Whom will the SME exchange benefit?
Moneylife Digital Team 10 August 2011

Given the poor interest of retail investors, state of the intermediaries and poor governance standards, SME exchanges are likely to be useless

While the market regulator has allowed the two national stock exchanges to launch exchanges for small and medium enterprises (SMEs) it is not clear whether these exchange segments have any chance of success. Given the current lack of interest among retail investors in equities, poor governance standards and absence of empathy for investors among regulators, SME exchanges are doomed to failure. SMEs are unlikely to look up to these exchanges to get access to funding, better valuation, and improvement in governance standards. Shady SMEs may in fact use the lax rules to exploit the system.

The rules of the new BSE SME specify that that the post-issue face value capital should not exceed Rs10 crore. The SMEs with post issue paid-up capital between Rs10 crore and Rs25 crore are given the option to list either on the SME Exchange or on the main board. The minimum application and trading lot size shall not be less than Rs1 lakh. The issues shall be 100% underwritten and merchant bankers shall underwrite 15% in their own account. SEBI (the Securities and Exchange Board of India) has compulsorily mandated market making of all scrips listed and traded on the SME Exchange. The market makers are required to provide two-way quotes for 75% of the time in a day.

These are designed for ease of entry, but in a country like India where the governance standards are so poor, this will cut both ways. Let's look at the possible pitfalls of the current set of rules based on ground realities. As per SEBI's rules, the merchant bankers shall be responsible for market-making for a minimum period of three years. We do not have the concept of seasoned market makers in the country as of now. Given the current state of investment banks, would they have the money, interest and desire to commit to market-making-that too of small companies?

As per the rule, the market maker shall be allowed to deregister by giving one-month notice to the exchange. What will happen to the illiquid SME and its investors? While the merchant banker is required to file a copy of the offer document (RHP, or red herring prospectus) with SEBI, the latter will not give any observation on it. Who will then monitor the quality of the SME issues, especially since SEBI even currently allows all kinds of shady companies to list, despite performing some oversight? The exchanges surely would not be interested in enforcing any governance standards. After all, the BSE is a den of illiquid and shell companies whose stocks are freely being manipulated, as Moneylife has repeatedly pointed out.

The compliance norms of SMEs have been simplified for no reason at all. They have been allowed to report results half-yearly, instead of quarterly. This is absolutely ridiculous. All companies now have to do e-filing of statutory accounting reports, income and sales tax etc. to the government.  Companies themselves are computerised in their accounting systems to obtain monthly reports. Basic financial accounting in all companies is directly on the computer. There is hence no technology limitation, on account of which the companies should submit half-yearly reports and not quarterly reports.

The lax rules also allow SMEs to send abridged versions of the annual reports instead of the full annual report. This will not help build investor confidence, especially in companies that are unknown. The SMEs have also been exempted from the criteria of track record of three years of profit making. It is sufficient to report profit in three out of five years for listing on the SME Exchange. This is another completely anti-investor rule. Why should small investors (no institutional investor would really be interested in small companies), be exposed to loss-making small companies, which anyway are far riskier? This will only encourage even more garbage to enter the listed space. Shares will be traded in a lot on the SME Exchange instead of single shares as is possible today. This is a deterrent for creating liquidity.

While formulating these harmful rules, the regulator seems to have forgotten that listing of small companies that happened in two large gushes in the mid-80s and mid-90s. The primary market scandal of 1994-95 led to the phenomenon of vanishing companies. Successive market scandals, price rigging, poor disclosures, and dubious accounting, etc., have meant poor returns and poor trading. Poor returns and illiquidity have put investors off the market, which in turn had discouraged businessmen to come and tap the public market for almost a decade. The NSE (National Stock Exchange) and BSE (Bombay Stock Exchange) had then put restrictions on small companies entering the market. The Indian market system, corporate governance standards and anti-investor bias has not changed much. The new small exchanges, if they ever get off the ground, will go the same way as the Over the Counter Exchange of India.

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