This story was originally published in 2018 when we had a small audience of a few hundred people. However considering "Scams" are all the rage these days, we thought this story would be relevant, so we are republishing the article with a few edits. Hope you find it useful :)
When we decided to work on our startup we felt there was an urgent need for reform in the Indian Stock Market. We firmly believed that institutions reporting on financial markets were excluding the novice retail investor base by talking about stocks using financial lingo that was simply too hard to understand and we thought we could fix this by writing stories that more people could relate to. This was at a time when Finshots wasn’t even born. It was only an idea that existed on paper. But we knew we what we wanted to do. We wanted to make stocks and financial news cool.
Unfortunately, we did not have an audience to talk to and we were out in the streets desperately looking for our big break. And then, after two weeks of waiting, we received a call from a stockbroker in Ahmedabad who seemed very keen on what we were doing. We agreed to meet at his office. We entered the building thinking we could work out a business proposal, hoping that the research division in the brokerage house would find value in our stories. The gentleman who greeted us was a big burly man with a pot belly and spoke with the authority of a market veteran. He quietly sized us up and spoke: “ Who is going to read your stuff ?”
We sat there staring at each other — because we didn’t really have an answer to his question until he finally spoke again.
“ You should start writing about SME IPO guys. You will get a lot of traction. We will promote your stuff. Don’t worry.”
He wasn’t interested in our stories or the kind of content we were creating. He wanted us to look at the SME (Small and Medium Enterprise) IPO(Initial Public Offering) Market in India. A few years earlier, the Government of India had initiated a proposal to help SMEs list on the exchanges in the hopes of making "retail investor money" accessible to fledgling businesses. Unlike big businesses who have access to cheap loans and instant capital, Small and Medium Enterprises often struggle to lift their business out of obscurity and so when the government green-lighted the initiative there was considerable euphoria in the market. With the backing of the government, the exchanges got to work and an SME platform was put together. The move was lauded by everyone in the financial eco-system. Investors were happy that they could now own a piece of the burgeoning SME market and the promoters of these small enterprises rejoiced in the knowledge that money would be less of a problem.
“This is a big contribution to the country where SMEs play a crucial role but face difficulties in raising capital for their potential businesses. This is an effective way to improve financial inclusion.” — C. S. Mohapatra, DEA, Ministry of Finance
Mr. Mohapatra was right. This was a terrific initiative to help the struggling SME industry in the country. The hope was that, once capital was made available, these small companies could scale up and add more value to the Indian economy. So it made a lot of sense for the government to encourage such a move. But by the time we started reporting on SME stocks, the segment had devolved into an ugly business of money making that lacked any significant oversight or accountability.
All that glitters is not gold
And so with the vote of confidence from our friendly neighbourhood stockbroker we got to work. Our first story was on a small Jewellery company involved in the wholesale gold business. On the face of it, the company looked like it was running a tight ship. Revenues of around a few million dollars and a customer base of a few hundred stores, we had no reason to believe the company was hiding anything. But once we started digging deeper, the story started to unravel rather quickly. The company only had about 10 employees in total. The CFO of the company had been working as a cashier in another jewellery company only a few months before the IPO. One of the full-time directors of the company responsible for administration was still in graduate school and was only 20 years old. Also, a significant portion of its business came from selling gold to another company owned and managed by the promoters themselves and they did all this by outsourcing their entire business operation.
“I can’t divulge all this information. Who are you guys?”
We tried calling the promoters and ended up talking to the 20-year-old director. He was confident, to begin with, but when we started pressing him on matters of financials he quickly got defensive. He kept insisting he could not offer us an explanation because this information was ‘proprietary’ and he couldn’t divulge such matters because of legal reasons and we did not press him further.
We wrote a scathing report on the company castigating the promoters and their business model, criticizing them for wanting to raise over a million dollars — only to then watch the retail public buy their stock and subscribe to the IPO like there was no tomorrow. The public wanted more of this company and it didn’t make any sense to us. “Who in their right mind is buying this?” scoffed Bhanu, one of our co-founders. We kept writing story after story, report after report pointing out loopholes in these businesses and the sorry state of the company financials only to watch the issue get subscribed time and time again.
