Home / Money / Personal-finance /  How they made Rs614 crore playing the system

Four small companies, a stock exchange platform, an intention to cheat, and misuse of tax laws—all came together to change the colour of the money.

Recently, in a letter to the Ministry of Finance, the Bombay Stock Exchange (BSE) suggested that differential treatment of capital gain between unlisted and listed securities should be harmonized as it is being used by some to manipulate stock prices and evade taxes. While long-term capital gains (LTCG) on listed shares is exempt from tax under Section 10(38) of the Income-tax Act, 1961, the same is 20% after indexation for unlisted shares.

The letter was motivated by a recent Securities and Exchange Board of India (Sebi) order, which looked into transactions related to four companies listed on the BSE’s small and medium enterprise (SME) platform. The transactions showed how the system was used by some “to convert ill-gotten gains into genuine one", stated the Sebi order.

Modus operandi

Sebi looked into the transactions related to four companies, namely, Eco Friendly Food Processing Park Ltd (Eco), Esteem Bio Organic Food Processing Ltd (Esteem), Channel Nine Entertainment Ltd (CNE) and HPC Biosciences Ltd (HPC). All are listed on the SME platform of the BSE. All four companies were listed between January and March of 2013. What caught the regulator’s eye was the massive increase in share prices of these companies. Eco’s share price went up about 64 times between 14 January 2013 and 31 December 2014. Similarly, Esteem’s share price went up about 32 times between 7 February 2013 and 31 December 2014. The other two companies (CNE and HPC) also registered comparable increase in their stock prices. This was despite no improvement in their fundamentals. That was only the beginning of the story.

The Sebi investigation found that an entity named Goldline International Finvest Ltd (Goldline) was holding shares in three of the above mentioned companies. Further, it was allocated shares on preferential basis and, later, these companies issued bonus shares. The idea was to increase the share capital on the books of the companies. As the share capital went up, they approached the market with an initial public offer (IPO). Meanwhile, before the IPO, Goldline had transferred its stake in these companies to other entities. During the IPO, it has now been discovered, common entities were buying or funding buyers for all companies. “It has been observed during preliminary inquiry that a set of common entities were funding the IPO of all the aforesaid companies either through directly transferring the amount in the escrow account of the companies on behalf of certain IPO allottees or by transferring the amount to the concerned IPO allottees’ bank accounts, who, in turn, applied for the shares in IPO," said the Sebi order.

After the IPO, the proceeds were transferred back to the funding entities either directly or through layers of transactions. That’s not all. What is interesting is that these IPOs came one after another and proceeds of one IPO were routed to buy shares of the other companies through the funding group. Naturally, the money raised through the IPO was not being used for the stated purpose. But that is only a minor offence in the given scheme and scale of operations.

People managing the show had different ideas. Once the shares were listed, as expected, the trading volume was low, but prices kept rising. As the lock-in period for the pre-IPO allotment of shares got over, volumes also began to rise. There was no corporate action to justify the spurt in volume and prices. In fact, as the regulator pointed out, these companies had poor fundamentals. Further examination revealed that connected entities were pushing stock prices for all the companies. This trading group also bought most of the shares from preferential allotees who had received them during the pre-IPO days. It was also learned that the trading group was receiving funds from several sources to do this. For example, one Ashvin Verma reported an annual income of 1.81 lakh in financial year 2012-13 but received around 38 crore between 12 September 2013 and 9 August 2014 from three different entities, which was later transferred to a stock broker. But why will someone give money to someone else to buy shares, and that too in companies that have no fundamental backing? As the market regulator discovered, the entire setup was created to make use of the stock exchange platform and misuse laws. Money was given to a set of participants to inflate stock prices and create a profitable exit route for investors who had received preferential allotment before the IPO.

“From the above facts and circumstances, I prima facie find that the preferential allottees, pre-IPO transferees acting in concert with Funding Group and Trading Group have used the stock exchange system to artificially increase volume and price of the scrip for making illegal gains and to convert ill-gotten gains into genuine ones," said Rajeev Kumar Agarwal, whole time member, Sebi, in the order dated 29 June 2015, which banned 239 individuals and entities from the capital market till further direction. Sebi is also of the view that all this would not have been possible without the involvement of promoters and directors of these companies. Agarwal observed that all this was done to create fictitious LTCG, so that the unaccounted money of preferential allottees is converted into accounted funds and income can be shown from a legitimate source, the stock exchange. Funds were provided to the trading group through layers of transactions, so that the people and entities who got shares in the preferential allotment and transfers before the IPO could exit profitably.

As a result, according to Sebi, all the preferential allottees and pre-IPO transferees, together made a profit worth 614 crore.

In response to Mint’s query about this case, a spokesperson of the Central Board of Direct Taxes said in an email, “Necessary action is being taken by the jurisdictional authorities in the Income Tax Department in the cases found actionable as per provisions of the Income-tax Act, 1961. Requisite coordination with Sebi is also being done wherever required."

Will changing tax laws help?

In order to avoid such misuse of the stock exchange platform in future, the BSE suggested in the letter mentioned earlier that differential treatment of capital gains in listed and unlisted companies be removed. “Going by Sebi’s observations, there is a strong case for removing exemption on long-term capital gains tax as it is being used to evade taxes," said Ashishkumar Chauhan, managing director and chief executive officer, BSE.

But not all are with the exchange on this suggestion. Prithvi Haldea, chairman and managing director, Prime Database, for example, said that the tax exemption on LTCG is for a reason and is a well thought out policy decision. “The problem is with law enforcement. You can change the tax laws but people will find some other way. My view is that surveillance and enforcement should be increased, and fear of punishment should work as deterrent," added Haldea. Others are in agreement. “My response is that it (suggestion to remove exemption) is unfair to a large number of ordinary investors. We have a small investor base and the exemption is an excellent motivation," said C.J. George, managing director, Geojit BNP Paribas Financial Services Ltd, adding that stock exchanges should improve their surveillance system. Dinesh Thakkar, chairman and managing director, Angel Broking Pvt. Ltd, also said that there is a need for processes that act as deterrents and remove people who use the system to evade taxes. “We have to follow the process that we are following. Since equity is a risky asset class, people need invectives to invest," he added.

Clearly, what the regulator has exposed is a problem that’s too big and runs too deep to be contained by simply changing tax laws. For investors, this case once again reinforces an argument that has been consistently highlighted in these pages—that individual investors should stay away from investing in small companies as these are difficult to follow and prices can be manipulated.

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