Sucheta Dalal :Bringing them to book
Sucheta Dalal

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Bringing them to book  

November 22, 1999

This week, as the Securities and Exchange Board of India plays host to the Emerging Markets Committee meeting of the International Organisation of Securities Commission, it is a good time to draw attention to a foreign practice which is distorting the primary market in India, confusing investors and creating one hell of a lot of problems. Yes, I am referring to book-building, the new big money business for investors and source of bafflement for brokers and investors alike.

The saga of creaming off money from investors, which began with the Hughes Software issue, continues with the HCL Technologies one. Hughes Software was the first issue to experiment with book-building. For the company, its investment bankers, and those investors who received shares it was a big success. A source connected with the issue tells me that the entire show, including all decisions, were managed by investment banker Kotak Mahindra Finance (not the second investment banker). The management is clueless about the stock market and chooses to remain that way.

My semi-official source cites this as Hughes Software's excuse for not reacting to investor complaints or responding to them. He also tells me that every aspect of the issue, including the extortionate services charges, were specifically cleared by SEBI.

Curiously, SEBI's top officials not only seemed ignorant about service charges being collected by the investment banker, but asked that they be refunded after our complaint (Kotak Mahindra had been collecting a non-refundable service charge ranging from Rs 2,000 to Rs 5,000 on applications for 100 to 500 shares respectively). It has also allowed them to pocket a further Rs 250 per application as processing charges which is equal to buying an application form for that amount.

Why rake up old issues?Because book building is a new phenomenon and the first few issues are going to be allowed to rip off investors by pleading trial-and-error leeway. So the first two issues need to be examined together.

Since the Hughes Software issue opened at a high of over Rs 1,800 as against the upper end of the offer price of Rs 650 one could well conclude that Kotak Mahindra underpriced the issue giving chosen successful allottees a massive profit on listing. In the circumstances, it obviously believed it had the right to collect service charges for the privilege of allowing an investor to apply.

The loser is obviously the company; but we do not know its arrangement with the lead manager Kotak Mahindra. If the investment banker was to handle the issue right from pricing and pre-issue hype to allotment, it probably expects to earn more than mere investment banking fees.

Incidentally, have you noticed how no business publication wrote about the service fee collections in the Hughes Software issue? As far as I know there have been only two exceptions. Brokers of the Ahmedabad Stock Exchange were angry enough to threaten that they would lobby with their exchange to disallow listing of the issue. But nothing was reported. Clearly when a share is offered at Rs 650 and is primed to open for listing at twice the price, it is a high stakes game that ensnares everybody.

HCL Technologies has come up with a slight variation in the book-building game. Investors are asked to bid but are not even given daily statistics about the number of bids that have come in: all the action is behind-the-scenes. The book runners have been quietly informing big investors that the placement will be at around Rs 800. Retail investors are playing safe by bidding at the upper end of the price band, but with only 15 per cent of the issue reserved for them allotment seems like a lottery.

The HCL Technologies issue will be a trend setter considering the issue size which will be in the range of Rs 710 crore to Rs 823.6 crore. The variation in the issue size is due to the price band of Rs 500 to Rs 580.

There is a bigger problem in the higher category. Applications above 500 shares are to be allotted entirely at the discretion of the investment bank. Also there is no application money and no commission offered to brokers. This means the bulk of the issue goes only to syndicate members and their friends. Clearly a recipe for lots of games to be played by everybody. Syndicate members confident of being allotted shares and making a killing on listing are busy doing deals. They are offering brokers unofficial commission procuring applications. A couple of South-based banks have been offered a 1.4 per cent commission.

The stakes are even higher for large investors. According to one market source, a fund manager who runs a $ 40 million fund told him that his organisation had cleared an application for US $ 150 million, since there is no application money to be paid. This is simply preposterous. He hopes that with an application this size, he will at least get $ 5 million and make a huge killing on listing.

He is not stopping at that. He is cementing his case by giving business to the brokerage firm run by the investment banker and creating a quid pro quo. Such applications will only create frenzy and drive up prices. Fund managers get the perfect opportunity to dump the stock on listing and make big money. Remember how Hughes Software, which opened at over Rs 1,800, was hammered to around Rs 1,500 by fund managers last week?

All over the world the book-building method of making IPOs is a rip-off. The stakes for bagging an investment-banking mandate of good companies are so high because of all the perks that come along. The banker chooses the syndicate, allots shares to who he pleases and generally calls the shots.

But in a highly developed market with a large number of savvy funds the scope for outrageous price bands and frenzy is limited. Even companies demand the correct price and the scope for imperfections is limited. In India, the offering is to a largely illiterate market. It is bad enough that investors do not study a prospectus but they are also capable of killing the market when they burn their fingers and lose interest. This is bad for the system.

In these circumstances it is SEBI's job to ensure that the book-building experiment does not kill the primary market. Indian regulation should provide for the imperfections of its market and this involves ensuring some amount of fair play.

One simple way of ensuring this is to demand that some amount of application money is mandatory. This will ensure that bids are not outrageous. Not only is the market imperfect, but the regulator too is not as alert. SEBI does not act quickly or decisively; so it is best that it reduces the discretion available to investment bankers until the market is mature enough to handle it. After all, SEBI is expected to develop the market and that can happen only gradually.

Remember Prudential Insurance of US, which was granted registration to act as a Foreign Institutional Investor in India? After we wrote that it had been indicated by US courts, fined for destroying documents and made to return $ 450 million collected from policy holders by misrepresentation SEBI had decided to cancel the registration.

We now hear that the US company has lobbied hard and SEBI has second thoughts. It argues that even in the US it has only been fined but not stopped from doing business.So why should it be kept out of India? Because Indian rules for registration of FIIs demand that they should be reputable; this clearly excludes companies indicted for malpractice.

Further, if the US investigators did not catch Prudential for 13 long years, it will be worse in India. If caught, it will never be punished because litigation will go on for decades. In these circumstances, SEBI would better stick to the rulebook and keep it

-- Sucheta Dalal