SEBI - Great Diagnosis but Poor Medication

Authors: Gaurav Jetley, Vice President, Analysis Group and Shriram Subramanian, Principal Consultant, Infosys

In any investigation related to securities fraud, the verdict and compensation meted out should not only be adequate to punish the guilty, but also act as a deterrent for future fraud by others. To this extent, SEBI should lay out proper guidelines on:
* philosophies that drive investigations
* basis on which punishments would be handed out and compensation will be provided
* accountability of those who commit fraud

A recent ruling by SEBI is taken up to illustrate our arguments. On March 6, 2007 the Securities and Exchange Board of India (“SEBI”) ruled on the matter Bonanza Biotech Limited (“BBL”). By way of background, SEBI was investigating the role of BBL in selling approximately 98 lakh unlisted shares of Design Auto Systems (“DASL”) in the secondary markets between November 2001 and January 2002. BBL had received shares of DASL via a questionable stock swap in which DASL issued 10 crore of its unlisted shares to BBL in exchange for 10 crore unlisted shares of BBL. In essence, DASL “manufactured” 10 crore shares, gave them to BBL, who in turn tried to sell the, essentially counterfeit, DASL shares to unsuspecting investors.

SEBI’s ruling in the BBL matter clearly details the scheme hatched by the directors of BBL and DASL to defraud investors, and how the scheme violated the Prohibition of Fraudulent and Unfair Trade Practices (“PFUTP”) regulations. However, the remedy suggested by SEBI for the “entrapped public shareholders of DASL” seems arbitrary.

Specifically, the ruling states that BBL, by virtue of being “instrumental” in selling the DASL shares should offer to buyback the 98 lakh shares at, “the higher of the prices to be determined on the following parameters: i) the price paid for an acquisition made by BBL in the 26 weeks preceding the reference date (January 14, 2002 – the date on which the DASL shares were delisted); ii) other parameters relating to shares of DASL including return on networth, book-value, earning per share, price earning multiple vis-à-vis industry average.” In addition SEBI has ordered BBL to pay 10% interest to the defrauded interest fro the period from January 14, 2002 through the ultimate payment date.

Both parameters identified by SEBI are likely to result in compensation that does not reflect the actual loss suffered by the entrapped investors. In fact a simple measure of harm suffered by the entrapped investors is the price they paid to acquire the DASL stock. For example, if Mr. X bought 100 shares of DASL at price of Rs. 6, from BBL on December 2, 2001, the loss suffered by Mr. X on December 2, 2001 is Rs 600, because the shares he bought were essentially counterfeit and worth nothing. Paying Mr. X something other than Rs.6 per share simply because BBL’s average acquisition during a given 26-week period is arbitrary at best. In fact, this particular parameter seems to ignore fundamental finance theory that informs us that at any point in time, share prices reflect information about the company, industry and economy at that point in time. Thus there exists no economic rationale for basing compensation for fraud on some average acquisition price over a 26-week period. At this point we will not even try to discuss the question: why pick a 26 week period?

SEBI’s second parameter, i.e., basing price on average industry book-value and other financial metrics, seems more involved, but is equally inadequate. First, company specific factors do have an impact on valuation metrics such as the ones identified by SEBI. For example, size, amount of debt and credit quality is likely to cause variation in price-to-earnings and price-to-book multiples. Thus, anything less than an involved econometric exercise is likely to result in estimates with an unknown, but large bias. Second, there seems to be little academic evidence that a model such as the one alluded to in SEBI’s second parameter can help anyone ascertain the “true value” of a company’s stock price. Three, and perhaps most importantly, the second parameter implicitly assumes that DASL’s disclosed financials are reliable. This is because SEBI’s second parameter prescribes using metrics based on DASL’s financial statements - book value, earnings, etc - in conjunction with multiples based on industry averages to compute DASL’s stock price. Given that DASL’s top management was involved in fraud, it may be prudent not to base compensation to victims of that fraud on financial disclosures that could have easily been manipulated as well.

In addition to drawing attention to questions about economic rationale for determining compensation for victims of securities fraud, SEBI’s order also highlights broader questions that need careful evaluation. One such question is – Who was harmed and by whom? For example, SEBI’s order suggests that only investors who bought approximately 98 lakh shares from BBL over relatively short period ending in January 2002 were harmed.

However, a case may be made that all shareholders of DASL, except of course the one who help perpetrate the fraud, were harmed, because BBL’s fraud caused DASL’s stock to get delisted. This would include all shareholders who bought DASL stock from someone other than BBL during the period when BBL was selling the 98 lakh at issue in this matter, as well as anyone who had bought it any earlier point in time. Clearly, delisting eliminated the ability of all DASL’s shareholders to liquidate their investments. In fact, BBL’s shareholders were also similarly harmed because BBL’s shares were also delisted as a result of the fraud.

Eventually, the philosophies that guide the investigations of SEBI should be
* overall healthy functioning of capital markets
* protection of all investors – be it retail investors or institutional investors – not from risks, but from fraud
* swift redress of frauds - going by the philosophy of “justice delayed is justice denied” any fraud should be investigated swiftly
In addition, SEBI should be seen as an agency with sufficient tooth and a nastier bite!