Safety net: Sebi’s barking up the wrong tree

Securities and Exchange Board of India (Sebi) has sought public comments on its proposal to have a mandatory “safety net” to protect the interests of small investors. Sebi’s view is that apart from disclosures, other measures are needed to bring in self-discipline in the pricing of initial public offerings (IPOs) and having a safety net mechanism is one such measure it has proposed. If implemented, issuers will have to buy back up to 5% of an IPO issuance from investors who put in applications worth 50,000 or less, in case the price of their shares fall by more than 20% relative to a broad market index.

This column has pointed out before that thanks to Sebi’s fervour in protecting the interest of retail investors, some of its guidelines end up being lopsided. (See http://tinyurl.com/sebi-retail). Equity market investing, by nature, will involve price risk. Protecting any category of investors from such price risk will result in unnecessary complications. If issuers have to provide a floor to a category of investors it is tantamount to writing an option, and some issuers may well price this in while deciding on the issue price. J.R. Varma of IIM-Ahmedabad says, “To get good price discovery in the IPO, it is necessary to ensure that investors live with the consequences of their pricing errors.”

Sebi’s primary market advisory committee has recommended that considering the recent post-listing price performance of IPOs, it is necessary to make the safety net mechanism mandatory for IPOs, so as to reinforce investor confidence in capital markets and discipline issuers and market intermediaries. All of the issuances in 2012 are trading above their issue prices. But investors had a bad experience with IPOs made in 2011. Nearly half of the total issuances have fallen by more than 25% in value and in nine stocks, the decline has been as much as 81-92%. But it must be noted that in the case of many of the companies whose value declined sharply, Sebi has already hauled them for creating artificial demand for their IPOs and for siphoning off large parts of the funds that were raised. Sebi names seven companies in its “small IPO scam” investigations. Thus, a large part of investors’ losses were because of an attempt to fraud investors, rather than merely overpricing.

Varma says, “Rather than pricing risk, investors can ask for protection against things like fraud, and even here the best protection is a regime of deterrence in which harsh penalties are imposed on wrongdoers.” Harsh punitive action will avoid a repeat of such cases, which is far more effective rather than provide a safety net for merely 5% of the issue size. In the small IPO scam, while Sebi did a good job of investigation, an appropriate punitive action is still awaited.

What about the general issue of overpricing, where no fraud is involved, but issuers attempt to get the best possible price without any regard for the interest of minority investors? Even here, it is best to leave it to the market to decide on issues such as pricing. A large universe of investors including institutional, high net worth and retail investors bid together to determine the success of the issue. While there may be many instances of investors acting irrationally while bidding for an IPO, this doesn’t call for a regulator to intervene and protect a certain category of investors.

Needless to say, Sebi is overly focused on the interests of retail investors. This results in lopsided rules such as assured allotment for retail investors and a safety net when prices fall. But while it seems good that the markets regulator is watching out for the interests of small investors, it must be noted that small uninformed investors are better off with advice that equity market investments will involve a price risk. A safety net teaches them just the opposite.

Besides, as pointed out in this column before, uninformed investors should be directed to make equity investments through mutual funds rather than come in directly. The new finance minister has done well to allow mutual fund investments under the Rajiv Gandhi Equity Savings Scheme, and Sebi’s attempt should be to educate small investors on the many benefits of investing through mutual funds. On the contrary, it is unwittingly inviting small investors to make direct investments through unwanted sweeteners.

Unified financial regulator

It is heartening to note that the financial sector legislative reforms commission (FSLRC) is advocating a unified financial regulatory agency, which will regulate all organized financial trading. Such a recommendation has been made in the past by the committee on Making Mumbai an International Financial Centre, but has faced resistance. Hopefully, FSLRC’s concrete recommendations on this will be implemented.

Financial trading is increasingly interconnected, with market participants taking positions simultaneously in different markets. As a result, it is important that there is one regulator who has a bird’s eye view on such positions across different asset classes. Besides, having one well-equipped regulator will remove the possibility of regulatory arbitrage, whereby some market participants may prefer to operate under certain regulators who are not as equipped as others. In India, it is apparent that the Forward Markets Commission is way behind Sebi in many aspects, including investigating and surveillance capabilities. A unified regulator will remove such anomalies from the Indian market, and should be embraced sooner than later.

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