A fraud exposed

At the SEBI office in Mumbai - PAUL NORONHA

The Securities and Exchange Board of India cracks the whip at the perpetrators of the Initial Public Offer scam.

IT is often said that when the Indian stock markets go through a boom, the whiff of a scam cannot be far behind. But it is not often that the regulator - the Securities and Exchange Board of India (SEBI) in this case - takes action. It is common knowledge that for several years cartels of operators have been cornering shares meant for retail investors in the primary market, referred to as Initial Public Offers (IPO). Often reviled as a "toothless wonder" for failing to protect investors and the integrity of the markets, SEBI issued an Interim Order on April 27, which was unprecedented in its stringency and stunning in its sweep.

The Interim Order arose out of an investigation, which covered 105 IPOs between February 2003 and November 2005. The 252-page order, while bolstering the findings of a similar (but smaller one in terms of scale and scope) investigation by SEBI completed in January, reveals shocking details of the fraudulent practices. More significantly, it unearths the complicity of several players who are supposed to perform the role of intermediaries in the market. It reveals how several players managed to open share trading accounts and bank accounts in thousands of fictitious names in order to corner shares issued through IPOs.

An IPO is the first sale of a company's shares to public investors. Typically, it is in the form of an auction sale, a portion of which is reserved for retail investors. Each application for an IPO has to be within a cut-off figure, which makes the applicant eligible for allotment in the retail investors' category. The scam is basically in the illegal cornering of shares meant for retail investors by financiers and market players.

After the advent of paperless trading, made possible by the introduction of demateralised shares, most market-savvy observers claimed that a technology-fix had been found for the widespread malpractices that were rampant in the regime of physical securities trading. One of the significant aspects of the SEBI report is its finding that nearly all sections involved in the regime of paperless trading have played an active part in the scam.

At the apex of the demat trading regime are the two depositories, Central Depository Services (India) Limited (CDSL) and National Securities Depository Limited (NSDL). The next in the link are the Depository Participants (D.P.), which act like banks for investors. Investors have to trade through a D.P. account and each demat account is linked to a bank account.

The most significant finding in the SEBI order relates to the role that D.P.s played in facilitating the scam. Moreover, it found that several leading private banks that are also in the D.P. business aided and abetted the scamsters.

The SEBI order banned two D.P.s from the market. One of them, Hyderabad-based Karvy Stock Broking Ltd., is one of the biggest D.P.s, reportedly serving 22 million investors. Karvy obtained an interim stay from the Andhra Pradesh High Court on May 2. Pratik D.P. was the other one to be barred by SEBI. In passing the order, G. Anantharaman, whole-time member, SEBI, said that the two D.P.s "prima facie do not appear to be fit to deal in [the] securities market as SEBI-registered intermediaries".

Significantly, he also barred several other wings of the Karvy group from their respective areas of operation. The order stated: "Since the other business groups of Karvy have appeared to have acted in concert in the gamut of the IPO manipulations, I further direct Karvy Stock Broking Ltd., Karvy Computershare Pvt. Ltd., Karvy Investor Services Ltd. and Karvy Consultants Ltd. not to undertake fresh business as a registrar to issue and share transfer agent, excepting those businesses already contracted." The SEBI order, which is also in the nature of a show-cause notice, gave the penalised parties 15 days to explain their position. It also barred 24 "Key Operators" who funnelled the illicitly obtained shares to financiers even before the shares were listed, from trading in the market. Eighty-five financiers who were the ultimate beneficiaries of the scheme were also barred from trading in the market. Twelve D.P.s, including those aligned to private banks such as the Centurion Bank, HDFC Bank, ING Vysya Bank and IDBI, were prohibited from opening fresh demat accounts "until further notice".

Soon after the order was issued on the night of April 27, Indiabulls Securities, one of the 85 ordered to stay out of the market for its role as a financier, moved SEBI officials for a review of the order. The fact that SEBI amended its order soon after the markets opened the following day has been cited as evidence of the pressure that is being mounted on SEBI. On May 4, the Gujarat High Court stayed SEBI's order barring Saumil A. Bhavnagari - one of the 85 financiers named in the interim order.

Despite the criticism that it has bungled as a regulator, there is no doubt that it was SEBI which first investigated the IPO scam. In late 2005 the Income Tax Department found that an investor in Ahmedabad had 5,000 demat accounts in his name. Later, in February 2006, the Central Bureau of Investigation (CBI) found that one of the Key Operators (or "Master Account Holders"), Ahmedabad-based Roopalben Panchal had issued advertisements offering to photograph people free of cost. The CBI found that she used these photographs to go with fictitious names for opening bank and demat accounts for investment in demat accounts.

SEBI had asked the stock exchanges to report suspicious off-market sales of shares soon after allotment but before listing. SEBI received the reports from the stock markets in October 2005, which indicated "large-scale off-market transactions" prior to the listing of the shares.

