there is a valid claim under the policy but cannot agree on the actual amount which is to be paid; • A condition will outline what is to happen if there are other policies in force covering the same loss. This concerns one of the basic doctrines of insurance, i.e., contribution. • There may also be a condition allowing the insurer to cancel the policy and saying how this is to be done; Many premiums are based on estimated figures and adjusted once the actual figure is available. For example, an employers’ liability policy premium will be based on the payroll of the insured. The insured provides an estimate of the payroll and on this basis the premium is calculated and charged when the policy is effected. At the end of the insurance year, the actual payroll figure is declared and an adjustment in premium will be required in case the actual premium is more or less than the deposit premium charged. A condition will lay down the time within which the insured is to provide the actual figure as well as what is to happen if he fails to do so. Express and Implied Conditions The conditions which appear on the policy are the express conditions. The implied conditions which do not appear on the policy include the three doctrines of insurable interest as mentioned below: • The fact that the subject matter of insurance actually exists and can be identified; • That the insured has insurable interest; • That there has been utmost good faith in the negotiations leading up to the formation

of the contract. Self-Instructional Material 169 Banking and Conditions Precedent to the Contract Insurance Sectors These refer to the conditions which ought to be satisfied in advance of the contract formation. The conditions implied belong to this category. In the case of non-compliance NOTES the entire contract’s validity is subject to doubt. Conditions Subsequent to the Contract These conditions have to be fulfilled after the contract comes into force. For instance, any condition concerned with the adjustment of premiums, or notification of alterations to the risk. Conditions Precedent to Liability These conditions are associated with claims and must be complied with in the case of a valid claim. One example would be prompt notification of the claim in the proper manner. These conditions are important and a breach of these conditions will be serious. The effect of a breach, however, will vary. For example, an insurer will not be able to repudiate a claim on the grounds of a breach of a condition that was not related to the loss circumstances. Cover Notes The cover note simply states that insurance is in force and gives brief details of the cover. The note is temporary and will be superseded once the policy is issued. Confirmation that the cover is in force need not always be in the form of a pre-printed cover note. It could take the form of a letter from the insurer to the insured. This may be useful where the insured needs to prove to some other party that insurance has been effected. A rather different situation exists in life insurance. Once the proposer has sent his completed proposal form to the insurer he will receive a letter of acceptance. This letter of acceptance is really an offer to the proposer and is accepted once the premium has been paid. The difference between this and the cover note is that the life assurance policy will only come into effect once the premium has been paid. Certificates Where insurance is compulsory, the law requires that a certificate is issued to prove that policy is in force. The information to be shown on a certificate is laid down by the respective statute. In the case of motor insurance certificate, the name of the policy-holder, the registration number of the car, the period of insurance, persons entitled to drive and limitations as to the use are all shown. The certificate must always be carried in the insured motor vehicle. The employers’ liability certificate is very similar in content to the motor certificate. The law often requires that the certificate must be displayed at all places of business including outdoor sites. Renewals The vast majority of policies will be for the periods of twelve months in general insurance business. Insurers are obviously anxious to have the person insured for a further year. There is no obligation on either side to renew the contract, but in most cases the insurer will initiate steps for securing the business for another year. In the normal course of events the insurer will issue renewal papers to the insured which take the form of a renewal notice that brings to the attention of the insured the Self-Instructional 170 Material fact that the period of insurance is almost at a close, and the premium for renewal of the Banking and policy is as shown. There is no commitment for issuing the notice, but it is clearly in their Insurance Sectors interest to do so for securing continuance of the policy. If the insured wants to renew, he sends his premium to the insurer and receives a confirmation of renewal along with any certificate appropriate to the insurance form, NOTES accompanied by a fresh policy document or a renewal endorsement on the previous year’s policy. Non-payment of Premiums Non-payment of a premium indicates that the contract will lapse on the renewal date on not being renewed. Nevertheless, there may be cases of non-payment of premium by the renewal date irrespective of an intention to renew. This could happen, for instance, in the case of loss of renewal papers or in case the renewal has been innocently overlooked by the insured. To handle cases like this, insurers offer a grace period. The grace period is not an extension of cover. They are 15 or 30 days into the next period of insurance. On the premium being paid, the cover applies from the renewal date, not the day of payment of the premium. This is understandable as if it was not the case, then insured would use the days of grace as extensions of cover beyond twelve months by the day of grace. Long-term Agreements Strong competition can exist for business, particularly for good business. The competition is at its highest whenever there is renewal of a policy and insurers and brokers are trying to secure the best deals for their insured clients. One way in which insurers try to retain business is by offering insured discount from the premium if they agree to offer the business for renewal over a period of years. This normally means a 5 per cent discount if the insured under-takes to offer the business to the insurer on each renewal date for three or five years. Both sides to the contract benefit, the insured enjoys the reduction in premium and the insurer has the knowledge that business will be renewed. Further, the insured is spared the hassle of renewal of insurance each year and the insurer would have reduced paper work. Declarations Adjustment of premium at the end of policy period when the original premium is based on an estimated amount and the actual amount is now available. In the case of an employers’ liability policy, the premium is arrived at by applying a rate to the wages paid by the insured. Another example is of a public/professional indemnity insurance where the premium is calculated on the business turnover during the policy period. The insured is required to make a declaration of the actual wages paid or the turnover made during the year to enable the insurer to compute the amount of premium payable for the policy period and recover/refund the difference between the actual premium payable and the estimated premium previously collected. It may be noted that the declaration must be Check Your Progress made irrespective of whether the policy is renewed or not for another year. 16. What are the two Insurance is a sophisticated instrument, and hence difficult to define. Nevertheless, in basic features of common terms, it has two basic features: insurance? 17. What is financial (a) Shifting or transferring a risk from one person to a group risk? (b) Sharing losses, on some equitable base, by all the group members Self-Instructional Material 171 Banking and There are some potential difficulties with the operation of such a plan, the most Insurance Sectors obvious being the possibility that some members of the group might refuse to pay their assessment at the time of a loss. This problem can be overcome by requiring payment in advance. To require payment in advance for the losses that may take place, it will be NOTES necessary to have some idea as to the possibility and the likely amounts of those losses. This may be calculated on the basis of past experience. Insurance Defined from the Individual’s Viewpoint On the basis of its function as described earlier, insurance may be defined from the individual’s viewpoint as follows: From the individual’s viewpoint, insurance is an economic instrument with the help of which an individual can substitute a comparatively small fixed cost (the premium) for a big uncertain financial loss (the contingency insured against) that will have to be borne if insurance was not available. The key role of insurance is the establishment of a counter balance against risk, i.e., security. Practically, insurance does not remove or decrease the uncertainty for the individual as to whether or not the event will happen. It does not even modify the possibility of a happening. However, it reduces the degree of financial loss related to the event. Risk Reduction through Pooling In addition to eliminating risk at the level of the individual through transfer, the insurance mechanism reduces risk (and uncertainty related to risk) for the society as a whole. As it will be seen, the risk faced by the insurance company does not comprise just the sum total of the risks transferred to it by the individuals; the insurance company is able to do something that the individual cannot, and that is to predict within reasonable limits the amount of losses that will actually occur. As long as its predictions are completely accurate, the insurance company faces no possibility of losses, for it will collect from each individual a share of the total losses and expenses as they occur. If the predictions are not accurate, the premiums that the insurer has charged may be inadequate and as such the insurer would incur a loss. If, on the other hand, premiums collected are more than adequate the insurer would make a profit. Bulk buying and self-insurance are two forms of pooling. Insurance from the Social Viewpoint The society and the national economy draw substantial benefits from the operation of the insurance mechanism. On one hand, life insurance and pension provide relief to the members of the society from financial difficulties arising from premature death of a bread earner or surviving to old age. Burden of the state to provide relief to destitute and aged citizens is reduced through the insurance mechanism. Besides, large sum of money becomes available for the period between the payment of premium and payment of claims. These sums can be invested in such a manner that the economy develops for the benefit of the society. Risk financing is concerned with providing funds to cover the financial effect of unexpected losses experienced by a business. Traditional forms of finance include risk transfer, funded retention by way of reserves (often called self insurance) and risk pooling. Risk transfer is buying insurance covers for businesses. Risk pooling is mostly performed by insurance companies, where a group of insurance companies cover another insurance company which may be facing a financial problem. This may be due to an earthquake, tsunami, etc. Self-Instructional 172 Material Role of Insurance in Managing risk Financing Banking and Insurance Sectors Business organizations and individuals take insurance policies. These insurance policies help them to cover the losses in case of any emergency. Here, the idea is to transfer the risk involved with the business to the insurance provider by taking an insurance policy. NOTES This insurance policy will honour claims in case certain emergencies disrupt the working of the organization. This type of financing strategy offers the benefit of knowing that even if the project faces financial trouble due to unseen events, the losses will be settled without having to use other company assets. However, these events will have to be mentioned in the insurance papers that the organization signs with the insurer. If an insurance policy does not cover theft, the organization cannot claim the amount from his insurer. The organization should maintain an adequate insurance to cover all insurance risks relating to the calamities that can happen. Insurance should be maintained in at least the following major areas of coverage such as: • Real and personal property • Machinery • Crime coverage • Extra expense and valuable papers • Workers’ compensation • Comprehensive general liability • Automobile liability and physical damage The term of the coverage should be updated according to the changes that happen in the organization. Making an insurance policy is protecting the property that is insured. Even though insurance policies give adequate cover in certain situations, they have their own limits. All risk insurance offers a high level risk that other forms of insurance leave out. Even though the risk insurance can be used for most of the risks there are certain exceptions. These are listed while giving the specifications for what the insurance would cover and what kind of risks it does not accept. It is an advantage, and at the same time, a disadvantage to the customers. It gives peace of mind for the customer that the property is insured. On the other hand, it accepts risks which rarely occur or never occur raising the cost of premiums. Premiums are monthly or yearly amounts that the organization taking the insurance has to pay to the insurance company. Need for Insurance Sense of security may be the next basic goal after food, clothing, and shelter for all human beings. An individual with economic security is fairly certain that he can satisfy his needs (food, shelter, medical care, and so on). Financial risk (which we will refer to simply as risk) is the possibility of losing economic security. Most financial risk happens when people are not prepared to face change in their original plans. Financial risks have always been managed with mutual agreement. When a person in a community fell ill or experienced financial trouble, others pooled in money to help. This act of pooling money created a cooperative that formalized as an insurance industry. Under the formal system of cooperative, policyholders do pool in risks with all other policyholders. However, these days it is not necessary for one policyholder to know another personally.

Self-Instructional Material 173 Banking and How Insurance Works Insurance Sectors An agreement wherein a stipulated payment called a premium is paid by one party to another upon a specific loss is called insurance. This claim payment amount can be NOTES either fixed or can be reimbursed in part. Premiums paid by the policyholder may reflect any special characteristics of the particular policy. Thus, insurances covers the financial losses of the policyholder. Thus, the policyholder transfers his financial risk to the insurance company. Examples of Insurance Organizing events on a large scale has become very popular. The success or failure of an event rests with the event organizers and they carry a huge financial risk on their heads. There have been events which have been non-starters, failures due to errors – human or natural or huge successes as well. An event cancelled mid-way causes heavy financial losses to the company and the client as well. To save the organizers and clients, Event Insurance helps cover the risk. For example, any event such as a fair or a fest, generally attracts a large number of people. Event Insurance offers various covers like event cancellation, accidents and burglary. Since it offers a special coverage, the premiums also tend to be very high. Sometimes on a particular day because of unexpected weather conditions, or by any other reason organizers force to cancel the event so the losses arises from it are covered through event insurance (e.g. loss of ticket revenue). The policy also offers covers to loss or damages to special equipments used in particular event. Insurance companies have nowadays started to offer terrorism cover as well which will insure the client from risk arising from the act of terrorism which has become necessary. Limits on Policy Benefits In all types of insurance there may be limits on benefits or claim payments. There may be a maximum limit on the total amount reimbursed. There may be a minimum limit on losses that will be reimbursed. Only a certain percentage of each loss may be reimbursed; or there may be different limits applied to particular types of losses. In each of these situations, the insurer does not reimburse the entire loss. Rather, the policyholder must cover part of the loss himself. This is often referred to as coinsurance.

6.12 SUMMARY

• India is considered among the top economies in the world, with tremendous potential for its banking sector to flourish. The last decade witnessed a significant upsurge in transactions through ATMs, as well as internet and mobile banking. • Commercial banks are organized on a joint stock company system, primarily for Check Your Progress the purpose of earning a profit. They can be either of the branch banking type, as 18. What happens after seen in most of the countries, with a large network of branches, or of the unit the non-payment of banking type, as seen mainly in the USA, where a bank’s operations are confined premium? to a single office or to a few branches within a strictly limited area. 19. State one way by which insurers try • The two essential functions of a commercial bank may best be summarized as to retain their the borrowing and the lending of money. They borrow money by taking all kinds business. of deposits. Deposits may be received on current account whereby the banker incurs the obligation to repay the money on demand. Interest is not payable on Self-Instructional current account deposits. 174 Material • A commercial bank provides a range of investment services. Customers can Banking and arrange for dividends to be sent to their bank and paid directly into their bank Insurance Sectors accounts, or for the bank to detach coupons from bearer bonds and present them for payment and to act upon announcements in the press of drawn bonds, coupons payable, etc. NOTES • The banks provide more than just a means for the settlement of debts between traders, both at home and abroad for the goods they buy and sell. They are also providers of credit and enable the company to release the capital which would otherwise be tied up in the goods exported. • In case where it is not possible to arrange a documentary credit and the arrangement is for payment to be made only when the goods have been sold, a bank can usually undertake the dispatch of the shipping documents and arrange the goods to be warehoused and insured in the name of a correspondent bank, pending delivery of the goods in part or in whole to the exporter’s agent against payment. • A commercial bank is a custodian of others’ surplus funds. Therefore, while earning a profit, the bank should never forget the fact that it is doing business with the funds of others, which it acquires because of its credit. It has been seen that these funds (deposits) are either repayable on demand or after the expiry of a fixed period. • Commercial banks always try to maintain their holdings of idle cash to the lowest extent possible. In their attempt to achieve this end, they unwittingly increase the total amount of money in circulation in the community. • Since everybody maintains an account with the bank, the transfer is effected by a mere book entry, i.e., by debiting the account of the drawer and crediting the account of the payee. But the case would be different where there are a number of different banks having different customers. • With the full-fledged development of banking institutions, various systems of commercial banks like ‘unit banking’, ‘branch banking’, ‘group banking’ otherwise known as ‘Holding Company Banking’ and ‘Chain Banking’ have come into vogue. • Group banking and chain banking systems, which have been referred to, are generally found in the USA only. More important systems of banking are the unit banking and branch banking. The USA and England may be taken as the typical countries which follow the systems of unit banking and branch banking, respectively. • Investment banks are organizations which assist business corporations and governmental bodies to raise funds for long-term capital requirements through the sale of shares, stocks. bonds, etc. These banks, unlike commercial banks, act primarily as middlemen between business corporations and investors. • The term ‘merchant bank’ is widely and loosely used today, being applied sometimes to banks which are not merchants and sometimes to merchants who are not banks, and sometimes to houses which are neither merchants nor banks. • The practice of banking has undergone significant transformation in the 1990s. While banks are striving to strengthen customer relationship and move towards ‘relationship banking’, customers are increasingly moving away from the confines of traditional branch banking and are seeking the convenience of remote electronic banking services. Self-Instructional Material 175 Banking and • Green IT (or green computing) refers to environmentally sustainable computing Insurance Sectors which is more environment-friendly. IT is becoming relevant to the banking sector. • One of the earliest of the functions to be discharged by a central bank is that of acting as a bank of issue. In addition, it is a controller of currency; a bankers’ NOTES bank and lender of the last resort, an agent, advisor and banker to the government, a custodian of the nation’s metallic reserves, etc. • An important function of a central bank is the issue of legal tender currency. The main reasons for the concentration of note issue in a central bank may be found in the necessity of bringing about uniformity in the note circulation of a country and of avoiding the anomaly of over-issue by many banks established with the primary motive of securing profits. • The function of instituting appropriate monetary policy measures is closely connected with the function of currency regulation. This function assumed importance with the growing popularity of bank credit and other forms of credit. • The Bank Rate Policy has been defined as ‘the varying of the terms and of the conditions, in the broadest sense, under which the market may have temporary access to the central bank through short-term assets or through secured advances.’ • Acting as banker, agent and advisor of the state is an important function of the central banks. As the banker to the state, the central bank conducts the banking accounts of government departments, boards and enterprises. • As the sole authority of note issue and as banker to the state, the central bank stands in a privileged position in the money market. This has made the commercial banks to recognize the supremacy of the central bank and to consider it as their bank. • Two fundamental features of insurance are: (i) Transferring or shifting of a risk from one individual to a group; (ii) Sharing losses, on some equitable basis, by all members of the group. • From an individual point of view, insurance is an economic device whereby the individual can substitute a small and relatively definite cost (the premium) for a large uncertain financial loss (the contingency insured against) that would have to be borne if insurance was not available. • Insurance from the point of view of the society is a mechanism which relieves the individual citizens and the industry from the burden of carrying on themselves the various risks they are likely to face from day to day. • At the apex of the insurance triangle there is the risk insured against. The insured— policyholder—is the person or company entering into the insurance contract and the insurer is the insurance company which has contracted with the insured to provide cover for the risk insured against. • Insurance market provides a financial service. It is a service industry in that it is supportive to industry producing goods or services. • Intermediary comprises the agent or broker who assists the insured or proposer at various stages in the transaction of insurance. • In the case of certain classes of business, particularly which the private insurers are unable or unwilling to take on, the government may choose to enter the field of insurance as an insurer.

Self-Instructional 176 Material Banking and 6.13 KEY TERMS Insurance Sectors

• Traveller’s cheque: A traveller’s cheque is a preprinted, fixed-amount cheque designed to allow the person signing it to make an unconditional payment to NOTES someone else as a result of having paid the issuer for that privilege. • Group banking: A plan offered by banks that generally provides incentives for groups, such as employees at a company, if the group establishes a banking relationship with the institution. • Bank rate: It is the rate of interest which a central bank charges on the loans and advances to a commercial bank. • Credit rationing: Credit rationing is employed by central banks as a temporary expedient or an abnormal measure dictated by special circumstances, or as a part of a comprehensive scheme of national economic planning. • The insured: The person or company entering into the insurance contract. • The insurer: The insurance company which has contracted with the insured to provide cover for the risk insured against.

6.14 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. Laghu Udyami Credit Cards were introduced in India for providing simplified and borrower-friendly credit facilities to retail traders, artisans, professionals and self- employed persons, small industrial units and small businessmen including those in the tiny sector. 2. Two main functions of commercial banks are agency services and general utility services. 3. The main difference between credit cards and debit cards lies in the words ‘credit’ and ‘debit’. In case of a credit card, the card holder makes the cash payment at the end of the month. On other hand, in the case of a debit card, it runs down ones deposit account the moment the sale is made. 4. The following items appear on the asset side of a balance sheet: • Cash in hand • Money at call and short notice • Bills discounted • Investments • Loans and advances 5. A bill of exchange is generally of three months duration and as such the loss involved in rediscounting it will not be very great, even when it is not shifted. 6. With the full-fledged development of banking institutions, various systems of commercial banks like ‘unit banking’, ‘branch banking’, ‘group banking’ otherwise known as ‘Holding Company Banking’ and ‘Chain Banking’ have come into vogue. 7. Investment banks are classified as ‘originators’, ‘underwriters’ and ‘retailers.’ As originators, they bring out new issues of securities; as underwriters they underwrite the issues; and as retailers they retail the securities to individual and institutional investors. Frequently a single institution may act in all these capacities. Self-Instructional Material 177 Banking and 8. The main advantage of universal banking arises from the resultant increase in Insurance Sectors economic efficiency in the form of lower cost, higher output and better products. 9. The virtual banking services include Automated Teller Machines (ATMs), Shared ATM Networks Electronic Funds Transfer at Point of Sale (EFTPoS), Smart NOTES Cards, Stored—Value Cards, Phone Banking, and more recently, internet and internet banking. 10. Three instruments of monetary policy are: • ‘Bank Rate Policy’, involving the alteration of discount rate so as to influence the market rate of interest, which plays a crucial role in the creation of credit. • ‘Open Market Operations’, involving the purchase and sale of securities in the open market so as to influence the total amount of money in circulation. • ‘Variable Reserve System’, involving the variation of the minimum reserves, which the banks are required to maintain with the central bank, so as to influence the power of banks to create credit. 11. The relationship between the bank rate and the market rate endows the central bank with the power to influence the credit creation of banks. In the simplest terms, a high bank rate is likely to decrease the total amount of money in circulation, and a low rate to increase the total amount of money in circulation. Thus, whenever the central bank deems it necessary to decrease the total amount of money in circulation, it will increase the bank rate. 12. The variable reserve ratio was first suggested by the Federal Reserve Board in its annual report for 1916. It was introduced in the USA in 1933 and was given a permanent status by the Banking Act of 1935. 13. Credit rationing is employed by central banks as a temporary expedient or an abnormal measure dictated by special circumstances, or as a part of a comprehensive scheme of national economic planning. 14. The term ‘rediscounts’ implies all forms of central form accommodation to the approved credit institutions in general and to the commercial banks in particular. 15. The Bank of England was the first central bank to act as a bank of central clearance. The plan adopted was to offset inter-bank indebtedness by effecting transfers in the accounts kept by the various banks with the Bank of England. 16. Two basic features of insurance are: • Shifting or transferring a risk from one person to a group; • Sharing losses, on some equitable base, by all the group members. 17. Financial risk is the possibility of losing economic security. Most financial risk happens when people are not prepared to face change in their original plans. 18. Non-payment of a premium indicates that the contract will lapse on the renewal date on not being renewed. Nevertheless, there may be cases of non-payment of premium by the renewal date irrespective of an intention to renew. 19. One way in which insurers try to retain business is by offering insured discount from the premium if they agree to offer the business for renewal over a period of years. This normally means a 5 per cent discount if the insured under-takes to offer the business to the insurer on each renewal date for three or five years.

Self-Instructional 178 Material Banking and 6.15 QUESTIONS AND EXERCISES Insurance Sectors

Short-Answer Questions NOTES 1. Outline the agency services rendered by a commercial bank. 2. Briefly mention the general utility services rendered by a commercial bank 3. Distinguish between a ‘documentary letter of credit’ and a ‘clean letter of credit’. 4. What are the advantages of a clearing house in relation to commercial banks? 5. Distinguish between group banking and chain banking. 6. Give a brief outline of investment banking. 7. Write a note on universal banking. 8. Give the salient features of merchant banking. 9. What is meant by virtual banking? 10. What are the instruments of monetary policy? 11. What do you mean by open market operations? 12. Define insurance from the social and individual’s viewpoint. Long-Answer Questions 1. Explain the functions of commercial banks and the services rendered by them. 2. Write an essay on the general utility services rendered by commercial banks. 3. Explain the mechanism of credit creation by commercial banks and point out the limitations in credit creation. 4. ‘Bankers are not merely purveyors of money, but also, in an important sense, manufacturers of money’. Bring out the meaning of this statement with suitable illustrations. 5. What do you mean by ‘unit banking’ and ‘branch banking’? What are the advantages and disadvantages of each? 6. Explain the meaning of ‘virtual banking’, bringing out its financial benefits. 7. Describe the role of a central bank as a bankers’ bank and lender of the last resort. 8. Describe the recent trends in central banking. 9. Examine in detail the recent trend in central banking towards state ownership and state control. 10. Describe the role of central banks in reference to developing economies. 11. What are the components of the insurance policy?

