Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 29 Nov 2006

Foreign Investment in Indian Exchanges

I wrote a piece in the Economic Times on Monday about permitting foreign investment in Indian exchanges. I wrote:

The ownership of exchanges should be largely left to market forces with minimal regulatory intervention. The regulatory goal should be to ensure that the securities trading industry is highly competitive. The death of the trading floor and the rise of electronic trading platforms have completely changed the nature of exchanges.

From being cosy clubs, they have become complex businesses that are technology driven. In the process, they have also become highly capital intensive. The ability to respond to the demands of a highly sophisticated and global user base has become paramount. SEs and derivative exchanges now require investors with deep pockets and willing to make the strategic investments required to grow the business.

Any attempt to exclude such investors tends to favour incumbent exchanges and perpetuate existing monopolies and duopolies. From the social point of view, this would lead to a less competitive and therefore less vibrant, less innovative and less investor-friendly capital market.

We must welcome foreign investment in our SEs and commodity derivative exchanges as well as the exchange-like entities that trade currency and fixed income products. SEs and derivative exchanges enjoy very attractive valuations in global markets today and we must allow our exchanges to tap these global markets to raise capital. Foreign exchanges and other strategic investors could also help revive and strengthen the less well performing exchanges and thereby foster greater competition.

India’s position on foreign ownership should be the same as that of the Financial Services Authority of the UK which has stated: “We will be indifferent to the nationality of the owners or the managers of the London Stock Exchange, and will be concerned to ensure that the future operation meets our regulatory standards.”

We too should focus on strengthening our regulatory framework so that ownership of the exchanges becomes irrelevant. We must not allow the incumbent exchanges to wrap themselves in the flag and appeal to our xenophobia to block much-needed competition.

Posted at 18:56 on Wed, 29 Nov 2006     View/Post Comments (2)     permanent link

Sat, 25 Nov 2006

SEBI Disgorgement Order - Response to Comments

Some of the comments on my previous post have made me realize that I did a poor job of explaining why it is incorrect to simply make restitution to the genuine retail applicants in the so called IPO scam. As I started fleshing out the details, I found that it takes a rather long post to explain why I say this though issuers have the freedom to price their shares and the price paid by the retail segment is the same as that paid by others. There are two aspects to my argument.

The first point is that in equilibrium in an efficient market, a person who has not applied to an oversubscribed offering would not expect to make any gains by applying. The costs of applying (including the costs of analysis, costs of financing and the transaction costs of applying and bidding) offset the expected gains of a successful application (times the probability of success) after appropriate adjustment for the risk that during the period up to listing, the fundamental value of the share could drop below the issue price.

This equilibrium is achieved by a rise in the rate of over subscription and a concomitant fall in the probability of success falling until equality of costs and benefits is achieved. In the non retail segment this happens at high levels of over subscription because of the lower transaction costs and the ability to make large applications. In the retail segment, this equality is achieved at lower levels of over subscription because of higher search and analysis costs, higher financing costs and the higher transaction costs of applying in multiple names (legally or illegally).

The fictitious applications reduce the allotment rate and thus the expected benefits from applying. They thus reduce the gains to those who do apply. But they also deter many retail investors from applying at all because the reduced expected gains are now below their costs. Thus the fictitious applications inflict some losses on those who applied and some losses on people who did not apply at all. The key point is that in the absence of the fictitious applications, some genuine applicants (with high costs of applying) would have applied and reduced the success rate of the actual genuine applicants. It is thus a mistake to compute the losses suffered by the actual applicants by simply recomputing the allotment proportion after deleting the fictitious applications. True restitution would have to be to a much larger pool of potential applicants and not to the actual applicants. This is operationally very difficult. More importantly, even this analysis is flawed because of the analysis that follows next.

