SEBI: Regulator Challenged

One of the perceived advantages that Indian stock markets have over other emerging markets is its regulatory framework. Our stock markets are among the most liquid with large retail participation. We have moved to electronic trading and settlement ahead of other markets without any disruption.

All these factors have given foreign investors considerable confidence in Indian markets. This is one of the reasons behind the huge overseas investment flows into the Indian markets over the last few years.

However, this confidence of both domestic and overseas investors may be shaken if SEBI does improve its track record of surveillance, supervision and investigation. The regulator is being buffeted by a multitude of challenges and it finds itself usually ineffective and slow in reacting to fast changing developments.

Making a mess of the IPO scam investigation
The way SEBI handled the IPO allotment scam clearly brings out the shortcomings of the market regulator. Inadequacies of market surveillance allowed scamsters to carry on milking the markets at the cost of genuine retail investors unhindered for more than two years. Even three months after discovering the scam, it has yet to come up with concrete measures to plug loopholes.

The investigation took a long time even with the help of an outside agency, reportedly a CA firm. At the end of the investigation a very lengthy interim order, with several tables and other data, was passed. The order had considerable ambiguity and caused much confusion. The following day, SEBI had to issue a clarificatory order to clear the position to investors.

IndiaBulls, one of the companies mentioned in the order, made a representation the very next day – carrying documentary proof to the SEBI office as shown by various television channels. SEBI accepted their defence and decided to suspend its order against the company.

If a decision taken against a company after months of investigation can be suspended after examining the documents produced by the company for a couple of hours, it puts the investigative rigour of SEBI and its hired agency in very poor light.

Suspension of the order against IndiaBulls encouraged the Karvy group, against whom much more serious charges have been levelled by SEBI, to take a more aggressive stand and brazenly defend its role in public. Will the investigations completed by SEBI against Karvy stand a more detailed scrutiny or will the order be overturned by the Securities Appellate Tribunal (SAT)?

The markets reacted to the flip-flop by SEBI in the IPO scam on expected lines. The day after the order was passed, the indices crashed before recovering later on news of the suspension of the order against IndiaBulls. Trading was extremely volatile, once again, as can be expected after such a significant development.

The SEBI chairman promptly blamed "a group of operators" for the volatility and promised an investigation. Even if a mysterious group exists, it was the really regulator's flip-flop which, allowed it to cause such volatility in the first place.

Information leaks and selective disclosures
In most markets across the globe, it is very common to find stocks rallying ahead of major positive announcements like takeovers, expansion plans, capital issues, etc. Curbing trading based on insider informed (informed trading) ahead of such developments is a major challenge for market regulators.

A recent study by the Financial Services Authority (FSA), the UK market regulator, detected such informed trading patterns in nearly 30 per cent of the 350 stocks on the FTSE350 index of largest companies listed in London.

In India, despite frequent statements from its officials, SEBI has yet to publicly announce any such investigation or study into informed trading. It is not because such instances are rare in this country. In fact, informed trading has been witnessed in almost all stocks including those of companies belonging to the largest industrial houses.

Stocks of companies belonging to the Anil Ambani group, have seen very significant rallies ahead of announcements. Stock prices of Reliance Energy and Reliance Capital gained substantially last year, before it was announced to the public that promoters would pump in money through preferential allotments.

Similar price movement was seen in the Reliance Natural Resources stock this year before the announcement of a preferential issue. The stock appreciated more than 100 per cent within a few days before falling back after the announcement.

The stock of Mphasis BFL appreciated considerably in the two weeks prior to the announcement of a takeover bid from EDS. In March, Zee Tele jumped nearly 50 per cent before the company announced a restructuring plan.

Even stocks of companies belonging to the Tata Group, widely regarded as the cleanest Indian business group, have witnessed such price movements. VSNL appreciated substantially ahead of the news of its acquisition of Teleglobe.

Whenever there is a media column or a report on such informed trading, SEBI officials promise a prompt investigation. Nothing evident seems to have emerged out of the frequently promised investigations so far.

The forgotten small stocks investigation
The market surge this year has, more or less, erased the bitter memories of the brief but sharp market correction, just six months back in October 2005. The correction was triggered by a SEBI investigation into price rigging in some small stocks.

