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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