Cleaning up the IPO market

Indian Express, May 2, 2006

SEBI's order against the "IPO scam" should be a chapter in the next

edition of Steve Levitt's Freakanomics, a study of how incentives

shape the behaviour of people. SEBI's order indicts a remarkably broad

swathe of finance firms. Why have hundreds of ordinary citizens turned

to fraud? Is this just about poor supervision, or is there a deeper

problem? Does the fault lie instead with the structure of incentives

on the IPO market?

SEBI has barred 24 market participants from participating in the stock

market for their role in the IPO scam. The "IPO scam" consists of more

than one application per person being put in. The guilty are said to

have been aided and abbeted in their crime by finance companies

who allowed them to open multiple accounts, get allotments and make

windfall gains by selling their shares. SEBI says that these companies

failed to "Know Their Customer" and turned a blind eye to muliple

names assigned to a single address. The issue came into prominence

with the case of the Yes Bank IPO, when Roopalben Panchal made tens of

thousands of applications. SEBI has taken action where

more than 20 "individuals" have the same address and where more than

500 benami entities have transfered shares into a single account

before listing.

How can a finance company prevent an individual from having multiple

identities? When a depository participant is shown proof of identity,

the account opening has to proceed. India does not police every

citizen, and there is no unique citizen identity. In the absence of a

biometric identity infrastructure, it is easy for ordinary citizens

people to have multiple identities. When SEBI tried to build MAPIN, a

system through which a unique identity could be given to large

investors, there was a hue and cry, until MAPIN was finally stalled.

A person can have multiple PAN numbers, since the income tax

authorities have no biometric capacity to verify that one number maps

to only one person. Multiple bank accounts by a single individual are

not uncommon. If a broker deals with clients who belong to one company

and they give the same address, how will he make sure that even though

their address is the same, they are different individuals? Unless the

Government of India has a strict unique identity system, which may be

quite a while away given the size of our population and the

difficulties in implementing it, it is quite unfair to expect the

regulator SEBI or the finance companies, the DPs or the depositories

it regulates to be able to enforce one IPO application per person.

What would be a fair expectation from the regulator? The power of the

regulator lies in creating an incentive structure such that the

entities it regulates follow the regulations it makes. The root of the

problem lies in rationing. Rationing has given rise to black markets

in every country and in every age from Soviet Russia to war time

Europe. India is seen plenty of black markets. There were black

markets for steel and cement when these were rationed.

The quota for individual investors has created an adverse incentive

structure in which people try to get allocations by all means because

the price at the first listing is higher than the price at which

shares are alloted. The situation is similar to the one in which

rationing leads to a black market.

When every application for cement entitles you to 50 bags of cement,

every child in the family puts in an application and a family of four

can get 200 bags of cement. But gangsters put in 100 applications to

get 5000 bags of cement, which they sell in the black market making a

profit on each bag. As long as there is a special quota for individual

investors, there will be an incentive to play such games. Even if

SEBI's order puts fear into the hearts and minds of the finance

companies involved, Roopalben and her ilk will be undoubtedly able to

find loopholes in the law. More importantly, ordinary middle class

households will tread into unethical behaviour by rounding up

applications in the name of every family member imaginable.

How can the problem be solved? With imported cars, custom duty

exemptions for travel companies encourages otherwise honest citizens

to work around the law and pay a lower duty for cars. With petrol

pumps, adulteration of diesel with kerosene occurs because kerosene is

available at a subsidied price. Remember the case of gold smuggling,

which continued as long as the custom duties on gold were high. The

list is endless.

As long as there are incentives to cheat, people try to cheat. The

Indian State does not have the capacity to go after pervasive

violations of rules by ordinary citizens. If we do not have the

capacity to police them, the way out is to change the law and remove

the incentives to cheat.

The quota for small investors in IPOs was intended to "benefit the

small investor". Instead the beneficiaries are those who enter the

market to make a quick buck. Let us not delude ourselves that the SEBI

order, however stern it might be, will put an end to unethical and

fraudulent practices on the IPO market. The COFEPOSA could not stop

gold smuggling for 15 years.

Instead of ravaging the landscape of the best companies in Indian

finance, making demands on them which are difficult to meet, SEBI

needs to address the problem at the core. There is a need to take away

the price difference that gives the incentive to cheat. The way to do

this is to convert the IPO market into a pure auction, without quotas

imposed by SEBI. Let all participate in an open auction of shares so

that the price at which the shares are sold is a reflection of the

demand and supply rather than an artificial scarcity. So far, SEBI has

tried to play policeman, seeking to implement a wrong policy. What it

really needs to do is replace this by a correct policy.


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