The second point is that the retail segment is permitted to bid at the cut off price. This has the potential to substantially reduce the contribution of this segment to price discovery. The under pricing of IPOs is a complex subject but at bottom under pricing can be regarded as a compensation for price discovery in the presence of asymmetric information. Succesful applicants normally earn their gains by contributing to price discovery. Those whose costs of analysis are lower earn more and those whose costs are higher earn less and the marginal investor earns nothing at all (this last statement simply rephrases my first point). But the retail segment has the ability to benefit from under pricing without contributing significantly to price discovery. The under pricing of the retail segment is then a dead weight loss to the company and its shareholders. The gains made by this segment are “rents” earned without doing anything economically useful and are thus “ill gotten”.

This argument can be made even without the ability to bid at cut off prices, but the argument then becomes more subtle. The point then would be that the retail segment crowds out more efficient investors whose information processing costs are lower and thereby forces the company to pay more (in the form of under pricing) to obtain price discovery. This again results in a dead weight cost on the company.

Therefore, I argue that the best way of achieving restitution of the ill gotten gains of the fictitious applicants is to pay this amount to the company and through it to its shareholders. Theoretically, the next best alternative is to pay it to all potential applicants to the issue. This is operationally infeasible. The naive alternative of restitution to those who happened to apply to the issue is simply wrong and indefensible.

Posted at 15:19 on Sat, 25 Nov 2006     View/Post Comments (2)     permanent link

Wed, 22 Nov 2006

SEBI Disgorgement Order

The Securities and Exchange Board of India has passed a bizarre “disgorgement” order for over rupees one billion (approximately $25 million) against both the depositories in India as well as a number of depository participants involved in the IPO scam that I blogged about last year. The most charitable explanation is that this is a penalty masquerading as a disgorgement. The less charitable explanation is that SEBI is merely behaving like class action lawyers who routinely proceed only against those with deep pockets because that increases the likelihood of recovering something if they succeed on the merits.

The IPO scam involved people submitting multiple applications in fictitious names to increase their allotment in a fixed price IPO. The disgorgement order does not target any of those who perpetrated the fraud but is directed against the depositories and the depository participants who opened the demat accounts used by the fraudsters. SEBI says in its order that “it stands to reason that the Depositories and Depository Participants who enabled the opening of numerous demat accounts (afferent accounts) in fictitious / benami names either by turning a Nelson’s eye to the compliance with KYC norms prescribed by SEBI or by actively participating in the scheme designed by the key operators and the financiers, should be held liable for the loss caused to innocent retail investors. Had each market participant played their respective roles diligently with a degree of real time sensitivity, the rampant cornering of IPO allotments, particularly on this scale would not have taken place. The failure of each intermediary in the hierarchy of intermediaries contributed cumulatively, (jointly and severally) to the market abuse.”

There are many problems with this theory. First of all, disgorgement is not about liability for loss caused to investors. In its own order, SEBI states the legal position regarding disgorgement as follows:

It is well established worldwide that the power to disgorge is an equitable remedy and is not a penal or even a quasi-penal action. Thus it differs from actions like forfeiture and impounding of assets or money. Unlike damages, it is a method of forcing a defendant to give up the amount by which he or she was unjustly enriched. Disgorgement is intended not to impose on defendants any demand not already imposed by law, but only to deprive them of the fruit of their illegal behavior. It is designed to undo what could have been prevented had the defendants not outdistanced the investors in their unlawful project. In short, disgorgement merely discontinues an illegal arrangement and restores the status quo ante (See 1986 (160) ITR 969). Disgorgement is a useful equitable remedy because it strips the perpetrator of the fruits of his unlawful activity and returns him to the position he was in before he broke the law. The order of disgorgement would not prejudice the right of the regulator to take such further administrative, civil and criminal action as the facts of the case may warrant.