Self-Instructional Material 179 Banking and Insurance Sectors 6.16 FURTHER READING

Weston, J Fred, Kwang S. Chung and Susan E. 1990. Hoag, Mergers, Restructuring NOTES and Corporate Control. New Jersey: Prentice Hall. Horne, James C. Van. 2002. Financial Management. New Jersey: Prentice Hall. Brealey, Richard A., Stewart C. Myers and Franklin Allen. 2008. Principles of Corporate Finance. New York: McGraw-Hill. Pandey, I.M. 2010. Financial Management. New Delhi: Vikas Publishing House. Muralidharan. 2009. Modern Banking: Theory and Practice. New Delhi: PHI Learning Private Ltd. Maheshwari, S.N. 1983. Banking Law and Practice. New Delhi: Kalyani Publishers. Gordon E. and K.Natrajan.1992. Banking: Theory, Law and Practice. Mumbai: Himalaya Publishing House. Sharma, K.C. 2007. Modern Banking in India. New Delhi: Deep and Deep Publications.

Self-Instructional 180 Material Introduction to UNIT 7 INTRODUCTION TO Business Combinations BUSINESS COMBINATIONS NOTES Structure 7.0 Introduction 7.1 Unit Objectives 7.2 Different Forms of Business Combinations 7.2.1 Mergers; 7.2.2 Acquisitions; 7.2.3 Amalgamation 7.2.4 Takeovers; 7.2.5 Leveraged Buyouts 7.3 Motives for Business Combinations 7.3.1 Types of Business Combinations 7.3.2 Motives and Benefits of Mergers and Acquisitions 7.4 Regulation of Mergers 7.4.1 Organization Restructuring; 7.4.2 Mergers and Consolidations 7.4.3 Friendly vs Hostile Takeover 7.4.4 Merger Process: Target Identification, Negotiation and Closing Deal 7.5 Regulation of Takeovers 7.5.1 Takeover Tactics; 7.5.2 Defence Tactics 7.5.3 Anti-Takeover Amendments 7.6 Companies Law 7.7 Income Tax Law 7.8 SEBI Guidelines for Takeovers 7.9 Other Applicable Laws 7.10 Summary 7.11 Key Terms 7.12 Answers to ‘Check Your Progress’ 7.13 Questions and Exercises 7.14 Further Reading

7.0 INTRODUCTION

In order to understand a business combination we must first understand the true meaning of a business. A business is best defined as a set of assets that are integrated in a manner which makes it potent and capable of yielding the desired returns for the investing members, owners and other participants. In this regard, a business combination refers to transactions wherein one company acquires authority (or at least a part of it) of the operations over another company. In other words, the overarching objective of a business combination is to amalgamate assets of businesses (two or more) and consolidate the different processes under the aegis of a single ownership. A business combination can be created and administered through voluntary acquisition, merger or even takeovers. It has been largely agreed upon that the most effective way of gaining control over a business combination is through getting a hold over the amount of stock. A merger is the most frequent manifestation of a business combination.

7.1 UNIT OBJECTIVES

After going through this unit, you will be able to: • Identify the different types of business combinations • Discuss the motives for business combinations Self-Instructional Material 181 Introduction to • Discuss the regulation of mergers Business Combinations • Explain the regulation of takeovers • Recall company law, income tax law and other applicable laws NOTES • State the SEBI guidelines for takeovers

7.2 DIFFERENT FORMS OF BUSINESS COMBINATIONS

Management of change has been one of the greatest managerial challenges of the present day when there is a constant improvement in technical know-how and the rate of obsolescence is very high. One of the ways by which the industry can bring about consolidation and strengthen its position for achieving the desired competitive edge is the process of restructuring corporate operations. Big companies in the private and public sectors are engaged in restructuring their operations. From banking to oil exploration, telecommunication to power generation, companies are coming together as never before. Progressive business groups and companies are redefining their business operations. They are shedding peripheral and unrelated business to concentrate on their core business. This has become imperative because of competition both in domestic and international markets, costs and quality consciousness amongst consumers and higher expectations of those who have put their money in the venture. Restructuring strengthens the marketing power, improves efficiency, enables continuous flow of supplies of raw materials, avoids duplicate facilities and consequent expenses, develops leadership, enhances company goodwill. The companies including MNCs are finding this as the quickest way to expand their products geographically to acquire corporate dominance in their operations.The prospect of gaining competitive advantage, maintaining it and even expanding it, is what persuade organizations to restructure, rationalize and reduce costs. Restructuring has become the compelling necessity to survive in this fiercely competitive environment. Restructuring is required primarily to maintain status quo and secondly for growth. Corporate houses are redefining their mission statements by focusing on core competence and competitive advantage in a bid to achieve market leadership. The term corporate restructuring encompasses business portfolio restructuring by the process of mergers, demergers, takeovers, acquisitions, foreign franchise purchase of brands and hiring of unrelated businesses, strategic alliances and joint ventures and above all internal financial restructuring and organizational restructuring. Restructuring is a process by which a firm does an analysis of itself at a point of time and alters what it owes and owns and refocuses itself to specific tasks of performance improvements. Restructuring would radically alter a firm’s capital structure, asset mix and organization to enhance the firm’s value. Corporate restructuring refers to episodic exercise in the life of a business firm involving a significant change in its pattern of ownership and contract, or structure of assets and liabilities or both. Corporate restructuring may lead to (a) expansion and (b) change in ownership and contract. Forms of restructuring business firms 1. Expansion (i) Mergers (ii) Acquisitions

Self-Instructional (iii) Amalgamations 182 Material (iv) Consolidation Introduction to Business Combinations (v) Compromise (vi) Tender offers (vii) Arrangement NOTES (viii) Joint Ventures (ix) Reconstruction 2. Sell-offs 3. Spin-offs 4. Split-offs 5. Split-ups 6. Divestures 7. Equity carve-outs 8. Corporate control (i) Premium buybacks (ii) Standstill agreements (iii) Anti-takeover amendments (iv) Proxy contests 9. Change in ownership structure (i) Exchange offers (ii) Share repurchases (iii) Going private (iv) Leveraged buyout Corporate restructuring has become vital for achieving all the ultimate managerial objectives. Corporate restructuring through mergers and acquisitions, takeovers, control and change in ownership structure is undertaken by companies for enlarging their size and for being benefited by the concept of economies of scale. Mergers and acquisitions are crucial in ensuring a healthy expansion of organizations as they evolve. Various stages of developmental growth mergers and amalgamations may facilitate entry into new services or product market. Many experts feel that corporate restructuring is neither a solution nor a quick fix for curing the problem of global competition. Corporate restructuring is not an easy process to manage. It is a difficult task demanding strong management skills, imagination, leadership attitude and also finance. Corporate restructuring may be termed as a process of self-transformation of the promoters, managers and the employees. Each corporation should re-examine itself to know whether it has the willingness and ability to reorient itself to withstand the pains of restructuring including adaptability to new processes and technologies and also the different demands of the customers. 7.2.1 Mergers If we go by the literal meaning of the words merger, acquisition or amalgamation, they mean the blending of one undertaking with another which may either be existing or new. It is a tool by which one or two undertakings come under the umbrella of one undertaking.

Self-Instructional Material 183 Introduction to The Income Tax Act provides that for taking benefits of carrying forward losses Business Combinations and depreciation of the amalgamating undertakings, the following conditions must be fulfilled. • All the assets and liabilities of the amalgamating companies must be transferred NOTES to the amalgamated company. • At least 90 per cent members of the amalgamating companies must become the members of the amalgamated company. • The shareholders of the amalgamated company must be given shares of the amalgamated company in exchange. Definitions According to M.A. Weinberg, ‘A merger may be defined as an arrangement whereby the assets of two companies become vested in, or under the control of one company, (which may or may not be one of the original two companies) which has its shareholders all or substantially all the shareholders of the two companies’. ‘A merger is a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed.’ ‘The combining of two or more companies, generally by offering the stockholders of one company securities in the acquiring company in exchange for the surrender of their stock.’ A merger involves the fusion of two or more separate companies into one. It is a special case of combining companies where one survives and the other loses its identity. The company that acquires the other company acquires the assets, stock as well as liabilities of the merged company/companies in the form of equity shares of the transferee company. The shareholders of the transferor company become shareholders in the transferee company. Merger generally means that one company that is of less importance opts to become non-existent after the merger, for example, TOMCO after the merger with Hindustan Lever. An example of a major merger is the merging of JDS Fitel Inc. and Uniphase Corp. in 1999 to form JDS Uniphase. Types of Mergers and Motives behind Mergers Mergers may be effected to increase profits and reduce losses through the reduction of competition, diversification of production, bringing in operation economies, or through revival or infusion of new management and personnel. The underlying rationale or motivation behind the merger and acquisition depends primarily on the type of merger. Let us understand the different types of mergers and the rationale behind them. Mergers appear in three dominant forms, horizontal, vertical and conglomerate, based on the competitive relationships between the merging parties. A horizontal merger brings together related business; a vertical merger, on the other hand, integrates businesses that are similar but operate at different stages of value chain. Such business share a supplier–customer relationship with the other units involved in the merger. A conglomerate merger involves combining unrelated businesses. 1. Horizontal Merger In a horizontal merger, both the merging firm(s) and the merged firm(s) produce and sell identical or similar products in the same geographic area. So if the parties involved in a Self-Instructional merger are in direct competition with each other, it is termed as horizontal merger. 184 Material For example, the acquisition of Parle products by Coke or the merger of Brooke Introduction to Bond India with Lipton India to form Brooke Bond Lipton India Ltd are the examples of Business Combinations horizontal combination. Such a merger reduces the number of firms competing in the relevant market and eventually results in market concentration. Since horizontal mergers have the effect of bringing down the competition and increasing the concentration in the NOTES industry, such mergers are actively on the scanner of the regulators. The purpose of horizontal merger is elimination or reduction in competition; putting an end to price cutting; and bringing in economics of scale in production, research and development, marketing or other functions. Examples: • A horizontal merger in the traditional sense is the combination of car companies Chrysler and Daimler Benz. Both companies wanted the merger and once combined were called Daimler Chrysler. In this case there was synergy in market share, operating costs and financial obligations that made the resulting company better than what the two companies were separately. • The 2002 merger of Hewlett-Packard (NYSE:HPQ) and Compaq Computer was a horizontal merger, and although there was concern about reduced competition in the high-end computer market, the Federal Trade Commission (FTC) unanimously approved the transaction. 2. Vertical Merger A combination of two or more firms that fall in the same industry but operate at different stages of production–distribution chain is termed as vertical merger. Such a merger involves combining with either a customer or a supplier. For example, a merger of cotton spinning unit with a cotton weaving unit is a vertical merger as the two units are in the same industry but at the different stages of value chain. Vertical merger may take the form of forward or backward merger (alternatively known as forward or backward integration). When a company combines with the supplier of material, it is called backward merger and when it combines with the customer, it is known as forward merger. The backward and forward mergers are alternatively referred to as upstream mergers and downstream mergers, respectively. The joining of pharmaceutical company with a drugstore chain is an example of downstream merger while the merger of an oil distribution company with an oil refining company is an example of upstream merger. Consumers can benefit from the increased efficiencies in the form of lower prices and/or better service resulting from supply chain integration caused by the merger and acquisition. A vertical merger is an important instrument available for the firms who want to move up or down the value chain. The purpose of such a merger may range from lowering the costs of inputs and distribution overheads to assured supplies of inputs or posing entry barriers for the potential competitors. Vertical mergers also affect the competitive situation in the industry as the combining firms are in a position to collectively affect the prices of the end products by forming cartels. But unlike horizontal mergers, they do not affect the completion directly and, hence, are not watched as scrupulously as the horizontal mergers by the regulators. Examples: • The acquisition of German drug major Betapharm by Dr Reddy’s Laboratories Ltd is an example of vertical integration as the acquisition is expected to give Dr. Reddy’s (a drug manufacturing company) access to the supply chain of Betapharm into Germany and the rest of the Europe. Self-Instructional Material 185 Introduction to • One of the most well-known examples of a vertical merger took place in Business Combinations 2000 when internet provider America Online combined with media conglomerate Time Warner (NYSE:TWX). The merger is considered a vertical one because Time Warner supplied content to consumers through NOTES properties like CNN and Time Magazine, while AOL distributed such information via its internet service. • Time Warner Incorporated, a major cable operation, and the Turner Corporation, which produces CNN, TBS, and other programming. The Federal Trade Commission (FTC) was surprised that such a merger would allow Time Warner to monopolize most of the programming on television. FTC ultimately allowed the merger but stipulated that the merger will not at any point do anything in which the public good was harmed. 3. Conglomerate Merger Mergers of unrelated businesses are termed as conglomerate mergers. Such mergers involve the firms that are neither competitors nor part of the same supply chain, i.e., if the merging units do not relate either horizontally or vertically the combination is known as conglomerate merger. It is a type of combination in which firm(s) established in one industry combines with other firm(s) in unrelated industry. It generally involves diversification of business activities and therefore is considered to pose no threat to competition. Such a merger results in the broadening of the business portfolio of the merged company. Mitigation of risk is the basic motivation behind such mergers as such mergers involve businesses that are diverse and, hence, have unrelated income streams. It results in the reduction of total risks through substantial reduction of cyclicality of operations. The merger of Alstom Transport and Alstom System with Alstom Power India Ltd is an example of conglomerate merger. Such a merger may either aim at market expansion or product extension. When the merger involves two or more companies that sell the same products in different markets it aims at market expansion. The aim of the merger is product extension when two or more firms are selling different but related product(s) in a common market. Such a merger allows the new, larger company to pool their products and sell them with greater success to the already common market that the two separate companies shared. Examples: • Procter & Gamble (NYSE:PG), a consumer goods company, engaged in just such a transaction with its 2005 merger with Gillette. At the time, Procter & Gamble was largely absent from the men’s personal care market, a sector led by Gillette. The product portfolios of the companies were complimentary, however, and one of the world’s biggest consumer product companies was created through this merger. • Another example of a conglomerate merger was the merger between the Walt Disney Company and the American Broadcasting Company. 4. Reverse Merger In case of an ordinary merger, a profit making company takes over another company which may or may not be making a profit. The objective is to expand or diversify the business. However, in case of a reverse merger, a healthy company merges into a financially weak company and the former company is dissolved. The basic philosophy of reverse merger is to take advantage of the provisions of Income Tax Act, 1961 which

Self-Instructional permits a company to carry forward its losses to set off against its future profits. 186 Material Reverse merger is also carried out through the High Court route, but where one Introduction to of the merging companies is a sick industrial company under Sick Industrial Companies Business Combinations Act (SICA), such merger must take place through the Board for Industrial and Financial Reconstruction (BIFR). Reverse merger automatically makes the transferee company entitled for the benefit of carry forward and set-off of loss and unabsorbed depreciation NOTES of the transferor company. There is no need to comply with section 72A of the Income Tax Act. It may be noted that in the context of the Companies Act, there is no difference between a regular and reverse merger. It is like any other amalgamation or merger. Example: • Portable digital device-maker Handheld Entertainment did this when it purchased Vika Corp in 2006, creating the company known as ZVUE. 5. Cross Border Merger and Acquisitions The term cross border merger and acquisition involves mergers and acquisitions of firms belonging to different countries of the world. In recent years, there has been a substantial increase in the quantum of such acquisitions and takeover in Europe and the USA. United Kingdom has been the most important foreign investor in the USA in recent years with British companies making large acquisitions. The business houses from France, Germany, Holland and Japan have also been recently very active in acquisition of companies in different parts of the world. Such acquisitions/mergers have been basically due to massive economic forces, viz., globalization of the market place for many products, increasing competition which has assumed a global character, explosion of technology based on massive investments in R & D, and privatization of state enterprises. Examples: • Nissan-Renault’s global partnership agreement was signed in March 1999, in which Renault spent US$5.4 billion to buy a 36.8 per cent equity stake in Nissan and a 22.5 per cent stake in Nissan Diesel. The highlight of the alliance is Renault’s huge capital investment into Nissan and the fact that Nissan has allowed Renault’s Chief Operating Officer to formulate plans for revival. In the face of a sluggish local economy and lower domestic demand, as well as increased competition worldwide, Nissan was forced to seek foreign capital. • The merger of GE Capital and the Toho Mutual Life Insurance Company in April 1998, leading to the establishment of ‘GE Edison Life’ in Japan; and the establishment of ‘Nikko Salomon Smith Barney’, a 1999 joint venture with a 51 per cent stake owned by Nikko Securities and a 49 per cent stake by Travelers Group (Salomon Smith Barney). 6. Market Extension Mergers A market extension merger takes place between two companies that deal in the same products but in separate markets. The main purpose of this type of merger is to make sure that the merging companies can get access to a bigger market which would entail a bigger client base. Example: • Merger of Eagle Bancshares Inc by the RBC Centura. Eagle Bancshares with headquarters in Georgia has 283 workers and almost 90,000 accounts. It looks after assets worth US $1.1 billion. Eagle Bancshares also holds the Tucker Federal Bank, one of the ten biggest banks in the metropolitan Atlanta region. One of the major benefits of this merger is that this acquisition enables the RBC to go ahead with its growth operations in the North American market. With the help of this Self-Instructional Material 187 Introduction to merger RBC has got a chance to deal in the financial market of Atlanta. This Business Combinations move would allow RBC to diversify its base of operations. 7. Product Extension Mergers NOTES A product extension merger takes place between two business organizations that operate in the same market and deal in products related to each other. The product extension merger allows the merging companies to group together their products and get access to a bigger set of consumers. This ensures that they earn higher profits. Example: • The acquisition of Mobilink Telecom Inc. by Broadcom is a good example of product extension merger. Broadcom deals in the manufacturing of Bluetooth personal area network hardware systems and chips for IEEE 802.11b wireless LAN. Mobilink Telecom Inc. deals in the manufacturing of product designs meant for handsets that are equipped with the Global System for Mobile Communications technology. It is expected that the products of Mobilink Telecom Inc. would be complementing the wireless products of Broadcom. 7.2.2 Acquisitions Acquisition is a corporate action in which a company buys most of the target company’s ownership stakes so as to control the target firm. Acquisitions are mostly done keeping the growth of the company in mind whereby it is more beneficial for the company to take over an existing firm’s operations and niche compared to expanding on its own. Acquisitions are often paid in cash, the acquiring company’s stock or a combination of both. Acquisitions can be either friendly or hostile. Friendly acquisitions occurs when a target firm expresses its agreement to be acquired, whereas in hostile acquisitions the acquiring firm needs to actively purchase large stakes of the target company in order to have a majority stake. A fundamental characteristic of merger (either through absorption or consolidation) is that the acquiring or amalgamated company (existing or new) takes over the ownership of other company and combines its operations with its own operations. Acquisition may be defined as an act of acquiring effective control over assets or management of a company by another company without any combination of businesses or companies. A substantial acquisition occurs when an acquiring firm acquires substantial quantity of shares or voting rights of the target company. Thus, in an acquisition, two or more companies may remain independent, have separate legal entity, but there may be change in control of companies. An acquirer may be a company or persons acting in concert, that act together for the purpose of substantial acquisition of shares or voting rights or gaining control over the target company. Acquisition Motives Acquisition motives may be defined in terms of the acquirer’s corporate and business strategy objectives. For example, a large food company with well-established brand names or distribution network may acquire a small, less well-known target in order to achieve marketing and distribution synergies. Other acquisitions may be motivated by the desire for increased market power, control of a supplier, consolidation of excess production capacity and so on. However, the strategies themselves are formulated to serve the interests of the stakeholders in the acquiring firm. Self-Instructional 188 Material Strategies are formulated and acquisition decisions are made by the managers of Introduction to the acquiring firm. Managers may be taking these decisions to further the interest of the Business Combinations owners of the firm, i.e., the shareholders. This is the neoclassical view of the firm, in which the shareholder interest is paramount and managerial interests are subordinated. Where managerial interests differ from those of the shareholders, acquisitions may be NOTES undertaken to serve the former. In the large, publicly owned modern corporations, managers wield considerable power and discretion, and are often subject to only feeble control by shareholders. This gives managers much scope to pursue their own self-interest at the expense of the shareholders. Acquisitions driven by managerial self-interest may fail and cause wealth losses for the shareholders. There is a wide perception that acquisitions ‘don’t pay’ for the shareholders of the acquirer. A possible reason for this is that they are motivated by managerial self- interest. In this section, we describe the alternative shareholder and managerial perspectives, and draw out the implications for the success of the acquisition when either the shareholder or managerial considerations dominate the other. It must be remembered that the conflict between the two perspectives may permeate all decisions made by managers and not just acquisitions. The causes of failure of acquisitions cannot be unambiguously attributed to managerial selfishness. Even if managers do act in the shareholder interest, acquisitions may fail for a variety of other reasons, such as weak acquisition strategy, bid dynamics and problems of post-acquisition integration. It may be argued that these are themselves an affirmation of managerial misconduct arising from pursuit of managerial self-interest. However, managerial incompetence untainted by malice towards the shareholders is at least a plausible villain in the acquisition drama. Shareholder Wealth Maximization Perspective In this neoclassical perspective, all firm decisions including acquisitions are made with the objective of maximizing the wealth of the shareholders of the firm. This means that the incremental cash flows from the decision, when discounted at the appropriate discount rate, should yield zero or positive net present value. Under uncertainty, the discount rate is the risk-adjusted rate with a market-determined risk premium for risk. With acquisition, the shareholder wealth maximization criterion is satisfied when the added value created by the acquisition exceeds the cost of acquisition: Added value from acquisition = Value of acquirer and the acquired after acquisition – Their aggregate value before acquisition Increase in acquirer share value = Added value – Cost of acquisition Cost of acquisition = Acquisition transaction cost + Acquisition premium Acquisition transaction cost is the cost incurred when an acquisition is made in the form of various advisers’ fees, regulator’s fees, stock exchange fees, costs of underwriting and so on. The acquisition premium is the excess of the offer price paid to the target over the target’s pre-bid price. It is also called the control premium. Where managers seek to enhance shareholder wealth, they must not only add value, but also ensure that the cost of the acquisition does not exceed that value. Value creation may occur in the target alone, or in both the acquirer and the acquired firm. The calculation of added value for the acquirer’s shareholders is illustrated in the following example.

Self-Instructional Material 189 Introduction to Predator plc. makes a cash bid for Sitting Duck plc. Their equity market values Business Combinations ahead of the bid are respectively £100 million and £20 million. Predator expects that, as a result of the operational and strategic improvements made to Sitting Duck, its value will, post-acquisition, increase to £30 million. It pays a premium of £5 million to Sitting NOTES Duck shareholders to win control in a hostile bid, which also entails transaction costs, in the form of advisers’ fees, etc., of £0.5 million. Added value from acquisition = £(100 + 30)m – (100 + 20)m = £10m Cost of acquisition = £5m + 0.5m = £ 5.5m Increase in Predator’s share value = £10m – 5.5m = £4.5m Assuming that the stock market correctly anticipates the expected benefits from the acquisition and the transaction costs, the market value of Predator will increase by £4.5 million at the time of takeover.

Exhibit 7.1

Tata Group Acquired Corus, October 2006 Tata Steel is India’s second largest steel company with a capacity of producing 3.8 million tonnes of crude steel. It has most of its plant in Jamshedpur, Jharkhand. It is considered as one of the best companies in producing steel. In October 2006, Tata Steels acquired Corus with an outstanding price of $12.98 billion. Bharti Airtel acquired Zain Africa, February 2010 Deal size: $10.7 billion, Country: Kenya At present, Bharti Airtel is the largest mobile network in India. It is also expanding its reaches throughout the globe. In February, 2010, Bharti Airtel added 180 million new customers in its list by acquiring an African Mobile Network provider called Zain Africa. This acquisition took place against an amount of $10.7 billion. Hindalco Industires acquired Novelis , February 2007 Deal size: $5.73 billion, Country: Canada Hindalco Industries is one of the main branches of the Aditya Birla group. It is headquartered in Mumbai and is one of the largest producers of aluminum in the world. On the other hand, Novelis is a Canadian company which has been the best in its kind during 2007.

