Cleaning up the small-stocks stable

Why does manipulation continue in small stocks despite 'improved' regulations and controls? How effective have SEBI and the exchanges been to control price volatility and unhealthy practices.

Indian stock markets are considered among the best regulated markets in the world. Our premier exchanges, the National Stock Exchange (NSE) and the Stock Exchange, Mumbai (BSE), feature among the top five exchanges globally in terms of traded volumes, and the number of participants in the markets is quite large.

Our exchanges and regulators boast of being among the best in terms of systems and practices, in emerging markets. Even foreign investors agree that our disclosure standards and regulatory framework are better than those in most other emerging markets.

All this is true, as far as the large-cap and frontline mid-cap stocks are concerned. But when it comes to the small caps, especially the thousands listed only on the BSE, it is a completely different universe. Companies with no operations for years, no facilities and sometimes, not even valid addresses, continue to be listed on the BSE.

Among them, disclosure standards are pathetic and corporate governance is virtually unheard of. Those with some ongoing operations are controlled by a few individuals or a family, and are run as personal fiefdoms despite being publicly listed companies.

During a bull run in the stock markets, several of these small-cap stocks perform their own version of the great Indian rope trick. They step out of the closet and build castles in the air. Big plans suddenly tumble out of in the public domain through a spate of announcements and many of them just change their names to 'transform' themselves into technology companies, finance companies or whatever is the flavour of the current bull season. With the obvious backing of small-time BSE members in smaller cities, these stocks embark on their own stage show.

The show attracts a lot of ordinary folks, who are inspired to 'play' the stock markets by the obscenely high profits their friends, relatives and neighbours are rumoured or presumed to have made. By the time the show comes to an end, many of them loose their life's earnings while the promoters of these companies and their stock broker friends make a fortune.

Why does this happen in every market without fail? Why are the stock exchanges and SEBI not paying enough attention to the small cap universe to enforce better controls, standards and disclosures? Why aren't SEBI and the stock exchanges proactively curbing unethical practices, till they threaten the markets as a whole?

It is not that the exchanges don't impose controls on these stocks. They do. But most of the methods they currently use to curb high volatility and manipulation do more harm than good.

Trade-to-trade or compulsory delivery
The most common response of the stock exchanges to unusual price movements in a stock is to shift it from the normal to the trade-to-trade category (the BE series on the NSE and the T group on the BSE). Under trade-to-trade, squaring-off of trades on the same day is disallowed. In other words, delivery of the stock is compulsory and traders and cannot do day trading. The assumption is that by keeping the day traders out, the volatility can be brought down, as they account for around four out of every five trades.

The biggest drawback of this system — the way it was being implemented — is its lack of transparency. For a long while, the BSE said that stocks are shifted to the T group based on an internal surveillance of price and volume activity. Recently, it was revealed that there are indeed certain laid-down criteria for deciding on stocks to be shifted to the T group. The criteria cover a wide range from increases in price and volume to non-compliance with some of the listing conditions.

Another drawback of the system is the arbitrariness with which it is applied by the exchanges. Though things have improved now, there was a time when stocks of companies with a good management and an excellent performance were being included in the T group only because their prices had moved up with higher volumes. The criteria, which the exchanges now claim existed even earlier, were not applied uniformly.

The exchanges have also been slow in shifting stocks to the T group based on unusual activity. By the time they announce the shift, much of the movements would already have taken place.

Till some time back, shifting of a stock to the T group had a significant impact on its price. Though most traders had no idea why a particular stock was being shifted to the T group, its price used to drop significantly as soon as the exchange announced the shift. While in the T group, the volume and price volatility of most stocks did come down significantly, as day-trading interest dried up. As soon as the exchange announced the return of the stock to the normal market, its price would jump.

In recent days, shifting of stocks to the T group or their return to the normal market have not had much of an impact on their prices. If the story and momentum was strong, the stock continued its run up even while it was in the T group. The decrease in traded volumes does not have much of an impact, as traders are more willing to take delivery positions.

Limitations of circuit limits
A price circuit is the maximum allowed price movement, either way, for a stock in a single trading session. Generally, stocks in the normal category have a 20-per cent circuit. This means the stock can fall or rise only 20 per cent from the previous day's closing price. Exchanges can fix different circuit levels for different stocks and shift any stock from one circuit level to another, at their discretion. Normally circuit limits are two, five, 10 and 20 per cent. Circuit limits are not applicable to some stocks, which are part of certain specified market indices.

Circuit limits are imposed to curb extreme volatility by limiting the price movement within a specified range. The assumption is that these limits, like speed breakers on a road, help avoid large, sharp price movements by spreading the movement over a few sessions.

In reality, circuit limits give a different picture to lay investors, especially when the allowed range is small. When a stock hits the upper circuit, there will be only buyers at the counter and no sellers. This gives the impression that there is a huge unmet demand for the stock, and more traders come in to buy it in subsequent sessions, keeping it on the upper circuit for a few days more. The reverse is true when the stock hits the lower circuit.

This pattern is observed in many stocks, especially those with thin volumes, where the circuit limit is 2 per cent or 5 per cent. There are cases on the BSE when some stocks have remained on the 2-per cent upper circuit for more than 50 days at a stretch. Many of the penny stocks, which saw substantial appreciation over a short period recently, were on the upper circuit for many days at a stretch. Similarly, some of the small cap stocks have been on the lower circuit ever since the markets crashed on 22 September.

Small circuit limits on heavily-traded stocks actually increases volatility. A case in point is that of Noida Toll Bridge, which is in the 5-per cent circuit. On most trading days the stock is at the circuit limit, either on the upper or the lower circuit.

