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Lead Story

A lot of hot air
The SME platform on the BSE is under a cloud after the recent Sebi order over suspect money laundering

V Keshavdev & Jitendra Kumar Gupta

On June 24, 2015, finance minister Arun Jaitley was hard-selling India’s growth story to investors in San Francisco as part of his whirlwind 10-day visit to the US. During the trip, he announced that a new law would come into effect from April 1, 2016, to tackle the black money menace and a compliance window would be offered for those with undeclared assets abroad to come clean by paying a penalty. What’s interesting about the whole brouhaha over money stored in Swiss vaults is that an equivalent amount of black money — if not more — is milling around on Indian shores. And as enterprising as that might seem, some individuals have already found a new route — one that leads straight to Dalal Street — to convert their illegitimate money into white.

Five days later, when Rajeev Agarwal put out an ex parte ad interim order barring four companies, 235 individuals and other entities for price-rigging and manipulation, it was not the kind of order that everyone is used to seeing from the market regulator. Instead, the investigation by the Sebi director — an IIT Roorkee alumnus and a former income tax commissioner — was an eye-opener that gave insights into the ingenious method being employed to launder money. The Bombay Stock Exchange’s (BSE) platform to help small and medium enterprises (SME) access the capital market was the perfect hunting ground, thanks to lax regulations and an overzealous exchange authority that had thrown open the gates of the platform to just about anyone.

So, what was the June 29, 2015 order all about? The market regulator has alleged that four companies — Eco Friendly Food Processing Park, Esteem Bio Organic Food Processing, Channel Nine Entertainment and HPC Biosciences — were engaged in the following modus operandi: a shell company would make a preferential allotment to select investors at a relatively insignificant premium before floating the issue. When the lock-in period expired after a year, the select shareholders would sell the shares to related entities at a much higher valuation.

The super-normal gains qualified for tax exemption as they were held for more than a year. In the course of the entire operation, the shareholders had effectively handed over the black money to an intermediary or entity that converts black money into white by facilitating stock market transactions. The related entities, which bore losses in these transactions, would be compensated in cash. 

“Such trading behaviour belies economic rationale and indicates existence of premeditated arrangement among preferential allottees, pre-IPO transferees, trading group and funding group entities,” states the Sebi order. The four companies, as per Sebi, collectively raised a little over ₹46 crore from the IPOs, of which ₹30 crore (65%) was transferred back to the entities of the funding group either directly or through layering, while the preferential allottees and pre-IPO transferees collectively made an illegal profit of ₹614 crore. Of these, 186 entities made a profit of ₹1 crore or above.

Not surprising, then, that Agarwal mentioned in his report: “I am of the considered view that the schemes, plan, device and artifice employed in this case, apart from being a possible case of money laundering or tax evasion, which could be seen by the concerned law enforcement agencies separately, is prima facie also a fraud in the securities market in as much as it involves manipulative transactions in securities and misuse of the securities market.” 

The Sebi director has even suggested a further detailed probe into the entire scheme to find out the ultimate owners of funds used for manipulating the price/volume of the scrips. “While Sebi would investigate the probable violations of the securities laws, the matter may also be referred to other law enforcement agencies such as [the] income tax department, enforcement directorate and financial intelligence unit for necessary action at their end as deemed appropriate,” states the order. While the jury is still out on what will be the outcome of a further probe by other law agencies, it’s astonishing to note how ingenuity and laxity have turned a fund-raising platform into a money-switching enterprise. 

Setting the stage

On March 13, 2012, when the BSE launched the SME platform with the customary bell-ringing, Sebi’s Agarwal had shared the dais with other government dignitaries, which — in hindsight — was an ominous sign of things to come. Agarwal could well be squirming now, having said at the launch, “As a regulator, several regulations have been eased, at the same time, a robust surveillance mechanism has been put in place. Investor protection will remain prime important. My heartiest congratulations to BSE…” To be fair, while the intent of the regulator in giving the go-ahead for the platform was noble, the devil was in the details. For one, the regulator did away with the rule of companies filing their draft prospectus with Sebi, and left that to the discretion of the exchanges. 