Holding Company A company can obtain the status of a holding company by acquiring shares of other companies. A holding company is a company that holds more than half of the nominal value of the equity capital of another company, called a subsidiary company, or controls the composition of its Board of Directors. Both holding and subsidiary companies retain their separate legal entities and maintain their separate books of accounts. Unlike some countries, like the USA or the UK, India it is not legally required to consolidate accounts of holding and subsidiary companies. Acquisition implies that one of the firms loses its identify and that it has been purchased by the firm that continues its existence. According to the Collins Business Dictionary an acquisition is the act of getting or buying something.

Self-Instructional 190 Material In the context of business combinations, an acquisition means purchase of share Introduction to capital of an existing company by another company. Theoretically, more than 50 per cent Business Combinations of the paid-up quality capital of the acquired company should be bought by the acquirer for enjoying complete control. However, in practice, even with 10–40 per cent share holding, effective control can be exercised. Since the remaining shareholders are usually scattered NOTES and ill-organized, they are not likely to challenge the control of the acquirer. An asset acquisition is an acquisition of all or part of the assets of a company pursuant to a contract entered into between the buyer and the seller. Asset acquisition requires that specific instruments of title must be delivered by the seller for transferring the legal title to the buyer. A share acquisition or takeover is an acquisition in which all or part of the out- standing shares of the seller is acquired from the shareholders of the seller company. A takeover is defined as a transaction or series of transactions in which a person (individual, group of individuals or company), acquires control of a company’s assets either directly by becoming the owner of those assets or indirectly by obtaining control of the company’s management where shares are closely held (by a small number of persons). A takeover will come into effect by an agreement with the holders of those shares. In case the shares are held by the public, a takeover may come into effect by an agreement between the acquirers and the controllers of the acquired company by purchasing shares on the stock exchange. A takeover or acquisition may be effected by the following: • An agreement between the acquirer and the majority • Purchase of shares in the open market as in the case of Genelec Ltd and Spencer Ltd. • A public offer to all the shareholders as in the case of Tata Tea Ltd. and Consolidated Coffee Ltd. • Private treaty for purchasing new shares • By means of a takeover bid Distinction between Merger and Acquisition The word merger is commonly used as an alternative to acquisition or takeover. However, there are some differences between the two also. The differences are as follows: • In a takeover, the companies involved continue their corporate existence without interruption, whereas in a merger only one company survives and the other loses its existence. • The consideration payable in a takeover is generally in the form of cash though it may also be paid in the form of equity shares or debentures or a mix of the various modes available. Consideration in a merger is paid for or received in shares. All shareholders receive money in future periods of time in the form of future dividends and/or capital appreciation. • Takeover generally takes longer than mergers because in a takeover the bid for controlling the stake in the target company is frequently against the wishes of the management of the target company, whereas in the case of a merger the bid is generally by the consent of the management of both the companies.

Self-Instructional Material 191 Introduction to • The legal routes to mergers and acquisitions are different in the Indian context. Business Combinations Sections 390 to 394 and 396 of the Companies Act require consent of shareholders, creditors, etc. and approval of the courts in case of mergers, whereas takeovers/ acquisitions are governed by the Securities and Exchange Board of India (SEBI) NOTES regulations. Meaning and Nature of Acquisitions and Amalgamations The term ‘merger’ refers to a situation where company acquires the whole of the assets and liabilities or a part thereof constituting an undertaking of another company (or companies) and the latter is (are) dissolved. The acquired company pays the shareholders of the merged company (or companies) cash or securities and continues to operate with the resources of the merged company (or companies) together with its own resources. It is thus synonymous with the term ‘absorption’. The term ‘amalgamation’ or ‘consolidation’ refers to a situation where two or more existing companies are combined into a new company. The old companies cease to exist and their shareholders are paid by the new company in cash or shares or debentures. Thus, technically there is a difference between merger and amalgamation. In case of merger, one existing company takes over the business of another existing company or companies; while in case of amalgamation, a new company takes over the business of two or more firms. As a matter of fact, the term amalgamation includes merger also. In the case of Sonmayazulu Versus Hob Purdhommee & Co. Ltd., the learned Judge observed that the term amalgamation is a ‘state of things under which two companies are joined so as to form a third entity or one company is absorbed into or blended with another’. The term ‘acquisition’ or ‘takeover’ refers to acquiring of effective working control by one company over another. The control may be acquired either through purchase of majority of shares carrying voting rights exercisable at a general meeting, or controlling the composition of the Board of Directors of the other company. The company acquiring controlling shares or voting power is termed as the holding company, while the company in which the shares are acquired is termed as the subsidiary company. It may be noted that for acquiring effective control over another company it is not necessary to own 51 per cent of the share capital of another company. For a widely held company, ownership of 20 per cent or as little as 10 per cent of the share capital outstanding may constitute effective working control. The advantage of acquisition is that it allows a company to acquire control over another company by investing much less than what would be necessary for a merger. According to the Monopolies and Restrictive Trade Practices Act 1969, the term ‘takeover’ means: • In relation to undertaking owned by a body corporate, the acquisition of not less than twenty five per cent of the voting power in relation to such body corporate. • In relation to any undertaking, includes the acquisition or control of management there of: whether by the acquisition of ownership of the undertaking or under any mortgage, lease or license or under any agreement or other arrangement. In acquisition or takeover, the shares may be purchased either for cash or in exchange of shares of acquiring company. The acquired company continues to exist but its shareholders change without any change in its constitution. Of course its operational control passes in the hands of a new management. Self-Instructional 192 Material Takeover can be friendly or hostile. Friendly takeovers are arranged between Introduction to companies through bargaining. Hostile takeovers are unfriendly acquisitions of shares in Business Combinations a way so as to hold controlling interests in the company.

7.2.3 Amalgamation NOTES The word amalgamation is not defined by the Companies Act. The word has no precise legal meaning. In commercial parlance, the word amalgamation is used when two or more independent companies combine to form a new business. In case of amalgamation, a new company is formed and all the amalgamating companies are liquidated. In Halsbury’s Laws of England, amalgamation is stated as the blending together of two or more undertakings into one undertaking and in such an act, the shareholders of each blending company become the shareholders of the blended undertaking. Amalgamation may take place either by transfer of two or more undertakings to a new company or by the transfer of one or more undertakings to an existing company. Incorporation of a new company to effect amalgamation is permissible. So a new company may be formed for amalgamation and takeover of an old company. However, it involves the formation of a new company to carry on the business of the old company. Generally, amalgamation paves the way for better and more efficient control in running the operations and leads to saving costs and improved profitability. Amalgamation is a legal process by which two or more companies are joined together to form a new entity or one or more companies are absorbed or blended with another, which will result in the amalgamating companies to lose its existence and its shareholders to become the shareholders of the new company or the amalgamated company. In an amalgamation, a new company may come into existence or an old company may survive while the amalgamating company may lose its existence. Amalgamation signifies an arrangement to bring together the assets of two companies under a single company’s control, which may or may not be one of the original two companies. Objectives of Amalgamation of Companies The reasons for which companies amalgamate with one another are as follows: • Avoid competition: The main purpose of amalgamation of companies is to avoid competition among themselves and give them an edge over their competitors. • Reduce cost: The amalgamated company can derive the operating cost advantage by lowering the cost of production. • Gain financially: The amalgamated company can derive financial gain which may be in the form of tax advantage, higher credit worthiness and lower rate of borrowing. • Achieve growth: The amalgamated company can pool its resources to facilitate internal growth and to prevent the advent of a new competitor. • Diversify the activities: The risk of a company can be lowered by diversifying its activities into two or more industries. At times, amalgamation may act as hedging the weak operation with a stronger one.

Self-Instructional Material 193 Introduction to Examples of mergers and amalgamations Business Combinations Indian banks have adopted the merger strategy to compete with foreign banks, since after the merger, the growth rate of deposits, income, total expenditure, profit, capital, NOTES number of employees and the number of branches increase considerably. Merger helps banks to increase asset size, strengthen their presence, optimize resources and diversify the range of products and services. The following is the list of mergers which has taken place in the last few years in our country. • Times Bank (Bennett Colemen & Company) has been merged with HDFC Bank. • ICICI a leading development bank was merged with ICICI Bank in 2002. • Global Trust Bank was amalgamated with the Oriental Bank of Commerce in 2004. • IDBI Bank was merged with its parent institution IDBI a development bank on 2 April 2005. • Lord Krishna Bank was merged with Centurion Bank of Punjab in 2007. • Centurion Bank of Punjab was merged with HDFC Bank. 7.2.4 Takeovers Generally speaking takeover means acquisition. A takeover occurs when the acquiring firm takes over the control of the target firm. An acquisition or take-over does not necessarily entail full, legal control. A company can have effective control over another company by holding minority ownership. Under the Monopolies and Restrictive Trade Practices Act, takeover means acquisition of not less than 25 per cent of the voting power in a company. Section 372 of the Companies Act defines the limit of a company’s investment in the shares of another company. If a company wants to invest in more than 10 per cent of the subscribed capital of another company, it has to be approved in the shareholders’ general meeting and also by the central government. The investment in shares of other companies in excess of 10 per cent of the subscribed capital can result into their takeovers. 7.2.5 Leveraged Buyouts A leveraged buyout (LBO) is said to occur when a company or a sole asset (such as real estate) is bought with a combination of equity and significant amounts of borrowed money, structured in such a way that the target’s cash flows or assets are used as the collateral (or ‘leverage’) to secure and repay the money borrowed to purchase the target-company/asset. Leveraged buyouts are a common occurrence in today’s scenario of mergers and acquisitions. The term leveraged buyout is usually employed when a financial sponsor acquires a company. A bank debt can also represent a leveraged buyout which may have the following different forms: • Management Buyout (MBO), Management Buy-in (MBI) • Secondary buyout and tertiary buyout Often seen in private companies, leveraged buyouts can also be seen, in some exceptional cases, in public companies. As financial sponsors look to boost their returns by engaging a high leverage (in the form of a high ratio of debt to equity), they have the added motivation to increase Self-Instructional 194 Material their debt ratio in order to sponsor an acquisition. This however has led to situations Introduction to Business Combinations where companies have been stretched beyond their limit. This particular condition has been termed as being ‘over levered’ which means that not enough funds have been generated to quell the debt which in turn has led to insolvency or debt-to-equity swaps in which the equity owners lose control over the business and the debt providers assume NOTES the equity. Characteristics of leveraged buyouts Of late leveraged buyouts have become very lucrative as they usually represent a win- win situation for the financial sponsor and the banks. This can happen as the financial sponsor boosts the returns on his equity by employing the leverage and banks tend to achieve a higher margin when supporting the financing of the leveraged buyouts. The amount of debt banks are willing to provide to support a leveraged buyout varies and depends on the following: • The quality of the asset to be acquired (stability of cash flows, history, growth prospects, hard assets) • The amount of equity supplied by the financial sponsor • The history and experience of the financial sponsor • The economic environment

7.3 MOTIVES FOR BUSINESS COMBINATIONS

Corporate restructuring includes mergers and acquisitions (M&A), amalgamation, take- overs, spin-offs, leveraged buyouts, buyback of shares, capital reorganization, sale of business units and assets, etc. M&A are the most popular means of corporate restructuring or business combinations. They have played an important role in the external growth of a number of leading companies the world over. In the United States, the first merger wave occurred between 1890 and 1904 and the second began at the end of the World War I and continued through the 1920s. The third merger wave commenced in the latter part of World War II and continues to the present day. About two-thirds of the large public corporations in the USA have merger or amalgamation in their history. In India, Check Your Progress about 1, 180 proposals for amalgamation of corporate bodies involving about 2,400 1. Define companies were filed with the High Courts during 1976–86. These formed 6 per cent of restructuring. the 40,600 companies at work at the beginning of 1976. In the year 2003–04, 834 mergers 2. Give the cohesive meaning of merger, and acquisitions deals involved ` 35,980 crore. In 2008, the M&A deals were US$ 19.8 acquisition and billion. Mergers and acquisitions, the way in which they are understood in the Western amalgamation. countries, have started taking place in India in the recent years. A number of mega 3. State M.A. mergers and hostile takeovers could be witnessed in India now. Weinberg's definition of merger. There are several aspects relating to mergers and acquisitions that are worthy of 4. Identify any three study. Some important questions are: types of mergers. • What are the basic economic forces that lead to mergers and acquisitions? 5. Define acquisitions. How do these interact with one another? 6. What is meant by • What are the manager’s true motives for mergers and acquisitions? amalgamation? • Why do mergers and acquisitions occur more frequently at some times than 7. When does a leveraged buyout at other times? Which are the segments of the economy that stand to gain or occur? lose?

Self-Instructional Material 195 Introduction to • How could merger and acquisition decisions be evaluated? Business Combinations • What managerial process is involved in merger and acquisition decisions? • What process is followed in integrating merging and merged firms post-merger? In this unit, we shall also discuss other forms of corporate restructuring like NOTES takeovers, leveraged buyouts and spin-offs. Corporate Restructuring and Business Combination Corporate restructuring refers to the changes in ownership, business mix, assets mix and alliances with a view to enhance the shareholder value. Hence, corporate restructuring may involve ownership restructuring, business restructuring and assets restructuring. A company can affect ownership restructuring through mergers and acquisitions, leveraged buyouts, buyback of shares, spin-offs, joint ventures and strategic alliances. Business restructuring involves the reorganization of business units or divisions. It includes diversification into new businesses, outsourcing, divestment, brand acquisitions, etc. Asset restructuring involves the acquisition or sale of assets and their ownership structure. The examples of asset restructuring are sale and leaseback of assets, securitization of debt, receivable factoring, etc. The basic purpose of corporate restructuring is to enhance the shareholder value. A company should continuously evaluate its portfolio of businesses, capital mix, and ownership and assets arrangements to find opportunities for increasing the shareholder value. It should focus on assets utilization and profitable investment opportunities, and reorganize or divest less profitable or loss-making businesses/products. The company can also enhance value through capital restructuring; it can design innovative securities that help to reduce cost of capital. 7.3.1 Types of Business Combinations There is a great deal of confusion and disagreement regarding the precise meaning of terms relating to the business combination, viz., merger, acquisition, takeover, amalgamation and consolidation. Sometimes, these terms are used in broad sense, encompassing most dimensions of business combination, while sometimes they are defined in a restricted legal sense. We shall define these terms keeping in mind the relevant legal framework in India. 1. Merger or Amalgamation A merger is said to occur when two or more companies combine into one company. One or more companies may merge with an existing company or they may merge to form a new company. In a merger, there is complete amalgamation of the assets and liabilities as well as shareholders’ interests and businesses of the merging companies. There is yet another mode of merger. Here one company may purchase another company without giving proportionate ownership to the shareholders of the acquired company or without continuing the business of the acquired company. Laws in India use the term amalgamation for merger. For example, Section 2(1A) of the Income Tax Act, 1961, defines amalgamation as the merger of one or more companies (called amalgamating company or companies) with another company (called amalgamated company) or the merger of two or more companies to form a new company in such a way that all assets and liabilities of the amalgamating company or companies become assets and liabilities of

Self-Instructional the amalgamated company and shareholders holding not less than nine-tenths in the 196 Material value of the shares in the amalgamating company or companies become shareholders of Introduction to Business Combinations the amalgamated company. We shall use the terms merger and amalgamation interchan- geably. Merger or amalgamation may take two forms: NOTES • Merger through absorption • Merger through consolidation 2. Absorption Absorption is a combination of two or more companies into an existing company. All companies except one lose their identity in a merger through absorption. An example of this type of merger is the absorption of Tata Fertilizers Ltd (TFL) by Tata Chemicals Ltd. (TCL). TCL, an acquiring company (a buyer), survived after merger while TFL, an acquired company (a seller), ceased to exist. TFL transferred its assets, liabilities and shares to TCL. Under the scheme of merger, TFL shareholders were offered 17 shares of TCL (market value per share being ` 114) for every 100 shares of TFL held by them. 3. Consolidation Consolidation is a combination of two or more companies into a new company. In this form of merger, all companies are legally dissolved and a new entity is created. In a consolidation, the acquired company transfers its assets, liabilities and shares to the new company for cash or exchange of shares. In a narrow sense, the terms amalgamation and consolidation are sometimes used interchangeably. An example of consolidation is the merger or amalgamation of Hindustan Computers Ltd, Hindustan Instruments Ltd, Indian Software Company Ltd and Indian Reprographics Ltd. in 1986 to an entirely new company called HCL Ltd. 7.3.2 Motives and Benefits of Mergers and Acquisitions It is believed that mergers and acquisitions are strategic decisions leading to the maximization of a company’s growth by enhancing its production and marketing operations. They have become popular in the recent times because of the enhanced competition, breaking of trade barriers, free flow of capital across countries and globalization of business as a number of economies are being deregulated and integrated with other economies. A number of reasons are attributed for the occurrence of mergers and acquisitions. For example, it is suggested that mergers and acquisition are intended to: • Limit competition • Utilize the under-utilized market power • Overcome the problem of slow growth and profitability in one’s own industry • Achieve diversification • Gain economies of scale and increase income with proportionately less investment • Establish a transnational bridgehead without excessive start-up costs to gain access to a foreign market • Utilize under-utilized resources—human and physical and managerial skills • Displace existing management • Circumvent government regulations

Self-Instructional Material 197 Introduction to • Reap speculative gains attendant upon new security issue or change in P/E ratio Business Combinations • Create an image of aggressiveness and strategic opportunism, empire building and to amass vast economic powers of the company. NOTES Are there any real benefits of mergers? A number of benefits of mergers are claimed. All of them are not real benefits. Based on the empirical evidence and the experiences of certain companies, the most common motives and advantages of mergers and acquisitions are explained below: • Maintaining or accelerating a company’s growth, particularly when the internal growth is constrained due to paucity of resources; • Enhancing profitability through cost reduction resulting from economies of scale, operating efficiency and synergy; • Diversifying the risk of the company, particularly when it acquires those businesses whose income streams are not correlated; • Reducing tax liability because of the provision of setting-off accumulated losses and unabsorbed depreciation of one company against the profits of another; • Limiting the severity of competition by increasing the company’s market power. 1. Accelerated Growth Growth is essential for sustaining the viability, dynamism and value-enhancing capability of a company. A growth-oriented company is not only able to attract the most talented executives but it would also be able to retain them. Growing operations provide challenges and excitement to the executives as well as opportunities for their job enrichment and rapid career development. This helps to increase managerial efficiency. Other things remaining the same, growth leads to higher profits and increase in the shareholders’ value. A company can achieve its growth objective by: • Expanding its existing markets • Entering into new markets A company may expand and/or diversify its markets internally or externally. If the company cannot grow internally due to lack of physical and managerial resources, it can grow externally by combining its operations with other companies through mergers and acquisitions. Mergers and acquisitions may help to accelerate the pace of a company’s growth in a convenient and inexpensive manner. Internal growth requires that the company should develop its operating facilities— manufacturing, research, marketing, etc. Internal development of facilities for growth also requires time. Thus, lack or inadequacy of resources and time needed for internal development constrains a company’s pace of growth. The company can acquire production facilities as well as other resources from outside through mergers and acquisitions. Specially, for entering in new products/markets, the company may lack technical skills and may require special marketing skills and/or a wide distribution network to access different segments of markets. The company can acquire existing company or companies with requisite infrastructure and skills and grow quickly. Mergers and acquisitions, however, involve cost. External growth could be expensive if the company pays an excessive price for merger. Benefits should exceed the cost of acquisition for realizing a growth which adds value to shareholders. In practice, it has been found that the management of a number of acquiring companies paid an excessive price for acquisition to satisfy their urge for high growth and large size of their

Self-Instructional 198 Material companies. It is necessary that price may be carefully determined and negotiated so that Introduction to merger enhances the value of shareholders. Business Combinations 2. Enhanced Profitability The combination of two or more companies may result in more than the average NOTES profitability due to cost reduction and efficient utilization of resources. This may happen because of the following reasons: • Economies of scale • Operating economies • Synergy Economies of scale Economies of scale arise when increase in the volume of production leads to a reduction in the cost of production per unit. Merger may help to expand the volume of production without a corresponding increase in fixed costs. Thus, fixed costs are distributed over a large volume of production causing the unit cost of production to decline. Economies of scale may also arise from other indivisibilities such as production facilities, management functions, and management resources and systems. This happens because a given function, facility or resource is utilized for a larger scale of operation. For example, a given mix of plant and machinery can produce scale economies when its capacity utilization is increased. Economies will be maximized when it is optimally utilized. Similarly, economies in the use of the marketing function can be achieved by covering wider markets and customers using a given sales force and promotion and advertising efforts. Economies of scale may also be obtained from the optimum utilization of management resource and systems of planning, budgeting, reporting and control. A company establishes management systems by employing enough qualified professionals irrespective of its size. A combined firm with a large size can make the optimum use of the management resources and systems resulting in economies of scale. Operating economies In addition to economies of scale, a combination of two or more firms may result in cost reduction due to operating economies. A combined firm may avoid or reduce overlapping functions and facilities. It can consolidate its management functions such as manufacturing, marketing, R&D and reduce operating costs. For example, a combined firm may eliminate duplicate channels of distribution, or create a centralized training centre, or introduce an integrated planning and control system. In a vertical merger, a firm may either combine its suppliers of input (backward integration) and/or with its customers (forward integration). Such merger facilitates better coordination and administration of the different stages of business operations— purchasing, manufacturing and marketing—eliminates the need for bargaining (with suppliers and/or customers), and minimizes uncertainty of supply of inputs and demand for product and saves costs of communication. An example of a merger resulting in operating economies is the merger of Sundaram Clayton Ltd (SCL) with TVS-Suzuki Ltd (TSL). By this merger, TSL became the second largest producer of two-wheelers after Bajaj. The main motivation for the takeover was TSL’s need to tide over its different market situation through increased volume of production. It needed a large manufacturing base to reduce its production costs. Large amount of funds would have been required for creating additional production Self-Instructional Material 199 Introduction to capacity. SCL also needed to upgrade its technology and increase its production. SCL’s Business Combinations and TSL’s plants were closely located which added to their advantages. The combined company has also been enabled to share the common R&D facilities. Yet another example of a horizontal merger motivated by the desire for rationalization of operations is the NOTES takeover of Universal Luggage by Blow Plast. The intended objectives were elimination of fierce price war and reduction of marketing staff. Synergy: Synergy implies a situation where the combined firm is more valuable than the sum of the individual combining firms. It is defined as ‘two plus two equal to five’ (2 + 2 = 5) phenomenon. Synergy refers to benefits other than those related to economies of scale. Operating economies are one form of synergy benefits. But apart from operating economies, synergy may also arise from enhanced managerial capabilities, creativity, innovativeness, R&D and market coverage capacity due to the complementarities of resources and skills and a widened horizon of opportunities. 3. Diversification of Risk Diversification implies growth through the combination of firms in unrelated businesses. Such mergers are called conglomerate mergers. It is difficult to justify conglomerate merger on the ground of economies, as it does not help to strengthen horizontal or vertical linkages. It is argued that it can result into reduction of total risk through substantial reduction of cyclicality of operations. Total risk will be reduced if the operations of the combining firms are negatively correlated. In practice, investors can reduce non-systematic risk (the company-related risk) by diversifying their investment in shares of a large number of companies. Systematic risks (the market, related risk) are not diversifiable. Therefore, investors do not pay any premium for diversifying total risk via reduction in non-systematic risk that they can do on their own, cheaply and quickly. For example, an investor who holds one per cent of shares of Company X and one per cent of shares of Company Y could achieve the same share of earnings and assets if Companies X and Y merged and he held one per cent of shares of the merged company. The risk from his point of view has been diversified by acquiring shares of the two companies. Of course, the merger of two companies may reduce the variability of earnings, but it would not necessarily reduce the variability of earnings vis-à-vis the market-related variables. What advantage can result from conglomerate mergers for shareholders who can diversify their portfolios to reduce non- systematic risk? The reduction of total risk, however, is advantageous from the combined company’s point of view, since the combination of management and other systems strengthen the capacity of the combined firm to withstand the severity of the unforeseen economic factors that could otherwise endanger the survival of individual companies. Conglomerate mergers can also prove to be beneficial in the case of shareholders of unquoted companies since they do not have the opportunity for trading in their company’s shares. An example of diversification through mergers to reduce total risk and improve profitability is that of RPG Enterprises (Goenka Group). The group started its takeover activity in 1979. It comprises a large number of companies, most of which have been takeover. The strategy has been to look out for any foreign disinvestment, or any cases of sick companies, which could prove right targets at low takeover prices. In 1988, RPG took over ICIM and Harrisons Malayalam Limited. In the case of ICIM, the parent company, ICL, continued to hold 40 per cent of the equity stake with the Goenkas acquiring 10 per cent of the equity by private placement of shares. For the Goenkas, this

