Identify the bigger bandicoots

Unscrupulous promoters are the greatest beneficiaries of the IPO scam

Chalapati Rao Delhi

Yet another IPO scam has visited the Indian stock market. About a decade ago, it was the vanishing companies that duped the unsuspecting investors and collected huge amounts through the primary market. This time around, it is the turn of vanishing investors who robbed genuine small investors of a chance to get a fair share of primary market offerings. According to some reports, it is not SEBI, the market regulator, which got wind of the goings on; it is a fall-out of the income tax raids on an Ahmedabad businessman which revealed that he was controlling over 5,000 demat accounts. The 35 per cent reservation in a book-built issue for retail investors (maximum application money Rs 1 lakh for each applicant; earlier it was Rs 50,000) and the proportional allotment in case of oversubscription, makes this category attractive. Multiple applications improve the chances of allotment on the one hand and allotment of larger number of shares on the other. The scamsters tried to exploit this provision.

According to SEBI, certain entities had cornered IPO shares reserved for retail applicants by making multiple applications in the names of fictitious applicants. Once they got the allotments, these applicants transferred the shares to their principals who in turn transferred them to the financiers. The financiers sold most of these shares on the first day of listing, making windfall gains. SEBI’s investigation suggests that certain depository participants masterminded the opening of thousands of demat accounts by falsifying documents to facilitate the application process. For instance, at NSDL there were 21 depository participants (DPs) wherein 500 or more account holders were sharing common addresses and the total number of such accounts with these 21 DPs was 44,637.  There is every possibility of many more multiple demat accounts existing than what the SEBI investigations reveal. It has been estimated that through these operations the financiers gained about Rs 72 crores. The scam brought into focus the malfunctioning of many an intermediary: banks, depositories, DPs, brokers, sub-brokers and internal auditors. Often the scrutiny turned out to be perfunctory, bordering on connivance. To the extent SEBI was oblivious of these goings-on, which went on for at least three years, it could be held guilty of not playing its role properly.

Registration of multiple companies

SEBI’s scrutiny was based on common addresses of demat accounts and the inter se transfer of shares. Identifying relationship with common addresses could only catch some culprits. The perpetrators could use multiple addresses. It is also not necessary that all such shares would be sold immediately after the listing.  During the 1980s, some listed companies were moved like kitten, in groups from one place to another in Delhi.  Linkages through board of directors, inter-corporate investments, auditors, stock brokers and bankers to the issue could be established from Assam and Kolkata in the east to Ludhiana in the north and to Mumbai in the west covering on the way places like Kanpur and Delhi (obviously, all these have stock exchanges). Stock brokers seem to have played the central role in creating these networks. Multiple company registrations probably peaked in the 1990s. Kolkata indeed is notorious for multiple company registration.  

The evidence shows that the extent of duplicity practiced by the Indian corporate sector is much more than what gets reflected from common registered office addresses. Such operators may have modified their modus operandi in the changed circumstances. But their objective is quite clear.  Take advantage of the stock market to make undue gains. Large business groups are also not far behind. Dozens of companies, at times running into hundreds, constitute their networks. It is pertinent to ask about the manner in which such companies are utilised by the promoters.

No more reservation for small investors?

Following the scam, there have been calls for removing the special dispensation extended to the small investors, which is the root cause of the present scam. In a boom time, as long as the issues are subscribed, the small investor is a disposable one. But when the going gets difficult, the very same investor is wooed to revive the market.  The critics are, however, conveniently keeping silent on the practice of financing of IPOs, which is the second major contributory factor to the scam. Why should this be allowed at all? After all, the real purpose of the stock market is to directly mobilise household savings for investment purposes and avoid intermediation. Would IPO finance turn “men of straw” (SEBI Order describes the slum dwellers whose election ID cards were used by the scamsters to open demat accounts) into “men of substance”?  It is common knowledge that many small investors exit by selling the allotted shares immediately after listing. It is more likely that a larger proportion of those who avail outside finance would be exiting the market at the first available opportunity. Does such type of investors’ involvement really help in resource mobilisation? If the financiers are bankers, there is no additional resource mobilisation. It is already there in the system!

