Capital market regulator Securities and Exchange Board of India (Sebi) has directed stock exchanges to initiate action against 331 listed firms that the Ministry of Corporate Affairs suspects are shell companies. The companies have protested — and several of them moved the Securities Appellate Tribunal against Sebi on Wednesday. Why has the regulator acted with this seemingly unprecedented harshness? What is the significance of the order, and where can this situation lead?
What is the Sebi order against the suspected shell companies?
Sebi has directed that shares of 331 companies will be kept in Stage VI of the Graded Surveillance Measures (GSM) with immediate effect. GSM is a framework of enhanced surveillance of companies that came into effect on March 14 this year, to enhance market integrity and safeguard the interests of investors. According to an FAQ on GSM on the web site of the Bombay Stock Exchange, “securities which witness an abnormal price rise not commensurate with financial health and fundamentals like Earnings, Book value, Fixed assets, Net worth, P/E [Price/Earnings ratio] multiple, etc.” will be put under GSM. Under the GSM framework, monitoring is carried out in six stages, with progressively tighter actions. Stage VI is the highest stage of surveillance.
Starting Wednesday, therefore, the shares of these companies have stopped trading on the bourses, and will be allowed to be traded only once (the first Monday) every month. The companies will be subject to independent audit, and to a forensic audit of their financials. After the completion of the audits, if the exchanges do not find evidence that these companies indeed exist, they will be delisted.They will not be permitted to deal in any security on an exchange platform, and their holdings in any depository account will be frozen until the completion of the delisting process. Of the 331 firms identified by Sebi for action, 162 were actively traded on BSE Ltd; 48 were traded on the National Stock Exchange (NSE). The rest have already been suspended by the bourses on account of irregularities.
How have the companies reacted against the regulator’s directive?
Several companies have protested the Sebi directive as unjust. Firms such as builder Parsvnath Developers, steel and mines company Prakash Industries, liquor manufacturer Pincon Spirits, financial software firm SQS India BFSI, and construction engineers J Kumar Infraprojects, have all said they are not shell companies. Some companies, including Prakash Industries and J Kumar Infraprojects, on Wednesday moved the Securities Appellate Tribunal (SAT), the statutory body to which appeals against Sebi’s orders lie.
But what is a shell company? Is it illegal to set up a shell company?
In common parlance, a shell company is a non-operational company that is used as a vehicle for various financial manoeuvres, or is kept dormant for future use in some other capacity. Interestingly, the term “shell company” is not defined under the Companies Act, 2013. A shell company is per se not illegal — as long as it is not used for an illegal act, such as manipulation of share prices, evading taxes, or financial fraud.
So, why did Sebi move against these companies?
These 331 companies are allegedly being investigated for tax evasion and corporate fraud, and have been referred by the Income-Tax Department and Serious Fraud Investigation Office (SFIO) to the Corporate Affairs Ministry and Sebi for further action. As part of its efforts to stamp out black money, the Ministry has already cancelled the registration of more than 1.62 lakh companies that have not carried out business activities for long. In July 2015, the Special Investigation Team (SIT) on black money had recommended proactive mining of the Registrar of Companies (RoC) database to weed out shell companies. The recommendation came after the SIT found shell companies were being used to provide accommodation entries to launder black money in a number of high-profile cases that had been investigated recently. The government has also constituted a task force under the co-chairmanship of Revenue Secretary Hasmukh Adhia and Corporate Affairs Secretary Tapan Ray to monitor actions against deviant shell companies by various law enforcement agencies.
And what is the significance of the Sebi directive?
This is probably the first time that Sebi has issued a circular naming so many companies as suspected shell companies. The regulator has in the past asked the bourses to suspend trading in companies and initiate penal action, including suspension of trading, for violations of its norms.
According to the BSE, the total public float of the 331 companies is Rs 12,000 crore. At least 13 firms had a market capitalisation of more than Rs 300 crore each. The ban on trading may adversely affect both institutional and small investors in these companies. The damage to their reputation is a big reason why companies are protesting.
While the companies accuse Sebi of having violated the principles of natural justice in not giving them a hearing before issuing the circular, proxy advisory firms feel Sebi’s move will help protect the interests of small investors. J N Gupta, co-founder and managing director of proxy advisory firm Stakeholder Empowerment Services, said Sebi’s preventive measure will have a temporary negative impact on the stock markets but will help weed out companies which do not have genuine business operations, and will limit the exposure of small investors to such companies in future.
According to Amit Tandon, founder and managing director of Institutional Investor Advisory Services, Sebi’s circular is in the direction of expanding the role of bourses, the frontline regulators that ensure compliance and keep a watch over economic offences and money laundering. “Stock exchanges will now have to gear up for this, and come up with mechanisms to monitor companies,” Tandon said.