Self-Instructional has provided an easy access to the electronics industry. 200 Material 4. Tax Benefits: Reduction in tax liability Introduction to Business Combinations In a number of countries, a company is allowed to carry forward its accumulated loss to set-off against its future earnings for calculating its tax liability. A loss-making or sick company may not be in a position to earn sufficient profits in future to take advantage of NOTES the carry-forward provision. If it combines with a profitable company, the combined company can utilize the carry-forward loss and save taxes. In India, a profitable company is allowed to merge with a sick company to set-off against its profits the accumulated loss and unutilized depreciation of that company. A number of companies in India have merged to take advantage of this provision. An example of a merger to reduce tax liability is the absorption of Ahmedabad Cotton Mills Limited (ACML) by Arbind Mills in 1979. ACML was closed in August 1977 on account of labour problem. At the time of merger in April 1979, ACML had an accumulated loss of ` 3.34 crore. Arbind Mills saved about ` 2 crore in tax liability for the next two years after the merger because it could set-off ACML’s accumulated loss against its profits. Yet another example of a merger induced by tax saving is the takeover of Sidhpur Mills by Reliance in 1979. The carry-forward losses and unabsorbed depreciation of Sidhpur amounted to ` 2.47 crores. In addition to tax savings, the merger provided Reliance with an opportunity for vertical integration (Sidhpur would supply grey cloth to Reliance) and capacity expansion (Sidhpur had 490 looms and 50,000 spindles and 40 acres of land). When two companies merge through an exchange of shares, the shareholders of selling company can save tax. The profit arising from the exchange of shares are not taxable until the shares are actually sold. When the shares are sold, they are subject to capital gains tax rate which is much lower than the ordinary income tax rate. For example, in India capital gains tax rate is 20 per cent while the personal tax rate is 30 per cent. A strong urge to reduce tax liability, particularly when the marginal tax rate is high (as has been the case in India) is a strong motivation for the combination of companies. For example, the high tax rate was the main reason for the post-war merger activity in the USA. Also, tax benefits are responsible for one-third of mergers in the USA. 5. Financial Benefits There are many ways in which a merger can result in financial synergy and benefits. A merger may help in: • Eliminating the financial constraint • Deploying surplus cash • Enhancing debt capacity • Lowering the financing costs Financing constraint A company may be constrained to grow through internal development due to shortage of funds. The company can grow externally by acquiring another company by the exchange of shares and thus release the financing constraint. Surplus cash A cash-rich company may face a different situation. It may not have enough internal opportunities to invest its surplus cash. It may either distribute its surplus cash to its shareholders or use it to acquire some other company. The shareholders may not really benefit much if surplus cash is returned to them since they would have to pay tax at Self-Instructional Material 201 Introduction to ordinary income tax rate. Their wealth may increase through an increase in the market Business Combinations value of their shares if surplus cash is used to acquire another company. If they sell their shares, they would pay tax at a lower, capital gains tax rate. The company would also be enabled to keep surplus funds and grow through acquisition. NOTES Debt capacity A merger of two companies, with fluctuating, but negatively correlated, cash flows, can bring stability of cash flows of the combined company. The stability of cash flows reduces the risk of insolvency and enhances the capacity of the new entity to service a larger amount of debt. The increased borrowing allows a higher interest tax shield which adds to the shareholders wealth. Financing cost Does the enhanced debt capacity of the merged firm reduce its cost of capital? Since the probability of insolvency is reduced due to financial stability and increased protection to lenders, the merged firm should be able to borrow at a lower rate of interest. This advantage may, however, be taken off partially or completely by increase in the shareholders’ risk on account of providing better protection to lenders. Another aspect of the financing costs is issue costs. A merged firm is able to realize economies of scale in flotation and transaction costs related to an issue of capital. Issue costs are saved when the merged firm makes a larger security issue. 6. Increased Market Power A merger can increase the market share of the merged firm. As discussed earlier, the increased concentration or market share improves the profitability of the firm due to economies of scale. The bargaining power of the firm vis-à-vis labour, suppliers and buyers is also enhanced. The merged firm can also exploit technological breakthroughs against obsolescence and price wars. Thus, by limiting competition, the merged firm can earn super-normal profit and strategically employ the surplus funds to further consolidate its position and improve its market power. We can once again refer to the acquisition of Universal Luggage by Blow Plast as an example of limiting competition to increase market power. Before the merger, the two companies were competing fiercely with each other leading to a severe price war and increased marketing costs. As a result of the merger, Blow Plast has obtained a strong hold on the market and now operates under near-monopoly situation. Yet another example is the acquisition of Tomco by Hindustan Lever. Hindustan Lever at the time of merger was expected to control one-third of three million tonne soaps and detergents markets and thus substantially reduce the threat of competition. Check Your Progress Merger or acquisition is not the only route to obtain market power. A firm can 8. What is business increase its market share through internal growth or joint ventures or strategic alliances. restructuring? Also, it is not necessary that the increased market power of the merged firm will lead to 9. What are the two efficiency and optimum allocation of resources. Market power means undue concentration forms that a merger or amalgamation that could limit the choice of buyers as well as exploit suppliers and labour. may take? 10. Outline any four objectives that 7.4 REGULATION OF MERGERS mergers and acquisitions are In an incisive study on corporate restructuring covering a number of companies over an intended to achieve. extended period of time, Gordon Donaldson examined the dynamics of corporate restructuring. He tried to look at issues such as why corporate restructuring occurs Self-Instructional 202 Material periodically, what conditions or circumstances induce corporate restructuring, and how Introduction to should corporate governance be reformed to make it more responsive to the needs of Business Combinations restructuring. The key insights of this study are described below: 1. Even though the environmental change, which warrants corporate restructuring, is a gradual process, corporate restructuring is often an episodic and convulsive NOTES exercise. Why? Typically, an organization can tolerate only one vision of the future, articulated by its chief executive and it takes time to communicate that vision and mobilize collective commitment. Once the strategy and structure that reflect that vision are in place, they acquire a life of their own. A constituency develops, with a vested interest in that strategy and structure, which resists change unless it becomes inevitable. As Gordon Donaldson says: ‘Hence resistance to change often preserves the status quo well beyond its period of relevance so that when change comes, the pent up forces, like an earthquake, capture in one violent moment, a decade of gradual change.’ 2. The conditions or circumstances which seem to enhance the probability of voluntary corporate restructuring, but not necessarily guarantee the same, are: (a) Persuasive evidence that the strategy and structure in place have substantially eroded the benefits accruing to one or more principal corporate constituencies; (b) A shift in the balance of power in favour of the disadvantaged constituency; (c) Availability of options to improve performance; (d) Presence of leadership which is capable of and willing to act. 3. Corporate restructuring occurs periodically due to an ongoing tension between the organizational need for stability and continuity as well as the economic compulsion to adapt to changes. As Gordon Donaldson says: ‘The “wrongs” that develop during one period of stable strategy and structure are never permanently “righted” because each new restructuring become the platform on which the next era of stability and continuity is constructed.’ 7.4.1 Organization Restructuring To cope with heightened completion, many firms have undertaken organizational restructuring and performance enhancement programmes. The common elements of these programmes are: (a) regrouping of businesses, (b) decentralization, (c) downsizing, (d) outsourcing, (e) business process re-engineering, (f) enterprise resource planning, and (g) total quality management. • Mergers involve a fairly long legal procedure and have significant tax implications. • The benefit of a merger is the difference between the present value of the combined entity and the present value of the combining entities if they remain separate. • Larson and Gonedes have developed a model of the exchange ratio determination. Their model holds that each firm will ensure that its equivalent price per share will be at least maintained as a sequel to the merger. • In practice, the commonly used bases for establishing the exchange ratio are: earnings per share, market price per share, book value per share, dividend discount model per share, and DCF value per share. • The key provisions of the SEBI Takeover Code relate to disclosure, trigger point, offer price, contents of the public announcement and creeping acquisition.

Self-Instructional Material 203 Introduction to • A wide-range of anti-takeover defences has been employed by target companies Business Combinations to ward off bidders. • Acquisitions are plagued by five sins: straying too far afield, striving for bigness, leaping before looking, overpaying, and failing to integrate well. NOTES • As the chances of failure in an acquisition can be high, it should be planned carefully. • Mergers, asset purchases, and takeovers lead to expansion in some way or the other. They are based on the principle of ‘synergy’ which says 2 + 2 = 5. Portfolio restructuring, on the other hand, involves some kind of contraction through a divestiture or a demerger. It is based on the principle of ‘anergy’ which says 5 – 3 = 3. • A demerger may take the form of a spinoff or a split-up. In a spinoff, an undertaking or division of a company is spun off into an independent company. In a split-up, a company is split-up into two or more independent companies. • A leveraged buy out involves concentration of equity in few hands with the help of debt. A holding company owns the stocks of other companies to exercise control over them. Alternative Forms of Corporate Restructuring In scholastic literature, the corporate restructuring pattern is often broken into two definite categories: operational and financial restructuring. Operational restructuring is accomplished by closing unprofitable or nonstrategic facilities. Financial restructuring describes action by the firm to modify its total debt and equity structure. Examples of financial restructuring include share repurchases or adding debt to either lower the corporation’s overall cost of capital or as part of an antitakeover defence. 7.4.2 Mergers and Consolidations Mergers can have both types of explanations, legal as well as economic. These different explanations matter significantly in cases of making deals, issue of regulatory notes and devising planning strategies. A Legal Perspective This perspective indicates the legalities involved in consummating a business deal. Such legalities probably assume many different forms, according to the type of transaction. In a merger, to or more companies combine to form a new business venture and legally they have no independent existence. The merged organization carries the name of one of the companies that has survived. In a typical merger, shareholders of the target company exchange their shares with those of the acquisitioning company, after a shareholder vote gives approval for the merger. It becomes mandatory for a few of the shareholders, who had not voted to support the merger, to go with the merger and exchange their shares with those of the acquired company. In case of the parent firm being the primary shareholder in the subsidiary, no approval is needed from the parent’s shareholders in most of the states. This type of a merger is known as a short form merger. The basic stipulation here is that the parent’s ownership is more than the minimum doorsill fixed by the state. For instance, in the case of Delaware, a parent corporation can get into a merger with the subsidiary even if there

Self-Instructional 204 Material is no shareholder vote. However, in this case, the parent should have the ownership of a Introduction to minimum of 90 per cent of the outstanding voting shares. Business Combinations A statutory merger is defined as that in which the acquiring company takes over the assets and liabilities of the target, in accordance with the legislatives of the state which houses the joint companies. On the other hand, in a subsidiary merger, the target NOTES becomes a subsidiary of the parent. In the face of the public, the functioning of the target company occurs under its brand name. However, its ownership is only with the acquirer. While the terms, ‘merger’ and ‘consolidation’, are frequently used in place of each other, a legislative alliance in which two or more than two companies join together to form a new company cannot be deemed a merger in principle. All legal entities that are consolidated are dissolved during the formation of the new company, which generally has a novel name. In a merger, either the acquirer or the target survives. The 1999 combination of Daimler-Benz and Chrysler to form Daimler Chrysler is an example of a consolidation. The new corporate entity formed as a result of consolidation or the surviving entity following a merger generally assumes ownership of the assets and liabilities of the merged or consolidated organizations. Stockholders in merged organizations characteristically swap their shares with those in the new company. A merger of equals is a merger structure usually functional every time the participants of the merger are similar in size and capacity to compete, productivity and market capitalization. In such circumstances, it is unclear which party is giving up control to the other and which party is generating higher amount of synergy. As an outcome of this, barely any significant premium is given to the target firm shareholders for their shares. As a practice, the former CEOs of the merged companies take care of the management of the newly formed company, who will be on the same level in hierarchy. The new joint venture will have the same number of employees from both the participant companies, even on the board of directors. In these types of Merger Process transactions, it is not common for the ownership to be divided equally among both the companies, with only 14 percent having a 50/50 split (Mallea, 2008). In 1998, when Citigroup was formed with the merger of Citibank and Travelers, it was a merger of equals. According to studies, it has been observed that it is common for the CEOs of target companies to negotiate to retain a vital degree of control in the merged company for both, their board and management in exchange for a lower premium for their shareholder (Wulf, 2004). An Economic Perspective There are three types of business mergers; these are: horizontal, vertical and conglomerate mergers. Classification of a merger is done on the basis of the similarity or differences between the industries of the merging companies and their positions in the corporate value chain (Porter, 1985). It is primarily important to determine business combinations in this manner from the viewpoint of antitrust analysis. The best way to understand horizontal and conglomerate mergers is to question if the merging companies are from alike or different industries. When the merging organizations are from the same industry, a horizontal merger takes place. Instances of horizontal mergers are: Procter & Gamble and Gillette (2006) in domestic items, Oracle and PeopleSoft in business application software (2004), oil giants Exxon and Mobil (1999), SBC Communications and Ameritech (1998) in telecommunications, and Nations Bank and Bank America (1998) in commercial banking.

Self-Instructional Material 205 Introduction to Conglomerate mergers are those wherein the buying company purchases Business Combinations companies from different industries. An instance of this would be U.S. S Steel’s acquisition of Marathon Oil to form USX, in the mid 1980s. Vertical mergers are best elucidated in functional terms, in the context of the corporate value chain. In a vertical merger the NOTES merging companies make their contributions at various different stages of the production or value chain. A simple value chain in the steel industry may differentiate between raw materials, like coal or iron ore; steel making, such as ‘hot metal’ and rolling operations; and metals distribution. In the same way, a value chain in the oil and gas industry would segregate activities like exploration into production, marketing and refining. An Internet value chain may distinguish between infrastructure providers, content providers, such as Dow Jones; and portals such as Google. A vertical merger is when companies that do not own operations in the important segments of the value chain choose reverse integration by acquiring a supplier or by acquiring a distributor. An example of forward integration is when paper manufacturer Boise Cascade acquired the office products distributor, Office Max, for $ 1.1 billion in 2003. An instance of reverse integration in the technology and media industry is America Online’s takeover of media and content provider Time Warner, in 2000. In addition to this, the acquisition also secures Nucor’s supply of scrap metal used to fire its electric furnaces.

In Bound Operations / Marketing Distribution / Customer Logistics Production Sales Support

Purchase of Manufacturing / Strategy / Product deli- Post-Sale Raw Materials IT Operations Promotion very & Services Support

Forward Integration

Backward Integration

Fig. 7.1 Corporate Value Chain

Gugler et al. (2003) say that the analysis of 45,000 transactions, during the period between 1981 and 1998, revealed that horizontal, conglomerate and vertical mergers were for 42 per cent, 54 per cent, and 4 per cent, out of the total number of transactions. Despite the fact that absolute vertical mergers are not at all common, according to Fan and Goyal (2006), approximately one fifth of the mergers that materialized between 1962 and 1996 showed some degree of vertical relevance. 7.4.3 Friendly vs Hostile Takeover In a friendly takeover, it is easy to approach the target’s board and management with the idea and suggest shareholder approval. To get control, the acquiring firm usually has to offer a premium to the current stock price. The extra offer, in addition to the offer price, over the target’s premerger share price is called a purchase, or acquisition premium. The average of the US merger premium averaged about 38 per cent between 1973 and 1998 (Andrade et al., 2001). Roosi and Volpin (2004) document an average premium of 44 percent during the 1990s for US mergers. The authors also found premiums in 49 countries ranging from 10 percent for Brazil and Switzerland to 120 percent for Israel and Indonesia. The widespread variety of estimates might mirror the value linked to the special privileges which are in turn linked to control in various countries. An instance of this is insiders in Russian oil companies have been able to capture a large fraction of profits by selling some of their oil to their own companies at prices less than the market. The purchase premium is an indication of the professed value of obtaining a calculating Self-Instructional 206 Material interest (i.e., the ability to guide the operations of the company) in the target, the value of Introduction to probable synergies (e.g. cost savings) significant from combining the two firms, and any Business Combinations overpayment for the target firm. Overpayment is the charge paid by an acquirer for a target firm that is in excess of the current value of future cash flows, inclusive of synergy. Often, efforts are made by analysts to classify the amount of premium paid for a controlling NOTES interest (i.e., control premium) and the amount of incremental value created. The acquirer is prepared to share with the target’s shareholders. An instance that precisely talks about control premium is a conglomerate that is ready to pay a considerable ongoing market price for a target firm to attain a controlling interest despite the limitations of impending operating synergies. Under these circumstances, the acquirer usually believes that he will be able to get the right value of the control premium, when superior management decision-making is done for the target firm. Emphasis importantly matters on what is usually known as a control premium in the popular or trade press. This actually is a purchase of acquisition premium inclusive of both, a premium for synergy and a premium for control. Merger process A tender offer can be defined as the offer to buy shares in another firm, generally by making the payment through cash, securities, or both. While tender offers are used in a number of situations, they most often result from friendly negotiations (i.e., negotiated tender offers) between the acquirer’s and the target firm’s boards. Self-tender offers are used when a firm seeks to repurchase is stock. To conclude, those that are unwanted by the target’s board are referred to as hostile tender offers. An unfriendly or hostile takeover occurs when—the initial approach was uncalled for; the target was not looking for a merger at that time; the approach was contested by the target’s management; and control changed hands (i.e., usually requiring the purchase of more than half of the target’s voting common stock). The acquirer may endeavour to thwart management by offering to buy shares directly from the target’s shareholders (i.e., a hostile tender offer) and by buying shares in public stock exchange (i.e., an open market purchase). Friendly takeovers often are consummated at a lower purchase price than hostile transactions. Ahostile takeover effort might draw new bidders, who or else may not have been attracted in the target. Such a result often is referred to as putting the target in play. In the ensuing auction, the final purchase price may be bid up to a point well more than the initial offer price. Acquirers also favour friendly takeovers; because the post merger integration process classically is accomplished more expeditiously with both parties cooperate fully. Due to these, the majority of deals are inclined to be friendly. M & A arbitrageurs When a bid is through for a target company, the target company’s stock price time and again trades at a little discount to the actual bid. Merger arbitrage refers to an investment strategy which tries to profit from this. Arbitrageurs (‘arbs’) buy the stock and make a profit on the dissimilarity between the bid price and the current stock price if the deal gets through. Hedge fund managers often play the role of ‘arbs’. Arbs may build up a substantial percentage of the stock held outside to be in a position to be able to influence the takeover attempt. For example, if there is some other offer then the arbs promote their positions to the managers and investors through phone calls and informing the financial press. Their main aim is to sell their shares to the highest bidder. In a hostile takeover attempt, Acquirers often buy as much of stock as

Self-Instructional Material 207 Introduction to possible with the objective of gaining power of the target by buying the stock from the Business Combinations hedge funds. Arbs also ensure stock price activities to determine if a particular stock investor is accumulating shares. This is done to recognize the target before the potential acquirer NOTES is required by law to announce its intentions. Due to the activities of the arb the stock price starts increasing before the announcement of the takeover attempt (Ascioglu, McInish and Wood, 2002). It is true that the share prices of the other firms from the same industry also increases as they are also viewed as the next targets for a takeover. Arbs also offer market liquidity during transactions. In a merger that is cash- financed, the merger arbitrageur who is interested in buying the target firm’s share eagerly offers to buy the shares from the shareholders who want to sell their shares just before or after the takeover. While arbitrageurs may offer some liquidity in the target firm’s stock, they may lessen liquidity for the acquirer’s stock in a stock-for-stock merger. The downward pressure on the acquirer’s share price at the time the transaction is announced from widespread short selling makes it tricky for others to sell without incurring a loss from the premerger announcement price. Do merger and acquisitions pay off for shareholders? The answer to this depends on for whom and over what period of time. On an average, the gain by the shareholders around the announcement date of an acquisition is considerably more; however, shareholders of the target firm gains more. Mostly over three to five years after the takeover, many acquirer firms either underperform or spoil the shareholder value. Nevertheless, it is less clear if the reason for this subpar performance and value destruction is due to the acquisition or other factors. Current situation suggests that the success rate among acquisitions possibly will be significantly higher than widely believed when M& A are analysed in terms of the characteristics of the deal. In an analysis of 88 empirical studies by Zola and Meier (2008) between 1970 and 2006 identified 12 approaches for measuring the impact of takeovers on shareholder value. Out of all these studies it was found that 41 per cent used the event study method to analyse premerger returns and 28 per cent utilized the long-term accounting measures to examine post merger returns. Other evaluation methodologies make use of proxies for financial returns, such as post merger productivity and operating efficiency improvements, revenue enhancement, and customer retention and satisfaction. Premerger returns to shareholders Constructive abnormal returns represent gains for shareholders, which could be due to factors such as better efficiency, tax benefits or pricing power. They surpass what an investor would in general expect to earn for accepting the risk. For example, if an investor can logically expect to earn a 10 per cent return on a stock but ends up earning 25 per cent due to a takeover, there would be a 15 per cent of abnormal or surplus return for the shareholder. Calculation of the abnormal return is done by subtracting the actual return on the announcement date from a yardstick which often are approximated by the capital asset pricing model or the return on the S&P 500 stock index. Abnormal returns in the share prices symbolize the present value of expected future cash flows. Consequently, the large positive M & A announcement date could reproduce expected future synergies which would result due to the combination of the target and acquiring firms. Abnormal or surplus returns to target shareholders are not necessarily the same as the purchase price premium they take for the delivery of their Self-Instructional 208 Material shares. The abnormal or excess return would be equivalent to the purchase price premium Introduction to if the premerger share price reflects the normal rate of return for the level of risk taken Business Combinations by investors in the target stock.

Postmerger returns to shareholders NOTES The second approach to assess M&As performance is to scrutinize accounting measures, such as cash flow and operating profit. These studies unfortunately provide contradictory evidence on the impact of M&A activity in the long-term. In a review of 26 studies of post merger performance within five years after the merger, Martynova and Renneboog (2008) discovered that 14 out of 26 studies showed a decline in operating returns, provided positive changes in profitability, and 5 showed a significant increase in profitability. Most probably, the longer the post merger time period analysed, the better is the likelihood that other factors, wholly not related to the merger, will influence financial returns. Furthermore, these longer-term studies are not able to contrast how well the acquirer would have done without the acquisition. Acquirer experience may not improve long-term performance of combined companies Abnormal returns to serial acquirers (firms making frequent acquisitions) have tended to turn down from one transaction to the next. Explanation of this trend has been given that the CEO of the serial acquirer becomes overconfident with each consecutive acquisition and has the tendency to overrate the value of synergies and the ease with which they can be realized. As a result, overconfident and over optimistic CEOs end up overpaying for their acquisitions. These conclusions differ from those of Harding and Rovit (2004) and Hyward (2002). They believe that the acquirers learn from their mistakes, thereby suggesting that the serial acquirers are more likely to earn heavy returns on their cost of capital. Finally, experience is an essential but not sufficient condition for flourishing acquisitions. According to Barkema and Schijven (2008), ‘experience contributes to improved financial returns if applied to targets in the same or similar industries or in the same or similar geographic regions.’ Do mergers and acquisitions pay off for bondholders? Mergers and acquisitions have comparatively modest impact on abnormal returns to either acquirer or target bondholders. The limited impact of M&As on the wealth of the bondholder is due to the relationship between management discipline and leverage. Increasing leverage helps the management to improve operating performance, whereas decreasing leverage has the opposite effect. Decreasing leverage encourages shareholders to increase future borrowing to increase financial returns to equity. The impact on abnormal returns to bondholders may be insignificant if the transaction results in a less leveraged business. Do mergers and acquisitions pay off for society? Although post-merger performance study outcome are vague, even studies show generally dependable results. These studies show that M&A activity improves aggregate shareholder value. If the position of the financial market is good then the combined shareholder values of the two firms reflect the positive results from the merger. Shareholders of the target firm gain from this increase. Mergers and acquisitions have continued to increase in number and average size in the past 30 years.

