Securities
and Exchange Board of India (Sebi) chairman Ajay Tyagi has a clean-up on his
mind. In the two months since he took over, he has tightened norms and decried crony independent directors at listed companies.

To
cauterise this market though, he must start by pruning promoter holdings to 50%
and searing shell companies that are
used for manipulating stock prices. It will be a bloody clean-up, but a
necessary one to boost investor confidence and limit market rigging in a highly
manipulated market.

India’s
publicly listed companies are seeped
in a promoter culture that overshadows their public obligations. This means two
things. If the promoters are ethical, transparent and take their
responsibilities seriously, the company behaviour reflects that.

On the
other hand, when promoters see a stock market listing as cheap big bucks, the
dirty games begin. It makes their firms schizophrenic, a twin personality, if
you like — public for tapping money, but less transparent on just about all
else from governance to accounting.

In this
highly muddled environment, chicanery
rules. So-called independent directors are typically friends or retired
bureaucrats with experience of navigating complex government red tape. In public sector firms,
gatekeepers are often picked from a cabal of known associates — folks who can
hardly be expected to raise a red flag. Team this with a mandated free float of
just 25% and it’s easy to see how the market lends itself to malfeasance. This is true especially
for small to mid-sized companies.

Often, the
public shareholding is held by institutional investors or big traders with an
arrangement with promoters, and get early tip-offs for their cooperation. Much
worse, the free float itself is cornered by promoters through an excruciating web of shell companies.
Recently, the ministry of corporate affairs stated that 9,00,000 registered
companies in India don’t file tax returns and are possibly used for illegal
activity.

The market
is further distorted by traders and corrupt business journalists who collude with promoters to spread
misleading stories to push prices up, or sometimes even short stock.

For all
this to fade, the free float has to be large enough to make it hard to corner,
and attractive enough for activist hedge funds, to play.

Everywhere
in developed markets, activist investors have held companies accountable for
their actions, especially to shareholders. In many cases, their activism has
dethroned errant executives found
guilty of wrongdoing or careless in managing company funds.

Several
investors, even conservative Blackrock, are increasingly questioning
ineffective value creation for shareholders, something regulators often fail to
do.

By
insisting that companies free up 50% of their stock for investors, Sebi will
open up the market to large institutional investors who can hold promoters
accountable. A higher free float will also automatically curb promoter ability
to put vast sums of money into the market to manipulate stock price.

Sebi’s other
challenge will come in clamping down
on trading using shell companies. The government plan to digitise databases
should help the regulator keep better track. It shouldn’t stop there though.
Sebi will need to invest in automated surveillance that some in Silicon Valley
are already developing. Using automation to
weed through and marry big data from banks, Aadhaar, tax offices and the
MCA can reveal manipulative trading and promoter linkages.

Traders are
already ahead of the game by using algorithms for high frequency trading (HFT),
often also used to spoof the market and distort trade. And the only way to sift
through legitimate trading from spoofing is through the use of artificial
intelligence and machine learning that mimics trader behaviour to spot lawless
trades.

This is not
to say it will end manipulation overnight. But at least the chance of getting
caught will act as a deterrent to
many.

The
regulator’s real grit, however, will
come from heavy punitive action
against errant traders and promoters. For too long, India has tolerated a
culture where traders and promoters caught red-handed get away with limp fines and continue to be active in
the market even when they are barred from it. It’s a VIP culture that money and
connections buy, and only one that the regulator can end. Tyagi must chart a
plan to level the playing field and bring relief to small retail investors.
It’s the only way to embark on Narendra Modi’s idea of ending the VIP culture
and replacing it with an EPI — Every Person is Important — one.

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