Also, the conditions on filing of the draft red herring prospectus (DRHP), obtaining in-principle approval of Sebi and issuing public notices were waived for the listing of the SMEs, as this supposedly saves about six months in getting the IPO off the ground. All that the merchant banker had to do was to file the DRHP and a due diligence certificate with the exchange, whose approval was sufficient. Compliance norms, too, had been eased — half-yearly compliance was sufficient instead of quarterly.

Companies needed to send only an abridged version of the annual report instead of the entire report and posting its soft copy on the website was deemed sufficient. More importantly, besides a minimum post-issue paid-up capital of ₹3 crore and a market-making mechanism, the minimum ticket size for an investor to apply for an IPO was pegged at ₹1 lakh, with a minimum of 50 allottees.

While the BSE SME platform took off in March, the NSE followed suit in September, when it launched its platform, Emerge. Three years since, the difference is starkly evident, with the BSE boasting of 88 companies, while the NSE has six companies to showcase. What is unsettling about the whole affair is the manner in which stock prices have soared on the platform and the kind of companies that are in the thick of action. “What explains a rise of nearly 900% in the SME Index within three years, from 100 in August 2012 to 873 as on date? It had reached a high of over 1,000 in 2014. Who’s buying and who’s selling to have made the gains and who’s lost? It won’t take you long to conclude the modus operandi, where all are winners and there is no risk and no taxes paid,” points out Gaurav Parikh, managing director, Jeena Scriptech Alpha Advisors, an investment advisory firm.

Gaurav Parikh, Jeena Scriptech Alpha Advisors In fact, five companies, including the four banned entities, account for 60% of the total ₹7,200-crore market capitalisation of the total SME platform. As a result, the BSE SME IPO index is now trading at nearly 185X its trailing earnings and 5.7X book value, exorbitantly expensive considering that even the BSE small-cap index is trading at 45X earnings and 2X book value, in comparison. If one were to exclude the four banned entities, of the remaining ₹4,000 crore market cap, the top five companies still corner 50%, or ₹1,977 crore, of the market cap. What’s worse, the SME index is populated with companies enjoying valuations that no financial matrix can justify. A case in point: the top ten gainers, which posted close to a 500% return since their listing, account for a combined market capitalisation of ₹5,558 crore on a total profit of just ₹14 crore. 

“The biggest concern here is quality. Many promoters try to get listed so that they have access to a platform and can get involved in circular trading. Except a few genuine cases, most of the companies listed on the BSE SME index are bogus,” adds VS Fernando, an independent primary market expert. In fact, most of the top-10 gainers on the index are floated by the same merchant banker. Dilip Davda, who keeps track of IPOs on SMEs, says, “I call the merchant banker the magician of SME exchanges. The same banker was about to list his 16th company recently but withdrew the IPO after I wrote about it. The price these companies trade at — in comparison with their fundamentals — is shocking. My suspicion is that most of these are being used as fronts to launder money.”

The ‘magician’ referred to here is the Kolkata-based Kamal Kumar Kothari of merchant banking firm Guiness Advisors, which incidentally acted as the merchant banker for all four companies banned by Sebi. In fact, Guiness is the very firm that has also advised the second biggest gainer in the SME space — Sunstar Realty Development. Launched in 2013 for ₹2 a share (adjusted for split), it trades at ₹37 today, a close to 1,750% return in less than two years. 

Pulling a fast one

The disconnect between the financial performance of such companies and their unreasonable market capitalisation has raised serious questions about the quality of SMEs, the intermediaries involved and the role of the exchanges, which have — in some ways — allowed these companies and operators to indulge in these activities. Parikh recounts the time he was exploring BSE’s SME platform route to raise funds for a genuine small company and checked up on a company, Kavita Fabrics. “When I examined the fundamentals of some of these companies, I was shocked. The capital structure was clearly contrived. Once listed, the quotes were being driven up over a year without the support of any fundamentals. All this had to be for a vested purpose and if laundering was not it, then what could be the reason?”

Take the case of Mumbai-based realty firm Sunstar, which is the second-highest gainer on the SME index, with a market capitalisation of close to ₹900 crore. The company was started in 2008 by a 39-year-old chartered accountant with little experience in real estate and was listed in 2012 with a professed presence in sectors such as infrastructure, SEZs, IT parks, residential and commercial projects. Sunstar has posted a turnover of ₹17.3 crore and net profit of ₹66 lakh in FY14, which does not in any way justify a ₹900-crore market cap. The situation is much the same when you consider the Delhi-based company Channel Nine Entertainment, which is backed by Guiness as well, and has posted a close to 1,340% return since its listing in March 2013. The company, which is reportedly into production, marketing, distribution of television serials, television programmes, films, video films and corporate films, barely managed ₹2 lakh-6 lakh in revenue between FY08 and FY11. 