These stocks had seen incredible price appreciation over short periods after the companies kept on making favourable announcements at frequent intervals. The trading patterns of promoters and some operators in these stocks were timed to benefit from the stock price movements following the announcements. After the preliminary enquiry, SEBI passed orders against some of the promoters, leading brokers including IndiaBulls, large market operators, etc.

Even after six months SEBI has not come out with a final order or taken any further action against the promoters or brokers. It is not even clear if the investigations have been completed.

Meanwhile, mid-cap and small-cap stocks, which had corrected substantially following the SEBI order, have rallied back and gone past their previous highs.

While some of the companies investigated by SEBI have gone completely silent, others are back in business. Prime Property Development, one of the companies against which SEBI had taken action, has announced yet another 'high profile' property venture.

Stock analysts on TV
SEBI guidelines require stock market analysts giving advice on public media to disclose their positions in the stocks mentioned. Given the large number of television channels, newspapers, websites and other media covering the stock markets, monitoring analyst recommendations and disclosures would not be easy.

Recently SEBI took action against Mathew Easow, a Kolkata-based technical analyst, for having trading positions contrary to his own recommendations on CNBC and its website. He was barred from giving any investment recommendations in public media.

In one of the cases cited by SEBI in its order, Easow recommended a stock and gave a higher price target while having a large short position in the same stock in the F&O segment. In some other cases, he utilised the short upswings immediately after his public recommendations to exist his own long positions.

The order was passed on January 19, 2006, but it does not specify the time period for which the restriction is being placed on Easow. As usual, it is an ad interim ex-parte order giving the respondent 15 days to file objections.

Easow disappeared from television after the order but resurfaced during the last week of April on the same channel. Has SEBI withdrawn or modified the order against him? No such revised order or press release is available on the SEBI website nor has the analyst mentioned any such order when he made the reappearance. The television anchor merely welcomed him back after a 'long gap'.

Small stock evangelists
There is another analyst who appears on the same channel, only once in few months. He specialises in stocks of small and obscure companies, which are listed mainly on the BSE. Apparently, he has written a book on such small cap stocks, which he claims are highly undervalued.

Most other analysts do not track such obscure stocks. In fact, most retail investors would probably have heard about such stocks for the first time only when this analyst recommends them. Most of these stocks are not very liquid with low floating stock.

Whenever this analyst would mention these stocks on TV, they would usually surge ahead and be locked in the upper price circuits. In many cases the stocks have been on upper circuits for many days after the recommendations.

In almost all the stocks mentioned, the analyst has direct personal positions taken before the recommendation. As these stocks appreciate considerably in such a short time, the analyst stands to benefit personally. Even if this particular analyst has no such intentions, what prevents others from recommending dubious stocks for personal gain?

There is nothing wrong in identifying undervalued stocks and recommending them in public. But when the stocks mentioned are of small companies, which are not covered by other analysts, investors have no means of getting an alternate view unlike larger stocks, which are covered by many analysts. Even if other analysts or investors try, it would be difficult to get sufficient information about these companies.

Shouldn't SEBI introduce stricter norms for analysts recommending small stocks and the media carrying those recommendations? Maybe, to start with, the media can be asked to provide other analyst views on the same stock.

Building a more effective SEBI
The NSE and BSE have average combined daily volumes of around Rs50,000 crore, in the cash and F&O segments put together. According to some estimates, this figure could grow 10-fold over the next five years if more and more retail investors take to the markets as expected.

Despite the best efforts of regulatory bodies, manipulations and violations would continue and scam sizes would only get bigger. Fraudsters may use faults in systems, procedures and technology to their advantage.

Is SEBI equipped to handle all these as investigations into future frauds and scams would need much more resources and skills? Considering the present state of affairs, not many would back SEBI's efforts to improve its effectiveness and speed.

Everyone accepts that regulatory guidelines issued by SEBI are top notch. However, the agency is severely lacking in market surveillance that helps prevent violations of guidelines, frauds and scams. To begin with, SEBI may consider setting up an independent full-fledged surveillance and investigation wing with adequate manpower and other resources.

SEBI's website says its vision is "to be the most dynamic and respected regulator – globally." The market regulator needs to scale up its skills and resources considerably and strategise better to achieve that vision.