Circuit limits can have a devastating effect when the markets decline suddenly, as during last month's crash. When prices move down, traders who have taken positions with borrowed money have to pay higher margins to compensate for the lower prices of the stocks. They cannot sell and exit their positions if the stocks are on the lower circuit, even if they are willing to sell at a much lower price, as there are no buyers. Hence they are forced to sell better performing stocks, mostly frontline stocks that are not on the circuit, to raise cash and pay margins. This exerts more pressure on the overall markets, leading to a further market decline.

Circuit levels of individual stocks are lowered when the exchanges feel that volatility is too high with a higher circuit limit. When a stock starts its upward journey based on some news or corporate development, the circuit would be higher, say 10 or 20 per cent. After a few days, when the stock has appreciated considerably, the exchange lowers the circuit to 5 or 10 per cent. When the selling starts, the stock hits the lower circuit very easily, and investors who had entered at higher levels find themselves locked to the stock, as at those prices there are no buyers.

Often circuit limits, are changed by the exchanges without any apparent reason.

This problem is fairly common with newly-listed stocks. The huge over-subscription levels of recent IPOs leads to a very strong opening day for these stocks. Since there are no circuits on the first day of trading, the price is often determined by the oversubscription level. The higher the demand for the IPO, the higher is its listing price. Once it closes at a large premium to the issue price on the first day, stocks often hit the 20-per cent upper circuit for the next few days.

More and more traders come in, attracted by the 20-per cent daily gains. By the time selling actually starts in earnest, the exchanges would have lowered the circuit limit to, say, 10 per cent to reduce volatility. The stock tend to go straight to the lower circuit and stay there for the next few sessions. Buying would emerge only slowly, as potential buyers are put off by the 10-per cent daily fall.

Why allow such small stocks listed?
One of the proposals that have come up in the last two weeks is to de-list the hundreds of small cap stocks on the BSE that have no operations or negative net worth caused by huge ongoing losses. Since manipulation continues unabated despite better controls and standards, it may be better to do away with such stocks. If they are removed from the system, regulators can focus on the larger companies and improve standards and controls further.

Till very recently, the BSE had a vested interest in keeping these stocks listed, as the exchange was managed by brokers, often with many of them having been active traders in these stocks. Moreover, the exchange would also receive a listing fee from each of these companies.

The exchange has now been corporatised and is planning an IPO. Any recurrence of manipulation within the exchange in the future would severely damage its credibility. It would be in the BSE's own interest to remove these stocks from its system. Better confidence in the exchange would result in higher traded volumes of large and better quality small stocks. The loss in listing fee revenues can be more than made up by the increase in trading fee income from higher volumes.

But what will happen to the small investors who are stuck with these stocks? They should be given an exit option. The promoters of these companies could be asked to buy out the minority shareholders, wherever possible, and de-list the stock. The exchange can increase the listing requirements and ask these small companies to comply with them within a specified period. This would encourage some promoters to buy out minority shareholders and de-list the stock.

Another option would be to shift stocks of all companies with a low capital base to a different trading platform, like the recently launched BSE Indonext. On this new platform, only delivery trades should be allowed, with a 100-per cent trading margin. Further controls like holding limits for individual investors can also be considered. Here also, disclosure and corporate governance standards should be improved to the levels applicable for large cap stocks.

Who should be the watchdog?
Being a quasi-judicial body responsible for the overall regulation of all Indian stock exchanges, SEBI should not be burdened with the day-to-day surveillance of trading activities. SEBI itself needs to improve its investigative skills and enforcement systems.

Right now, SEBI's conviction rates for past offences are very low and many of its high-profile orders have been overturned by the appellate tribunal. It should focus on bringing out regulatory guidelines to ensure best practices, and conduct investigations into reported violations.

Ideally, SEBI should not be involved in vetting public issue prospectuses of companies and mutual funds. It should limit its role to framing guidelines and leave the routine administration to another agency. This way it would be able to concentrate its resources to investigating serious violations of guidelines and unhealthy practices.

At present, the exchanges themselves carry out some monitoring and checks. For example, it is their responsibility to ensure that companies adhere to listing conditions. This would not be an ideal situation in future, when shares of the companies operating the stock markets, like BSE Limited, start trading on the exchanges. They cannot monitor and check on themselves.

We need a separate body to police the routine compliances and disclosure requirements of companies. We also need regular surveillance of trading activity, independent of the exchanges, as against the current practice of 'watching the situation' only when things go wrong. This body could initially be set up as a part of SEBI and granted a legal status subsequently. Many developed markets have such independent bodies.

We already have a Central Listing Authority (CLA), formed by SEBI more than two years ago, with a retired supreme court chief justice as its chairman. Its job, initially, was limited to scrutiny and approval of public issues. The CLA did, in fact, scrutinise some IPOs referred to it. Unfortunately, the body has not met even once during this financial year, casting an uncertainty over its present status and role.

SEBI should take immediate steps to empower the CLA by providing it with the necessary resources. The CLA should recruit its own staff and, perhaps, some of the compliance staff currently working for the exchanges. The government should consider giving this body statutory recognition, to make it truly independent and effective.

The events of the last half of September prove that at least a segment of our stock markets have a long way to go to ensure better transparency and attain investor confidence. It is high time the government and SEBI come up with the necessary measures to ensure that the small cap mess is cleaned up. If the situation continues to remain the same, it may affect investor confidence in the stock markets in general. That would not be a very healthy development when the world, at very least, has started talking about India.