Then, just before its IPO, this figure shot up to ₹2.9 crore in FY14, with a profit of ₹5.3 lakh the same year. On the back of such dismal figures, the firm has a market capitalisation of ₹840 crore, which translates into an FY15 P/E multiple of over 6,265X and 38X its book value. Yet another example is that of Mumbai-based financial group GCM, which has three companies listed on the SME index — GCM Capital Advisors, GCM Commodity and GCM Securities. These three companies, which were incorporated in 2013, have a market capitalisation of close to ₹700 crore, which is about one-fourth the market capitalisation of one of India’s largest financial intermediary, Motilal Oswal Financial Services. What is even more surprising is that these three companies have a ₹700-crore market capitalisation on a profit of ₹1.2 crore and a sales turnover of ₹3.5 crore. The GCM group is run by 36-year-old Manish Baid, a commerce graduate who claims to have capital market experience. 

Mahabir Metallex, which got listed recently, raised ₹3.9 crore on a sales turnover of ₹3 lakh in FY14. Its financial history shows that the company has no revenue over the years and has been loss-making since 2010. Similarly, Akme Star Housing Finance, which got its licence from the National Housing Bank in 2009, has managed to raise about ₹4.8 crore on listing. The company had a revenue of ₹60.5 lakh in FY13 along with a housing loan portfolio of ₹65 lakh, which shot up to ₹2.6 crore in FY14. And these are not the only companies to raise huge sums of money without a history or assets to back their businesses. Mumbai-based SPS Finquest raised ₹25.8 crore on a net worth of about ₹2.3 crore. 

Had any of these companies gone to a private sector bank to raise capital, their requests would have been rejected outright. In comparison, the SME platform is cheaper and easier to crack, which explains why a glut of companies is cashing in on this trend. But it is difficult to believe that any of these companies could have gotten the valuation they have unless there was some nexus between promoters and intermediaries, with the latter being ready to sell an issue for a premium in return for quick money for their clients. Case in point: JLA Infra, which owns the little-known e-commerce website Infraville, raised ₹2 crore after incurring issue expenses of ₹38 lakh (20% of the issue size) on a sales turnover of ₹9 lakh and profit of ₹1.5 lakh. The company, which was launched in 2013, now wants to venture into the real estate business. 

Illiquidity rules

Very often, once the initial listing phase of about a month is over, the stocks for a majority of companies becomes illiquid, which is a good sign for punters to speculate and play around with the share price, say experts. That apart, low float makes many of these companies susceptible to speculation. Almost 70% of stocks on the BSE SME platform do not see any trade. On a typical day, the BSE SME index witnesses a total turnover of about ₹20 crore, which is a mere 4% of the turnover of the BSE Small-Cap Index. 

To deal with this disparity, the exchanges have mandated the appointment of a market maker for each listed company on the SME platform. The role of the market maker is to provide liquidity within a 6-10% price band, facilitating easy entry and exit for investors. However, despite — and due to — the presence of a market maker, the scope for speculation is high. “Punters and speculators often enter a scrip and rig the price to their advantage by using low liquidity to their benefit,” says Ajay Kejriwal, director at Choice Equity, which holds the market-making mandate for about 17 SME companies.

Ajay Kejriwal, Choice EquityKejriwal adds that taking advantage of low liquidity, speculators can keep pushing a stock higher by hitting the upper circuit for prolonged periods of time. “We are helpless and have nothing to do with these speculative runs. If the market wants to take a stock higher, we can do nothing but provide the requisite number of shares,” says Suresh Kumar Saraf, CEO, Bindal Equities, which is the market maker for GCM Capital Advisors. Once a market maker has exhausted its holding in the company, it will have no control and buyers might continue to push the price higher. The market maker makes its money on the spread, which may or may not be in its favour. 

