Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

SEBI Disgorgement Order – Response to Comments

Some of the comments on my previous
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

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

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.


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