Is Sebi stepping into industry-wide insider trading probe?

L&T Finance insider trading case has potential to blow up as biggest insider trading investigation for the investment banking industry.

For the first time in many years, Sebi seems to have hit the right place to prevent insider trading. Sebi's ex-parte order preventing Factorial Master Fund a hedge fund based out of Cayman Islands is the first step in this direction.

The Case:

L&T Finance Holdings undertakes OFS to meet the Sebi minimum shareholding guidelines. The company appoints Credit Suisse has Seller Broker for the OFS. Credit Suisse undertakes market gauging exercise to determine demand and price acceptable for such an offer. It undertakes this exercise with around 70 entities in the market. One of these entities is said to be the Factorial Master Fund. The hedge fund is said to have gone aggressively short on March 13th 2014. Infact, Sebi says the hedge fund accounted for 86.83 percent of the market-wide open interest positions on the short side. The hedge fund is said to have followed up by participating in the OFS which open the next day. The announcement of the OFS was made late evening on March 13th. As Sebi says, the action of the hedge fund makes the trades even more aberrant and suspicious. Sebi further says it has found that chat transcripts using Bloomberg Messaging services reveals communication between one Credit Suisse employee to other in the equity team messages points to discussion on L&T Finance OFS price point like, 'likely to come in at a steep discount about 70 types'.

Issues at Hand:

First, The hedge fund made a killing by profiting to the tune of Rs 20 crores during the OFS, but L&T lost as it could have raised further more from the market, since the stock was trading at least 20% higher in the open market. Should there be a pricing formula for issuances under OFS. Clearly, by selling the stock at a steep discount, the investors who are buying from the open market are clearly discriminated. For a liquid stock like L&T Finance Holdings, being priced at Rs 70 per share in the OFS, there has to be a substantial justification why the sale happened at steep discount.

SEBI needs to revisit this pricing methodology while selling via OFS or IPP or QIP route at a substantial discount.

Secondly, SEBI has been caught napping with respect to the malpractice of market gauging exercise. 70 institutional entities were contacted for an OFS. The very fact that Seller Broker shared undisclosed price sensitive information with over 50 entities raises clear alarm bells what the regulator is doing in this aspect. This is not first time this is happening, it is an industry practice. If SEBI undertakes a detailed investigation on all the OFS or QIP or IPP that were undertaken in the last few years, it will be shocked that similar practice was followed by all Investment Banks and hence unpublished price sensitive information was shared selectively by almost all investment banks with FIIs, hedge funds participating via ODIs or Participatory Notes. What will SEBI do in these cases? This case opens the entire can of worms as far as insider trading is concerned and every investment bank will have some role.

That's not all, today investment bankers don't launch a book (read OFS, IPP or QIP) unless the book is built offline and almost fully subscribed. Which means, the investment bankers today share the price and book size informally with all respective clients and investors selectively, gauge the demand and mean price before they actually file with exchanges for launch of share sale process. These are blatant violation of the insider trading guidelines and SEBI has been a silent watcher so far. Its' not that SEBI is not aware of these practices, but it seems SEBI is more convinced by the arguments of the investment bankers than that of responsibility to prevent selective leakage of unpublished price sensitive information to dozens of entities who not only participate in setting the price of an issue but also follow up by participating in it.

Third, i am not convinced with the argument that large brokerage and investment banking organisations have Chinese Walls. The argument of Chinese Walls is the biggest myth in the industry. The research does detailed report on a company with blue-sky projections and estimates, then goes into black-out period when the investment banking arm comes in and takes the mandate, sells the company on the research report that was made prior to them receiving the mandate officially. And once the event is completed, the research again re-initiates coverage. This whole process is distrustful, and i have never believed in these Chinese Walls.

SEBI may have barred Factorial from accessing capital markets and given the hedge fund 21 days to reply. But this investigation could well be the beginning of the clean-up process for investment banking industry. That if SEBI wants to take this to a logical conclusion.

L&T Finance stock price

On June 06, 2014, L&T Finance Holdings closed at Rs 76.15, down Rs 1.1, or 1.42 percent. The 52-week high of the share was Rs 88.35 and the 52-week low was Rs 53.00.

The company's trailing 12-month (TTM) EPS was at Rs 1.14 per share as per the quarter ended March 2014. The stock's price-to-earnings (P/E) ratio was 66.8. The latest book value of the company is Rs 20.55 per share. At current value, the price-to-book value of the company is 3.71.