India's market regulator has barred JM Financial from taking on new public issues of bonds after it said it had observed unfair practices that could affect the orderly functioning of the debt market, suggesting that some demand for retail issues was inflated.
The Securities and Exchange Board of India on Thursday forbade JM Financial to take new lead manager mandates for any public issue of debt securities for the next 60 days, though it can act as a lead manager for existing mandates.
The sanction came two days after the Reserve Bank of India prohibited JM Financial Products, the group's non-bank lending unit, from any form of financing against shares and bonds, including loans against IPOs, citing "serious deficiencies" in its lending processes.
Sebi said that after a routine examination of a particular public bond issue it had observed that "a significant number of individual investors sold the securities allotted to them on the day of listing itself". Also, "the holding pattern of the securities showed that a very large percentage of securities issued changed hands on the day of listing, as result of which retail ownership came down sharply," which was unusual.
The loans extended to retail investors to buy that bond issue were disproportionate to their declared income, according to Sebi. Some applicants were granted loans that were double the amount of their annual income, and some individuals took loans at a 10% interest rate to invest in bonds paying 9.35%.
The particular bond issue which Sebi investigated was by Piramal Enterprises, according to market participants. Sebi did not name the issuer, but gave details of the size, tenors, coupons and issue period, which exactly matched Piramal's deal.
The non-bank lender raised Rs5.33bn (US$64m) in tenors of two to 10 years at 9% to 9.35% on November 3 last year in a deal rated AA by Care. AK Capital Services, JM Financial, Nuvama Wealth Management and Trust Investment Advisors were the other lead managers on the deal and have not been accused of wrongdoing. Piramal did not immediately respond to an email seeking confirmation that it was the issuer of that deal.
Sebi noted that JM Financial Products, which received the largest share of the deal, acted as "counter party to the trades of these individual investors and had also provided the funds deployed by these investors for subscribing to the issue," and subsequently, on the same day, offloaded a significant portion of the bonds that it had acquired from these investors to corporate investors at a loss.
Retail and high-net-worth investors were allocated 75% of the bonds in the offering, while institutional investors were allocated zero. On listing day, 1,106 of the 9,121 individual investors sold their bonds to JM Financial Products. Within two hours of listing, JM Financial Products bought Rs10bn in principal amount of the bonds from them at an average price of Rs1,002.5 and resold most of them within an hour to corporates and a broker at Rs994, for a 0.8% loss. It repeated the pattern several times that day.
These transactions were done in a "pre-determined" and "synchronized manner," whereby JM Financial gave assured exits to certain investors at a profit "thereby incentivizing them to apply in the public issue in contravention of the regulatory mandates", said Sebi. The regulator said the manner in which the subscriptions were managed was "shocking" and compromised market integrity and fair price discovery.
"Transactions were cross-subsidized within the JM entities to ensure success," said Sebi. "Some transactions were done for free and others at a loss. However, the issue was a win-win for its ecosystem, its related entities and its investors."
Meanwhile, on Tuesday, the RBI said that JM Financial Products had "repeatedly helped a group of its customers to bid for various IPO and NCD [non-convertible debenture] offerings by using loaned funds. The credit underwriting was found to be perfunctory, and financing was done against meagre margins." Apart from regulatory violations, there are "serious concerns on governance issues" at the company, the central bank said.
"The application for subscription, the demat accounts and the bank accounts, all were operated by the company using a power of attorney and a master agreement obtained from these customers without their involvement, whatsoever, in the subsequent operations," RBI said. A demat account allows investors to hold shares and securities in electronic format.
JM Financial is a large Indian financial group which offers IPO financing, broking and merchant banking.
Slow growth
Market participants said the regulators' moves will slow down the previously booming market for retail issues of bonds and shares, and bring into question just how much real demand there was for past sales.
Public bond offerings reached Rs174.4bn since the start of the current fiscal year on April 1 last year, the highest for any fiscal year in the past five years, according to Sebi data.
A fund manager claimed that retail subscription numbers for public bond offerings did not give a true picture of demand, as many orders were driven by leverage.
"The retail investors were not more than 5% to 20% in any particular issue," said another market source who earlier worked on a public issue. "The arrangers for public issues were making money on the fee and the spread in the coupons between retail and institutional investors."
A DCM banker said the practices have been "rampant for many years" and "there was synthetic/artificial retailisation, as retail investors were incentivised to participate" by the lure of quick returns.
"Public issues in the bond market will prevail, but with the right practice," said a second DCM banker.
The RBI's action could also have an impact on subscription numbers for IPOs in India.
"We are seeing massive oversubscription in the IPO market in India. The oversubscription levels will come down a bit temporarily following the RBI move," said a director at an equity broking and wealth management firm in Mumbai.
While Sebi has examined only one public bond issue, "the bank statements of the investors, operated through power of attorney by the JM Group entities, suggest that this practice is followed in most public issues" and it is "not an isolated incident", it said.
The market regulator said that it had taken an interim action, pending a fuller investigation, "to prevent any further erosion in market integrity by virtue of such practices".
JM Financial did not immediately respond to a query about Sebi's order.
In response to Sebi's query on providing an exit to investors, JM Financial said it is "constantly looking at debt papers in the market to do active market making for the purpose of creating liquidity," and accordingly purchased the bonds from investors who "wanted to exit, to avail other opportunities".
JM Financial, which saw its shares plunge 14% on March 5 following the RBI's action, denied any wrongdoing in relation to that probe. It said in a statement on March 5 "there have been no material deficiencies in our loan sanctioning process. Further, the company has not violated applicable regulations. We also wish to reaffirm that there have been no governance issues whatsoever and we conduct all our business and operational affairs in a bona fide manner."
The non-bank lender said it will continue to service its existing customers as advised by the RBI and fully cooperate with the central bank's investigation.