Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

IPO Frauds

IPO procedures were in the limelight again last week, this time in India
(see my

post
last month about the United Kingdom).

In India, small investors (applying for shares worth less than Rs 50,000 in a
share offering) are given preference in allotment when the issue is oversubscribed.
In the case of the Yes Bank IPO, the portion reserved for these investors was oversubscribed
9.96 times while the portion available for larger non institutional investors was
oversubscribed by 43.68 times. This meant that the proportionate allotment to an investor
applying in the small investor category was four times more than the proportionate
allotment to larger non institutional investors.

This of course presents an arbitrage opportunity to those who are willing to break the
rules. The Securities and Exchange Board of India found that one investor had put in more
than 6,000 different applications in different names in the small investor category. This
allowed her to receive allotments of nearly a million shares worth about Rs 43 million
at the issue price. On listing, the shares of Yes Bank traded at a price approximately
36% higher than the issue price. The profits earned by flipping the shares in the market
immediately after listing were obviously quite large.

While an investor applying in 6,000 different names is rather exceptional, multiple
applications on a less ambitious scale are quite common. The same IPO witnessed another
investor putting in over 1,300 applications. Those who put in only a hundred or so
applications were probably not detected at all.

Clearly, the system of cross subsidizing small investors in the allotment process
is the root cause of this abuse. A month ago, when an official was murdered while trying
to prevent the adulteration of diesel with subsidized kerosene, many commentators in India
were quick to point out that the irrational cross subsidy in the pricing of petroleum
products was the root of the problem. There seems to be less willingness to recognize that
a similar cross subsidization is the root of the problem in the IPO abuse as well.

Today the technology exists to ensure that IPO allotments are made to all investors
at the same market clearing price in a completely non discriminatory manner.
There is no need to reserve shares for some categories of investors. Nor is there
any need to give issuers or their investment banks any discretion in the process of
allotments. There is no reason at all why the primary market should be any less
efficient than the secondary market.
The path that Google took in its IPO was clearly the right one. There is no
need to permit any other way.

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