After The Satyam Scam 7 Ways to Clean Up the Market
January 13, 2009
COVER STORY (MoneyLIFE Issue, 29th Jan 09)
In an excellent article in The New York Times, Michael Lewis, who wrote Liar’s Poker, and David Einhorn, who wrote Fooling Some of the People All of the Time, have analysed why America and its regulators failed to check the rampant greed and wrongdoing that ended in massive financial collapse and triggered a global recession. Lewis and Einhorn paint a worrying picture of the powerful Securities and Exchange Commission (SEC) and how difficult it was to get its officials to recognise wrongdoing. In the throes of what is the biggest financial crisis, the collapse of Bernard L Madoff’s $50 billion Ponzi scheme still had the power to shock the world. Here is something worse. Lewis and Einhorn say that one Harry Markopolos spent nine fruitless years trying to get the SEC to see that Madoff “couldn’t be anything other than a fraud” because his “investment performance, given his stated strategy, was not merely improbable but mathematically impossible.” At one stage, SEC even gave him a clean chit. But even in 2005, Markopolos wrote a 17-page letter to the SEC pointing to the likelihood that “Madoff Securities is the world’s largest Ponzi Scheme.” It was.
The events at Wall Street hold several lessons for India’s regulators and, unlike the US, we don’t need to wait for a new president to usher in the much-needed change. We also need to chart our own course by framing policies suited to the Indian market and its investors. Assuming that the Securities & Exchange Board of India (SEBI) and various policymakers are interested in a set of comprehensive reforms, what can be done? Here are seven key issues to tackle. Investors need to track the progress of these issues to see if the regulators are actually working for them to make the Indian markets safer and fairer.
Unfortunately, the task will not be easy, since Indian regulators, especially SEBI, have already internalised what is at the core of the US failure – intolerance for divergent views and general lethargy about acting on feedback from investors, intermediaries or those affected by malfeasance and manipulation. In India too, there are plenty of examples where investors are tired of sending letters to SEBI only to have them dismissed as expressions of vested interests.
1. Political Meddling
While India has not been as badly affected by the global financial crisis, the comparisons between the US situation and India are pretty chilling. For instance, the authors say, “The SEC has somehow evolved into a mechanism for protecting financial predators with political clout from investors.” Isn’t it the same here? How else do you explain the Zee group getting away with a mere warning after the Ketan Parekh scandal, when it had already offered to pay as much as Rs5 crore by filing consent terms? Nobody wants to revisit the case.
According to the writers, the SEC was under constant political pressure to avoid any action that could “roil the financial markets.” Ditto in India. From 1992 to 2000 and beyond, no corporate house has been punished, despite their deep involvement in financial scandals. It is only brokers and bank officials who end up as scapegoats. In the past four years, former finance minister P Chidambaram’s obsessive interest in the capital market ensured protection to non-transparent investment in the form of participatory notes (PNs). SEBI’s policy flip-flop and reversal of the post-crisis curbs on issue of fresh PNs attracted wide criticism because it kept the door open for the inflow of non-transparent money. (PNs are derivative instruments representing underlying Indian securities purchased by those who are “otherwise not eligible to invest in the Indian market.”)
In the US, the SEC only targeted and questioned short-sellers, although they were the ones with the sensible contrarian view. In India, SEBI was quick to give short-sellers a clean chit even after well-respected bankers and institutional heads had complained about their share prices being hammered by short-sellers. Why? Because the only short-selling done in India was by foreign institutional investors (FIIs) through PNs. The regulator alone has access to all FII data and we have been told that the quantum of short-selling was too insignificant to impact the market. Those who had complained to SEBI have maintained a discreet silence in public.
Meanwhile, SEBI cannot seem to come up with a workable stock lending and borrowing scheme (SLBS) that will allow domestic investors to short-sell and is making no move to bar FIIs from short-selling through the PN route (it has only conveyed a verbal disapproval of this practice). Only two trades were registered under the revised SLBS launched on 22nd December. So we have an amazing situation where foreigners alone can short-sell Indian stocks in the Indian market.
