A play with penny stocks

Print edition : October 21, 2005

THEORETICALLY, the price of a company's share is supposed to reflect its worth. After several scams, now it is evident that this is mostly not the case. But when stocks of companies that have long since gone out of business suddenly start shooting up, the whiff of a scam cannot be far away. Penny stocks - so called because that is what they really ought to be worth - are in the limelight again, as they always were in the wake of a sharp increase in share prices. Those who followed the Harshad Mehta-engineered scam of the early 1990s would recall that the shares of several dud companies, which were so obviously beyond hope, started going up sharply at the height of the boom.

Why do these shares behave the way they do? Who stands to gain from this? What is the modus operandi?

The most obvious thing about penny stocks is that they appear cheap, mostly quoting below their par value (the price at which they were issued) at the time their prices are rigged. Or, they are stocks of companies that have been barred from trading because they have violated their listing agreements with the stock exchanges. Of course, investors would wonder, not unreasonably, how shares of such companies can even be traded if they have violated listing agreements.

Essentially, the manipulators of penny stocks try to make them appear attractive by driving up their prices. This is generally achieved by using the device of "circular" trading. Prithvi Haldea, managing director, Prime Database, explains that a cartel of manipulators of the targeted stock buy and sell the stock among themselves. In the process, the price is ratcheted up. The manipulators' objective is to spread the word around that the stock concerned is doing well. The timing of the ratcheting up of the share price is important; in fact, a bull run is a necessity for the success of the entire operation. The paucity of "good" stock at a reasonable price is essential to draw investors to buy the stock of a good company.

The recent upsurge in penny stocks has an additional twist - the involvement of the tax evader-broker combination. A window of opportunity for this was provided after P. Chidambaram's first Budget in 2004, when Long Term Capital Gains Tax (LTCG) was reduced to zero (for equities long term is defined as holdings that are held for one year). The tax-evader arrangement works like this: The tax evader would pay the broker an initial up-front investment in penny stock, using legitimate money. It would then be the broker's responsibility to rig the price of the stock to a pre-arranged target by creating euphoria about the stock in the market. The two parties would then share the profits. The arrangement, which commenced in October 2004 after the new LTCG regime came into play, could only have been consummated in October 2005 when the investments would qualify for zero tax. Thus far, however, revelations in the media about the scheme have thwarted these attempts at money-laundering.

The Bombay Stock Exchange (BSE) lists shares that fail to meet regulatory compliance in the Z category, indicating that they are risky. However, speculators see them as easy prey for manipulation because the prices are low. Moreover, since they are traded so little it is easy for unscrupulous brokers and manipulators to rig the share prices. These shares should obviously be de-listed but stock exchanges apparently hesitate because doing so would not enable existing investors to exit the market. It seems, however, that protecting markets from unscrupulous money launderers and speculators is more important than showing concern for those who remain invested in dud companies.

The Securities and Exchange Board of India (SEBI) cracked the whip after the media exposed several cases of jacked-up penny stocks. It has taken a series of actions against promoters and directors of several near-defunct companies whose share prices were rigged during the boom in the last few months. SEBI found that in one case the shares of the company were rigged from Rs.53 in July to Rs.300 in September. The increase was made possible by obviously calculated announcements of the company's improved performance and changes in its equity structure.

On September 30, the Calcutta Stock Exchange (CSE) barred six companies and several brokers from trading. The shares of one of the companies increased by almost 1,000 per cent in three months; another registered an increase of more than 700 per cent during the same period. The CSE claimed that share prices were jacked up by brokers indulging in "continuous self-deals executed on the same (trading) terminal". Meanwhile, after SEBI's crackdown on 11 city brokers, trading volumes in the CSE crashed to Rs.58.35 lakhs on September 30, from Rs.15-18 crores a few days earlier.

L.C. Gupta, Director of the Society for Capital Market Research and Development (SCMRD), asks: "Has anyone been punished for manipulating the prices of penny stocks?" "The government," he said, "only says that it is keeping a watch and that it has increased surveillance. The point is that the government has never been able to catch the thief."

Prithvi Haldea says that SEBI should develop the capital market through regulation. "Punishment should be swift and harsh - something that would utterly ruin the perpetrator," he says.

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