The Invisible hand of the Stock Operator
It was only much later we found out how subscriptions actually ran. Usually, it’s not your average retail investor that buys shares during the primary offering (IPO). Instead, companies hire stock operators who — subscribe to the issue, bump up the prices artificially post the listing and then offload them to the general public once the price becomes attractive enough for gullible investors to jump in. There is always a retail investor looking to make a quick buck off of “stocks-on-the-rise” and once the dust settles they are often left with a dud stock that is pretty much worthless. We spoke to one such operator. He talked to us in a very nonchalant manner and told us this was all part and parcel of the SME market and that if it weren’t for people like him most issues would go unsubscribed.
“I don’t go to promoters. They come to me. Its these guys that ask me to subscribe the issue for a discount. If I get a 6 Crore ($850,000) issue for 5 Crores ($700,000) I will buy the whole thing and operate the price” — Friendly Operator
So the designated operator decides to bid for all the shares through his network of professionals and then when the actual transaction is complete, the promoter returns some money to the operator as kickbacks for his service. There are good incentives for the promoter to go through with such an arrangement. If the issue isn't subscribed fully, the exchange will drop the listing, return all the money raised and the promoter will end up losing a considerable sum of money — money spent in trying to list his company in the first place. So if an operator will bear the burden of ensuring a complete subscription, the promoter will gladly comply. Once the listing is complete, the operator will bide his time, ramp up the prices and offload his shares to the retail public. This is one way you could get an issue subscribed.
Along the way, we’ve covered many SME companies. But perhaps one of the most egregious cases cropped up when a certain Film Distributor wanted to raise over a million dollars for his company with a combined financial track record of a mere 11 days. To put that into context, you could theoretically start a business today, infuse some capital (mostly cash) and raise over a million dollars from the public in just under 2 weeks, once you have the Red Herring Prospectus approved. The red herring prospectus is a document submitted by a company (issuer) as part of a public offering of securities (shares). This document contains the risks and the potential pitfalls associated with investing in a newly listed company. The only catch here is that SMEs don’t actually require the explicit approval of SEBI — India’s regulator for the securities market. Instead, the prospectus is approved by the exchange and the company gets the go-ahead to list itself on the SME exchange portal. Although the rules for listing have since changed, exchanges don’t often flag objections because of an inherent conflict of interest. Exchanges make money when companies go public and so there is little incentive for exchanges to play spoilsport, except when it thinks the regulator could step in. When we met an insider from one of the exchanges and quizzed him about this matter he simply said
“Nobody reads the RHP (Red Herring Prospectus) for these SMEs. Not the investors, Not even the promoter” *laughs*
Despite the slew of negative stories we’ve published on SME’s, there were a couple of companies that offered some hope. One company, in particular, had a lot going for it. When we found discrepancies in the balance sheet and called the compliance officer, the CFO personally assured us that the erroneous figure was a misprint and offered us an elaborate explanation of the company’s financials. It was in the Government’s interest to promote companies like these when the proposal for an SME stock platform was initiated. It is quite unfortunate that it’s being hijacked by greedy promoters and fringe financial institutions that are looking to profiteer off of SME’s by duping the public and getting away with millions scot-free.
Our hope is that both the exchange and SEBI look into this matter with intent and focus on getting more credible companies on board, instead of letting a few bad apples rule the roster. The lax compliance standards for SME’s were put in place to make the listing process hassle-free. However, it is quintessential to balance this act to prevent sham companies uproot the integrity of the entire industry. A thorough re-evaluation of compliance standards for SME listings could go a long way in promoting the interests of both SMEs and the Indian Retail investor.
And if you know anyone who's been raving about scams, this is the story they should be reading. So don't forget to share on Whatsapp, Twitter and LinkedIn.
Also, no Briefs today since most of our team is on leave. It's the festive season after all. However, we will be back tomorrow. So stay tuned :)