Self-Instructional Material 209 Introduction to If failure is defined as the ultimate sale or liquidation of the business, the failure Business Combinations rate tends to be low. If failure is defined as the incapability to meet or surpass financial objectives, the rate of failure is higher. If failure is definite as not achieving largely strategic objectives, managers often are very content with their acquisitions. NOTES The concept that most M&As fail in some substantive manner is not supported by data. Event studies have identified a number of situations in which acquirers receive good abnormal returns. These situations comprise acquisition of private firms and subsidiaries of public firms, comparatively small acquirers, when acquirers use cash rather than stock as a form of payment, when targets are small, and acquisitions of target firms early in a consolidation cycle. Besides, such firms often continue to do better than their peers in the years immediately following closing. Commonly cited reasons why some mergers and acquisition fail to meet expectations In a survey of acquiring firm managers, Brouthers (2000) found that whether M&As are viewed as having failed depends on whether failure is defined in terms of easily measureable outcomes. If failure is defined as the ultimate sale or liquidation of the business, the failure rate tends to be low. If failure is defined as the incapability to meet or surpass financial objectives, the rate of failure is higher. If failure is definite as not achieving largely strategic objectives, managers often are very content with their acquisitions. The concept that most M&As fail in some substantive manner is not supported by the data. As noted earlier, event studies identified a number of situations in which acquirers receive optimistic abnormal returns. These situations comprise acquisition of private firms and subsidiaries of public firms (often accounting for more than one half the total number of annual transactions), comparatively small acquirers, when targets are small relative to acquirers, acquisitions of target firms early in a consolidation cycle, and when acquirers use cash rather than stock as a form of payment. Besides, such firms often continue to do better than their peers in the years immediately following closing. Even though the average abnormal return for all bidders tends to be about zero, the average firm still earns at or close to its cost of capital. 7.4.4 Merger Process: Target Identification, Negotiation and Closing Deal By and large, a merger is carried out with the help of three essential steps: (i) planning, (ii) resolution and (iii) implementation. Planning is the most complex part of the merger process and involves various complex actions such as analysis, formulating an action plan and the negotiations between the parties involved. There is no specific time for planning and each company has its own specifications to look into. However once this stage is complete the merger process can be said to be well on its way. The next stage is resolution and here the most important task is to get the management’s approval. The third and the final step is the implementation which includes enrolment of the merger deed and other official procedures and paperwork. 1. Screening the Market and Initiate Negotiations One of the most essential parts is the screening and selecting the right candidates. It is believed that successful mergers are the ones where the potential value and synergies are 100 per cent obvious and do not need to be argued about. Only if this joint value is

Self-Instructional 210 Material seen and shared by all parties involved, there is sufficient motivation by all participants to Introduction to endure the long strategy, positioning and valuation negotiations that a merger requires. Business Combinations The merger team puts great attention to this process and has developed analytics and matching matrices. The merger will perform to: • Identify target candidates, often with the help of the client NOTES • Target comparison and asset matching in the aspects of revenue size, profitability, strategy and product match • Look into potential hurdles at shareholder structure, regulatory or customer conflicts • Initiate talks between shareholders, management and key employees 2. What to Look For It is very difficult for investors to come to know of genuine deals. Some of the criteria that an investor should look for in successful mergers are: • A reasonable purchase price: A 10 per cent premium on the market price is reasonable than a premium of 50 per cent. • Cash transactions: Companies that pay in cash tend to be more careful when calculating bids and valuations. • Sensible appetite: Smaller companies should be targeted by the acquiring companies. Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality. 3. Doing the Deal Start with an offer A tender offer is first offered by the CEO and top managers of the acquiring company. The process begins by buying the shares of the target company discreetly by the acquiring company. The company can buy only 5 per cent of the total outstanding shares after which it needs to file with the SEC. The company needs to file and declare the number of shares it owns and whether it intends to buy the company or keep the shares purely as an investment. The acquiring company arrives at an overall price that the acquiring company is ready to pay in cash and shares after consulting the financial advisors and investment bankers. The tender offer is then advertised in the business papers, stating the offer price and the deadline by which the shareholders in the target company must accept (or reject) it. The target’s response The target company can do one of several things once the tender offer has been made: • Accept the terms of the offer: If the top managers and shareholders of the target firm are happy with the terms of the transaction, they will go ahead with the deal. • Attempt to negotiate: There can be a negotiation on the offer money if the target company is not happy with it. They may then try to work out more agreeable terms. Furthermore, managers have more negotiating power if they can show that they are crucial to the merger’s future success.

Self-Instructional Material 211 Introduction to • Execute a poison pill or some other hostile takeover defense: A poison pill Business Combinations scheme can be triggered by a target company when a hostile suitor acquires a predetermined percentage of company stock. In defense, the target company grants all shareholders the option to buy additional stock at a dramatic discount. NOTES This dilutes the acquiring company’s share and intercepts its control of the company. • Find a White Knight: As an alternative, the target company’s management may seek out a friendlier potential acquiring company, or white knight. The white knight might offer an equal or higher price for the shares than the hostile bidder. At the same time mergers and acquisitions may face scrutiny from regulatory bodies. For example if the two biggest long-distance companies in the U.S., AT&T and Sprint, wanted to merge, the deal would require approval from the Federal Communications Commission (FCC). 4. Closing the Deal Once the target company agrees to the tender offer and the regulatory requirements are met, the merger deal will be executed. The acquiring company will have to pay the target company in cash, stock or both. Target company shareholders receive a cash payment for each share purchased. This transaction is treated as a taxable sale of the shares of the target company. It is not taxable if the transaction is in stock only. There is simply an exchange of share certificates. M&A deals are carried out more as stock-for-stock transactions to avoid tax. The shareholders of the target company are only taxed when they sell their new shares. When the deal is closed, investors usually receive a new stock in their portfolios- the acquiring company’s expanded stock. Sometimes investors will get new stock identifying a new corporate entity that is created by the M&A deal.

7.5 REGULATION OF TAKEOVERS

Takeover can be either ‘friendly’ or ‘hostile’. In case of a friendly takeover, the promoters/ management of the target company are also, in principle, agreeable to be taken over by the acquirer and are willing to peacefully give up control over the target company to the acquirer. This happens when the entire promoter group is willing to exit. Sometimes the target company is open to only one specific acquirer (or one out of a select few), and the latter agrees to the price and other conditions of takeover such as Check Your Progress non-retrenchment of employees, post-acquisition role of existing promoters/management, 11. Why does non-compete fees, continuation of certain businesses, etc. At other times, the promoters/ corporate management of the target company are open to any acquirer who offers them an overall restructuring occur periodically? best deal. 12. What are the In the third case (which is most likely), the promoters/management of the target objectives of company have a negative list of acquirers in mind that they do not want to sell out to. organizational restructuring and Outside this negative list, they are open to sell out to anyone who offers them an overall performance best deal. enhancement programmes? Thus, when the promoter group that is collectively in exit mood receives an offer 13. How is from the prospective acquirer whom they do not mind selling out to, the takeover takes classification of a a friendly mode. merger done? On the other hand, sometimes promoter group receives an offer from a prospective acquirer whom they do not want to sell out to. It may even occur that some of the Self-Instructional 212 Material entities in the promoter group are against the sale out. On these occasions, the hostile Introduction to takeover battle follows. Business Combinations In the case of Tata Steel’s acquisition of Corus, the latter was also looking for a prospective acquirer, who was a low-cost producer of steel, was close to it culturally and who would not retrench its employees. Hence, they were willing to sell out to Tata NOTES Steel. Corus was also open to being acquired by a Brazilian company Companhia Siderurgica Nacional (CSN). Therefore, there was a bidding war between Tata Steel and CSN. However, the acquisition was still a friendly one, since Corus was willing to sell out to Tata Steel. On the other hand, in the case of Mittal Steel’s acquisition of Arcelor, the management of Arcelor was strongly opposed to the takeover by Mittal Steel, whom they sneered at as a company of Indians. Hence, Mittal had to resort to a hostile takeover. In the case of Indian Aluminium Company Limited (Indal), the management was not ready to sell out to Sterlite, but they had no objection to Hindalco taking them over. Whenever the takeover is friendly, there is a cooperation between the acquirer and the target company. The target company shares the critical information required by the acquirer to carry out valuation of the target company. It also facilitates due diligence by the acquirer and cooperates in carrying out legal formalities. On the other hand, in case of hostile takeover, an acquirer has to depend upon information available only in public domain and force his way for due diligence and regulatory compliance. Chances are always better that an acquirer would offer a better price and better terms and conditions in case of a friendly takeover. Also, chances of the acquirer allowing the promoters/management of the target company to continue having important role post acquisition are far better. A case in sight is the friendly takeover of Ranbaxy by Daiichi Sankyo, wherein the erstwhile promoter and CEO of Ranbaxy, Mr Malvinder Singh, has continued as its CEO post acquisition. In India, most of the takeovers are friendly, though there are some hostile ones like demerger of Larsen and Toubro’s (L&T) cement business from UltraTech Cement Limited, which was then taken over by Grasim. Even in the United States, out of the five takeover waves between 1893 and 2000, only the fourth takeover wave between 1981 and 1989 was characterized by hostile takeovers (Five waves: 1893– 1903, 1919–29, 1945–73, 1981–89 and 1992–2000). Other periods and even the post-2000 years have mostly seen friendly acquisitions. In case of a friendly takeover, neither does the acquirer have to adopt any ‘tactics’ to acquire, nor does the target company have to resort to ‘tactics ’to defend itself. However, in case of hostile takeover, both sides indulge into tactics. Let us now discuss some of the ‘takeover tactics’ and ‘defence tactics’. 7.5.1 Takeover Tactics The various takeover tactics are as follows: 1. Dawn Raid In this tactic, brokers acting on behalf of acquirer/raider swoop down on stock exchange(s) at the time of its opening and buy all available shares before the target/prey wakes up.

Self-Instructional Material 213 Introduction to This is really not a good tactic. First of all, an acquirer can get a sizeable chunk in Business Combinations the dawn raid only if the scrip is highly liquid in comparison to its total paid-up capital. Secondly, whether the target wakes up or not, the investors certainly would. This would make the price shoot up requiring the acquirer to shell out much more money. It may NOTES also happen that the investors, sensing the acquisition, may hold back the quantity offered thereby reducing the liquidity and making the dawn raid fail. In the Indian context, dawn raid would be more expensive. Indian takeover regulations prohibit the acquirer, along with the persons acting in concert with him, from acquiring 15 per cent or more shares or voting capital (including the shares or voting capital already held) of the target company without making an open offer. Thus, just through dawn raid one cannot acquire a controlling interest in a company in India. Further, the open offer price is linked to the past prices of the scrip and also the highest price paid by the acquirer in a certain period (discussed in the book later on). Dawn raid, therefore, would typically push up the market acquisition price as also the open offer price, making acquisition very expensive and even unviable. It is rather more prudent to gradually acquire upto slightly below 15 per cent over a period of time and then make an open offer. 2. Bear Hug The acquirer makes a very attractive tender offer to the management of the target company for the latter’s shareholders and asks them to consider the same offer in the interest of the shareholders. This is a sound tactic. Normally, such an offer is backed by the acquirer’s preparedness to make a hostile open offer to the public shareholders if the board of the target company rejects the offer. Though such offer of the acquirer is unsolicited (in case of a hostile takeover), the board of the target company is bound to consider it impartially on account of its fiduciary capacity in protecting public shareholders’ interests. Further, if the offer is really very good for the public shareholders, the board generally cannot reject it just to protect the interests of the promoters of the target company. This is so because if they reject the offer on frivolous grounds, chances are that the public shareholders, particularly institutional shareholders, would favourably respond to the offer either through private negotiated deals or in the subsequent hostile open offer made by the acquirer. 3. Saturday Night Special This is the same tactic as bear hug, but made on the Friday or Saturday night (last working day of a week) asking for a decision by Monday (first working day of the next week). The idea behind this is to give very little time to the promoter/board of the target company to set up their defences. This is also called ‘Godfather Offer’. 4. Proxy Fight In this tactic, the acquirer convinces majority (in value) shareholders to issue proxy rights in his favour, so that he can remove the existing directors from the board of the target company and appoint his own nominees, thereby taking control of the target company. However, this method in which the control is sought to be acquired without acquisition is not sustainable since every time the acquirer will have to keep on acquiring proxies from the geographically scattered shareholders. Also, such removal or appointment of majority of directors will be treated as an acquisition of control over the

Self-Instructional 214 Material target company requiring the acquirer to make an open offer. Hence, proxy fight cannot Introduction to be sustainable tactic of hostile acquisition. Business Combinations

7.5.2 Defence Tactics NOTES The various defence tactics are as follows: 1. Crown Jewels The target company sells its highly profitable or attractive business/division to make the takeover bid less attractive to the raider. It is needless to add that no company will like to resort to selling its profitable business unless it is forced to do so. 2. Blank Cheque The target company makes a preferential allotment to existing promoters or friendly shareholders to increase the control of the promoter group. In India, such a preferential issue is governed by the SEBI (Disclosure and Investor Protection) (DIP) Guidelines, 2000, which stipulate a pricing formula based on the past twenty-six weeks’ and past two weeks’ prices. Due to this, the existing promoters have to pay a price close to the market price, which makes such preferential allotment expensive. Further, normally, existing promoters of the target company would be holding shares in excess of 15 per cent. As per takeover regulations in India, when the promoters’ holdings are between 15 and 55 per cent, they can acquire only 5 per cent of the paid-up share capital in any financial year without making an open offer. In case of promoters who are holding between 55 and 75 per cent, they can acquire upto 5 per cent in any financial year without making an open offer only through stock market. But otherwise, such promoters holding between 55 and 75 per cent cannot buy any shares without making an open offer. Any preferential issue made to promoters for consolidation of holdings for the purpose of defence against takeover, is likely to be more than 5 per cent of the share capital of the company. Thus a preferential allotment would normally trigger an open offer requiring the promoters to buy additional 20 per cent from the public. As far as the allotment to friendly shareholders is concerned, the concept of persons acting in concert would apply (if so proved), thereby triggering the open offer, even if such allotment is made to friendly shareholders. This makes the blank cheque tactic very expensive in India and cannot be effectively used. 3. Shark Repellents The target company amends its charter, i.e., Memorandum of Association or Article of Association or the like to make the takeover expensive or impossible. To take an example, a company may stipulate a certain minimum educational qualification and/or experience for directors, so that an acquirer finds it difficult to depute his people on the board. However, in today’s world, this cannot be an effective tactic since highly qualified and experienced people are available in plenty and the acquirer can always hire them. Another shark repellent could be stipulating that a super majority (say 90 per cent) would be required to approve a merger. This would make it impossible for the acquirer to merge the target company with the acquirer company. However, this tactic would work only if the actual merger is critical to achieve synergies and the acquisition Self-Instructional Material 215 Introduction to would be unviable without such synergies derived from the merger. But such cases are Business Combinations rare. In most of the cases, an acquirer can achieve his objectives through just an acquisition without merger.

NOTES 4. Poison Pill The term ‘poison pill’ is generally used to refer to any strategy which, upon a successful acquisition by the acquirer, creates negative financial results and leads to value destruction. Poison pill can take various forms: • The target company may issue rights/warrants to the existing shareholders entitling them to acquire large number of shares in the event an acquirer’s stake in the company reaches a certain level (say 30 per cent). Such rights/warrants would be available either to a certain set of shareholders only or to all the existing shareholders but not to the acquirer. Further, the acquisition price would be very lucrative to the shareholders so they would certainly exercise their right upon acquisition of the trigger percentage by the acquirer, thereby diluting the acquirer’s stake. This is also called ‘shareholders’ rights plan’. In India, however, this is not possible under extant regulations. • The target company may add to its charter a provision that gives the current shareholders a right to sell their shares to the acquirer at an increased price (say 100 per cent above the last two or four week’s average price), if the acquirer’s stake in the company reaches a certain limit (say 30 per cent). This kind of poison pill may not be able to stop a determined acquirer, but would at least ensure a high exit price for the existing shareholders. In India, however, this would not be allowed under extant regulations. • The target company may borrow large long-term funds from banks or financial institutions, or other lenders, for its genuine need. However, the repayment terms would be such that in the normal course the loan would become repayable towards the end and also in a staggering manner, but in the event of a takeover of the target company the same would become repayable immediately. It may further add twist by making the loan repayable at a premium. This tactic is possible in India. However, if the acquirer has enough clout with the banks and other lenders, he can get the terms amended post acquisition. • In a different version of the tactic in the point above, the target company may borrow not for its genuine needs but for paying one time huge dividend to the shareholders. This tactic is also known as ‘leveraged cash out’. In India, this is possible subject to the company having enough distributable profits as provided in section 205 of the Companies Act, 1956. However, in this tactic, the target company’s financial health would get negatively affected immediately and if the acquirer does not proceed with the acquisition, the existing promoters would have to face the music. • In yet another variation of the strategy under point three above, the target company may buy back its shares using borrowed funds. This will have a double effect of increasing promoters’ stake (since they would not tender their shares in buy- back) and the negative effect on cash flows. The latter would make the target company less attractive to the acquirer, who may drop the plan of acquisition. This is also called as ‘leveraged recap’ or ‘leveraged recapitalization’. Self-Instructional 216 Material Use of buy-back as a takeover defence tactic in India, whether out of borrowed Introduction to funds or otherwise is discussed below separately. Business Combinations Poison pills can be administered in some other forms also. Poison pills were invented primarily in the United States during 1981–89 acquisition wave, which was characterized by hostile takeovers. However, in many countries, other than the United NOTES States, most of these poison pills are not permitted. 5. Poison Put The tactics of leveraged recapitalization and leveraged cash out discussed above are called as poison put by some authors. 6. People Pill In this tactic, current management team of the target company threatens to quit en masse in the event of a successful hostile takeover. It is very difficult to engineer this tactic, in practice, since many of the employees, even at senior level, may not be willing to lose their jobs due to their own compulsions. The effectiveness of a people pill will depend on the circumstances of the case. If the management team is really efficient, the company will be left without experienced leadership following a takeover. This may deter an acquirer from proceeding further provided, of course, if he is not able to bring in equally effective management from his own team or from outside. But a great number of takeovers are the result of inefficient leadership in which management would be fired anyway. In such cases, the people pill will be ineffective. 7. Scorched Earth Scorched earth is originally a military tactic that involves destroying anything that might be useful to the enemy while retreating from an area. As a takeover defence, it virtually destroys a company while it is being taken over or when it is likely to face a takeover threat. This could be achieved either through extreme form of poison pill or extreme form of crown jewel tactic or through stripping of significant assets. We must note that in India this tactic can be used prior to an acquirer making public announcement of an open offer. However, once such announcement is made, the takeover regulations do not permit any asset stripping, etc, till the open offer is closed. 8. Pacman The target company or its promoters start acquiring sizeable holding in the acquirer/ raider’s company, threatening to acquire the raider itself. This makes the acquirer run for cover and forces him to hammer out a truce. This tactic is possible in India prior to the acquirer hitting the trigger for open offer and making the public announcement thereof. Also, the target company needs to take care that it does not trigger the open offer for the acquirer’s company. 9. Green Mail The target company or the existing promoters arrange through friendly investors to accumulate large stock of its shares with a view to raise its market price. This makes the takeover very expensive for the raider. In India this is possible; however, if it is done in such a manner that the nexus between the existing promoters and the friendly investors who are accumulating the stock is proved, it may trigger an open offer by the existing promoters themselves.

Self-Instructional Material 217 Introduction to Sometimes a ‘green mail’ is used to describe an arrangement called ‘target block Business Combinations repurchase with standstill agreement’. This means that the existing promoters of the target company agree to buy back the shares being accumulated by the raider at a substantial premium. In return, the raider enters into agreement that neither he nor any NOTES of his associates shall acquire any sizeable stake in the target company for a stipulated period of time or even forever. This tactic is also possible in India with the attendant risk of the existing promoters themselves triggering an open offer. 10. White Knight In this tactic, the target company or its existing promoters enlist the services of another company or group of investors to act as a white knight who actually takes over the target company, thereby foiling the bid of the raider and retaining the control of existing promoters. This tactic is possible in India. It was used by the professional management of Indal to foil Sterlite’s bid. Only difference was that the white knight was not an outsider but the existing promoter itself, i.e., Alcan. 11. Grey Knight In this tactic, the services of a friendly company or a group of investors are engaged to acquire shares of the raider itself to keep the raider busy defending himself and eventually force a truce. This is also possible in India. 12. Golden Parachute In this tactic, a contractual guarantee of a fairly large sum of compensation is issued to the top and/or senior executives of the target company whose services are likely to be terminated in case the takeover succeeds. However, this is actually not a tactic for defending the company from the takeover but to ensure that the existing top management is well taken care of in case the takeover initiative becomes successful. 7.5.3 Anti-Takeover Amendments There are several defence mechanisms in case of an anticipated takeover strategy. The most popular defence mechanism is to change the Articles of Association of a company which is popularly known as ‘Shark Repellants’. Shark Repellants is a takeover defence tactic under which the target company makes changes in the charter or AoA of a company to pass a resolution for takeover. Under this several byelaws and regulations are amended to create either hurdle in the takeover process or to make takeover bid less attractive to the raider. As per the Indian Companies Act, 1956, the company has the power to make changes in its Articles of Association by passing a special resolution. But this alternation will not be implemented with a retrospective effect. The only condition to change the articles of association of a company is that it should not be in contravention to the scope of Articles of Association specified in the Companies Act, 1956. The second condition is that the power to alter the Articles of Association must be as per the conditions mentioned in the Memorandum of Association of the company. Above all in no case such type of alteration should harm the interests of minority stakeholders of the business. Types of Anti-takeover Amendments The following are the basic types of anti-takeover amendments generally used. 1. Supermajority Amendments: Under this tactic the voting power for approval of a takeover bid is required to be passed with a minimum of two-third shareholders Self-Instructional 218 Material and it can be extended up to 90 per cent voting power too. For this only outstanding Introduction to Business Combinations shares having voting power are considered. In various cases this supermajority amendments are implemented with board-out clause under which the board is given the powers to identify that under what circumstances the provisions of supermajority will be applicable. In a pure form of supermajority amendment NOTES agreement, the limits on a takeover bid and management’s choice is seriously imposed. 2. Fair Price Amendments: This amendment has an add-on to the provision of supermajority. Under this tactic, the supermajority provisions are implemented with a board-out clause and in addition to a fair price is decided to be paid to the shareholders of the target company. This fair price is actually the highest price required to be paid by the bidder in a specified period of time. But in case of hostile takeover it cannot be an essential provision. In case the board of the target firm has not approved, then fair-price amendments work as defence tactic against two-tier tender offers. 3. Classified Boards: It is another anti-takeover amendment through which the classified or staggered board of directors tries to make delay in the actual transfer of the controlling interest. For example a board of 12 members can be divided into 3 classes of board members each having four board members. In India Section 255 of the Indian Companies Act, 1956 has put many restrictions on such practices. This section keeps a control on the perpetuity of management at board. Similarly, Section 284 of the Companies Act, 1956 deals with the removal of the directors. Any takeover defence tactic cannot contradict the scope of the Companies Act, 1956.

