Cleaning up the markets

Over the past few weeks, newspapers have been full of advertisements of some of the most amazing corporate turnaround results you can think of. In just the quarter ended December, for instance, one textile company, India Polyspin Limited from Surat, recorded close to double the sales it had in the full 12-month period last year!

Another software firm, InnoVision eCommerce Limited of Pune, that provides “software solutions & internal messaging systems” to companies like “Hindustan Leaver” (that’s how the company’s ad spells it) saw profits in the last quarter grow almost 18 times that for the full 12 months of 2002-03.

Naturally, with such huge spurts in profits, if there’s any huge surge in the share price, few will suspect any manipulation.

Well, what the Bombay Stock Exchange (BSE) did was quite remarkable, especially given the somewhat relaxed manner in which authorities police the market in India.

It called some of these companies to tea with members of its Listing Committee, to figure what was behind these fantastic unaudited results. So, companies were asked to give details of the new customers they had, the number of employees, and so on.

Now, if the company had 10 new customers but if the number of employees required to service these customers had fallen, there was clearly a discrepancy that needed further exploring — basically, if promoters were lying, they’d get caught in their own web.

Last week, India Polyspin and InnoVision eCommerce were transferred to the exchange’s Z category of shares as the “fundamentals of the companies, in the discretion of the Exchange, (were) weak”.

Some brokers who were involved in moving scrips of these companies were also reported to Sebi for further investigation, and a front-page advertisement was put out in major newspapers warning investors to be wary of unaudited financial results of companies.

Another important innovation made by the BSE that could go a long way in cleaning up markets relates to the “free float” concept. The principle behind moving to the free-float was simple: all scrips don’t have the same percentage of free-floating stock (typically, government-owned firms have very little stock available in the market for trading), but what matters to investors is really the stock that’s available for trading.

Clearly the stocks owned by the promoters were not free-float. Similarly, stock owned by relatives and business associates was also unlikely to be free-float, as also stocks owned by venture capital firms, collaborators, group customers/suppliers and the like.

While some of this information was already available through clause 35 of the Listing Agreement, it was not adequate to determine the free float, and that’s why BSE designed a new format. A key element of the revised form forces companies to categorically state if shareholders are related to the promoters.

The response to the new forms was slow initially, but an efficient follow up ensured launch of the free float Sensex in September last year.

The new form also seeks the names of real owners of GDRs/ADRs (so you know if the GDR/ADR money is from genuine investors, and not just the promoters’ own funds).

It also seeks the address and the father’s name for each shareholder who owns more than one per cent of the company’s stock — again, this is a tool to see if seemingly unrelated shareholders are related.

In the case of Home Trade, for instance, what tripped up Sanjay Agarwal was that when the shareholders list was put through a data-check, it was found that one address in Kolkata was the registered office for quite a few finance firms, and that address was that of a relative of Agarwal — once this was done, it was found that the promoter’s shareholding in the firm was not 62 per cent but more like 92 per cent.

If the new form is introduced, a large number of companies shall be hauled up for wrong disclosures in the past.

But, more important, the new form is vital for effective enforcement of almost every Sebi regulation, on insider trading, on takeovers, and so on — in each case, it is critical to clearly identify the complete list of promoters/persons in control.

Take the case of insider trading. It is obvious that the first person to have any information about a company is the person who controls it.

So, if the public knows who are the people who control the company, any buying and selling of shares by them will be closely watched. Anyone who’s familiar with Indian corporates also knows that most owners have scores of investment firms that hold their shares.

But since it is not known these investment firms belong to the owners, their trading in the parent company’s shares is never exposed as insider trading.

In fact, this is the reason why India has such a poor record in catching promoters involved in ramping up their shares — all transactions are made by seemingly independent investors!

While the new disclosure norms are clearly a very useful tool to spot insider trading, and for investors to know if there’s any hanky-panky in a surge/fall in a company’s scrip, the BSE is not really in a position to enforce the new disclosures.

The onus rests with the regulator and this obviously has to be done in participation with all market players. For example, depositories like the NSDL will have to amend their software to build in a new information field, and they would need to address the issue of additional costs.

And there’s little point BSE asking for such disclosures if the NSE doesn’t. So, if Sebi mandates all exchanges and other market-participants to collect and then make such information public, the rampant insider trading prevalent in Indian markets could then, largely, be a thing of the past. Think of it.