When the Securities and Exchange Board of India (Sebi) decided to scrap discretionary allotment for qualified institutional buyers (QIBs) and switch to the more transparent proportionate allotment system, it became the first regulator to stand up to the powerful investment banking community anywhere in the world. Once the decision was taken, it was evident that the exaggerated outrage and predictions that large institutional investors would shun IPOs were completely baseless.
That decision recognised the specific needs of the Indian capital market and was the result of pressure from investor groups. The path to mandatory grading of IPOs has been rocky, with enormous opposition from companies, investment bankers, fund managers, market experts and Sebi board members. We learn that the final decision came about in the face of strong opposition by certain board members (apparently not full-time) and that too only, with a twist in the tail, which dilutes the original proposal.
The alleged opposition of the regulator’s board members raises an interesting question. All board-level discussions must, indeed, remain confidential in order to ensure free and frank expression, but what is the fiduciary responsibility of board members of a watchdog organisation, who have no knowledge, training or expertise about capital markets, when they choose to oppose recommendations of the Primary Market Advisory Committee that are endorsed by the regulator? It is also important to remember that investor groups have been pressing for IPO grading for several years; first with the Investor Education and Protection Fund (attached to the ministry of company affairs), which developed cold feet and dropped even its plans for a pilot project and later with the capital market regulator.
Over the years, those opposed to IPO grading have constructed several elegant arguments to rubbish its utility, but from an investor standpoint, the logic is simple. The disclosure-based model adopted by the regulator, leads to a bulky, jargon-filled prospectus that can neither be read nor understood by the average investor; consequently, a simple, one-page evaluation of disclosures by an expert agency, which also helpfully condenses its findings into a single numerical grade on a scale of five, is clearly a blessing. The offer price of the IPO will remain an important factor in the final investment decision—after all, even the best companies can be bad investments at the wrong price. But that is a reasonable decision to leave to the investor.
The twist in the tail is in Sebi’s decision to permit companies to shop for ratings by asking them to pay for the rating themselves
Secondly, just as debt market ratings offered a good basis of comparison when there was a large enough body of ratings, the efficacy of IPO ratings will improve when more ratings are available to provide benchmarks and peer group comparisons. Today, mutual funds and portfolio managers are notorious for striking deals with issuers to ensure the success of overpriced, low-grade IPOs. Ratings will force them to restrict such deals to fundamentally strong companies, even if they goof up on pricing. That is because investors will now have a basis for challenging questionable investments.
The twist in the tail is in Sebi’s decision to permit companies to shop for ratings by asking them to pay for the rating themselves. Even when Sebi cleared optional grading (a non-starter), it was clear that the ratings would be paid for by investor protection funds of exchanges. The two national bourses between them have over Rs 300 crore as investor protection funds and were willing to pay out the fee of around Rs 5 lakhs (estimated by the leading rating agencies). Why then would the SEBI board decide otherwise? At a time when modern good governance rules ensure that every management decision by listed companies is scrutinised by their independent directors, why shouldn’t the regulator’s decision be open to public scrutiny?
For investors, the good news is that rating agencies that choose to rate IPOs will be under public scrutiny themselves. Unlike the rating of debt, which is monitored only in a select group of institutional investors, IPO ratings will be watched by millions of investors. How IPO grading will eventually work depends on whether they are properly publicised. Sebi will have to mandate clear disclosure of the grading in the prospectus as well as public issue advertisements. For instance, Orbit Corporation, which voluntarily opted for an IPO grading, was assigned the lowest grade of 1 out of 5 by the rating agency Care. Orbit published its rating only when pressured by Sebi, but even then, it merely mentioned that it was assigned a grade of 1, without saying that it would the lowest on a five-point scale, leaving plenty of scope for investors to assume the opposite.
Having said that, the Sebi board has done well to tighten disclosure norms for realty companies before they turned into an embarrassment for the regulator. There have been far too many instances already of companies that raised money through exaggerated and/or outright dubious land-bank claims or have rampantly manipulated post-IPO prices on the secondary market through fake claims.
Sebi has plugged the first loophole by asking companies to separate ownership from mere agreements to purchase land and make all documents available for scrutiny if required. Valuation of land-banks will have to be based on current prices and not on future projections, and there will have to be on-going disclosure of developments.
Given that realty companies hope to raise Rs 16,000 crore from the market this year, the Sebi decision couldn’t have been more timely.