Is Sebi’s mandatory safety net a good idea?

I have a piece in today's Financial Express opposing a proposed 'safety net' for IPO invsetors. Here is the full piece:

We come across these crossroads every few years. Some noble soul offers the magic potion to revive the equity markets. Unlike the comic book Asterix though, there is no druid and no magic potion which will cure the Indian equity market of its torpor.

In short, the specialist advisory committee on primary markets and the SEBI board are testing the waters to introduce a scheme which will guarantee a minimum return on initial public offers (IPOs). To put it more accurately, the scheme mandates that the promoters should guarantee small shareholders, upto a money limit and time limit, that they will not lose over 20% of their capital. The 20% capital loss is to be calculated over and above any loss suffered by the broader index and the compensation is capped at 5% of the capital raised.

This is a wrong direction for several reasons. Broadly, this doesn’t solve the problem of the depressed market, doesn’t cure the malady of promoter rigging, and positively forces a legal manipulation of the market.

Risk is a factor which is intrinsic to the equity market. That is risk of market movement, rather than the risk of fraud. I sympathise with SEBI as I understand why it is trying to attempt this feat. Over the recent past, SEBI has unearthed several IPOs where the promoters had set up financiers to rig the IPO with subscription money. After listing, these IPOs have tanked as the financiers take their money out of the capital raised by the company from the public, leaving a deflated balloon of a company in its wake.

The problems with the IPO market are not primarily caused by fraudulent promoters, but by an anaemic economy, repo-ing governmental policy, high volatility, a vast global crisis, mis-selling of various financial products, unreal investor expectations from the IPO market and finally and not least importantly a lot of bad luck. Sure some fraud has occurred in small non-descript companies, but that is not even a significant cause of the pain. Several blue chip companies have fallen by nearly 90% in the past 3 years alone.

The scheme is unlikely to dis-incentivise crooked promoters. These kind of promoters pay upto 50% of the issue proceeds to illegal financiers and would  be willing to pay an additional 5% to a SEBI approved fraudulent scheme. They would still be net gainers, the way they look at it – 45% return rather than 50% return. The answer to such fraud is strict enforcement action, which SEBI has ably conducted over the past year, rather than this kind of scheme.

The mechanism is likely to backfire by bringing about a change in the attitudes of honest promoters who would seek to avoid IPOs altogether. You still would have the crooked promoters eager to do IPOs. The recommended rule will penalise patient and hard working entrepreneurs who have spent decades building the company (promoters) or takers of a ten year risk cycle (private equity) who must pay money to speculative investors who want free money in 1 - 2 weeks for doing no work and providing no long term capital. SEBI must decide whose side it is on.