Similarly a report prepared by the US Securities and Exchange Commission pursuant to the Sarbanes-Oxley Act describes the legal position regarding disgorgement:

Disgorgement is a well-established, equitable remedy applied by federal district courts and is designed to deprive defendants of “ill-gotten gains.” In contrast to actions for restitution or damages in private actions, which are brought to compensate fraud victims for losses, disgorgement orders require defendants to give up the amount by which they were unjustly enriched. Before exercising their discretion to order defendants to pay disgorgement, courts have required findings that a causal connection exists between the defendants’ wrongdoing and amounts to be disgorged. “[D]isgorgement extends only to the amount with interest by which the defendant profited from his wrongdoing.” To assist in determining the amount of disgorgement, the Commission often seeks, and courts require, that defendants provide an accounting of the funds and other assets they received in the course of their wrongdoing. In ordering disgorgement, courts have not required the Commission to determine the exact amount of the defendant’s ill-gotten gains. The Commission has the burden, though, of showing that the amount sought is a “reasonable approximation of profits causally connected to the violation.” Once the Commission has satisfied its burden, a defendant who asserts that the amount should be less has the burden of demonstrating that the amount should be reduced. As long as the measure of disgorgement is reasonable, courts have held that the wrongdoer should bear the risk of uncertainty regarding the precise amount. [footnotes omitted]

The only ill gotten gains for the depositories and their participants would be the account opening charges and transaction fees that they levied on the fraudulent demat accounts. This would be a miniscule fraction of the billion rupee disgorgement that has been ordered.

The second problem is that the deficiencies pointed out in the SEBI order against the depositories and their participants are largely in the nature of negligence or lack of diligence. The appropriate response to that is a penalty or a suit for damages.

Another problem is the joint and several liability that is imposed by this order. Joint and several liability is rooted in the principle that a wrongdoer is liable for the reasonably foreseeable acts of his fellow wrongdoers committed in furtherance of their joint undertaking. US courts have held that joint-and-several liability is appropriate in securities cases when two or more individuals or entities collaborate or have close relationships in engaging in the illegal conduct. It is difficult to see how this applies to several depository participants acting largely independently of each other.

Above all, it must be remembered that from a finance purist’s point of view, the notional gain made by even the genuine applicants in the retail quota of the IPO are in some sense “ill gotten gains” as they were given shares at less than their fair value. This gain really comes at the cost of the existing shareholders of the company and of those who bought shares under the non retail quota. Thus we should not get into the trap of believing that the IPO scamsters defrauded the genuine applicants in the retail quota. The correct way of looking at the situation is that the retail quota itself amounted to looting the company and the scamsters only changed the proportion in which this loot was shared. If the so called disgorgement were ever to be turned into a restitution, the recompense must go the company that did the IPO (and therefore to all its shareholders) and not to the genuine applicants in the retail quota.

Finally, the SEBI order raises serious questions about the capital adequacy of the depositories. If this is the kind of liability that SEBI intends to fasten on the depositories, they need to have a lot more capital than they currently have. The joint and several liability that the order imposes on the country’s largest depository, NSDL, represents 45% of its net worth as disclosed in the the 2005-06 annual report. It needs to have a lot more capital to protect against actual losses caused to investors by failures in its systems.

Posted at 09:38 on Wed, 22 Nov 2006     View/Post Comments (5)     permanent link

Wed, 15 Nov 2006

Edgar Full Text Search

The US SEC has at long last enabled full text searching of its Edgar database of corporate filings. The new search page is here. In the past, searching Edgar was quite painful and I usually went to Edgar only after identifying the form type and approximate filing date through other sources. Now it is much simpler. For example, I clicked on “advanced search” and typed in “pretexting” in the “text” field and “Hewlett Packard” in the “Company Name” field and I obtained links to the two 8-K filings on this issue that I have blogged about earlier.

Under Chairman Cox, the US SEC seems to be taking the internet quite seriously. Cox posted a comment on a blog recently in his official capacity. He is also pushing for adoption of XBRL in Edgar filings. Regulators elsewhere have a lot of catching up to do. I hope that the Securities and Exchange Board of India (SEBI) upgrades its Edifar database to include the full text of the financial statements (and not just the summary financial numbers) as also the material event disclosures that companies currently make only to the exchanges. Only after that can one start asking for search capabilities!

