The Indian regulator’s recent crackdown on 331 suspected shell companies is a significant step in the government’s bid to punish money laundering and black money, but it comes at a cost to foreign investors.
Authorities in India have taken a number of measures in recent months to curb centuries-old corruption entrenched in the system, including the demonetisation of high currency notes and pushing cashless transactions. The latest directive by the Securities and Exchange Board of India (Sebi) to India’s stock exchanges to halt trading of the 162 listed firms in the circular is unprecedented.
‘If you are an investor there you are stuck, because you can only sell on the first Monday of every month… and that too, if there is a buyer,’ Sudip Mahapatra, partner at law firm S&R Associates told Citywire Asia. ‘The [Sebi] circular says the buyer has an enhanced margin requirement so it’ll be difficult to find a buyer even on that one day you can trade the stock.’
The circular, dated August 07, stated that buyers will have to pay an ‘additional surveillance’ deposit of 200% of trade value to the exchange, which will be retained for five months. Foreign institutional investors hold stakes in as many as 24 companies, according to moneycontrol.com, an Indian online trading and news website.
Some companies have challenged the order through the country’s Securities Appellate Tribunal and have been allowed to trade in the interim as authorities carry out investigations. Yet, the impact on share prices has been significant.
J Kumar Infraprojects, a relatively well-known construction company, saw its share price tank 20% after it resumed trading.
‘The number of people willing to sell is huge so I think a lot of foreign investors are looking to get out. Unfortunately, there were only sellers and no buyers at one point,’ said Mahapatra. ‘That’s another problem facing foreign investors.’
The firm is partially owned by foreign institutional investors and mutual funds, such as Goldman Sachs Asset Management, BlackRock and Wellington Management, according to Morningstar data. Fullerton Lux Funds – Asia Small Cap Equities had a small exposure to the company as of March 31.
US-headquartered smart beta pioneer Dimensional Fund Advisors has also bought shares of some of the listed companies, including Prakash Industries, which was allowed to resume trading last week but also hit the lower circuit of 20%. The mining and steel company released an open letter to the National Stock Exchange of India, stating that it was not a shell company by ‘any stretch of imagination’ and had an annual turnover of INR 2400 crores ($375 million) and profit of INR 78 crores. It currently has 52,000 shareholders, according to the statement.
The Securities and Exchange Board of India hasn’t disclosed what it defines as a ‘shell company’ but according to local parlance, shell companies don’t simply indicate entities without assets for tax evasion purposes. They also include firms that help convert black money to white and act as vehicles for money laundering.
‘With the curbs on cash transactions following demonetisation, the government has been tracking whether there has been a spike in digital transactions and whether that’s concomitant with their business activities,’ Siddharth Goel, senior analyst, South Asia at Control Risks said in an interview. ‘With certain companies, where they’ve found red flags, they’ve flagged to the regulator.’
According to research done by First Post, an Indian media house, at least 10 of the listed companies have no net sales.
‘As a foreign investor, why would you invest in a company with no net sales? There’s a clear red flag there,’ said Mahapatra. ‘Another red flag is if the revenues and assets don’t justify the valuations,’ he added.
According to Goel, aside from looking at the financial and legal statements of firms, foreign investors ‘need to have a more comprehensive risk management approach’.
‘Proper checks on business activities, ownership structures, have they been flagged in the past by regulators and stock exchanges for irregularities, for example,’ he said.
As more companies challenge the circular, it is now a wait-and-watch game, but the future looks bleak for firms that will be declared as shell companies.
‘There will have to be either compulsory buybacks or liquidation. But if it is a shell entity, who will do the buybacks? So far, there’s no clarity around this,’ said Mahapatra.