India’s stock markets are on a roll. During the past year, Indian companies raised more than $6 billion in capital on the Bombay Stock Exchange, the National Stock Exchange and other regional stock exchanges. By some measures, stock prices have gone up by nearly 50% in recent months. When stocks soar to such giddy heights, that places a heavy burden on the Securities and Exchange Board of India, or SEBI, which is responsible for protecting investors. M. Damodaran, SEBI’s chairman, is a soft-spoken regulator who combines candor with a taste for poetry. Before taking charge at SEBI, he helped manage crucial transitions at the Unit Trust of India and the Industrial Development Bank of India. He spoke with India Knowledge@Wharton about issues ranging from the transparency of financial reporting to the principal risks that confront global institutions rushing to invest in India.
Knowledge@Wharton: In the 1970′s and 1980′s, before the Indian economy was liberalized, some trade union leaders did something curious when they went to negotiate with managements. When they entered the conference room for the meeting, the first thing they did was pick up the annual report and balance sheet and throw them into the garbage bin. The point they were trying to make was that there was no correlation between the economic reality of the company and the financial disclosure in those documents. Now, after liberalization, has the environment changed? Is the state of financial disclosure in India more credible and transparent?
Damodaran: I haven’t heard anybody in recent times picking up an annual report and throwing it in that manner so clearly, much of that must be ancient Indian history. That said, I think no regulator or for that matter no investor, no shareholder ought to be ever entirely satisfied with the state of disclosures. The minute that constituency is fully satisfied, clearly complacency sets in and then managements are tempted to either to say less or to say things less clearly, and you don’t want either.
Knowledge@Wharton: In what areas do the challenges still remain, as far as disclosure goes?
Damodaran: I think some of it is historical. Some of it was that in a closed economy, in an economy in which companies did not have as many shareholders as they now have, lesser number of companies were listed and corporate governance was not on anyone’s active vocabulary. In that kind of a situation, fewer questions tended to get asked. So long as the returns were reasonable and there was some appreciation in the value of stocks you held, shareholders did not think it important enough to ask how the company was being run, could it have been run better, could it have been run differently, whether the company was doing well enough within its sector, and questions of that kind.
Today, those questions are getting increasingly asked. As a result, managements are either seeking to answer them or anticipating those questions and putting out the answers. I think that there is also the recognition that the market, over time, has tended to reward companies that disclose more and disclose better.
Knowledge@Wharton: Before you came to SEBI in February 2005, you were instrumental in engineering a turnaround at the Unit Trust of India, India’s largest mutual fund. The UTI, at that time, had gone through a crisis that has come to be known as the “US-64 Scam”. For those of our readers and listeners who are not familiar with that situation, could you describe what happened at UTI and how you were able to turn the situation around?
Damodaran: Let me tell you first something about the institution as it then existed; it has undergone a change since then. In 1963 the act was passed; it’s a creature of a separate statute. In 1964 its first scheme, which was Unit Scheme-64, abbreviated as US-64, [that's the way it is remembered now] was launched. It was intended to be a vehicle to mop up the savings of the average Indian and put it to productive use. This was the first ever attempt of that kind.
There were no assured returns promised at any point of time from 1964 until 2002 when the scheme was wound up. I have read every single offer document pertaining to those times, considering the circumstances in which I got to UTI. There was no assurance for protection of capital. And yet, every investor that invested believed that the returns would only get better — the capital in any case was protected. There was a perception that the government of India was behind the scheme. The institution could not fail, the scheme could not fail, the upsides are yours to capture and there could never, ever be downsides. It was not a case of conscious miss-selling, but it was a case of not correcting the perception and the understanding of the average Indian – in the scheme as it existed.
Over time, as things changed in the market, the intrinsic value of the unit suffered. You had a scheme of administered sale and repurchase prices which were completely out of sync with the intrinsic value. This was not a NAV [Net Asset Value] based scheme. It was much later that it was made a NAV-based scheme in January 2002. That’s the background of the institution and the scheme.