Posted at 08:04 on Wed, 15 Nov 2006     View/Post Comments (0)     permanent link

Tue, 07 Nov 2006

XBRL and Financial Statement Preparation

I wrote an article for CFO Connect about the use of (eXtensible Business Reporting Language (XBRL) in the preparation of financial statements rather than just for their dissemination and analysis. Scanned image is available here.

Financial analysts have begun to love XBRL and the US SEC is also now pushing companies to use XBRL in their Edgar filings. Companies however tend to think of this as another investor relations expense rather than as a productivity tool for themselves as preparers of financial statements. I argue on the other hand that it is high time that we got rid of all those spreadsheets and word processor files and used XBRL to automate the process completely and integrate it completely with the corporate ERP systems. This would improve reliability, increase speed and reduce manual interventions.

Posted at 14:19 on Tue, 07 Nov 2006     View/Post Comments (0)     permanent link

Sat, 04 Nov 2006

Ownership of Exchanges in India

I participated in a discussion on the CNBC TV channel last night on the ownership of Indian exchanges. This issue has become controversial because of the reported desire of the government and the regulators to discourage Indian companies and foreign entities from becoming strategic investors in Indian stock exchanges

My views on this are very simple. It is far more important to ensure that the securities trading industry is highly competitive than to regulate the ownership of exchanges. Stock exchanges are highly capital intensive technology driven businesses which require deep pocketed investors who are willing to make the strategic investments required to grow the business. Any attempt to exclude deep pocketed investors tends to favour incumbent exchanges and perpetuate existing monopolies and duopolies. From the social point of view, this would be a most unfortunate outcome as it would lead to a less competitive and therefore less vibrant, less innovative and less investor friendly capital market.

Much has been written about the alleged conflict of interest that would arise if certain categories of investors were to become controlling shareholders of exchanges. It has been suggested that ownership by financial institutions is the best solution. I do not agree with this view at all. Almost any potential owner of an exchange is conflicted because of the pervasive role of stock exchanges in a modern market economy. Financial investors are among the most highly conflicted of all potential owners. Some of them own broking subsidiaries and it is surely absurd to get rid of broker ownership only to reinstate it through the back door. All banks and term lending institutions live in mortal fear of the capital markets disintermediating them out of existence. Sixty years ago, the conflict of interest between banking and capital markets was taken so seriously that the US passed the Glass-Steagal Act prohibiting banks from owning securities firms. That was surely silly, but the idea that they are the best possible owners of stock exchanges is even more silly.

It is only an anti capital market mind set that can think of financial institutions as preferred investors in exchanges. Unfortunately, that mind set is in abundance in policy making circles in India.

Posted at 14:19 on Sat, 04 Nov 2006     View/Post Comments (4)     permanent link

Thu, 02 Nov 2006

US CFTC Policy on Foreign Exchanges: Lessons for India

The US Commodities and Futures Trading Commission (CFTC) has issued a statement of policy regarding foreign exchanges offering their products in the United States. This issue had become controversial in the context of the UK based ICE Futures trading US energy contracts in the US that I blogged about here.

The CFTC has decided to maintain the existing policy framework of exempting exchanges like ICE from US regulation. In particular, the CFTC states that:

  1. the trading volume originating in the US is not determinative of US location
  2. the fact that the contract is based on a US produced or economically important commodity is not probative of location

These put to rest the two critical arguments that were raised against ICE Futures.

I think the CFTC has shown the way for regulators in India to allow foreign exchanges to offer their contracts directly in India through electronic trading platforms. The RBI now allows Indian citizens to remit up to $50,000 a year outside India for investment purposes. What better thing can we give these investors than the ability to buy foreign stocks or bonds or derivatives sitting in front of their computer screens in India? We must not let protectionist arguments prevail in denying Indian residents the best investment opportunities in the world and force them to park their money in foreign bank deposits.

What is more, acceptance of the CFTC principles would allow foreign exchanges to offer trading in India on ADRs of Indian companies provided the Indian investor pays for them in dollars. This would produce better price discovery in the ADR market and reduce the price gap between the Indian and offshore markets.

Posted at 13:29 on Thu, 02 Nov 2006     View/Post Comments (0)     permanent link