On the other hand, one could even argue that to increase small investors’ participation, IPOs/fresh issues of capital could be made a two-tier affair. At the first stage the entire issue could be reserved for them and after a pre-determined period of say three or four days, the un-subscribed portion, if any, could be thrown open to everyone. ‘IP’ in IPO would then indeed stand for the Indian public. As of now, theoretically, the share of retail investors would work out to just about 9 per cent (35 per cent of 25 per cent) of the total equity capital after an IPO. Promoters and venture capital have a vested interest in keeping the offer small at the time of IPOs so that the issues can command high premium and deliver huge capital gains on their investments while the promoters continue to retain control. Alternatively, the issue could be opened for all kinds of investors simultaneously but allotment would be first made to individual investors and the remaining portion if any, would be distributed among the institutional bidders. Why should the institutional investors be given preference at all? After all, as said earlier, the purpose of stock markets is to promote disintermediation between savers and enterprises. Instead of enabling only a few lucky domestic individual investors, a good number of whom may not retain the shares, let larger numbers benefit. With promoters being allowed to retain/acquire majority equity, the floating stock turns out to be quite limited. If in the remaining portion institutional investors have a major say, very little room is left for individual investors.  Assuming a conservative 2:1 debt-equity ratio, and 75 per cent promoter holding, the non-promoter shareholding would work out to a maximum of 8 per cent of the total funds deployed. Would it be that difficult to mobilise 8 per cent of the total funds required, when 92 per cent funds are already tied up?  What additional benefit accrues due to the listing of such companies? Will it help faster economic growth? Will it bring larger sections of the economy under market discipline? Would it help promote professionalisation of managements? On the other hand, it is easy to see that the promoters, intermediaries and speculators have a vested interest in such listing. Instead of ‘encouraging’ companies to come to the public with low level of public shares, the stipulation should be that non-promoter shareholding should always be in majority.

Discipline the promoters who could be bigger bandicoots

The real damage to small/retail investors’ interest could be done by the promoters. A SEBI spokesman used the word ‘bandicoot’ to describe the ultimate beneficiaries of the IPO scam. Would not unscrupulous promoters turn out to be bigger bandicoots? This is where the regulator needs to be proactive. It is not enough to draw up corporate governance codes and disclosure requirements. It is the responsibility of the market regulator to see that these are observed in the letter and spirit of the law. There is a need for meticulous research in this regard. For instance, one comes across many instances where the so-called general public or the non-promoter corporate bodies are clearly ‘related’ to the promoters. In one instance, the company itself was a co-promoter of the so-called non-promoter shareholding corporate body.

Keeping certain of the companies under the non-promoter category would help the promoters at least to avoid insider trading regulations and takeover code and also help siphon-off profits to undeclared related parties. It is a sheer coincidence that a number of major South Korean companies are facing scrutiny of the country’s regulator for embezzlement of funds. Chairman of Hyundai Automotive has already been indicted. Some have promised donations to the society by way of compounding their offences. In all, about 10 major business groups of Korea are reported to be under investigation to “eradicate the deep-rooted practice of often illegal business transactions among their affiliates” (Korean Herald). In case of India, however, such practices generally do not come into the open; more often than not they are known only when disputing family members wash their dirty linen in the public for personal gains or when loyal employees start lining their own nests. Once the dispute is settled, no one seems to be interested in pursuing the cases further and bring out the truth.

In the Indian context, a number of questions arise.  How many of the so-called non-promoter shareholders are benamis of the promoters? How independent are the independent directors on whom so much reliance is being placed to protect the interests of non-promoter shareholders? Who monitors the related party transactions from the point of their essentiality and arms-length pricing? Is the criticism about the failure of the book-building route in price discovery, enriching the companies at the expense of ordinary shareholders unfounded? How much have the promoters gained in the process? Last but not the least; is there any mechanism to ascertain the antecedents of foreign portfolio investors to whose tunes the Indian stock market dances? The SEBI investigation report into the IPO scam and the subsequent newspaper reports indicate that the concerned officials were emotionally charged.  It is probably a welcome sign as it could be the indication of longstanding frustration at noticing the goings on but not being able to do anything for one reason or the other to bring the culprits to book.  One hopes that SEBI would not only start looking into these issues but also make them public.

Need for clarity in objectives

The issue of benami/fictitious applications is only a minor facet of the malfunctioning system. In any case with PAN becoming mandatory to open demat accounts the menace of bogus accounts could be controlled. SEBI will have to set its own house in order. As we have said elsewhere, there is a need for stating the objectives clearly. Is it to provide capital cheaply to enterprises? Is it to enable international capital flows? Is it to let the savings of the household sector flow directly into the market and thereby let the fruits of enterprise be distributed over wider sections of the population? Is it to somehow create successful Indian enterprises (and possibly by protecting them from takeovers) even at the cost of unbridled growth of concentration of economic power? The government has to take the responsibility and the initiative to clarify them and to set appropriate guidelines.