[Avinash Kotval and Aviral Bhardwaj are final and penultimate year BBA LL.B. (Hons.) students, respectively, at Jindal Global Law School, Sonipat]
On April 19, 2024, the Securities and Exchanges Board of India (‘SEBI’) released a consultation paper on ‘Framework for Price Discovery of Shares of listed Investment Companies & listed Investment Holding Companies’. This consultation paper intends to solicit comments from the public on a new framework to facilitate the price discovery of shares of listed Investment Holding Companies (‘IHCs’) and Investment Companies (‘ICs’). It follows the regulator’s observation that the stocks of these companies are trading at a substantial discount on their book value. While the proposed framework may assist in achieving a more accurate price discovery for such investment companies, it does so at the expense of relinquishing certain existing price discovery mechanisms designed to protect investors and the market at large.
Background
The consultation paper has emerged in response to a concerning trend reported surrounding the trading activity of certain ICs and IHCs. These companies, which predominantly generate revenue from interest and capital appreciation on investments, often find their shares trading infrequently at prices significantly below their disclosed book value. ICs, devoid of day-to-day operations, focus solely on holding investments across various asset classes, including substantial stakes in other listed entities. Similarly, IHCs, having 51% or more in different companies, follow a similar model. Despite the considerable market value of their investment portfolios, there exist discrepancies between their book value and market value, specifically when their underlying investments are predominantly in shares of other listed companies. This discrepancy has raised concerns among certain market participants, who emphasize that it is “adversely affecting liquidity, fair price discovery and the overall interest of investors” of such companies.
Further, market participants also have made representations stating that the current model of price discovery is restricted by the presence of differential price bands and circuit breakers, making it impossible to discover the prices of these stocks closer to their value that can be represented by the investments these ICs and IHCs hold. A consequence of this significant difference between the market price and book value is that the volume of the traded stocks is meagre, with the liquidity near zero.
The Consultation Paper
As a result of the concerns mentioned above, these market participants have suggested allowing for a “free price discovery” model. SEBI proposes to do this through a ‘special call-auction’ mechanism conducted by the stock exchanges without any differential price bands for the shares of ICs and IHCs being traded below a particular discounted value.
Differential price bands and circuit breakers are crucial mechanisms implemented by SEBI to regulate stock market volatility. Differential price bands, applicable on individual stocks, delineate permissible price ranges within which a stock’s value can oscillate during a trading day. Any trades attempted outside this range are automatically rejected by the exchange. These bands are determined by the respective exchanges based on the previous day’s closing price and vary from 2% to 20%, depending on the various factors. Circuit breakers, on the other hand, are overarching safety nets tied to market indices like the BSE Sensex and NIFTY. Triggered by significant index movements, these breakers halt trading activities across equity and derivatives segments at 10%, 15%, and 20% thresholds. Trading is halted for a specified period based on which threshold is reached and the time of the day at which the threshold is triggered. Circuit breakers and differential price bands act as safeguards against market crashes, allowing for a temporary pause to reassess market conditions and restore stability.
A call-auction, as opposed to continuous trading, allows market participants to submit their orders to buy or sell securities at specified bid or ask prices, as prescribed under Paragraph 17 of Chapter 1 of SEBI Master Circular for Stock Exchanges and Clearing Corporations, 2023. These orders are then gathered and matched together at predetermined time intervals. In this system, buyers indicate the maximum price they are willing to pay for shares, while sellers specify the minimum price at which they are ready to sell. Unlike continuous trading methods, where orders are matched as they come in, call-auctions execute all collected orders at a single price, representing the best overall match.
There are three main criteria for the ICs and IHCs to be eligible for the special call-auction. Firstly, the stock exchanges must have listed the company for at least one year, and the company must comply with the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. Secondly, they must have invested at least 50 per cent of their assets in shares of other listed entities. Finally, the six-month volume-weighted average price (‘VWAP’) of the scrip must be less than 50 per cent of its book value. Further, the stock exchanges may make these special call-auctions available to the ICs and IHCs based on their existing industry classification.
Regarding the procedure for conducting this call-auction, the consultation paper notes that once the stock exchanges have identified the eligible ICs and IHCs, they shall initiate the process of the special call-auction with seven days of prior notice. The onus is on the stock exchanges to publish detailed and updated information on the overall book value of the ICs and IHCs, their book value based on current investments, the list of investments held, and the price at which the stocks are traded on the stock exchange’s website. The special call-auction may only be treated as successful if at least five unique buyers and sellers participate in the process. If it is deemed successful, the discovered price shall be the new price of the stock. If the call-auction is unsuccessful on the first day, it shall continue to the next day, until the special call-auction is successful.
Analysis and Suggestions
The proposed solutions to achieve the objectives laid down by SEBI have to be critically analyzed to prevent malicious activities associated with the stock of the ICs, and IHCs. There are two central issues linked with the proposed framework. Firstly, the removal of the differential price bands for the purposes of price discovery has the potential to subject the price to severe volatility and market manipulation. The movement of the stock in the absence of the differential price bands makes the stock vulnerable to manipulation in the hands of traders. There is a substantial likelihood for collusion between the market traders in such a case to artificially inflate or deflate the price of the stock, which would still show variation from the book value.
The second issue that can be identified is the minimum requirement of five unique traders for the successful completion of the call-auction. With the low number of traders required to qualify a successful call-auction session, it is not inconceivable to foresee increased market manipulation by colluding buyers and sellers. This concern is only amplified by the suggestion to remove price band and other market surveillance mechanisms.
The bold nature of the proposal is essential in achieving the goals laid out under the consultation paper. However, certain checks and balances are necessary to prevent the misuse of such a special call-auction session. Firstly, instead of conducting a special call-auction without any differential price bands, it would be prudent for the regulators to increasing differential price bands from the existing price bands to 30% and 40%. Secondly, increasing the lower threshold of the number of unique traders required to qualify for a successful call-auction from five to ten, which would further reduce the threat of stock manipulation through colluding traders. With such an implementation, the safety mechanisms of price bands will be retained preventing stock manipulation while also providing flexibility to discover the accurate price.
Finally, if the suggested differential price bands are implemented, it would be prudent to increase the number of days over a period of a year where the special call-auction would take place. With the increased number of call-auction sessions, price discovery would ensue progressively. It would also facilitate a gradual and more accurate discovery of price of the stocks of the ICs and IHCs. Such a mechanism would further combat volatility of the stock, while also protecting the overarching interest of the investors.
Conclusion
While SEBI’s proposed framework presents a promising system by which the traded values of the stock eventually align with the companies’ book value, it falls short in safeguarding against market manipulation due to forsaking the very market surveillance mechanisms it deems crucial. By integrating measures addressing these gaps, SEBI can foster a market environment conducive to accurate price discovery and mitigate the risks of collusion among market participants.
– Avinash Kotval & Aviral Bhardwaj
