SEBI `disgorgement' order that isn't

SEBI has passed a `disgorgement' order against depositories and DPs in the `IPO scam'. For the background, my earlier blog entries on the `IPO scam' are here and here.

There are all kinds of slippery issues of language, on this issue, that require care. The IPO `scam' wasn't much of a scam, it was a mountain made out of a molehill caused by a wrong policy in the first place. And, this SEBI order fails to achieve `disgorgement' of unlawful gains - it merely inflicts fines upon parties who made no unlawful gains.

Jayanth Varma has an excellent blog entry on this order. An edit in Business Standard says:

However, several questions arise in the present case. First, the money to be paid to retail investors who lost out has to be taken from those who enjoyed unwarranted gains, i.e. those who `engorged' in the IPO scam. These are not the market intermediaries whom Sebi has focused on, namely the depositories and depository participants (DPs), who only got their regular fees and nothing more. These intermediaries may be guilty, as Sebi has already determined, of violating the `know your client' norms, but they are not the ones who `engorged' and who therefore should now be asked to disgorge. The `engorgement' was done by the dummy investors in whose names shares were allotted, and it should be possible to take those shares and sell them in the market, with the loss that has been calculated by retail investors being paid to them, and the balance returned to those who got the allotment. The logical flaw in Sebi's order is in mixing up a penalty for misconduct (which it can legitimately levy on market intermediaries who err) with disgorgement; both are a financial drain, but the logic of each is quite different.

The Rs 116-crore question is what happens to the disgorgement fund, since the money has been made payable to Sebi. In the US, the SEC set up the Fair Funds for Investors in 2002 to benefit investors who have lost money because of illegal practices of other investors or companies, and fair funds are now playing an increasing role in enforcement. But even in the US, the aggrieved parties have received little money despite a provision for the appointment of an administrator. The task of identifying the affected parties involves detailed work, but should not be shirked for that reason. The outcome to be avoided is Sebi pocketing the money - as the tax authorities do when they recover excise duties illegitimately collected from customers by companies. That would be very unjust engorgement.

The Economic Times editorial says:

Sebi’s final order on the case is still awaited. Its earlier order of April 27, 2006 is an interim one. Some respondents have gone on appeal against the findings and their appeals are pending at various stages. In such a scenario, to come down so heavily on intermediaries when they have not gained any monetary benefit defies logic.

Neither the depository nor the DPs have derived any ‘ill-gotten gains.’ That gain has been made by the scamsters. However, Sebi says, “it is expected the intermediaries will take prompt steps in their own interest to pursue other wrongdoers and perpetrators of the illegal actions and attempt to collect sums from such individuals/companies.” Given the nature of the legal system, that will be a Herculean task. Moreover, it is cumbersome to determine the identity of those who presumably lost out in the allotment process or to quantify the extent of loss.

Sebi’s order justifies its penalty by claiming that “each intermediary in the hierarchy of intermediaries contributed cumulatively to the market abuse”. But if CSDL and NSDL are guilty of failing to police the DPs, then Sebi as the regulator at the top of this hierarchy can also be accused of sleeping on the watch. Instead, it has chosen to gloss over its own culpability and that of the RBI, which as the banking regulator has constructive responsibility for the mistakes of bank DPs, and pinned the blame entirely on market intermediaries.

If disgorgement was the goal, careful detailed work is required in five steps:

1. Reconstructing the orders placed in the IPO auctions,
2. Identifying the people (the Roopalbens) who obtained unlawful gains,
3. Identifying the people who would have won allocations in the auction if these unlawful bids were removed;
4. Extracting money from the Roopalbens who obtained unlawful gains;
5. Transferring this to the people who would have won allocations.

Each one of these steps is hard work, but it is the hard work that a regulator has to do if it aspires to achieve disgorgement. SEBI has not done any one of these fives steps. It has hence failed to achieve disgorgement of unlawful gains. Plucking a number out of thin air - a fine of Rs.45 crore - and inflicting it upon a conveniently accessible NSDL - does not achieve disgorgement.

Update: There was an ET debate on this, with two good pieces by Rajiv Luthra and Somasekhar Sundaresan.