Therefore, as we got closer to dealing with the problem, you discovered that there was a huge gap between what you owed to people, assuming you were not an NAV based scheme and you hadn’t assured a price that you announced in advance and the intrinsic value. It was also a large scheme. If it had attempted to sell all of the stock in an effort to meet the redemption requirements, clearly that stock would get hammered over time and the value would only decrease. That was the background.
After I moved in, my colleagues and I decided that not matter how bad it looked — it was time to tell people the truth. So we made it NAV based. For people who saw re-purchase prices in the double digits, in the high double digits, you were looking at an NAV of 5 rupees and 91 paise. That was a shock, but we thought that the shock was best administered so that everyone knew which way the cards lay.
Once that was done, we disclosed our portfolio. It was the first time between 1964 and 2001 that the portfolio was disclosed. So people knew what the value of that portfolio was. There were excellent companies and terrible companies in the portfolio. But we needed to deal with that. We also needed to preserve value in the better companies.
We decided to tell the market that all of our holdings were not going to be sold tomorrow or the day after, thereby hurting ourselves in the process, because the market knew what we had, and what we needed to sell in order to repay. So along with the government of India, we entered into an arrangement where bonds with a 6.75% tax-free return every six months were given to the investor in lieu of the Unit certificates. This meant that we didn’t unload our stocks in the market and therefore the overhang that the market had expected it would cash on did not exist. The market went up thereafter, and a lot of cleaning was done.
My personal belief is that all organizations are about people, processes and products. If you address all three, no matter how bad the organization is, you’ll get it right.
Knowledge@Wharton: Did you learn any lessons from your UTI experience that might to any systemic issues in the Indian economy or stock markets? Could such situations recur?
Damodaran: I don’t think the situation will recur because such products are not on offer. We now have clear communication to the investors on the nature of the product, so there is no conscious or unconscious mis-selling of the product. I don’t speak for the entire financial industry. That said, investors ought to watch out for what they are investing in. I don’t fear recurrence. I think that what will happen over time is that good players will survive and bad players will disappear. And that’s the law of the market in any case.
Knowledge@Wharton: From the Unit Trust you moved on to the Industrial Development Bank of India (IDBI). What was your principal challenge there?
Damodaran: The IDBI was a model that was outdated. It was a development financial institution. Its principal intervention was project finance. Project finance ceased to be important after banks started providing both working capital and long-term finance. It was important for as long as you needed to go to a bank for working capital and somewhere else to finance your projects. When it became a single window system of the banks delivering it, as an organization that had no access to low cost deposits, clearly it could not compete effectively in the market.
Therefore, I think the organization did not reposition itself. It should have become a bank much, much earlier. I did manage to convert it to a bank and also to merge the IDBI Bank, which had floated on its own and create a model where you had a development finance function in a SBU and a commercial banking function with the possibility of raising low cost resources on one side and deploying it for the product good on the other. There was also a need to reduce the manpower, which again was something I did in the UTI in much larger measure — we reduced it by more than 50%. Here it was much more modest, but you needed to reduce that, to see that those skill sets were less relevant to the changed regimes who are no longer on your rolls.
Knowledge@Wharton: Since then of course, you have been at the Securities and Exchange Board of India [SEBI]. What have you found, from your vantage point at SEBI, to be some of the principal abuses to which average investors tend to be subjected? For example, how have you dealt with insider trading?
Damodaran: I’m glad that you brought up insider trading, because even if you hadn’t brought it up, I would have looked at that as the major challenge that faces us today. This is because in markets like ours, where you have all categories of investors, the extremely well informed and those that are completely uninformed of the nature of the asset class and yet are investing good money there for whatever reason, the real problem is information asymmetry.
The issue is really the availability of information, and it’s also the timeliness of information. Some people are getting information that’s market sensitive a little bit before some people, and all regulators in this space need to address information asymmetry as the major challenge because if that’s addressed you will get closer to addressing most of the other issues.
Our record in India of dealing with insider trading is not one to write home about. This is largely because our enforcement machinery as well as our investigation machinery over time did not develop the skill sets to put together the degree of proof that you need to sustain an insider training charge in a court of law. Today, we would seem to have addressed some of it. I don’t want to tell you tomorrow’s story today, but maybe we will demonstrate to the market that insider trading is something that in the same circumstances will not go past us very easily.