In the end, even the market makers are appointed by merchant bankers, who, in turn, work for the issuers for a fee. What stops the promoters and market makers from playing around with prices, then? “Though we are not aware of any such cases, there is nothing that can stop promoters and market makers from getting together to speculate,” says Kejriwal. However, BSE, in an emailed response to the illiquidity observation, points out that most shareholders are investors who may not be frequent traders. “Assuming an investor holds the stock on average for five years, you might get 20 trades in a year and, hence, the need for market makers who stay on for the first three years of the company getting listed.” 

It’s black, it’s white

Though the regulator has cracked down on the four companies for suspected money laundering and unearthed the modus operandi that involved price manipulation, there are instances that show an unusual price pattern. If one were to exclude the four banned entities and scan through the other 82 companies, there are stocks that have seen a sharp spike and then a sudden drop. Of the 82 companies that account for over ₹4,000 crore market cap, the share price pattern of two companies that account for 35% (₹1,370 crore) of the total market cap makes for unusual reading. Sunstar Realty, which got listed in March 2013, saw its share price zoom from ₹2 a share to ₹42.6 by December 10, 2014, a gain of 2,030%, and then dropped sharply to ₹24 within 15 days. In other words, anyone who sold at the peak would have booked huge long-term capital gains. At ₹42, it was a ₹1,000-crore company on a sales turnover of ₹17 crore.  

Similarly, the GCM Securities stock, within a span of 18 months from April 2013 onwards, rose by 4,400% from ₹2 a share to ₹90 a share and, over the following seven-month period, eroded almost 80% of those gains. Incidentally, around this period, the stake of corporate bodies in the company went up from 3.93% in April 2013 to 50.26% by March 2015. Ajay Thakur, head of the SME index at BSE, says, “There might be a few cases of fraud on the index but that hardly accounts for 7-8% of the total number of firms listed. Besides, the SME index is for informed investors and we have built in an investment limit to discourage retail investors. The players in this market are all HNIs and fooling them is not easy, even if we assume that there are a few bogus companies,” he says.

Ajay Thakur, BSE SME IndexWhile tax evasion should be a concern for the government, the threat to the market emerges from lax regulatory standards. “If I were to put myself in the investor’s shoes, I would seek a minimum governance benchmark in terms of disclosure and audit standards. Today, of the over 3,000 companies listed, you see active trading in over 50% of large and mid-cap companies because of robust disclosure. If any SME has dreams of making it really big, it cannot shy away from maximum disclosure,” says Rajesh Dubey, former CEO of rating agency Smera and currently partner at SME BOT, a financial management consultancy for SMEs. That would mean that market intermediaries, too, are held accountable. It will be interesting to see how the regulator and the exchange finally deal with tainted merchant banker, Guiness Advisors. “Banning scamsters is like shutting the stables after the horse has bolted. The game’s over and done and the scamsters don’t really care,” says Parikh. 

Despite the unexplainable distortion in stock prices of the listed entities and the Sebi order, the BSE management maintains: “We are the only exchange that maintains the highest standard of ethics and transparency. BSE firmly believes that the stock exchange mechanism should not be misused by any entities, whether in SME or in main board or in any other way.” Incidentally, the exchange has changed the norms for SME listing from April onwards. Now, companies will need to have a post-issue paid-up capital of ₹3 crore, as against ₹1 crore earlier. “If the applicants don’t have a good track record for at least two years, they will need to have a minimum net worth of ₹5 crore,” points out Thakur. But will that change in criteria help? “BSE’s drive to chase quantity over quality has led to genuine companies becoming more an exception rather than the rule,” opines Parikh.

PR Ramesh, Economic Laws PracticeFurther, with the exchanges operating as for-profit entities, there will always been an inherent conflict of interest. “Exchanges should compete on technology and effective delivery of trades, leaving supervision to an independent entity,” says PR Ramesh, senior consultant, Economic Laws Practice, who spent 12 years at Sebi working in various roles spanning surveillance, demutualisation and corporate finance.

Though the regulator has eased the rule of prior clearance, the onus is now clearly on the exchanges to ensure that there is no dilution of standards. “It would be appropriate to enhance the scrutiny at the time of IPO and, thereafter, while giving the NOC for further issuances. Surveillance and prompt action will ensure that any mischief in using the trading platform is nipped in the bud,” says Ramesh, who was also the officer on special duty at the scam-hit NSEL. Maybe the time has come for Sebi to revive its plan for a Central Listing Authority, which will ensure common minimum standards and also reduce compliance cost. It’s better late than never.

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