Indian investors can, of course, short-sell through the futures & options (F&O) route. But, even a decade after we launched F&O trading, there is no move to switch to a delivery-based market. The method of selecting scrips for inclusion in the F&O segment has attracted criticism even from the broker community. The automatic inclusion of large-cap stocks in the derivatives segment immediately on listing also used to trigger rampant speculation and price manipulation. But former SEBI chairman, M Damodaran, did not bother to initiate quick action, despite repeated representations by investor associations. It is only in the past few weeks that the National Stock Exchange (NSE), which has a virtual monopoly in this segment, is dropping some of the more dubious companies from the derivatives list. Is the Exchange driven only by a compulsion to increase the turnover? The NSE’s growing monopoly (especially after cross margining) is not a healthy development for the Indian capital market. But the government is making no attempt to put the Bombay Stock Exchange (BSE) back on its feet or to permit strong new players in the capital market segment.
Capital market-related pressure from the political powers was not restricted to SEBI. Former RBI governor, Dr Y Venugopal Reddy, was under tremendous pressure and attracted orchestrated criticism for his conservative approach to esoteric new products. A central banker tells us, “If Indian banks had any honesty, they will get together to thank YV Reddy for saving them by ignoring their slick presentations seeking permission to launch toxic derivatives in India and for standing up to pressure from the finance minister.” Ironically, the banks remain silent; P Chidambaram is taking credit for the relative safety of our financial system; and Dr Reddy has chosen not to speak or make any public appearances for a year after stepping down as governor.
2. SEBI to Dalal Street
What stopped the US SEC from cracking down? It is the prospect of earning fat bonuses that drove Wall Street executives to ignore flashing danger signals as they issued, amassed and hard-sold toxic debt or fancy homes and credit cards to those who could not afford them. It was a combination of political pressure and self-interest that prevented the SEC from acting against corporate malfeasance, say Lewis and Einhorn. SEC officials, they say, are guided by their self-interest in maintaining good relations with Wall Street. A large number of SEC officials switch to well-paid private-sector jobs. It is exactly the same in India. The best way to land a terrific job in the financial sector is probably through SEBI. A majority of those who leave SEBI get private sector jobs with market intermediaries; in fact, deputation with SEBI is the most attractive option for bureaucrats as well as revenue and enforcement officers in government precisely for this reason.
3. Deaf to Investor Complaints
The speed of resolution of investor grievances is a never- ending work-in-progress. One positive move has been the introduction of ‘applications supported by blocked amount’ (ASBA) scheme which keeps retail investors’ money in their bank accounts until allotment. This will discourage the orchestrated hype to garner heavy oversubscription and collect large float funds. However, the efficacy of ASBA will only be tested when the primary market revives.
The market collapse since early 2008 has triggered a flood of investor complaints and exposed how they exploit broker-client agreements and depository accounts. SEBI has finally acknowledged the misuse of designated depository accounts and has ordered the inspection of several brokers’ books. Several years after we flagged the issue, the regulator now plans to examine the broker-client agreement and initiate steps to safeguard investors’ rights. But SEBI has still to recognise the hardship faced by investors in resolving disputes with brokers. Stock exchanges, the first line of regulation, are party to harassing investors by pushing them into arbitration proceedings even when the disputed amounts are small. When CB Bhave took over as chairman, he agreed with this writer that stock exchanges must make an attempt to resolve disputes before shoving investors into arbitration; nothing has happened so far.
4. Attention Deficit Disorder
Another problem that afflicts the SEC also exists at SEBI – a lack of understanding of the complex derivative instruments that it is supposed to regulate. The top officials at SEBI, who pass orders on a host of complex issues, have to be geniuses if they are instantly able to grasp the nuances of capital markets embodied in the regulation. Naturally, they depend on junior officials to make recommendations. The extent of their knowledge is also questionable, since SEBI officials are not open to market intelligence and public inputs in the investigation process. Also, the organisation is structured in a way that information is not adequately shared between the primary and secondary market departments and those handling investor complaints, with the investigation and enforcement divisions.
5. It’s Consensual
A few years ago, when SEBI was being battered by the Securities Appellate Tribunal (SAT) overturning its most significant orders, it decided to adopt the consent process made popular by the SEC to settle market disputes. Under the process, which was formally introduced in April 2007, those accused of violating the rules could agree to file consent terms and get away by paying a fine but without admitting or denying any wrongdoing. Over the past eight months, the consent process has been operating in high gear. The regulator has collected over Rs40 crore through the rapid disposal of over 400 cases. In fact, the much-hyped multiple-application scam, which was a claimed highlight of M Damodaran’s tenure as SEBI chief, has been disposed off through the consent route.