Knowledge@Wharton: You referred to information asymmetries; research at Wharton and at other business schools has shown that one of the most striking effects of information asymmetry is the run-up in stock prices on the first day after an IPO. Do you face this situation as well and have you tried to deal with that?
Damodaran: We do face a situation where stock prices run up on day one. Even in the recent past, we’ve had quite a few stocks that ran up on day one. It is easy to explain, almost facile, to explain it in terms of the issue not having been rightly priced and the unsatiated appetite in the market pushing it to higher levels, and explaining all of that in terms of price discovery on day one.
What we found in a very recent case — and I’m sure that it indicates a problem that is more significant — is that a lot of people placed orders on day one that they never ever seriously intended to have executed. Thereby they pushed up volumes and gave unsuspecting investors the impression that there was a huge appetite for the stock. And therefore he or she came in on day one, not having got the IPO allotment.
In a county that has not seen a large number of big IPO issues, there is an appetite for the IPOs. This is also because, not just leaving something on the table for the investors post listing, but for whatever reason people who are pricing it, not having got it right. There are issues that even without any wrongdoing in the market, will post listing go up, somewhat, because of unsatiated demand. That plus some of the manipulation in the market on day one has helped to drive up some prices.
We are [today] contemplating the introduction of a price band even on day one, even though we recognize that this militates against price discovery post listing. This is because we believe the lesser evil is discovery over time, rather than discovery of this manner on day one – which is really not discovery.
Knowledge@Wharton: What about short selling? Some new rules are about to take effect. Could you explain what those might be and what impact they will have on the market?
Damodaran: In the Indian market today, individuals are allowed to short sell; institutions are not. We believe that for a market as big as ours, it is an anomaly, and you can’t have that for a long time. We recognize that all mature markets the world over have seen the benefits of short selling, providing there are no problems that they give rise to. Short selling brings with it the need also for a fairly robust stock lending and borrowing mechanism. We had mechanisms of that kind in India before. In fact, even today, we have rules for short selling except that they are not operational. They faced some problems. There were some irritants that cropped up. There were some systematic issues that got thrown up and therefore those had to be discouraged. So we took some time as an organization, it’s been a few years now, to put together a system where these will be done through the exchanges and not done as it was done in the past. Therefore, you will get some measure of first-level regulation because the exchange is involved in this. We’ve run this past people who are market participants, academics, experts on the subject. All of them seem to believe that what we are now putting in place might be the answer to what the market needs, after factoring in all of the learning of the past, in terms of what went wrong and what has happened in other jurisdictions.
Knowledge@Wharton: As the regulator of the Indian stock market, whose goal is to protect the credibility of the market, do you feel that SEBI has the authority that you need to deal with the abuses that we have talked about, like insider trading? Perhaps you could talk about the number of cases that you may have prosecuted and what impact they have had on investor confidence.
Damodaran: I think the numbers really don’t tell the whole story. What we have today on our plate are large numbers of cases, some of which are very, very small — they reflect merely technical violations of a first-time offender — and serious violations. You can’t deal with all of this in the same manner. Some cases are important for the system and others are unimportant for the system.
Until now, we believed, because the SEBI Act did not expressly say so, that we did not have the powers that the SEC had, for example, of settling cases without a plea of guilty or not guilty. We have today written into the 11th Provision of the SEBI Act the powers that are available to us have been available to us over time. And that is intended to be used in order to clear up a lot of the backlog.
SEBI does not suffer from shortage of powers. If anyone said that SEBI suffered from shortage of powers, I would urge him or her to read the Act again. We have all of the powers we need.
Have we put them to the right use? Possibly not as well as we could have. The problem in enforcement is that enforcement takes time. If, from start to finish, we’re talking about a few years before we bring home guilt and we actually punish someone, the element of deterrence is not there. We need to now focus on the bigger cases, which is why we will clear most of these very shortly and then focus on the big ones to see that in real time you will be able to deal with it quickly. We are revisiting processes to see how, without sacrificing natural justice, we can move a little faster towards the justice delivery system. I think that in the next 12 months you’ll see evidence of this.