Exhibit 7.2

Section 255 of Companies Act, 1956 Appointment of directors and proportion of those who are to retire by rotation. (1) Six [Unless the articles provide for the retirement of all directors at every annual general meeting, not less than two-thirds] of the total number of directors of a public company, or of a private company which is a subsidiary of a public company, shall: (a) be persons whose period of office is liable to determination by retirement of directors by rotation; (b) save as otherwise expressly provided in this Act, be appointed by the company in general meeting. • Subs. by Act 31 of 1965, s. 29, for ‘public company’ (w. e. f. 15- 10- 1965 ). • The words ‘and every private company which is a subsidiary of a public company’ omitted by Act 65 of 1960, s. 81. • Subs. by Act 31 of 1965, s. 29, for ‘private’ (w. e. f. 15- 10- 1965). • The words ‘which is not a subsidiary of a public company’ omitted by Act 65 of 1960, s. 81. • The words ‘public or private’ omitted by s. 82, ibid. • Subs. by s. 83, ibid., for ‘Not less than two-thirds’. (2) The remaining directors in the case of any such company, and the directors generally in the case of a private company which is not a subsidiary of a public company, shall, in default of and subject to any regulations in the articles of the company, also be appointed by the company in general meeting.…

Self-Instructional Material 219 Introduction to 4. Authorization of Preferred Stock: In continuation to the rights available to the Business Combinations board of directors, the right to issue a new class of securities with special voting rights can be used as a takeover defence tactic against hostile takeovers. Otherwise the traditional use of these special class of securities was made to give flexibility NOTES to the board members to take strategic decisions under various economic conditions. 5. Refusal to Registrar to Transfer the Shares: The Articles of Association give the right to board members to refuse the registrar for any transfer or transmission of shares. In case of a public limited company, the articles of association give the absolute power to the board members for this takeover defence tactic. This power is given to board members to avoid any undesirable happening against the interest of the company. The registrar can further approach the court for this matter and if reasons specified by the board members are found inadequate then court may interfere in the process of transfer of shares. Section 111(2) of the Companies Act, 1956 explains the powers of transferee in case of refusal to the registrar to transfer the shares. In India, anti-takeover amendments are meant to give certain defence tactics to the target firm under the provisions of law to prevent itself from the acquirer. If the target company is not able to save itself then at least it can cause delay and hurdles in the intentions of the acquirer company. It may be at the time of acquisition or some future period of time. Any provision for anti-takeover amendments used by the target company also gives a message to other parties looking for taking over the control of the target company. Despite all takeover defence tactics if the target firm is going to be acquired then the shareholders of the target company get in a position to avail better premium for their shares in the target company. In India, Section 255 as discussed above clarifies that only one third of the board members can be retired in one AGM for any trouble caused in the company due to perpetual management. Further, Section 284 deals with the removal of director in AGM. The earlier DIP guidelines also clarified on the buying of share warrants within a span of eighteen months otherwise it will lapse automatically. After eighteen months the target company has to revert to shareholder to renew their right plans. In 2009, it was made mandatory that MoA and AoA of target company to comply with DIP guidelines. The Employee Stock Option Scheme (ESOS) is another important part of poison pill defence tactic and can be used as anti-takeover amendment provision under poison pill. The ESOS is governed under the regulations of SEBI. The SEBI continuously makes amendments in the regulations and bye laws for the protection of interest of the investor. In 2009, SEBI prohibited the issuance of any shares with special voting rights or special dividend. A large number of companies are listed in India and it is made mandatory for Check Your Progress all the listed companies to bring their DVRs (differential voting rights) at par value with 14. Define a friendly other shares. No doubt that all acquisitions are not in the interest of shareholders of the takeover. target company, therefore, under certain situation some defence mechanism is required. 15. State the various Hence, the availability of some anti-takeover amendment provisions can at least takeover tactics. provide some better premium to the shareholders of the target company. But the law is 16. State the various also not in favour of using defense tactics if an integrated business can add value to both defence tactics. the corporate and develops synergy in the future operations of the integrated business. 17. Name the different types of anti- The synergy so developed should also be in such a manner that legal provisions in the takeover takeover deal will automatically get adjusted and optimize the benefits hidden in the deal. amendments. The SEBI as a watchdog looks at all the aspects in a takeover deal and its purpose to facilitate a takeover deal is just to remove incompetent companies run by incapable

Self-Instructional management and family set-up and making them competent in the global market. 220 Material Introduction to 7.6 COMPANIES LAW Business Combinations

The Companies Act, 1956, is a very comprehensive code that governs all aspects of the functioning of a company—be it incorporation, winding up, maintenance of accounts or NOTES declaration of dividend or any other. From the perspective of corporate restructuring, it governs the activities of merger, demerger, reduction of capital and buy-back of securities. Although it is the responsibility of advocates to draft complicated legal documents pertaining to these activities, basic knowledge of the relevant provisions of the Companies Act, 1956, is a must for every student of corporate restructuring from the perspective of planning and execution of these activities. Who can approve an amalgamation or a demerger? Section 391 deals with the powers of a court (i.e., a high court) when an application is made to it proposing a compromise or an arrangement between a company and its creditors (or any class of creditors) or between a company and its members (or any class of members). The word ‘compromise’ implies pre-existence of a dispute or a difference which is being sought to be resolved through a compromise. The word ‘arrangement’, on the other hand, does not presume the existence of a dispute and has much wider import. Some of the typical cases of ‘arrangement’ could be: • Reorganization of share capital of a company by consolidation of different classes of shares or by division of shares into different classes or both [section 390 (b)] • Non-convertible debenture holders agreeing to convert them into equity shares • Secured debenture holders agreeing to release a part or whole of the security • Creditors agreeing to accept part payment or agreeing to accept debentures in lieu of payments or both • Cumulative preference shareholders agreeing to forgo unpaid dividend in part or in full Thus, under section 391 a court (i.e., a high court) has a very wide power to consider and approve or disapprove any type of compromise or arrangement, reconstruction by way of amalgamation or demerger being only specific cases thereof. Section 394 deals with the powers of a court (i.e., a high court) when an arrangement under section 391 is of the nature of reconstruction or amalgamation involving transfer of the whole or any part of the undertaking, property or liabilities of any company (called transferor company) to another company (called transferee company). These powers relate to matters such as transfer of property and liabilities, continuation of legal proceedings by and against the transferee company, dissolution without winding up of the transferor company, etc. It is opined by some experts that this section is strictly applicable to the cases of amalgamation and not to those of demerger. The holders of this view argue that the section specifically uses the word ‘amalgamation’ and does not refer to ‘demerger’ anywhere. Further, according to them, the word ‘reconstruction’ used in the section does not cover demerger. They argue that while the process of reconstruction involves

Self-Instructional Material 221 Introduction to transfer of assets and liabilities from an existing company to another company as in case Business Combinations of demerger, the two are different because of the following reasons: • In reconstruction, the transferor company ceases to exist, whereas in demerger, the demerged company and resulting company both continue to exist. NOTES • In reconstruction, the transferee company carries on substantially the whole of the business of the transferor company, whereas in demerger, the demerged and resulting companies carry on different businesses of different undertakings of the demerged company, earlier both carried by the demerged company. • In reconstruction, the rights of the shareholders in the transferor company are satisfied and extinguished, in exchange of the shares in the transferee company, whereas in demerger, usually, the shareholders acquire shares in the transferee company while retaining shares in the demerged company. However, Palmer, an authority on company law has defined ‘arrangement’ and ‘reconstruction’ as any form of internal reorganization of the company and its affairs, as well as, schemes for the merger of two or more companies or for the division of one company into two or more companies. Based on this, one could take a view that the word ‘reconstruction’ in Section 394 covers demerger. In any case, regardless of the view whether section 394 covers demerger or not, the ambit of section 391 is very wide to cover both amalgamations and demergers. Due to this reason, the application/petition for amalgamation or demerger is usually made under both the sections, i.e., Sections 391 and 394. It may also be noted that the Companies (Second Amendment) Act, 2002, substituted the word ‘Tribunal’ for the word ‘Court’, thereby seeking to delegate the powers of a Court to the National Company Law Tribunal. However, this change was to be effective from a date to be notified. Since the Indian Government has not yet notified the said date, even after six years, the jurisdiction continues with the court (i.e., the high court). Also, we must remember that even in cases of the companies, which are listed on any stock exchange, the Securities and Exchange Board of India (SEBI) does not have any powers to approve or disapprove an amalgamation or a demerger. In fact, as observed by the division bench of the Bombay High Court, while considering the appeal in the case of Sterlite Industry Limited’s scheme of buy-back under section 391, SEBI did not even have a locus standi to appeal under Section 394A. Thus, the power to approve or disapprove any amalgamation or demerger rests only with the High Court. Accordingly, companies seeking to merge one of the companies into other or both companies into a third one need to make applications to the high court under Section 391. Please note that both the companies have to make separate applications. In case, the registered offices of the two companies are in different states (say Maharashtra and Gujarat) the applications have to be made to the respective High Courts, under whose respective jurisdictions the companies come. However, in case both the companies have their registered offices in the same state and hence come under the jurisdiction of the same high court, they can make a joint application as well as joint petition. Similarly, a company proposing to demerge has to make an application under section 391 to the high court of the state in which its registered office is situated. Further, where either an amalgamating company or an amalgamated company is a listed company or both are listed companies, it or they, as the case may be, need to

Self-Instructional 222 Material obtain approval from the stock exchange or exchanges on which they are listed under Introduction to sub-clause (f) of clause 24 of the listing agreement. Similarly, in case of demerger of a Business Combinations listed company, by virtue of the same clause, i.e., clause 24(f), approval of the stock exchange(s) is required. NOTES Conditions precedent to approval by the high court Before the high court could grant its approval, to an amalgamation or a demerger, the company or the companies involved have to satisfy conditions such as: Approval by creditors and shareholders Upon receipt of an application for amalgamation or demerger, the high court may (normally) direct both the companies to hold meetings of its creditors and members and also prescribe the manner in which these meetings are to be conducted [section 391 (1)]. In practice, holding of creditors’ meeting can be dispensed with by making a suitable application to the high court, which would generally dispense with the holding of the creditors’ meeting after taking into account the reputation of the company or companies involved and the reputation of their management or promoters, their financial position, track record of defaults in the past, pending litigations for dues payable or otherwise. But, while dispensing with the creditors’ meeting, it would generally stipulate that either all the creditors or the creditors above a certain value should be given individual notices at least twenty-one days before the hearing of the petition. The high court may also order to obtain and file written approvals from all the creditors above a certain value or from the creditors of a certain class (say, secured creditors which would primarily consist of lender banks and financial institutions). In case of a closely-held company, the high court may dispense with the holding of shareholders’ meeting, if the number of shareholders is not too large, on the condition that each shareholder’s written consent to the proposed amalgamation or demerger is obtained and filed with the high court. At the shareholders’ meeting and the creditors’ meeting (if not dispensed with by the high court), the resolution approving amalgamation or demerger has to be passed by a simple majority in terms of number and three-fourth majority in terms of value of members/creditors present and voting in person or by proxy [Section 391(2)]. Section 391 (2) refers to the stipulated majority in number and value of the persons present and voting. Hence, the creditors or members, who do not attend either in person or by proxies or attend but do not vote, get ignored and the resolution passed by those present and voting becomes binding on them also. However, the high court is required to satisfy itself that the members present and voting are fairly representative of the class of creditors or members whose meeting was held. To take an example, if only 500 members out of total of 5,00,000 members were present and voting, the high court can take a view that the entire class of members was not fairly represented and hence the resolution passed is not binding on all the members. In such a case, depending upon the facts of the case it may reconvene the meeting or disapprove the arrangement or the scheme. Disclosure of all material facts to the high court After the consent of the creditors and members has been obtained as above, the company is required to file a petition with the high court seeking its approval of the arrangement/ scheme. The high court may sanction the petition and the scheme of amalgamation or Self-Instructional Material 223 Introduction to demerger contained therein only after satisfying itself that the applicant has disclosed to Business Combinations the high court, all material facts relating to the company such as the latest financial position of the company, the latest auditor’s report, pendency of any investigation proceedings against the company, etc., [proviso to section 391 (2)]. NOTES Disclosure of all material information to the creditors and members whose meeting(s) has/have been called Section 393 (1) (a) requires that with every notice calling the meeting, which is sent to the creditors or members, a statement needs to be sent setting forth the details of the arrangement (i.e., the scheme of amalgamation or demerger as the case may be) and explaining its effects and in particular stating any material interests of the directors. Section 393 (1) (b) requires that in case the notice is given by way of an advertisement and not by sending individual notices, the advertisement has to either include the above mentioned explanatory statement or include the name and address of the place where such statement will be available to the creditors or members as the case may be. Report of the official liquidator No order of dissolution of a transferor company can be made by the high court unless the official liquidator scrutinizes the books of account of the transferor company and submits a report to the high court stating that the affairs of the company have not been conducted against the interests of the members or against the public interests [proviso to Section 394 (1)]. The high court is required to satisfy itself that: • The requirements under ‘a’ to ‘d’ above have been satisfactorily complied with • The proposals contained in the scheme have been made in good faith and there is no mala fide intention behind them and that the scheme as a whole is just, fair and reasonable • The scheme is not violative of any law or not contrary to public policy Notice to Central Government (Section 394A) The high court is required to give notice to the Central Government of every application made to it either under Section 391 or 394 and take into consideration the representations, if any, made by the Central Government. Powers of the High Court under Section 394 As stated earlier, under Section 394, the high court has powers to make orders in case of reconstruction (which could be in the form of demerger) of a company or companies or amalgamation of companies. These relate to following matters: • The transfer of the whole or any part of undertaking, property or liabilities from the transferor company to the transferee company • The allotment by the transferee company of any shares, debentures, policies or the like, under the scheme, to or for any persons • Continuation by or against the transferee company of any legal proceedings pending by or against the transferor company • Dissolution, without winding up of the transferor company Self-Instructional 224 Material • Making of provision for any dissenting persons if the high court deems fit Introduction to Business Combinations • Any matters incidental, consequential or supplemental to the scheme of reconstruction or amalgamation Effective date and appointed date NOTES The order passed by the high court under Sections 391 and 394 approving the amalgamation or demerger does not become effective unless filed by every company involved in the amalgamation or demerger with the Registrar of Companies (ROC). Section 394 (3) makes it mandatory for every such company to file the same with the ROC within thirty days of the high court passing the same. This date on which the order is so filed is called the effective date. On the other hand, while formulating the scheme of amalgamation or demerger, the companies are required to specify an appointed date, i.e., the date from which the assets and liabilities shall retrospectively be transferred from the books of the transferor company to the books of the transferee company. Cross-border amalgamations and demergers Section 394 (4) (b) stipulates that the transferee company shall not include any company other than a company within the meaning of this Act; but the transferor company may include any ‘body corporate’. As per section 3 of the Act, a company within the meaning of the Act means company incorporated in India, whereas, the word ‘body corporate’ includes company incorporated outside India as well as within. Due to this, one cannot amalgamate or demerge an Indian company into a foreign company but can do vice versa (provided the law of that country where the transferor company is registered does not prohibit the same). Other important issues • While the high court has a duty to see that the amalgamation or demerger is reasonable, just, fair and neither violative of any law nor against any public policy or interest, it has no jurisdiction to sit in judgement over the commercial wisdom of the scheme. • It is not necessary that the companies involved in the amalgamation or demerger should have specific power to amalgamate or demerge in their memorandum. • Amalgamation cannot be refused because the transferee company’s object clause does not include the object of carrying out the business being transferred to it. However, it is prudent and convenient for the transferee company to amend its memorandum and incorporate a suitable object clause. • In case there is a reduction in the capital of a transferee company due to its holding shares of the transferor company, no separate procedure under section 101 (relating to reduction of capital) is required to be followed. Other provisions • Section 392 empowers the high court to supervise, implement and modify the order made by it under Section 391. It also empowers the Court to wind up a company if it is satisfied that the compromise or the arrangement sanctioned by it under Section 391 is not likely to work.

Self-Instructional Material 225 Introduction to • Section 393 contains provisions regarding the contents of the explanatory statement Business Combinations to be sent with the notice of the general body called for approving the proposed compromise or arrangement, as also the contents of the advertisement in case the notice is given through the advertisement and other allied matters. NOTES • Section 396 deals with powers of the Central Government to suo moto amalgamate the companies. • Section 396A stipulates that the books and papers of the amalgamating company shall not be destroyed or disposed off without prior approval of the Central Government.

7.7 INCOME TAX LAW

Basic taxation issues involved in case of amalgamations and demergers are as follows: • Amalgamation involves transfer of property (fixed assets, investments and current assets) from the amalgamating company(ies) to the amalgamated company. Similarly, in case of demerger there is a transfer of property from the demerged company to the resulting company(ies). Would this transfer attract capital gains tax? If so, the amalgamation or demerger can be so prohibitively expensive that it would become a non-starter. • Similarly, the shareholders of an amalgamating company are issued shares of the amalgamated company in lieu of the shares held by them in the former. Would this amount to ‘transfer’ as contemplated in the Income Tax Act, 1961, and attract capital gains tax? What will happen, if in addition to the issue of shares of the amalgamated company, cash or bond or the like is paid to the shareholders of the amalgamating company? In case of a demerger, the shareholders of the demerged company are allotted shares in the resulting company. Would this attract capital gains tax? • In case, an amalgamating company has unabsorbed depreciation or carried forward losses, would the amalgamated company be eligible for setting them off against its future profits? In case of a demerger, if there are carry forward losses and unabsorbed depreciation relating to the undertaking being demerged, prior to the demerger, who can set them off against future profits? Is it the demerged company or the resulting company? At the outset let us look at the definitions of amalgamation and demerger under the Income Tax Act, 1961 (hereinafter in this unit called as the ‘Act’). These definitions are important since only those amalgamations or demergers which conform to these definitions get various tax benefits under the Act.

Check Your Progress Amalgamation [Section 2 (1B)] 18. Outline the main In order to qualify as amalgamation within the meaning of the Income Tax Act, 1961, the aspect of the following three conditions need to be satisfied [Section 2 (1B)]: Companies Act, 1956. • All the properties of the amalgamating company, immediately before an 19. State any two amalgamation, should become properties of the amalgamated company by virtue powers of the High of amalgamation. Court under Section 394. • All the liabilities of the amalgamating company, immediately before an amalgamation, should become liabilities of the amalgamated company by virtue Self-Instructional of amalgamation. 226 Material • Shareholders holding not less than three-fourth (in value) of the shares in the Introduction to amalgamating company (other than the shares already held by the amalgamated Business Combinations company or by its nominees) should become shareholders of the amalgamated company by virtue of amalgamation. For the purpose of the last condition above, the term shareholders includes holders NOTES of all classes of shares, i.e., equity and preference and within equity, the normal equity shares and also the shares with differential voting rights. Transactions which are not amalgamations though there exists an element of merger in them: • Where the property of the company which merges with the other company is sold to the other company and the merger is the result of such transaction of sale; or • Where the company which merges is wound up in liquidation and the liquidator distributes its property to the other company. Observations that can be made from the above are as follows: • The definition of amalgamation does not stipulate that the assets and liabilities have to be transferred at the book value only. Thus both the types of amalgamations, i.e., amalgamations by way of merger and amalgamations by way of purchase, as defined in AS 14 are eligible to qualify as amalgamations under this definition. • The definition also does not stipulate that the consideration to the shareholders of the amalgamating company has to be paid only by issue of shares of the amalgamated company. Therefore, if besides the shares in the amalgamated company, the shareholders of the amalgamating company are allotted something more, say cash or bonds, then the amalgamation should still qualify as amalgamation under the Act. However, in terms of the judgement of the Gujarat High Court [CIT v Gautam Sarabhai Trust [1988] 173 ITR 216 (Guj)], in such a case, the benefit of exemption from the capital gains tax under section 47 (vii) to the shareholders of the amalgamating company shall not be available. Hence, the amalgamated company has to allot only shares to the shareholders of amalgamating company. Demerger [Section 2 (19AA)] In order to qualify as demerger under the Income Tax Act, 1961, the following conditions need to be satisfied: (a) Both the entities involved should be companies. (b) Conditions of Sections 391 to 394 of the Companies Act, 1956 should have been complied with. (c) There must be a transfer of an undertaking to the resulting company. Undertaking essentially implies all assets which taken together as a whole, constitute a business activity and not individual assets which by themselves are not able to run the business activity. (d) All properties belonging to an undertaking should be transferred to the resulting company. Please note that the section does not say that nothing more can be transferred. So if some asset which is truly not belonging to that undertaking is transferred to the resulting company over and above all the assets of the undertaking that is being