Is this a healthy trend? Or has the consent mechanism turned into a pay-and-get-away scheme because of the utter lack of transparency and clarity on how it functions and who decides the gravity of, and payment for, a particular offence? Here too, there is a high-level committee that recommends action to SEBI and orders are passed by a bench of two directors. But it turns out that the process of taking issues up to the committee has dwindled into a murky, non-transparent mechanism handled by a committee of junior SEBI officials who have turned incredibly powerful. After complaints about the arbitrariness of the consent process, some corrective action was initiated in December 2008 which will be implemented in the coming days.
The willingness to initiate corrective action is an important development, but will work better if the regulator keeps an open mind. It will then be in a position to anticipate problems instead of reacting to them. Recently, SEBI barred early exits from close-ended mutual fund schemes such as fixed maturity plans (FMPs). Had this action been initiated as soon as panic withdrawals began to hurt the funds, it would have saved investors the money they lost on hefty exit loads on premature withdrawals. SEBI has now barred premature withdrawal from close-ended mutual funds and made listing on the bourses mandatory. This is a welcome move. But SEBI must also stop the exploitation of retail investors by ensuring that mutual funds either charge an identical load to retail and large corporate investors, or have separate schemes for the two. SEBI’s other directive – mutual funds cannot have an asset-liability mismatch in investments – will also have to be checked through regular inspections.
6. Rating the Raters
Lewis and Einhorn say that the problem central to the creation of toxic debt was simply this: “that the raters are paid by the issuers.” Well, guess what? Several of us have spent years making this argument to SEBI in the context of IPO ratings. The SEBI board, in its wisdom, ignored the recommendation. It is now reworking the regulation of rating agencies to align it with the needs of different regulators in multiple markets. We will soon know whether this exercise addresses the issue of who will pay the rating agencies.
7. Stock Exchange Issues
The past year has seen several interesting developments on the stock exchange front. SEBI became the designated regulator for currency exchanges leading to the launch of three new bourses. This has led to a nasty war for supremacy, especially since the NSE has been challenged for the first time. So far, the regulator has chosen to be a spectator rather than a referee. Meanwhile, the BSE is languishing in the currency bourse too, calling attention to how the government may have ended up destroying India’s oldest exchange. Instead of a professionally managed and demutualised bourse, what the government has achieved is a rudderless organisation with mediocre management, installed by a process mandated by SEBI and the finance ministry.
SEBI has also cleared rules for an SME (small and medium enterprises) bourse which has led to howls of protest from the market because they seem so clearly structured as to ensure that only the NSE qualifies to enter this segment. The third development is an exit route for over 20 regional stock exchanges that have been languishing without business for nearly 15 years. This exit scheme seems genuinely workable if government revenue agencies do not raise new demands. Another positive move was to raise the cap on shareholding in stock exchanges from 5% to 15% for certain categories.
One gaping hole in the regulatory structure remains untouched. It is the lack of clarity about SEBI’s regulatory writ over depositories (National Securities Depository Ltd and Central Depository Services (India) Limited) and custodians such as the Stock Holding Corporation of India Limited (SHCIL). All three entities have diversified into businesses over which SEBI has no regulatory jurisdiction. SHCIL, in particular, has been embroiled in a serious scandal that is being investigated by the Central Bureau of Investigation and the Serious Fraud Investigation Office. SEBI has to clarify its regulatory mandate over these entities or ring-fence their capital market-related activities and ensure that investors’ money is protected and not used to subsidise other growth plans.
SEBI is conducting two investor surveys to understand why investors stay away from the stock exchanges – one through the Centre for Monitoring Indian Economy and the other through the National Council of Applied Economic Research (NCAER). Ironically, the last time the regulator conducted such a survey, it was immediately after the primary market crash in 1996. At that time, the NCAER survey had simply blanked out the entire IPO mania that killed the primary market for 10 long years.
It is only to be hoped that this time the surveys actually get the right investors and highlight all the issues, the red tape, the cumbersome processes and the lack of security about the safety of their savings that keeps the majority of middle-class investors away from the capital market.