Wednesday, October 24, 2012

Taking The Risk Out of Risk Capital

The Securities & Exchange Board of India ("SEBI") has recently come out with a  Discussion Paper on "Mandatory Safety Net Mechanism" . As the title indicates, the regulator's idea  here is to boost the primary capital market activity by providing a "Put option" to original retail subscribers in an IPO and mandate the promoters to write (or cause another person to write) the put contingent on obtaining of certain events, for a certain period after the listing of the stock.

In a sense, this is a move-on from the "opt-in" mechanism envisaged in Regulation 44 of the SEBI ICDR Regulations, 2009 where the Issuer "may" have provided for a safety net mechanism, for a certain period after listing. The reason for this proposal appears to be the empirical finding that, out of the 117 scrips listed in the period from 2008  through 2011, 62 % of the scrips (72 out of 117) were trading below issue price, six months from the date of listing. 55 out of those 72 scrips witnessed a loss of more than 20 % from the issue price. Apparently, if the trend continues,  investors, especially, retail individual investors, would lose confidence in the capital markets. And so the safety net in the nature of a Put Option.

To flesh out the detail : The safety net will trigger only in the event, the unsystematic (absolute) price dilution  in the stock is more than 20 % of its issue price, within 3 months from the listing date. Further, the obligation to would be capped at 5 % of the issue size. (By absolute price dilution, I mean price dilution in the stock over and above the movement of the stock owing to the broader market index. This condition ensures isolation of the impact of issuer policies on the market price of the stock). And finally, the safety net is open  for all the allotted securities to retail shareholders who made an application for up to INR 50,000.

 The mandatory safety  net proposal needs to be panned on several counts :

Firstly, a mandatory safety net essentially adds to the flotation costs of the issuer in as much as it has to arrange for a potential buy back either through the Promoter, or the underwriter. It creates disincentives for the Promoter to seek listing of the issuer by making it primarily responsible for the buy back should it happen.  Promoter disincentives and incremental flotation costs are clearly antithetical to the stated objective of the proposal, to wit, promote primary capital market activity. One wonders how the mandarins at SEBI missed this natural consequence. These incremental costs will merely  keep honest promoters from going to the markets. Further to the extent the 5 % cap is indexed to market capitalization, the policy promotes smaller issues rather  than large, other things being equal.

Secondly, the indiscriminate promoter can always hoodwink the safety net by using its shell companies and related parties to trade in the scrip and "support" the price and retain it above the thresholds at which the "Put option" triggers. Securities laws experts point out that indiscriminate promoters pay as much as 50 % of the proceeds to I-bankers to overprice the IPO and leave as little as possible on the table for the investors subscribing the IPO. A 5 %  mandatory outlay  is unlikely to deter them from hitting the markets.

Thirdly and finally,  an "Opt in" safety net that the extant regulation 44 of the ICDR Regulations, 2009 contemplates, cures the "adverse selection" problem in capital markets by enabling the  efficient promoter to signal  the quality of the issue by opting in the safety net mechanism. (Rather like a guarantee that consumers get on merchandise.  Such guarantees/opt in safety nets serve as devices for the entrepreneur to signal that her business model is robust to movements in the capital markets).  A mandatory safety net has no such beneficial impact. On  the contrary, it promotes and induces moral hazard in the retail shareholder and thus inhibits inculcation of equity culture and market discipline among the "bottom of the pyramid" investors.

An epic fail.