transferred, the condition is not violated. Self-Instructional Material 227 Introduction to In case of assets that are used partly for the undertaking that is being demerged Business Combinations and partly for the remaining undertaking, the same may not be transferred. (e) The resulting company must take over all the liabilities of the undertaking being transferred. Here all liabilities shall mean: NOTES (i) Specific liabilities of that undertaking. (ii) Specific loans or borrowings including debentures raised, incurred and utilized solely for the activities and operations of that undertaking. (iii) Common loans and borrowing apportioned in the same ratio as the book value of the assets transferred to the resulting company bears to the total book value of the assets of the demerged company prior to demerger. This third condition of apportioning common loans in the ratio of assets transferred leads to commercial anomalies in many case. Often, the cash credit account or an overdraft facility from a bank is taken for the company as a whole. It can so happen that the undertaking that is being demerged may have proportionately much bigger investment in the fixed asset than the retained undertaking but relatively very low investment in the current assets as compared to the retained undertaking. Therefore, in reality, the cash credit account or the bank overdraft would have been mainly used by the retained undertaking; but the peculiar method of apportionment prescribed above would lead to anomalous higher apportionment of cash credit or overdraft liability to the resulting company. In fact, the apportionment of common loans is a decision that needs to be taken keeping in mind the internal ground realities and commercial wisdom and hence best left to the board of directors of the company. It may, therefore, augur well for the government to remove this not so logical condition. (f) All properties and liabilities are to be transferred at the book value only. Moreover, any change in the value of any asset consequent upon revaluation (done in the past or during the course of demerger) has to be ignored. The effect of this provision is that the assets of the undertaking being transferred, which were earlier revalued, have to be restated at a cost (less accumulated depreciation in case of fixed assets) while transferring to the resulting company. Normally, this would be done by adjusting the revaluation reserves outstanding in the balance sheet in respect of these assets. A peculiar situation would, however, arise if the company has already capitalized these reserves by the issue of bonus shares. In such a case, the transferor company would end up adjusting the diminution in the value of assets against its general reserves. However, the bigger problem that arises from this condition is that it prevents ‘fair value accounting’, especially when anyway under the tax law, the depreciation is not linked to the book value. Moreover, fair value accounting is allowed in cases of amalgamations without jeopardizing their tax neutrality. There is no reason why the provisions of fair value accounting should not be available to demergers. Hence, here too, it may be worthwhile for the government to remove this onerous condition. (g) The transfer of the undertaking should be on going concern basis. • Only shares in the resulting company are issued to the shareholders of the demerged company and the same is done on a proportionate basis. • The word proportionate basis implies that share holders of a class of shares are given shares of the same class in proportion to their holding. Self-Instructional 228 Material • Persons holding not less than 75 per cent of the shares (in value) of the Introduction to demerged company (excluding shares held by a resulting company in the Business Combinations demerged company) become shareholders in the resulting company. It can be observed from the above that the definition of demerger is very restrictive. However, since it is not feasible to forgo various tax exemptions/benefits available to the NOTES company as well as shareholders, the companies have to follow these norms very strictly. Implications in terms of capital gains tax In respect of those amalgamations and demergers which conform to their respective definitions, following transactions are not treated as transfer of a capital asset and therefore no capital gains tax is chargeable: (a) Transfer of a capital asset in the scheme of amalgamation, if the amalgamated company is an Indian company [Section 47 (vi)]. Subsequently, if the capital asset is sold or transferred by the amalgamated company, the cost of acquisition in the hands of the amalgamated company shall be the same as it would have been in the hands of the amalgamating company, had it continued to hold the asset, for the purpose of its own business [explanation 7 to Section 43 (1)]. Please note that the above rule applies to those capital assets which do not form a part of any block of depreciable assets. The actual cost of the block of (depreciable) assets in the case of an amalgamated company shall be written down value of that block of assets as in case of the amalgamating company for the immediately preceding previous year as reduced by the amount of depreciation actually allowed in relation to the said previous year [explanation 2 to Section 43 (6)]. The period for which the asset was held by the amalgamating company is to be included for determining whether capital gain is long term or short term. However, the indexation benefit, if applicable, will be available from the date the asset was transferred to the amalgamated company. (b) Transfer of a capital asset in the scheme of demerger, if the resulting company is an Indian company [Section 47 (vi b)]. Subsequently, if the capital asset is sold or transferred by the resulting company, the cost of acquisition in the hands of the resulting company shall be the same as it would have been in the hands of the demerged company, had it continued to hold the asset, for the purpose of its own business [explanation 7 A to Section 43 (1)]. The period for which the asset was held by the demerged company is to be included for determining whether capital gain is long term or short term. However, the indexation benefit, if applicable, will be available from the date the asset was transferred to the resulting company. (c) Allotment of shares in an amalgamated company in lieu of shares of an amalgamating company if • The transfer is in consideration of the shares of the amalgamated company. • The amalgamated company is an Indian company (Section 47 (vii)). We have discussed earlier that under Section 47 (vii), the shareholder has to receive only shares of the amalgamated company. He cannot additionally receive Self-Instructional Material 229 Introduction to any cash or bonds or the like, otherwise he would lose the benefit of exemption Business Combinations under Section 47 (vii). Further, the shares given to him have to be of the amalgamated company only. He can not be given shares of any other company, not even of the parent company where amalgamated company is 100 per cent NOTES subsidiary of the parent company. Subsequently, when the shares of the amalgamated company are sold or transferred by the shareholder, the cost of shares of the amalgamated company shall be considered to be the same as the cost of acquisition of the shares of the amalgamating company by him [Section 49 (1)]. The period for which shares were held in the amalgamating company shall be included for determining whether the capital gains are short term or long term. However, indexation, if applicable, will be available from the date of allotment by the amalgamated company. (d) Any issue of shares by the resulting company, in a scheme of demerger to the shareholders of the demerged company [Section 47 (vi d)]. Subsequently, when the shares of a resulting and/or demerged company are sold or transferred by the shareholder, the respective costs of shares of the resulting and demerged companies have to be worked out by apportionment of the original cost of acquisition of the demerged company’s shares prior to demerger. For this purpose, the cost of the resulting company’s shares shall be an amount that bears to the cost of acquisition of the demerged company’s shares, the same proportion as the net book value of the assets transferred bears to the net worth of the demerged company immediately before demerger [Section 49 (2C)]. On the other hand the cost of demerged company’s shares shall be worked out by reducing the cost of resulting company’s shares, as worked out under Section 49 (2C) above, from the original cost of the demerged company’s shares [Section 49 (2D)]. The period for which shares were held in the demerged company shall be included for determining whether the capital gains are short term or long term. Indexation, if applicable, for the resulting company’s shares, however, will be available from the date of allotment by the resulting company; whereas indexation, if applicable, for the demerged company’s shares shall be available from the date of original acquisition. (e) Transfer of shares in an Indian company held by a foreign company to another foreign company under the scheme of amalgamation of two foreign companies [Section 47 (vi a)] provided: (i) At least 25 per cent of the share holders of the amalgamating foreign company continue to be the share holders of the amalgamated foreign company. (ii) Such transfer attracts no capital gains tax in the country in which the amalgamating company is incorporated. Subsequently, when the shares of the Indian company are sold by the foreign amalgamated company, the cost in its hands will be considered the same as the cost was in the hands of the foreign amalgamating company. Also the period for which the shares in the Indian company were held by the foreign amalgamating company shall be included for determining whether the capital Self-Instructional gains are short- term or long-term. 230 Material (f) Transfer of shares held in an Indian company by a demerged foreign company to Introduction to the resulting foreign company [Section 47 (vi c)] provided Business Combinations (i) At least 75 per cent of the share holders of the demerged foreign company continue to be the share holders of the resulting foreign company. (ii) Such transfer attracts no capital gains tax in the country in which the NOTES demerged company is incorporated. Subsequently, when the shares of the Indian company are sold by the foreign amalgamated company, the cost in its hands would be considered the same as the cost was in the hands of the foreign amalgamating company. However, the period for which the shares in the Indian company were held by the foreign amalgamating company shall be excluded for determining whether the capital gains are short- term or long-term. While the Section 47 (vii) provides for tax exemption in case of a share swap during the course of amalgamation, no such benefit is available for acquisitions made by share swaps wherein there is no cash or other consideration flowing to the target company’s shareholders. This poses difficulties to many of the Indian corporates who may not be so cash rich as compared to their foreign competitors bidding for the same target company. Further, even as of now the Indian financial system is not much proactive or liberal in funding acquisitions. Therefore, in order to provide level playing field to Indian corporates vis-à-vis their foreign competitors, it is high time that a similar exemption be made available in case of acquisitions by Indian companies through pure share swap deals. Another area where the level playing field is missing is in Sections 47 (vi a) and 47 (vi c). While these sections provide exemptions in case of amalgamations or demergers of foreign companies in respect of Indian shares held by them, there is no such exemption available to amalgamations or demergers of Indian companies who hold shares in the foreign companies. Given that many Indian companies are acquiring companies abroad, it is necessary to extend similar benefit to their amalgamations and demergers in India. Implications in terms of carry forward and set off of losses and unabsorbed depreciation (a) Section 72 of the Act provides that when a loss (including unabsorbed depreciation) under the head ‘profits and gains of business or profession’ cannot be set off against the income under the same head or under a different head in the same year, because of the absence or inadequacy of income of the same year, it may be carried forward and set off against the profits of any business in the subsequent years. While the loss can be carried forward only for eight assessment years subsequent to the assessment year in which it was incurred, unabsorbed depreciation can be carried forward indefinitely. However, one main condition of such carry forward and set off is that the loss can be carried forward and set off by the same assessee. This would have created a problem in respect of amalgamations and demergers but for the provisions of Section 72A discussed below. To take an example, if an amalgamating company has accumulated losses, the amalgamated company, being a different assessee would not have been entitled to carry forward and set off losses against its future profits. Same would have been the case in respect of losses of the undertaking Self-Instructional Material 231 Introduction to being demerged which the resulting company—a different assessee—could not Business Combinations have claimed after the demerger. (b) In order to resolve this problem, Section 72A provides certain exceptions to the rule that the loss can be carried forward and set off by the same assessee. Two NOTES of these exceptions are amalgamations and demergers. Under Section 72A, the accumulated loss and unabsorbed depreciation of an amalgamating company are deemed to be the carried forward loss/depreciation of the amalgamated company for the previous year in which amalgamation had taken place provided the following conditions are met: (i) The amalgamating company has to be an industrial undertaking, ship or a hotel or a banking company amalgamating with SBI or a subsidiary of SBI. From the current year, this benefit is also extended to the amalgamation of a PSU airline with another PSU airline. Industrial undertaking is an undertaking which is engaged in: • Manufacturing or processing of goods • Manufacturing of computer software • Generation or distribution of electricity • Mining • Construction of ships, aircraft or rail systems • Providing telecommunication services whether basic or cellular or paging • Providing domestic satellite services, network of trunking, broadband network and internet services (ii) The amalgamating company has been engaged in the business in which the accumulated loss or unabsorbed depreciation has occurred at least for three years. (iii) The amalgamating company has held continuously as on the date of amalgamation, at least three-fourth of the book value of the fixed assets held by it two years prior to the date of amalgamation. (iv) The amalgamated company continues to hold at least three-fourth of the book value of the amalgamating company’s fixed assets for five years from the date of amalgamation. (v) The amalgamated company continues the business of the amalgamating company at least for a period of five years from the date of amalgamation. (vi) The amalgamated company achieves at least 50 per cent capacity utilization before the end of the fourth year and continues the level achieved till the end of the fifth year. First of all, the benefit of Section 72A is restricted only to certain sectors such as manufacturing, mining, electricity, telecom, hotels, software, shipping, etc. The entire service sector, which now accounts for close to 50 per cent of the gross domestic product (GDP) is denied of this benefit. Companies in the industries such as healthcare, financial services, retail chains, business process outsourcing (BPOs), knowledge process outsourcing (KPOs), advertisement agencies, private airlines and so on cannot avail of the benefit of Section 72A. The Government needs to correct this anomaly on top priority.

Self-Instructional 232 Material Further, most of the other conditions, too are very onerous and do not serve any Introduction to meaningful purpose. Business Combinations The condition that the amalgamating company should have been in a business for a minimum of three years prior to amalgamation really serves no purpose. In fact, because of this condition, even if within a year or two of starting business, a NOTES company sees the writing on the wall that to become profitable and viable it needs to merge with another company, it would be forced to continue accumulating further losses till three years are over. Similarly, forcing an amalgamated company to continue amalgamating company’s business for five years is an unwarranted provision. True, that amalgamation should not be allowed to be used purely for tax avoidance. But that objective can be achieved in a different manner. For that purpose, forcing an amalgamated company to continue for five years, the loss-making business whose revival appears to be impossible, is ensuring value destruction for the shareholders. If the motive behind compelling the amalgamated company to hold at least three- fourth of the book value of the amalgamating company’s fixed assets for five years is to avoid asset stripping, the provision is ineffectual. Asset stripping is primarily done in case of surplus land and real estate. Companies that had bought the land fifty, thirty or even twenty years back had them at throwaway prices in comparison to the present land prices. These land banks would be appearing in their balance sheets at not even 1 per cent of the total book value of all the assets at the time of amalgamation in the present times. The above provision, thus, cannot come in the way of asset stripping by sale of such lands. It would only come in the way of the replacement of old, junk, outdated plant and machinery whose value in the books would account for substantial percentage of the total book value of assets at the time of amalgamation. Similarly, condition of capacity utilization really serves no purpose. Also, it is irrelevant to the service sector. However, the companies have to abide by the law in section 72A being what it is, in case they want to carry forward the amalgamating company’s losses and unabsorbed depreciation in the books of the amalgamated company and reduce its future tax liability. One good thing about Section 72A though, is that the losses of the amalgamating company that are carried forward in the books of the amalgamated company, are treated as the amalgamated company’s losses for the year in which the amalgamation takes place, thereby enabling them to be carried forward for a further full period of eight years. (c) In case of demerger also, Section 72A allows/requires the resulting company to carry forward and claim the accumulated loss and unabsorbed depreciation to the following extent: (i) In case the loss/depreciation is directly related to the undertaking transferred to the resulting company, the whole of such loss/depreciation has to be carried forward. (ii) In case the loss/depreciation is common to the retained and transferred undertakings, then the loss apportioned on the basis of book value of assets transferred and retained, has to be carried forward.

Self-Instructional Material 233 Introduction to Reverse Mergers Business Combinations Reverse merger is defined in two ways: (i) Where a holding company merges with the subsidiary or investee company NOTES (ii) Where a profit-making company is merged with a loss-making company This second concept of reverse merger is relevant from income tax point of view. We have seen above that the benefit of Section 72A is available only to certain sectors and a large number of other sectors, mainly service sector has been denied this benefit. Thus if a loss-making retail chain is merged with a profit-making one, the merged entity would be denied the benefit of carry forward and set off of losses and unabsorbed depreciation. In case of a reverse merger, since profit-making company is merged with the loss-making one, the surviving entity is the erstwhile loss-making company. With this, the condition that the same assessee has to carry forward and set off the loss is satisfied, and the merged entity can, in future, set off the past losses against the future combined profits. Often, the companies, post reverse merger, chose to change the name of the amalgamated company to the name of the erstwhile profitable amalgamating company that went out of existence during the reverse merger.

7.8 SEBI GUIDELINES FOR TAKEOVERS

The key provisions of the SEBI Takeover Code are as follows: 1. Disclosure: Any acquirer who acquires shares of voting rights in a company (hereinafter called holdings), which when aggregated with the existing stock of such holdings of the acquirer in the company exceed 5 percent, 10 percent, and 14 percent of the total shall disclose at every site the aggregate of the holdings of the company and to the concerned stock exchange(s) the stock exchanges shall put such information under public display immediately. 2. Trigger Point: No acquirer shall acquire holdings which, when aggregated with the existing stock of such holding of the acquirer in the company, equal or exceed 15 percent of the total, unless such acquirer makes a public announcement to acquire shares through a public offer to the extent stipulated in the code (currently 20 percent). 3. Merchant Banker: Before announcing a public offer, the acquirer has to appoint Check Your Progress a Category I merchant banker registered with SEBI. The merchant banker should ensure that the public announcement of the offer is made in terms of the regulations, 20. Give an observation the acquirer is able to implement the offer, and that firm arrangements for funds that can be drawn from Section 2(1B) to fulfill the obligations under the offer are in place. vis-à-vis 4. Public Announcement: The merchant banker should make public announcement amalgamation. within four working days of the agreement or the decision to acquire shares/ 21. Outline any two conditions that need voting rights in excess of the specified percentages. The public announcement to be satisfied in shall, inter alia, provide information about the number of shares proposed to be order to qualify as acquired, the minimum offer price, object of acquisition, the date by which the demerger under the Income Act, 1961. letter of offer will be posted, and the opening and closing dates of the offer. 22. What are the two 5. Offer Price: The offer price to the public shall not be less than the highest of the ways in which following: negotiated price; average price paid by the acquirer; preferential offer reverse mergers can price if made in the last 12 months; and the average of the weekly high and low be defined? for the last 26 weeks.

Self-Instructional 234 Material 6. Obligation of the Acquirer: The acquirer must ensure that the letter of offer Introduction to reaches shareholders within 45 days from the date of public announcement and Business Combinations payment is made to shareholders who have accepted the offer within a period of 30 days from the date of the closure of offer. 7. Obligation of the Board of the Target Company: Unless the approval of the NOTES general body of shareholders is obtained after the date of the public announcement of the offer, the Board of Directors of the target company cannot dispose assets, issue capital, enter into material contracts, or appoint additional directors during the period of public offer. 8. Competitive Bids: Subject to certain conditions, competitive bids can be made within a period of 21 days of the public announcement of the first offer and in response, the acquirer who made the earlier offer can revise the offer. 9. Provision of Escrow: As a security for performance, the acquirer is required to deposit at least 25 percent of the consideration payable for the public offer up to ` 100 crore and 10 percent of the consideration exceeding ` 100 crore in an escrow account. When an offer is subject to a minimum level of acceptance, the acquirer is required to deposit at least 50 per cent of the consideration payable for the public offer in an escrow account. The escrow account should consist of cash deposit, or bank guarantee in favour of the merchant banker, or deposit of acceptable securities with appropriate margin with the merchant banker. 10. Creeping Acquisition: No acquirer together with persons acting in concert can acquire more than 5 per cent of holdings in any financial year ending 31st March without complying with the open offer requirements, if the existing holdings are between 15 per cent and 55 per cent. In other words, such acquirer who already has more than 15 per cent can do a creeping acquisition of upto 5 per cent per year without triggering off the open offer requirement. However, any such purchase or sale transaction amounting to 2 per cent or more of the share capital of the target company shall be reported within two days in the same manner as described in the above point relating to disclosure. The purpose of SEBI guidelines is to (i) import greater transparency to takeover deals, (ii) ensure a greater amount of disclosure through public announcement and offer document, and (iii) protect the interest of small shareholders.

7.9 OTHER APPLICABLE LAWS

Competition is the essence of any market economy. If the markets were to protect and promote the interest of consumers, competition among all the market players, especially among the producers and distributors of goods and services, is very vital. Recognizing this, most countries in the world have laws that protect and promote competition. Importance of competition law is well summarized in a judgement of the Supreme Court of India, which states ‘the main objective of competition law is to promote economic efficiency using competition as one of the means of assisting the creation of market response to consumer preferences. The advantages of perfect competition are three- fold: allocative efficiency, which ensures the effective allocation of resources, productive efficiency, which ensures that costs of production are kept at a minimum and dynamic efficiency, which promotes innovative practices’.

Self-Instructional Material 235 Introduction to However, ‘competition’ has many dimensions and accordingly there are several Business Combinations ways in which transactions can be adversely affected to an appreciable extent. These can be broadly classified into three: by formal or informal agreements between or among the producers and/or distributors of goods or services, by business entities creating and/ NOTES or abusing dominant market positions and through creation of business combinations (i.e. mergers, acquisitions, purchase of assets/businesses) in a manner and of the scale that they would create dominant market position capable of being abused. In 1964, the Government of India appointed the Monopolies Inquiry Commission. The purpose of this commission was to find out the extent and effect of the concentration of economic power in private hands and the existence of monopolistic and restrictive trade practices in the country. Based on the report submitted by this commission in 1965, the Monopolies and Restrictive Trade Practices Act, 1969 (the MRTP Act) came into force with effect from 1 June 1970. The Act was amended several times thereafter. During its existence, the MRTP Act became sufficiently notorious due to its draconian provisions that imposed several restrictions on expansion of businesses to global scale and stymied the ambitions of business leaders. Post launching of reforms in 1992, it was felt that the Act had totally outlived its utility, since in the new economic era, it is essential to shift focus from curbing monopolies to promoting competition. Accordingly, based on the recommendations of the Raghavan Committee, the MRTP Act was abolished and the Competition Act, 2002, was enacted. The new act, the Competition Act, 2002, received the assent of the President on 13 January 2003 and was gazetted on the next day. Its various provisions were implemented in a phased manner beginning 31 March 2003. In terms of the provisions of this act, the Competition Commission of India (CCI) was established on 14 October 2003 and Mr Dipak Chatterji was appointed the first Chairperson of the CCI. The legal battle that ensued over his appointment, which need not be discussed here, led to substantial amendment of the act in 2007, making the CCI truly functional. One of the important amendments made via the amendment act of 2007 was to make approval of business combinations by the CCI mandatory. The other change was to provide Indian nexus for combinations involving a foreign entity and an Indian entity. However, the first set of regulations relating to the functioning, powers and procedures of the CCI was promulgated only in 2009 and the regulations relating to the procedure for approval of business combinations only in 2011. It can, thus, be seen that the CCI became truly functional, especially with regard to regulation of business combinations, only very recently. Overview of the Act and Role of the CCI As you have seen, in India, the present day competition law is embodied in the Competition Act, 2002, as amended by the Competition (Amendment) Act, 2007. For the sake of brevity, this act shall be referred as ‘the Act’ in this unit. This act has four main objectives: • To prevent practices having adverse effect on competition • To promote and sustain competition in markets • To protect the interests of consumers • To protect the freedom of trade carried on by other participants in the market These objectives are sought to be achieved, primarily, through four sections of the Act, namely Sections 3 to 6, which contain the substantive provisions prohibiting three types of anti-competitive transactions:

Self-Instructional 236 Material • Prohibition of anti-competitive agreements [Section 3] Introduction to Business Combinations • Prohibition of abuse of dominant position [Section 4] • Regulation of (business) combinations [Section 5 and 6] In order to achieve the objectives stated above, the Act provides for the NOTES establishment of the Competition Commission of India under Section 7 (1) of the Act. Under Section 18, a duty has been cast upon the CCI to achieve all the four objectives of the Act as mentioned above, and for this purpose it has been vested with required powers through various sections of the Act. Particularly, section 64 of the Act empowers the CCI to lay down regulations required for achieving the objectives of the Act. Important Provisions Relating to Combinations Definitions Section 2 of the Act defines various terms. We will, however, be studying only those terms that relate to business combinations. The Act uses the terminology ‘combinations’ instead of ‘business combinations’ and we shall be following the same. (a) Acquisition [Section 2 (1)] ‘Acquisition’ means, directly or indirectly, acquiring or agreeing to acquire: (i) shares, voting rights or assets of any enterprise; or (ii) control over management or control over assets of any enterprise. It may be observed from the definition that all acquisitions whether planned or consummated, direct or indirect, are covered. More importantly, even acquisition of a business or its assets (not involving acquisition of the entity that owns the business and its assets) is also covered. (b) Enterprise [Section 2 (h)] ‘Enterprise’ means a person or a department of the government, who or which is, or has been, engaged in any activity, relating to the production, storage, supply, distribution, acquisition or control of articles or goods, or the provision of services, of any kind, or in investment, or in the business of acquiring, holding, underwriting or dealing with shares, debentures or other securities of any other body corporate, either directly or through one or more of its units or divisions or subsidiaries, whether such unit or division or subsidiary is located at the same place where the enterprise is located or at a different place or at different places, but does not include any activity of the government relatable to the sovereign functions of the government, including all activities carried on by the departments of the central government dealing with atomic energy, currency, defence and space. Explanation: For the purposes of this clause: (a) ‘Activity’ includes profession or occupation; (b) ‘Article’ includes a new article and ‘service’ includes a new service; (c) ‘Unit’ or ‘division’, in relation to an enterprise, includes: (i) A plant or factory established for the production, storage, supply, distribution, acquisition or control of any article or goods; (ii) Any branch or office established for the provision of any service. It may be noted that the term ‘enterprise’ includes any entity that is engaged in the production, storage, supply, distribution, etc., of goods and services. It is also significant to note that even the Government departments, to the extent they are engaged in the Self-Instructional Material 237 Introduction to production, storage, supply, distribution, etc., of goods and services, are included in the Business Combinations definition. At the same time, any government activity of discharging functions such as law and order, justice, foreign affairs, etc., or any activity of any central government department that relates to atomic energy, currency, defence, space, etc., is excluded NOTES from the definition. As we have seen earlier, the term ‘enterprise’ is important in the context of its acquisition to form a combination. Needless to add that there cannot be acquisition of a government department by acquisition of its shares or voting rights or control over it. But there could be acquisition of its assets leading to forming of a combination as explained later on. (c) Person [Section 2 (l)] ‘Person’ includes: • An individual; • A Hindu undivided family; • A company; • A firm; • An association of persons or a body of individuals, whether incorporated or not, in India or outside India; • Any corporation established by or under any central, state or provincial act or a government company as defined in section 617 of the Companies Act, 1956 (1 of 1956); • Any body corporate incorporated by or under the laws of a country outside India; • A co-operative society registered under any law relating to cooperative societies; • A local authority; • Every artificial juridical person, not falling within any of the preceding sub-clauses. It may be noted that such a wide definition of the term ‘person’ is intended to cover any conceivable form of an enterprise, whose acquisition may lead to a combination. (d) Relevant market [Section 2 (r)] ‘Relevant market’ means the market which may be determined by the Commission with reference to the relevant product market or the relevant geographic market or with reference to both the markets. (e) Relevant geographic market [Section 2 (s)] ‘Relevant geographic market’ means a market comprising the area in which the conditions of competition for supply of goods or provision of services or demand of goods or services are distinctly homogenous and can be distinguished from the conditions prevailing in the neighbouring areas. (f) Relevant product market [Section 2 (t)] ‘Relevant product market’ means a market comprising all those products or services which are regarded as interchangeable or substitutable by the consumer, by reason of characteristics of the products or services, their prices and intended use.

