SEBI Disgorgement Order - Response to Comments

Some of the comments on my previous post have made me realize that I did a poor job of explaining why it is incorrect to simply make restitution to the genuine retail applicants in the so called IPO scam. As I started fleshing out the details, I found that it takes a rather long post to explain why I say this though issuers have the freedom to price their shares and the price paid by the retail segment is the same as that paid by others. There are two aspects to my argument.

The first point is that in equilibrium in an efficient market, a person who has not applied to an oversubscribed offering would not expect to make any gains by applying. The costs of applying (including the costs of analysis, costs of financing and the transaction costs of applying and bidding) offset the expected gains of a successful application (times the probability of success) after appropriate adjustment for the risk that during the period up to listing, the fundamental value of the share could drop below the issue price.

This equilibrium is achieved by a rise in the rate of over subscription and a concomitant fall in the probability of success falling until equality of costs and benefits is achieved. In the non retail segment this happens at high levels of over subscription because of the lower transaction costs and the ability to make large applications. In the retail segment, this equality is achieved at lower levels of over subscription because of higher search and analysis costs, higher financing costs and the higher transaction costs of applying in multiple names (legally or illegally).

The fictitious applications reduce the allotment rate and thus the expected benefits from applying. They thus reduce the gains to those who do apply. But they also deter many retail investors from applying at all because the reduced expected gains are now below their costs. Thus the fictitious applications inflict some losses on those who applied and some losses on people who did not apply at all. The key point is that in the absence of the fictitious applications, some genuine applicants (with high costs of applying) would have applied and reduced the success rate of the actual genuine applicants. It is thus a mistake to compute the losses suffered by the actual applicants by simply recomputing the allotment proportion after deleting the fictitious applications. True restitution would have to be to a much larger pool of potential applicants and not to the actual applicants. This is operationally very difficult. More importantly, even this analysis is flawed because of the analysis that follows next.

The second point is that the retail segment is permitted to bid at the cut off price. This has the potential to substantially reduce the contribution of this segment to price discovery. The under pricing of IPOs is a complex subject but at bottom under pricing can be regarded as a compensation for price discovery in the presence of asymmetric information. Succesful applicants normally earn their gains by contributing to price discovery. Those whose costs of analysis are lower earn more and those whose costs are higher earn less and the marginal investor earns nothing at all (this last statement simply rephrases my first point). But the retail segment has the ability to benefit from under pricing without contributing significantly to price discovery. The under pricing of the retail segment is then a dead weight loss to the company and its shareholders. The gains made by this segment are “rents” earned without doing anything economically useful and are thus “ill gotten”.

This argument can be made even without the ability to bid at cut off prices, but the argument then becomes more subtle. The point then would be that the retail segment crowds out more efficient investors whose information processing costs are lower and thereby forces the company to pay more (in the form of under pricing) to obtain price discovery. This again results in a dead weight cost on the company.

Therefore, I argue that the best way of achieving restitution of the ill gotten gains of the fictitious applicants is to pay this amount to the company and through it to its shareholders. Theoretically, the next best alternative is to pay it to all potential applicants to the issue. This is operationally infeasible. The naive alternative of restitution to those who happened to apply to the issue is simply wrong and indefensible.

Posted at 8:49 pm IST on Sat, 25 Nov 2006         permanent link

Categories: regulation

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