Knowledge@Wharton: How do you view the role of the Securities Appellate Tribunal or SAT? Does the SAT let potential wrongdoers off the hook?
Damodaran: No, I think it is extremely unfair — and I’ve heard this mentioned before — to say that because an appellate tribunal exists, some people invoke it and benefit from it. Appellate tribunals in all good systems exist because no man is infallible. It is always good to have a second person, at a higher level, look at something. We might be carried away by excessive enthusiasm in dealing with a case. It is entirely likely that because we are the prosecutor and the judge at the first level, we might have got it wrong. You need an expert body, and this SAT is now headed by a retired Chief Justice of a high court. You need a body of that kind to look at a case objectively and say whether we’ve got it wrong.
If you look at the numbers — and I think that this is important — cases where the Appellate Tribunal has not just agreed with our findings but also thought that the same penalty was worthwhile, are fairly large. If you look at cases where they agreed with our findings but reduced our penalty a little bit, for whatever reason, because they thought that the penalty was excessive — there are those cases. If you look at cases where they disagreed with our findings — they felt that we had, maybe, come to the wrong conclusion and punished the guys wrongly — those are not as big as we would imagine them to be. Unfortunately those are the cases that get highlighted. There is no news value in upholding a judgment; there is news value in overturning a judgment. It is the ‘man bites dog and the dog bites man’. And therefore there is the perception that much of what we do tends to get undone. I have the numbers to show — and we’ve shared them with a lot of people — that that isn’t the case.
Knowledge@Wharton: Let’s turn to the tremendous amount of global investment that is flowing into India from private equity groups, venture capitalists and so forth. From your perspective, what challenges does that create for an institution like SEBI?
Damodaran: At the stage of development where India is, it is reasonable to expect that there would be interest both by private equity as well as venture capital in India. We’ve seen evidence of this for some time. Private equity has been around in India for a while. In fact, there are some companies and I will not name names. (I take great pleasure in saying that regulators, if they suffer from one handicap, it is that that cannot name names.) There are companies where private equity firms have invested and this has raised the company’s visibility as well as its performance to a higher level. After that, the private equity naturally exits with a king’s ransom or its equivalent. We should not grudge them that if they have added value. If there is too much of this, we would need to look at the practices. In any group you will find the good, the bad and the ugly. Are there people who are taking liberties with the rules, regulations and things of that kind? If things of that kind happened, we would certainly be concerned.
But the flow of money into India, looking to invest in big companies, is not something to worry about. There are some restrictions, and today we are way below those restrictions. I don’t see that really as a concern. At the end of the day, good investors will seek good investments.
Knowledge@Wharton: Are you concerned about hedge funds coming to India?
Damodaran: No. In fact, hedge funds are extremely topical. At a recent conference in Mumbai, one of the four panel discussions that we had was on hedge funds.
We’ve seen what has happened in other jurisdictions. We have also noticed, courtesy of the latest U.S. ruling, after the registration exercise was mandated by the SEC, that there is no single category that’s homogeneous that you can call a hedge fund. What is a hedge fund is really an open-ended question. Within that category there are people that have very credible investors, whether they are pension funds, educational institutions, museums in some cases, things of that kind, long-term investors, there are lock-in periods for some of them. There are people that have a track record of being long-only funds. To believe that these funds, being present directly in your market, could be destabilizing is not something that I buy.
To say that hedge funds are not present today in the Indian market is also incorrect because they are present through the off-shore derivative instrument. Would I, as a regulator, not have people present in my market, in their own name registered and visible and responsible for their acts? I would be extremely comfortable with any institutional investor that conforms entirely to our regulations of 2004, putting in an application and saying, “I want to be in your market in my own name rather than as a holder of a p-note”. We would welcome that because I think that you get comfort in dealing with people directly rather than through an anonymous channel.
