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The authors are Ashu Daga, a third year student at Maharashtra National Law University, Mumbai, and Shivkumar Daga, Share Broker and Market Analyst.
Introduction
Indian markets have been on a growing traction since the inception of Bombay Stock Exchange in the year 1875. Today, India has amongst the largest securities markets around the globe with a huge volume of stocks and trade taking place on a day-to-day basis. This can be reflected in the fact that India has now overtaken China as the most attractive Emerging Market (EM) for investment. The report by Invesco titled ‘Invesco Global Sovereign Asset Management Study' marks India as the most favoured macroeconomic environment, becoming a bull’s eye for investors. A lot of this growth and success can be accredited to the timely and organized interventions by Securities and Exchange Board of India (SEBI). Established in 1992, the basic functions and objective of SEBI is to protect the interests of investors in securities along with the regulation of the securities, as stated in the Preamble of SEBI Act, 1992. It is responsible for setting the legal framework for the two stock exchanges of India- BSE and NSE, in order to check the exploitation of investors. But there are certain policy decisions that adverselyaffect the interests of investors as well as companies, albeit introduced with an intention of promoting and safeguarding interests of investors. One such regulation that this article focuses on is the Enhanced Surveillance Mechanism (ESM), which is a step in order to curb volatility of small-cap counters by bringing them under excessive scrutiny.
What if a company is identified under Enhanced Surveillance Mechanism?
Companies with market capitalization of less than 500 crore would be subject to enhanced surveillance. As per SEBI, this measure would be significant in inspecting and managing price fluctuations leading to a stable market. It is being speculated that this measure would prove efficient in bolstering the investor confidence and would lead to sustained and organic market growth. Once a company is under enhanced surveillance, it would be determined if it falls within ESM – Stage 1 or ESM- Stage 2. The price band for a company falling under ESM- Stage 1 is 5%, which means that the maximum fluctuation of the stock prices of the company would be limited to 5%, the base being the previous day’s closing price. Similarly, a company falling under Stage 2 will have a price band of 2%. The common element of both stages is that the investor needs to have a margin of 100% which means that investor has to deposit with their broker or exchange to cover the credit risk the holder poses for the broker or the exchange as a collateral. A margin account enables the investor to purchase more securities than they could otherwise buy with balance in their account. But under the 100% margin requirement, collateral margins would no longer be provided. There are certain restrictions on the intraday trading of such securities. Moreover, these securities have to undergo a review period of three months if identified under Stage 1 and an additional review period of 1 month if the security identified under Stage 2 is transitioning to Stage 1. The price variation must be limited to 8% over this month for a security to transition to Stage 1. Ultimately, it is believed it would alert and advice investors to be extra-cautious as well as advice market participants to carry out due diligence while dealing in these securities.
Is ESM actually safeguarding and promoting interests of the investors?
Albeit, prima facie it seems that ESM as a measure would lead to stability in the market but in reality this leads to apprehensions amongst the investors to invest in the securities market. This leads to hinderance of market growth and would in long run result in stalling the growth of the securities market. If an investor, has purchased stocks of XYZ company and due to price fluctuations, such company comes under enhanced surveillance, then this takes away the opportunity from the investor to exit from the stock which under normal circumstances an investor would have been able to do without bearing much losses. This is because when a stock is classified under ESM, a negative market perception is created that such stock is involved in price rigging or market manipulation strategies. This leads to curtailment of trade since there are no buyers for that particular stock as a result of the negative market perception. The outcome of this is that liquidity in the market starts drying up leading to a creeping market growth as opposed to an investor friendly - liquidity oriented market growth. Liquidity determines the ease of trading a stock without any effect on the prices. Therefore, a higher liquidity is a sign of a healthy market. Moreover, the restrictions upon intraday trading further exemplify the adverse effects on the liquidity in the market. Furthermore, being classified as ESM affects a company’s reputation and it becomes difficult for the promoter to raise capital and get loans.
The author argues that Enhanced Surveillance measure might be a welcoming step towards maintaining market integrity, but the basis on which a company is brought under Enhanced Surveillance is questionable. Objective parameters are being taken into consideration mainly – High low variation, close to close price variation, standard deviation and market capitalization. It is pertinent to note that all these considerations revolve around the price fluctuations, as a result of which even a company whose performance has been exceptional in the past, who has shown steady growth and has an excellent management would be under enhanced surveillance, just because of the price fluctuation. The author argues that the parameters taken under consideration need to be broadened in order to avoid organically growing companies hindering their growth and development as a result of being identified under enhanced surveillance. Parameters like management of the company, its past records, debt-to-equity ratio, interest ratio coverage , operating profit margin and more such fundamental parameters that determine the health of a company must be taken into consideration. For example, recently a renowned defence manufacturing company named Walchand Nagar Industries is under the scrutiny of enhanced surveillance (Stage 2) on the basis of price fluctuations. This company has been part of multiple ISRO projects, is a part of Indian Space Association and has been showing stable and steady growth over these years. The reputation of the company has been adversely affected as a result of enhanced surveillance and this would stall the growth of such a contributing and valuable company. There are many more examples of companies that have suffered collateral damage due to the ESM measure. “Not all companies under ESM are involved in rigging or malpractices, there are some with genuine balance sheets and involved in real groundwork,” as stated by the founder of Mercury EV Tech. They have challenged the ESM framework at Securities Appellate Tribunal (SAT). Subsequent to this, SEBI decided to ease the rules for trading in stocks identified under Stage-II. As per the revised rule, from July 24 stocks under Stage-II are allowed to trade on all days but with the +/- 2% price band and other restrictions remaining unaltered. Despite of the ease in the regulations, the parameters on the basis of which a company is identified under ESM, and as a result of which it has to face the adverse effects on the growth in the market, remain questionable.
There already exists a surveillance mechanism named Additional Surveillance Measure (ASM), that has similar provisions to ESM. SEBI could achieve its objective of curbing volatility of small-cap counters by bolstering the ASM, which is blanketly applicable on all the stocks irrespective of the company’s market capitalization. The need to classify the company based on the market capitalization and introducing ESM as a similar mechanism to the already existing ASM seems to be an unnecessary intervention by SEBI. Thus, SEBI needs to justify the introduction of ESM specifically for Micro-Small Companies. Securities Appellate Tribunal (SAT) must question the ESM framework on these grounds.
Conclusion
The underlying objective behind SEBI's Enhanced Surveillance Mechanism (ESM) to promote and safeguard interests of the investors is creditable. However, the narrow focus placed on price variations results in turning a blind-eye to the fundamental aspects of a company's health, resulting in an unfair categorization and damage to reputable companies. A justified balanced approach is quintessential, considering fundamental aspects and industry reputation to avoid curtailing the growth of genuine emerging companies. The questions posed by market players and the hearing underway at the Securities Appellate Tribunal (SAT) highlight the need for SEBI to re-evaluate and justify ESM's introduction, especially when a similar mechanism (ASM) already exists. Potential adverse effects on market liquidity and investor conviction must also be given due regard in the re-evaluation.
In conclusion, market integrity must be maintained with a more integrated and exhaustive outlook to surveillance, striking a fair balance between protecting investor interests and fostering a healthy, organic growth-oriented market environment.
Good read, well argued and reasoned.