Friday, April 28, 2006

SEBI better not let these scamsters go scot free this time - IPO Scam

The Securities Exchange Board of India, on 27 Apr 2006, unearthed a big scam in the primary market. The regulator came down heavily on the intermediaries (such as Karvy, Indiabulls, among others) for their alleged involvement in the fraud.

In an interim order released last evening the SEBI said -

In the recent past while examining off-market transactions in the IPOs of Yes Bank Ltd. (‘YBL’) and Infrastructure Development Finance Company Limited (‘IDFC’), it came to the notice of SEBI that certain entities had cornered IPO shares reserved for retail applicants by making applications in the retail category through the medium of thousands of beneficiary accounts in the name of fictitious/benami entities with each of the application being of small value so as to be eligible for allotment under retail category. After the allotment, these fictitious/ benami allottees transferred these shares to their principals who in turn transferred the shares to their financiers. Most of these shares were sold immediately on listing.

The entire order can be downloaded from here.

SEBI pulled up some of the best known banks in the country, namely - HDFC Bank, IDBI Bank and ING Vyasa Bank. These banks are also banned from opening fresh demat accounts. So much for the clean image that these banks carry on their shoulders !!

However, I think the bigger problem is not these entities (ie. either pple like roopalben, karvy or the aforesaid banks), but the whole system of quotas (for eg. 25% for retail participants, 50% for institutional investors, etc.) in IPO allotment. I think there is great incentive for pple to apply for shares in IPO via multiple accounts (fictitious or otherwise). Even my 15-yr old cousin could comprehend the way out for non-allotment of shares during IPOs - put more applications. Multiple applications simply increase the probability of individuals getting some shares during the allotment process.

Possible solution (or is it ?)

What if we revamped our IPO process to something like what Google did last year, ie. can companies simply auction their shares without having to resort to any of the intermediaries and without having these quotas. They can be allowed to set a minimum price, but let mkt forces decide the final IPO price (instead of the weird book-building process with a tight price band).
Once the price is decided by the investors bidding for shares of a company, the allocation should be done on a pro-rata basis across-the-board. Further, large investors (QIBs or Institutional) be required to put up application monies upfront. Currently they are exempted from this. This system can (or rather I think it does) attract frivolous applications that can be used to artificially show higher demand. To summarise -

1.Shift the IPO process from a quota-based one to a pure auction process
2. Make allocations on a pro-rata basis
3. Let the market decide the final issue price, instead of the co. providing a small band (5-10%) which is really a mockery of the book-buliding and the price discovery process.
4. Make sure all entities pay application monies upfront, so as to avoid frivolous applications.


4 comments:

Nitin said...

Hi Ravi,
Couldnt agree with you more on the need to change the IPO process.

If you think about it,how many of us have applied to IPOs in diff names-our parents/wives/children/siblings so that we get more shares?
Only diff is that we put in 2-3 applications whereas Roopalben and co did it in thousands.

This feeling that "Everybody does it" is probably the reason that DPs like HDFC Bank, Karvy etc didnt bother 2 much about opening multiple accounts.

I also find it mildly amusing about the cry about "protecting" the small investor.Like Buffet says,if you are playing a poker game and you dont know who the patsy is...you are the patsy !

Most small investors dont know the ABC of investing...cant read balance sheets etc...in fact to call these traders "investors" would be a fallacy.

Ann Sherman said...

This was very interesting. I didn't know about this scandal with Indian IPOs.

But I've done research in general on IPO auctions, such as the one used by Google. Such auctions have been used in more than 20 countries over the last few decades, and they've done very poorly. The US was one of the last countries to 'discover' this method, long after it had been tried and rejected by Singapore, Japan, the UK, France, Switzerland, Argentina and many other countries.

Here's my paper, with my co-author Ravi Jagannathan:

http://ssrn.com/abstract=874344

As Nitin pointed out, not everyone that places an order for an IPO is well informed. If all auction bidders were well informed and had an incentive to place reasonable bids, the system might work well. But in practice, there are all sorts of incentives to try to game the system, and the auctions is open to millions of possibly poorly informed bidders.

The biggest problem is the free rider problem (which Google mistakenly called the "winner's curse"). People that don't know how much the shares are worth but want some anyway have an incentive to bid high, to be first in line. The highest bid wins, but that bidder pays the same as everyone else, so some people may be tempted to use this short-cut to get shares. But if too many people do it at once, there can be big trouble!

Ravi Purohit said...

Hi Ann,

Thats an interesting point. I think you are right when you say that there will be an incentive for the bigger players to put in really really large bids and skew the allocation in their favour. I think it will work well in smaller issues, may not work in cases of issues that are as big as ONGC, RPL, DLF, etc.

Coming back to the original question. What other possible solutions can we think of to avoid such scams?

I think making PAN card identification a must should be a good step. As the same will weed out a lot of frivolous applications.

Ravi Purohit said...

And, compulsory it is now. On 5th May, SEBI made PAN cards a mandatory requirement to open Demat accounts. I think this is a good step forward.