Our regulations do not expressly or by necessary implication bar hedge funds. It’s just that there has been a mind-set issue over a period of time. We need to look at each of these on its own merits and see whom we want to register and whom we don’t want to register.
Knowledge@Wharton: Our readers and listeners include affluent investors who want to invest in India. What would you tell them about the principal risks of such investments and what SEBI is doing to mitigate those risks?
Damodaran: I think that in terms of disclosures today our market is as good as any other. Therefore, informed investors with deep pockets from overseas who want to buy into the India growth story are certainly welcome. They are welcome to invest on the basis of a disclosure regime which we believe, while no way near perfect, is certainly comparable to what many mature markets offer — but we are still working on it.
I would urge investors to look at the governance of companies. It is not just my personal belief but it’s also an organizational belief that over time, markets will reward companies that are governed better. Therefore, we would expect that to happen.
I would expect to see a little more investor activism. I know that that is a double-edged sword. In some markets there are problems that excessive activism creates. But in our market, at the level at which it is now, I would want to see investors asking more questions of company managements. They should ask questions about board composition; have you got the right people on the board? They should ask about certification systems and also about the functions of audit committees. Today, executive compensation is not so much of an issue in India as it is in the U.S., but it could be an issue tomorrow. Why not ask questions before the problem surfaces? I would want investors to come in asking questions and expecting to reward managements that have proper answers for those questions.
Knowledge@Wharton: Last week there was a conference in New York. One of the topics that came up for discussion was Indian real estate. There was an active debate on the question of whether or not there is a bubble in Indian real estate prices. What are your views, and what implications might this have for real estate companies that are trying to go public?
Damodaran: Whether there is a bubble in real estate or in any other asset class anyone’s guess is as good as any others. Only time will tell. This is because there are some bubbles that burst, and some that don’t. Everyone has their own view about that.
Some real estate companies have come to the market; some companies have raised money; some are waiting to come to the market. We have asked them that in regard to their disclosures regarding land banks — which is a major item of information for investors — these companies need to clearly indicate what they own. This is different than the numbers they aspire to or the amount of land they will buy after they have taken investors’ money. I want to know what you have today on that basis and on the basis of plans that seem grounded in reality. We’ve tightened disclosures for them.
We’ve also told these companies that they must look at valuations. We’ve told the experts who have commented on valuations to be more careful about what they do. I think there has been an appreciation of the fact that disclosures have gotten better. Those who now come to the market from that sector will clearly need to state more things and to state them better.
Knowledge@Wharton: What would you say has been your biggest achievement at SEBI? And what has been your biggest challenge?
Damodaran: There is only one challenge for anyone at any level at SEBI, and that is how to persuade the average Indian that the Indian securities market is a market in which you can make informed investment decisions and expect reasonable returns with reasonable risks being taken. It is not a casino or a place where you go in blind. It is not a place where you invest in stocks on the basis of information that you haven’t asked the right questions of, which has been given to you as information but could be completely unsubstantiated.
We want informed investors who recognize that equity as an asset class is something that they need to look at for investing a part of their surplus. This will always remain a challenge. It was a challenge for my predecessors, and I’m sure it will be a challenge for my successors also.
As for what has been our achievement, I think being a part of the India growth story, seeing Indian capital markets develop in sync with the growing economy, would qualify. Clearly, for all of SEBI, this has not been an achievement but it is something you feel nice about. It is good to have been a part of the process and a part of the growth story and also contributing in some small measure to that story.
Knowledge@Wharton: What keeps you up at night?
Damodaran: Television programs.
Knowledge@Wharton: What do you do to relax?
Damodaran: I relax all the time, I think. I do crossword puzzles. I read English poetry.
Knowledge@Wharton: Which poets do you read?
Damodaran: Oh, a lot of them…too many to name names. I know that some of them are unfashionable to this generation. [John] Milton certainly is somebody that I think has written very well, but he is not particularly fashionable considering both the length and the intensity that he brought to his poetry. I watch a lot of football on television, and I follow it very closely. I hope to write about it in my next career.
Knowledge@Wharton: What was the last book you read?
Damodaran: Gerald Ford’s Commentary on the Warren Commission.