SEBI noticed "a large number of multiple dematerialised accounts with common addresses". SEBI passed an interim order restraining such account holders from participating in all future IPOs. It also directed the depositories to freeze effectively these dematerialised accounts. Soon after this, in January, SEBI passed another Interim Order based on its investigation of another major IPO, that of the IDFC (earlier Infrastructure Development Finance Corporation). It found that "the very same players" played a similar role in this case too.

The SEBI investigation reveals three significant actors in the IPO scam - financiers, "Key Operators" and the thousands of benami applicants who filed thousands of IPO applications (afferent accounts in SEBI parlance). The financier was the lynchpin in the entire operation and also the ultimate beneficiary of the scheme. The Key Operator's primary function was to act as a funnel to consolidate the successful allotments of the benami applicants. The audit trail, investigated by SEBI, shows that in most cases they also provided finance to the Key Operators for making the applications for the IPO. The investigation also found that the financiers sold the allotments that they purchased "off-market" soon after allotment from the Key Operators for a premium upon listing. SEBI found that the Key Operators "allowed their demat accounts for temporarily parking credits received from benami applicants before transferring them to the financiers". The benami demat account holders constituted the last leg in this sordid scheme. The successful applicants transferred their allotments to the Key Operators before the shares were listed, in off-market transactions.

Since multiple demat accounts does not constitute an abnormality, for the purpose of the investigation SEBI determined that entities that gained from transactions involving the off-market sale from 500 or more accounts were those of Key Operators.

SEBI found that the 24 Key Operators it had identified had resorted to "abusive practices" in 21 of the 105 IPOs it investigated. It also found that a total of 58,938 fictitious accounts had been used for cornering the retail portion of the IPO. Nearly 85 per cent of these accounts were held with Karvy DP. For instance, Roopalben Panchal used 81,708 demat accounts for applying to 16 IPOs during the period covered by the SEBI investigation. All the demat accounts were with Karvy Stock Broking. An overwhelming proportion of these accounts were solely meant for applying for IPOs. For example, of the 7,751 accounts that were opened on August 16, 2004, only 15 remained active when SEBI conducted its investigation. Many of these belonged to Roopalben.

It found that many of these accounts had been opened on a few dates close to the date of the IPO. Moreover, the addresses of these demat account holders were the same as those of the Key Operators identified by SEBI. Significantly, 14 of the 24 Key Operators had their demat accounts with Karvy DP. The order observed that while Karvy DP was "actively in league" by opening demat accounts for many of the Key Operators, it also served as a conduit for the bulk of the benami demat account holders. Anantharaman pointed out that "the numbers are too significant to be dismissed as normal incidence of business".

SEBI has also castigated the banks that facilitated these illicit transactions. For instance, it found "numerous irregularities and non-adherence to Know Your Client norms". It observed that the fact that 286 savings bank accounts were opened by one of the Key Operators with HDFC's D.P. operations is "clearly proof enough for the plan to open multiple demat accounts to channel the funds in a manner that would bury the audit trail".

In the wake of the IPO scam there have been suggestions that banks should stay at arm's length from D.P. operations. There is commendable reason why the two need to be separated by a safe distance. The relationship between an investor and a D.P. is basically a contract between two private parties. The D.P., without actually having access to the shares of its client, acts as a custodian of the shares in demat form.

Banks, however, are in a completely different league. Their fiduciary responsibilities extend beyond their immediate clients because they raise deposits from a larger customer base. The ease with which private banks are able to mix fee-based D.P. activities with their banking operations thus appears to be dangerous for the health of the financial system.

The depositories have also drawn flak in the order. Anantharaman has pointed out that there were "contributory lapses" on the part of NSDL, which accounts for 80 per cent of the depositor business. SEBI found that the depository had used "dummy numbers" in its databases, particularly for dates prior to April 1999. It also found instances of "junk data".

SEBI's critics have said that it has bungled by acting hastily. In particular, they fault SEBI for passing an ex parte order. However, SEBI's action has drawn praise from those who feel that the regulator has not acted decisively in the past. L.C. Gupta, director of the Society for Capital Market Research and Development, told Frontline that SEBI had the powers to pass an interim order. Prithvi Haldea, managing director of Prime Database, an entity that tracks IPOs, has also argued that SEBI's stringent action has been long overdue.

Perhaps the most significant revelation is that the entire IPO process is riddled with lacunae. The SEBI report reveals that intermediaries along the chain, including registrars and transfer agents of the issues, depositories, depository participants, merchant bankers and banks, have played a part in the scandal.

It would be a pity if SEBI's painstaking work is reduced to a matter of keeping a few shady operators at bay. Much more - the very health of the financial system - is at stake.