Self-Instructional 238 Material Definition of Combinations [Section 5] Introduction to Business Combinations Section 5 defines when combination is deemed to have been formed or likely to be formed. When any person acquires or proposes/seeks to acquire one or more enterprise(s), NOTES or when two or more enterprises are merged or amalgamated or proposed/sought to be merged or amalgamated, a combination would get formed if any of the following conditions are satisfied: A. In case of an acquisition, (i) If the parties to the acquisition i.e. the acquirer and the enterprise acquired, jointly have • (where they have assets and operations only in India) the assets of more than `1,000 crore or the turnover of more `3,000 crore in India; or • (where they have assets and operations both in India and abroad) the assets of more than US$ 500 million or turnover of more than US$ 1500 million in aggregate in India or outside, of which more than `500 crore assets or more than `1,500 crore turnover is in India; (ii) If after the acquisition, the enterprise acquired would belong to a ‘group’, and such group would jointly have • (where such group has assets and operations only in India) the assets of more than `4,000 crore or the turnover of more `12,000 crore in India; or • (where such group has assets and operations both in India and abroad) the assets of more than US$ 2 billion or turnover of more than US$ 6 billion in aggregate in India or outside, of which more than `500 crore assets or more than `1,500 crore turnover in India [Section 5 (a)]. B. In case any person acquires control over an enterprise and such person already has a direct or indirect control over another enterprise that is engaged in the production, distribution or trading of goods or provision of services that are similar, identical or substitutable to the goods or services engaged in by the enterprise whose control is now acquired, (i) If both the enterprises mentioned above, over which the person now has a control have • (where they have assets and operations only in India) the assets of more than `1,000 crore or the turnover of more `3,000 crore in India; or • (where they have assets and operations both in India and abroad) the assets of more than US$500 million or turnover of more than US$1,500 million in aggregate in India or outside, of which more than `500 crore assets or more than `1,500 crore turnover is in India; (ii) If after the acquisition, the enterprise acquired would belong to a ‘group’, and such group would jointly have • (where such group has assets and operations only in India) the assets of more than `4,000 crore or the turnover of more `12,000 crore in India; or • (where such group has assets and operations both in India and abroad) the assets of more than US$ 2 billion or turnover of more than US$ 6 billion in Self-Instructional Material 239 Introduction to aggregate in India or outside, of which more than `500 crore assets or more Business Combinations than `1,500 crore turnover in India [Section 5 (b)]. C. In case of a merger or an amalgamation NOTES (i) If the enterprise remaining after merger or the enterprise created out of amalgamation • (where such enterprise has assets and operations only in India) the assets of more than `1,000 crore or the turnover of more than `3,000 crore in India; or • (where such enterprise has assets and operations both in India and abroad) the assets of more than US$500 million or turnover of more than US$1,500 million in aggregate in India or outside, of which more than `500 crore assets or more than `1,500 crore turnover is in India; (ii) If after such merger or amalgamation, the enterprise so remaining after merger or created out of amalgamation would belong to a ‘group’, and such group would jointly have • (where such group has assets and operations only in India) the assets of more than `4,000 crore or the turnover of more `12,000 crore in India; or • (where such group has assets and operations both in India and abroad) the assets of more than US$2 billion or turnover of more than US$6 billion in aggregate in India or outside, of which more than `500 crore assets or more than `1,500 crore turnover in India [section 5 (c)]. The explanation ‘b’ to section 5 defines ‘group’ as two or more enterprises, which, directly or indirectly, are in a position either to exercise 26 per cent or more voting rights in the other enterprise or to appoint majority of the directors on the board of the other enterprise or control the management of the affairs of the other enterprise. You will notice that in conditions ‘A’ above, what is required is to add up the asset values or the turnovers of the acquirer and the enterprise being acquired and check if either of these sums crosses the relevant value threshold that have been stipulated. Same is the case of condition ‘C’, where the (combined) asset value or the (combined) turnover of the enterprise remaining after merger or created out of amalgamation is required to be compared with the respective threshold values. Both these conditions implicitly relate to those situations where both parties to the combination are ‘enterprises’ themselves, having their own assets and/or turnovers. Also, in both these conditions, there is no stipulation that they have to be engaged in production or distribution of similar, identical or substitutable goods or services. On the other hand, it appears that condition ‘B’ has been drafted keeping in mind a situation that the person acquiring control over an enterprise, is not having its own operating assets or turnover, i.e., the acquirer is either a natural person or an investment or holding company. In such a case, however, one has to look at the combined asset value or turnover of only those enterprises under such person’s control that are engaged in production or distribution of similar, identical or substitutable goods or services. Why so, defies logic, especially when one looks at group’s combined asset value or turnover, in all the three conditions, there is no stipulation that all the companies should be engaged in the production or distribution of similar, identical or substitutable goods or services.

Self-Instructional 240 Material It may be also noted that the value of assets shall be determined by taking the Introduction to book value of the assets as shown, in the audited books of account of the enterprise, in Business Combinations the financial year immediately preceding the financial year in which the date of proposed merger falls, as reduced by any depreciation, and the value of assets shall include the brand value, value of goodwill, or value of copyright, patent, permitted use, collective NOTES mark, registered proprietor, registered trade mark, registered user, homonymous geographical indication, geographical indications, design or layout design or similar other commercial rights [explanation ‘c’ to section 5]. Let us also note that section 5 only defines what a ‘combination’ means. It does not mean that the Competition Act prohibits formation of a ‘combination’. What the Act intends to prohibit is forming of those combinations that have an appreciable adverse effect on competition within relevant markets in India. This is regulated under section 6 discussed hereafter. Regulation of Combinations [Section 6] Section 6 (1) stipulates that no person or enterprise shall enter into a combination which causes or is likely to cause an appreciable adverse effect on competition within the relevant market in India and such a combination shall be void. However, what will happen if a combination is formed and then the CCI determines it to be having an appreciable adverse effect on competition? At this stage, reversing the process by demerging the companies that merged, or by reversing the control acquired by a person over an enterprise etc would create a totally messy situation impossible to manage in practice. Therefore, section 6 (2) stipulates that whenever a combination is likely to be formed, any person or enterprise which proposes to enter into a combination must give a notice to the CCI, within 30 days, either of passing of the merger or amalgamation proposal by the board of directors (in case of a combination by merger or amalgamation) or of execution of any agreement or document (in case of an acquisition or acquisition of control). Section 6 (3) stipulates that no combination shall come into effect until 210 days of the date of the notice or until the CCI has given its approval under section 31 of the Act, whichever is earlier. In other words, if the CCI does not give its decision within 210 days or within such extended time as provided under various provisions of the Act, the combination is deemed to have been approved. It may be noted that prior to the amendments made in 2007, the requirement of giving notice to the CCI was voluntary and not mandatory for the parties intending to form a combination. Because of this the CCI, then, was really not having any effective control over the combinations, which now it has. Under Section 31, the CCI may either approve the combination or it may direct that the combination shall not be formed. Under the section, the CCI has also powers to propose appropriate modifications to the combination where it is of the opinion that the combination is likely to have an appreciable adverse effect on the competition, but the same can be mitigated by its proposed modifications. If such modifications are accepted by the parties to the combination, they are required to carry out those modifications within the time stipulated by the CCI. On the other hand, the parties also have a right to reject the proposed modifications, in which case they are prohibited from forming the combination. The procedures required to be followed by the CCI while investigating whether the proposed combination is likely to have an appreciable adverse impact on the Self-Instructional Material 241 Introduction to competition within relevant markets in India and its powers of passing various orders in Business Combinations relation thereto are laid down in Sections 29, 30 and 31 of the Act. The entire procedure of seeking approval under Section 6 (2), the fees payable by the applicants for the same, the procedure of scrutiny by the CCI, etc., is also laid down in the regulations promulgated NOTES by the CCI, i.e., the Competition Commission of India (Procedure in regard to the transaction of business relating to combinations) Regulations, 2011. These regulations, for the sake of brevity, have been referred to as ‘the Regulations’ hereunder. Exemption from Seeking Approval of the CCI [regulation 4] While Section 6 (2) requires that a notice of every proposed combination needs to be given to the CCI in prescribed manner as discussed above, regulation 4 of the Regulations mentioned above gives general exemption from this procedure to 11 types of transactions. Some of the important ones are: • An acquisition of shares or voting rights, solely as an investment or in the ordinary course of business in so far as the total shares or voting rights held by the acquirer directly or indirectly, does not entitle the acquirer to hold twenty-five per cent (25%) or more of the total shares or voting rights of the company. • An acquisition of shares or voting rights, where the acquirer, prior to acquisition, has fifty per cent (50%) or more shares or voting rights in the enterprise whose shares or voting rights are being acquired, except in the cases where the transaction results in transfer from joint control to sole control. • An acquisition of assets, not directly related to the business activity of the party acquiring the asset or made solely as an investment or in the ordinary course of business, not leading to control of the enterprise whose assets are being acquired except where the assets being acquired represent substantial business operations in a particular location or for a particular product or service of the enterprise, of which assets are being acquired, irrespective of whether such assets are organized as a separate legal entity or not. • An acquisition of stock-in-trade, raw materials, stores and spares in the ordinary course of business. • An acquisition of control or shares or voting rights or assets by one person or enterprise of another person or enterprise within the same group. • A merger or amalgamation involving a holding company and its subsidiary wholly owned by enterprises belonging to the same group and/or mergers or amalgamations involving subsidiaries wholly owned by enterprises belonging to the same group.

7.10 SUMMARY

• A business is best defined as a set of assets that are integrated in a manner which makes it potent and capable of yielding the desired returns for the investing Check Your Progress members, owners and other participants. 23. State any four key • A business combination can be created and administered through voluntary provisions of the acquisition, merger or even takeovers. SEBI takeover code. 24. Give any two other • One of the ways by which the industry can bring about consolidation and strengthen applicable laws. its position for achieving the desired competitive edge is the process of restructuring corporate operations.

Self-Instructional 242 Material • The term corporate restructuring encompasses business portfolio restructuring Introduction to by the process of mergers, demergers, takeovers, acquisitions, foreign franchise Business Combinations purchase of brands and hiring of unrelated businesses, strategic alliances and joint ventures and above all internal financial restructuring and organizational restructuring. NOTES • Restructuring is a process by which a firm does an analysis of itself at a point of time and alters what it owes and owns, refocuses itself to specific tasks of performance improvements. • The terms merger, amalgamation and acquisition are often used interchangeably to denote the situation where two or more companies combine into one economic entity to share risks, keeping in view their long-term business interest. • If we go by the literal meaning of the words merger, acquisition or amalgamation, they mean the blending of one undertaking with another which may either be existing or new. • According to M.A. Weinberg, ‘A merger may be defined as an arrangement whereby the assets of two companies become vested in, or under the control of one company, (which may or may not be one of the original two companies) which has its share- holders all or substantially all the shareholders of the two companies’. • A merger involves the fusion of two or more separate companies into one. • Mergers appear in three dominant forms, horizontal, vertical and conglomerate, based on the competitive relationships between the merging parties. • Acquisition implies that one of the firms loses its identify and that it has been purchased by the firm that continues its existence. • An asset acquisition is an acquisition of all or part of the assets of a company pursuant to a contract entered into between the buyer and the seller. • Asset acquisition requires that specific instruments of title must be delivered by the seller for transferring the legal title to the buyer. • The term ‘merger’ refers to a situation where company acquires the whole of the assets and liabilities or a part thereof constituting an undertaking of another company (or companies) and the latter is (are) dissolved. • The term ‘amalgamation’ or ‘consolidation’ refers to a situation where two or more existing companies are combined into a new company. • In Halsbury’s Laws of England, amalgamation is stated as the blending together of two or more undertakings into one undertaking and in such an act, the shareholders of each blending company becomes the shareholders of the blended undertaking. • The term ‘acquisition’ or ‘takeover’ refers to acquiring of effective working control by one company over another. • A leveraged buyout (LBO) is said to occur when a company or a sole asset (such as real estate) is bought with a combination of equity and significant amounts of borrowed money, structured in such a way that the target’s cash flows or assets are used as the collateral (or ‘leverage’) to secure and repay the money borrowed to purchase the target-company/asset.

Self-Instructional Material 243 Introduction to • It is believed that mergers and acquisitions are strategic decisions leading to the Business Combinations maximization of a company’s growth by enhancing its production and marketing operations. • Growth is essential for sustaining the viability, dynamism and value-enhancing NOTES capability of a company. • The combination of two or more companies may result in more than the average profitability due to cost reduction and efficient utilization of resources. • Diversification implies growth through the combination of firms in unrelated businesses. • When two companies merge through an exchange of shares, the shareholders of selling company can save tax. • A strong urge to reduce tax liability, particularly when the marginal tax rate is high (as has been the case in India) is a strong motivation for the combination of companies. • There are many ways in which a merger can result in financial synergy and benefits. A merger may help in: eliminating the financial constraint, deploying surplus cash, enhancing debt capacity and lowering the financing costs. • Even though the environmental change, which warrants corporate restructuring, is a gradual process, corporate restructuring is often an episodic and convulsive exercise. • Corporate restructuring occurs periodically due to an ongoing tension between the organizational need for stability and continuity and the economic compulsion to adapt to changes. • Mergers can have both types of explanations, legal as well as economic. • A statutory merger is defined as that in which the acquiring company takes over the assets and liabilities of the target, in accordance with the legislatives of the state which houses the joint companies. • In a merger, either the acquirer or the target survives. • There are three types of business mergers; these are: horizontal, vertical and conglomerate mergers. • Classification of a merger is done on the basis of the similarity or differences between the industries of the merging companies and their positions in the corporate value chain. • In a friendly takeover, it is easy to approach the target’s board and management with the idea and suggest shareholder approval. • A tender offer can be defined as the offer to buy shares in another firm, generally by making the payment through cash, securities, or both. • When a bid is through for a target company, the target company’s stock price time and again trades at a little discount to the actual bid. • Constructive abnormal returns represent gains for shareholders, which could be explained by such factors as better efficiency, pricing power or tax benefits. • Abnormal or surplus returns to target shareholders are not necessarily the same as the purchase price premium they take for the delivery of their shares.

Self-Instructional 244 Material • Mergers and acquisitions have comparatively modest impact on abnormal returns Introduction to to either acquirer or target bondholders, apart from in special situations. Business Combinations • By and large, a merger is carried out with the help of three essential steps: (i) planning, (ii) resolution and (iii) implementation. NOTES • Takeover can be either ‘friendly’ or ‘hostile’. • In case of a friendly takeover, the promoters/management of the target company are also, in principle, agreeable to be taken over by the acquirer and are willing to peacefully cede control over the target company to the acquirer. • The Companies Act, 1956, is a very comprehensive code that governs all aspects of the functioning of a company—be it incorporation, winding up, maintenance of accounts or declaration of dividend or any other. • A reverse merger is defined in two ways: (i) where a holding company merges with the subsidiary or investee company (i) where a profit-making company is merged with a loss-making company.

7.11 KEY TERMS

• Sell-offs: The swift selling of securities, stocks, bonds and commodities. • Spin-offs: The making of a new separate company from the existing firm. • Split-offs: The reorganizing an existing corporate structure. • Split-ups: A single company splits into two or more separately run companies. • Divestitures: The action of selling off subsidiary business interests or investments. • Conglomerate: A conglomerate is a combination of two or more firms engaged in entirely different businesses. • Leverage: A means of multiplying profit or loss. • Relevant market: Refers to the market which may be determined by the Commission with reference to the relevant product market or the relevant geographic market or with reference to both the markets. • Relevant geographic market: Refers to a market comprising the area in which the conditions of competition for supply of goods or provision of services or demand of goods or services are distinctly homogenous and can be distinguished from the conditions prevailing in the neighbouring areas. • Relevant product market: Refers to a market comprising all those products or services which are regarded as interchangeable or substitutable by the consumer, by reason of characteristics of the products or services, their prices and intended use.

7.12 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. Restructuring is a process by which a firm does an analysis of itself at a point of time and alters what it owes and owns and refocuses itself to specific tasks of performance improvements. 2. The cohesive meaning of merger, acquisition and amalgamation is that they represent a situation where two or more companies combine into one economic entity to share risks. Self-Instructional Material 245 Introduction to 3. M.A. Weinberg’s definition of merger is as follows: ‘A merger may be defined as Business Combinations an arrangement whereby the assets of two companies become bested in, or under the control of one company, (which may or may not be one of the original two companies) which has its share-holders all or substantially all of the shareholders NOTES of the two companies. 4. The three types of mergers are as follows: Horizontal merger, Vertical merger and Conglomerate merger. 5. Acquisition implies that one of the firms loses its identity and that it has been purchased by the firm that continues its existence. 6. The word amalgamation is not defined by the Companies Act. The word has no precise legal meaning. In commercial parlance, amalgamation is used when two or more independent companies combine to form a new business. In the case of amalgamation, a new company is formed and all the amalgamated companies are liquidated. 7. A leveraged buyout occurs when a company or a sole asset (such as real estate) is bought with a combination of equity and significant amounts of borrowed money, structured in such a way that the target’s cash flows or assets are used as the collateral (or ‘leverage’) to secure and repay the money borrowed to purchase the target-company/asset. 8. Business restructuring involves the reorganization of business units or divisions. It includes diversification into new businesses, outsourcing, divestment and brand acquisitions. 9. The two forms that a merger or amalgamation may take are: • Merger through absorption • Merger through consolidation 10. Any four objectives that mergers and acquisitions are intended to achieve are: • Limit competition • Achieve diversification • Displace existing management • Create an image of aggressiveness and strategic opportunism, empire building and to amass vast economic powers of the company. 11. Corporate restructuring occurs periodically due to an ongoing tension between the organizational need for stability and continuity as well as the economic compulsion to adapt to changes. 12. The objectives of organizational restructuring and performance enhancement programmes are: • Regrouping of businesses • Decentralization • Downsizing • Outsourcing • Business process re-engineering • Enterprise resource planning • Total quality management 13. Classification of a merger is done on the basis of the similarity or differences between the industries of the merging companies and their positions in the corporate value chain.

Self-Instructional 246 Material 14. A friendly takeover is when the promoters/management of the target company Introduction to are also, in principle, agreeable to be taken over by the acquirer and are willing to Business Combinations peacefully give up control over the target company to the acquirer. 15. The various takeover tactics are as follows: • Dawn raid NOTES • Bear hug • Proxy fight 16. The various defence tactics are as follows: • Crown jewels • Blank cheque • Shark repellents • Poison pill • Poison put • People pill • Scorched earth • Pacman • Green mail • White Knight • Grey Knight • Golden Parachute 17. The different types of anti-takeover amendments are: • Supermajority amendments • Fair Price amendments • Classified boards 18. The Companies Act, 1956 is a very comprehensive code that governs all aspects of the functioning of a company—be it incorporation, winding up, maintenance of accounts or declaration of dividend or any other. 19. The following are the two powers of the high court under section 394: • Dissolution, without winding up of the transferor company • Making of provision for any dissenting persons if the high court deems fit 20. One observation that can be drawn from Section 2(1B) vis-à-vis amalgamation is: the definition of amalgamation does not stipulate that the assets and liabilities have to be transferred at the book-value only. As a result, both the types of amalgamations i.e., amalgamations by way of merger and amalgamation by way of purchase, as defined in AS 14 are eligible to qualify as amalgamations under this definition. 21. In order to qualify as demerger under the Income Act, 1961, the following two conditions need to be satisfied: • Both the entities involved should be companies • All properties belonging to an undertaking should be transferred to the resulting company. 22. A reverse merger is defined in the following two ways: • Where a holding company merges with the subsidiary or investee company • Where a profit-making company is merged with a loss-making company 23. The following are the four key provisions of the SEBI takeover code: • Disclosure • Trigger points Self-Instructional Material 247 Introduction to • Offer price Business Combinations • Competitive bids 24. Two of the other applicable laws are as follows: • Relevant market [Section 2 (r)] NOTES • Definition of Combinations [Section 5]

7.13 QUESTIONS AND EXERCISES

Short-Answer Questions 1. Define business or corporate restructuring. 2. List the different forms of restructuring business firms. 3. What are mergers? List the different types of mergers. 4. Differentiate between mergers and acquisition. 5. Give the meaning and nature of acquisitions and amalgamations. 6. What are leveraged buyouts? 7. State any two motives and benefits of mergers and acquisitions. 8. Highlight the ways in which a merger can increase the market share of the merged firm. 9. Give four reasons for organizational restructuring. 10. Write a short note on the legal perspective or corporate restructuring. 11. Differentiate between friendly and hostile takeovers. 12. Highlight the importance of Section 391 in approving an amalgamation or a demerger. Long-Answer Questions 1. Give a comprehensive overview of the ways in which restructuring takes place in a business firm. 2. Define mergers and identify the various types of mergers. 3. Define amalgamation and give examples of mergers and amalgamations. 4. Define acquisitions and differentiate between mergers and acquisitions. 5. Explain takeovers with the help of an example. 6. Give examples of mergers and acquisitions in India and write the benefits that came about as a result of it. 7. Write a critical analysis of the factors that are involved in the regulation of mergers and acquisitions. 8. Give a detailed explanation of takeovers. 9. Summarize the important aspects of the Companies laws, Income tax laws as well as other applicable laws. 10. Give a detailed account of the SEBI guideline for takeovers. 11. Define takeovers and explain any three takeover tactics in detail. 12. Write a brief note on the importance of target identification vis-à-vis the merger process. Self-Instructional 248 Material Introduction to 7.14 FURTHER READING Business Combinations

Weston, J Fred, Kwang S. Chung and Susan E. 1990. Hoag, Mergers, Restructuring and Corporate Control. New Jersey: Prentice Hall. NOTES Horne, James C. Van. 2002. Financial Management. New Jersey: Prentice Hall. Brealey, Richard A., Stewart C. Myers and Franklin Allen. 2008. Principles of Corporate Finance. New York: McGraw-Hill. Pandey, I.M. 2010. Financial Management. New Delhi: Vikas Publishing House. Muralidharan. 2009. Modern Banking: Theory and Practice. New Delhi: PHI Learning Private Ltd. Maheshwari, S.N. 1983. Banking Law and Practice. New Delhi: Kalyani Publishers. Gordon E. and K.Natrajan.1992. Banking: Theory, Law and Practice. Mumbai: Himalaya Publishing House. Sharma, K.C. 2007. Modern Banking in India. New Delhi: Deep and Deep Publications.

Self-Instructional Material 249

B. R. Ambedkar Bihar University (Directorate of Distance Education)

List of Study Centres

1. Directorate of Distance Education, B.R.A. Bihar University, Muzaffarpur 2. Arcade Business College, Rajendra Nagar, Patna 3. B.M.D. College, Dayalpur, Vaishali 4. B.P.S. College, Desari, Vaishali 5. Balmiki Teachers' Training College, Vaishali 6. Chanakya Institute of IT & Management, Near V.K.S. University, Ara 7. Chetan Sadhan Institute & Technology, Juran Chapra, Muzaffarpur 8. Darbhanga National College, Mohalla+PO-Lalbagh, Near (C.M. Science College), Dist- Darbhanga 9. Dr. Jagannath Mishra College, Muzaffarpur 10. Dr. Zakir Hussain Institute, Baily Road, Hartali Mod, Patna 11. Dr. Zakir Hussain Institute, Banka 12. Dr. Zakir Hussain Institute, Bhagalpur 13. Dr. Zakir Hussain Institute, Munger 14. Fundamental College of Education, Bhagalpur 15. Gurukul Institute, Sitamarhi 16. Helping Hand College of Education, Technical Chowk, NayaTola, Muzaffarpur 17. J.P. Institute of Paramedical Science & Higher Edu., Old Motihari Road, Bairia Gola Road, Near Kolhua Chowk, Muzaffarpur 18. Jawahar Lal Nehru Memorial College, Nawahi, Sursand, Sitamarhi 19. Jyoti Institute of Technology, Aghoria Bazar, Muzaffarpur 20. L.N. Mishra College of Business Management, Bhagwanpur, Muzaffarpur 21. L.N.D. College, Motihari 22. Laxman Foundation, Akharaghat Road, Muzaffarpur 23. M.D.D.M. College, Muzaffarpur 24. M.G.C.S.M. College, Kalisthan Road, Begusarai 25. Mahatma Buddha Teachers' Training College, Sitamarhi 26. Muzaffarpur Eye Hospital, Juran Chapra, Road No. 02, Muzaffarpur-842001 27. N.G.M. College, Raxaul 28. Om Sai Nursing Home, Juran Chapra, Muzaffarpur-842001 29. Priya Rani Degree College, Bairgania, Sitamarhi 30. R.N. College, Hajipur, Vaishali 31. R.N. Institute of Health Science, Juran Chapra, Muzaffarpur-842001 32. R.S.S. Science College, Sitamarhi 33. Romaela Institute of Rehabilitation Training & Research, Motihari 34. S.R.A.P. College, Bara Chakia, Motihari 35. Shayam Nandan Sahay College, Dheeranpatti, Muzaffarpur 36. Vaishali Institute of Rural Management, Narayanpur Anant Station Road, Muzaffarpur 37. Zakir Husain Institute, Bela Road, Mithanpura, Muzaffarpur

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