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| November 27, 2006 | Monday | Ziqa'ad 5, 1427 |
Tackling fictitious applications in initial public offering
INDIA’S capital market regulator, the Securities and Exchange Board of India (SEBI), last week introduced the concept of ‘disgorgement and restitution’ into the country’s business lexicon.
The SEBI’s Chief, M. Damodaran slapped an order on two depositories and eight depository participants (DPs), instructing them to disgorge over Rs1.15 billion jointly and severally within six months in connection with last year’s IPO (initial public offering) scam. Inaction by the depositories and the DPs resulted in manipulators exploiting loopholes in the system and grabbing a large chunk of shares that were on offer.
According to Damodaran, the disgorgement order would ensure the restoration of status quo. It was not a punishment, but just part of a larger process of restoring illegally taken out funds to the system. The SEBI has still to decide how the amount disgorged by these entities would be distributed to retail investors (restitution) who had suffered because of the fraud.
“Disgorgement and restitution are two steps in the same large process,” notes Damodaran. “At the time of disgorgement, we are not required to spell out who will get how much of the money. All we are saying is that according to our information, certain people have unjustly benefited, and we’ll take that money out of the system.” The IPO scam related to the fictitious applications made by individuals in some cities in Gujarat, who applied for the shares of a few companies. The scam surfaced when it was found that scores of individuals had applied from one single address in cities like Ahmedabad. The scamsters had opened multiple demat accounts in fictitious names to corner the shares.
SEBI in its interim order blamed the two depositories – the National Securities Depository Ltd (NSDL) and the Central Depository Services Ltd (CDSL) – and eight DPs including banks like the HDFC Bank, the IDBI Bank, and the ING Vysya Bank, for procedural lapses and not detecting the fraud in time.
The capital markets watchdog points out that it is not accusing the depositories and the DPs of enriching themselves from the scam. It was for these entities to recover the money from clients who had profited from the scam, argues Damodaran. And irrespective of whether they do so or not, they will have to pay SEBI Rs1.15 billion within six months.
SEBI’s earlier interim order issued in April has been challenged by some of the affected parties. The disgorgement order is also likely to be challenged in an appellate tribunal. However, if the enquiry into the scam finds that the 10 entities are not guilty, then they will not have to disgorge the amount.
Worried about the recurrence of IPO-related scams, the Indian government last week decided to examine all IPOs that have raised more than Rs500 million in the last three years.
The Ministry of Company Affairs directed the Registrar of Companies to track all such IPOs since 2004. Scores of public issuers have raised over Rs250 billion since 2004, and it would be a massive task to find out whether the funds raised have been utilised for the stated purpose.
While the government has not pinpointed any particular industrial group or company, the registrar is expected to monitor the proceeds of the IPOs and see whether the promoters have stuck to their commitments.
In the past – especially during bull-runs in the stock markets – many companies vanished after raising millions of rupees from investors. This had happened during the dot.com boom in the late 1990s, when thousands of investors burnt their fingers investing in companies that approached the public for funds.
Shockingly, some of these promoters floated new companies and once again approached the capital markets with IPOs. Both the government and SEBI failed miserably in protecting investors, who have lost billions of rupees in such scams.
The government is also worried about the increasing inflow of ‘hot money’ into the country’s capital markets from FIIs (foreign institutional investors), routing their funds through tax havens like Mauritius. The government plans to direct SEBI and the Reserve Bank of India (RBI), the central bank, to prepare a negative list of tax havens, to check misuse by FIIs.
A government committee has recommended that entities registered in countries like Mauritius – with which India has a double taxation avoidance treaty – should not be granted the FII status. Since Mauritius does not have capital gains tax, entities registered there do not pay short-term capital gains tax on profits made in the Indian capital markets.
There are nearly a thousand registered FIIs operating in the Indian stock markets, through a complicated network of sub-accounts. About 150 of them were registered just last month. The government suspects that some of the outfits have been set up in Mauritius to launder funds that are illegally brought into India.
The capital market watchdog allows the FIIs to operate on behalf of clients – not registered with SEBI – on the basis of participatory notes (PNs). Rumours of a ban on the PNs a few months back had led to a crash in the markets. The government is treating the entire issue of the PNs and the FIIs with a lot of sensitivity, as any wrong move could impact foreign investor sentiment.
SEBI is also concerned about Mauritius-based investors acquiring Indian companies, and has sought clarifications from the government whether these investments are to be treated as the FII or the FDI (foreign direct investment). There are fears that some foreign companies, with a low capital base, acquire control of the Indian companies through stock market acquisitions.
The FIIs can raise their stake beyond 24 per cent if the listed Indian company’s board passes such a resolution. SEBI is worried that the Indian companies could be acquired by unknown entities, who could even indulge in asset stripping. The FDI investments are transparent, where the promoters background and other details are known, unlike in the FII inflows and takeovers.
Similar fears of the takeover of stock exchanges led SEBI last week to insist on a cap of five per cent on holdings by investors wanting to acquire such marts. SEBI has directed all stock exchanges in India to go in for ‘demutualisation,’ (or corporatisation).
Exchanges like the Bombay Stock Exchange (BSE) were traditionally owned by brokers, who also used to manage the exchanges. However, following the new orders, all exchanges have to be transformed, and they have to offer 51 per cent of their shares to the public.
Exchanges can opt for IPOs, sale of shares by brokers now controlling the exchange, or even private placement of shares. However, there should be a minimum of 11 shareholders, and no single shareholder can control more than five per cent stake in the exchange, says SEBI. The market watchdog would also have to approve investors holding more than one per cent stake in the exchange.
But SEBI has not touched on the contentious aspect of foreign holdings in stock exchanges, and claims that the Indian government will have to take a call on this matter. Globally, there is a lot of churning going on in commodity and stock exchanges, especially in the US and Europe.
Many international exchanges are eyeing other exchanges, and a lot of consolidation is occurring. Some international exchanges are also keen on acquiring a stake in the BSE. The country’s premier exchange was on the lookout for a strategic partner, who could invest up to 26 per cent in it.
However, the new rules barring any single holder from acquiring over five per cent in a stock exchange will delay the BSE’s plans. The BSE planned to sell the 26 per cent stake by the end of this year, and was also planning an IPO by early next year.
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