SEBI barred investment bank JM Financial from leading any new debt offerings. The reason: JM did a few financial gymnastics to inflate subscription numbers. A long read:

Investment banking is notoriously competitive. You’re constantly competing with tens of other banks looking to do deals. In most cases there is little to differentiate you from the bank across the street. You probably hire people from the same set of colleges, suck their souls the same way, and the suckers then move around within the same set of banks.

So if a client comes to you and tells you that he wants to do a plain old vanilla debt offering—what exactly is the differentiator that you’re going to offer? The client company wants to sell bonds to investors, give them a fixed coupon rate, and it wants a bank to prepare the documents, do the disclosures, market the bonds to investors, etc. It doesn’t get simpler than that!

Here’s a possible differentiator. You promise the company that its debt offering will be successful. Say you’ve already received commitments from investors. Mostly things will go fine. It’s a straightforward debt offering, after all. Investors will buy the bonds, you’ll get your fees, and life will go on. Sometimes things will go wrong.

Earlier this month, SEBI issued an order barring investment bank JM Financial from leading any more debt offerings for some time until it finishes an investigation. Here’s what SEBI noticed:

1. Piramal Enterprises sold bonds worth ₹533 crore ($65 million).
2. 75% of those bonds were bought by individual investors. 25% from medium-size investors like small companies, partnerships, and the likes. Institutional investors like large banks or insurance companies bought nothing.
3. The same day that these bonds were listed on the stock exchange, (at least) 1016 investors sold ₹142 crore worth of bonds. 26% of the initial sale.
4. JM Financial Products, an NBFC owned by JM Financial, bought these bonds. The NBFC paid more than what the bonds were sold for just a few days. It then turned around and sold a large chunk of those bonds to other medium-size investors but for cheaper than even the original price. JMF’s NBFC bought high and sold low!
5. Only—those 1016 investors? The NBFC was the one that had lent money to those investors to buy those bonds in the first place. Also, the investors came via JM Financial Services, a broker owned by (no surprises here) JM Financial.

That’s a lot of JM Financial companies! And quite a bit of financial gymnastics. The investment banks needed investors, so the broker brought the investors. The investors needed money, so the NBFC lent them money. Then the investors needed buyers for their bonds, so the NBFC bought the bonds. Only to sell them for a loss.

The only takeaway I have from these events is that it takes a village to raise a debt offering.

It takes a village

One of the jobs of an investment bank leading a debt offering—maybe even the most important—is to market the bonds to investors. You’ll call up some pension funds and mutual funds and the likes, ask if they want to buy some hot bonds from Piramal with a 9% yield for 2 years. [1] They might say yes, or they might say no. You note down their interest, ideally you’d even get more commitments than you’d need so that there’s some cushion. That’s also why bond offerings, or even stock sales for that matter, don’t fail. The big buyers are lined up in advance.

Piramal’s bond offering had a total of 0 institutional investors! These are the folks that are supposed to be easier to get. As a banker you’re supposed to have an existing relationship with them. They’re the ones who have the money to actually buy your bonds!

Okay so JM Financial couldn’t convince any institutions to buy the bonds. Hey that’s bad but not the end of the world. It owns a brokerage! And the broker has connections with tons of small investors! So JM Financial probably decided to get its broker to market the bonds to small investors instead. Thousands of them.

Of course, there are a few problems:

1. It’s not easy to convince a thousand people to do a single thing.
2. Even if you do convince them to do your thing, unlike large institutional investors, between the time you convince them and the time they actually pay up, they might change their mind.
3. Retail investors don’t have large sums of money lying around to invest in bonds. These bonds needed at least ₹10 lakh per investor.

(3) is where the NBFC came in. The investors didn’t need to have the money, the NBFC would lend them nearly all of it. [1] JM Financial took care of (2) by opening a separate dedicated bank account for these investors and getting their authorisation to operate those bank accounts.

And to deal with (1)—how do you convince a thousand people to take loans from you and not even allow them to touch their money? You guarantee them an instant profit!

For whatever reason, Piramal’s bonds weren’t really in demand. The company wanted to raise up to ₹1,000 crore [3] and it managed to raise just about ₹533 crore. This was a bond that wasn’t really in demand! If you bought it and then sold it immediately, you’re probably going to have to sell at a discount. Why else would someone buy the bond from you anyway?

But JM Financial had propped up thousands of investors via its broker who wouldn’t really be accepting a loss here. So it gave them a profit. The investors had bought the bonds at ₹1,000 each. JM Financials’s NBFC paid them between ₹1,002–₹1,002.5 per bond.

But, of course, JM Financial didn’t really want those bonds! It had to get rid of them.

Remember when JM Financial tried to line up investors before the sale? It couldn’t convince any large investors to buy them but it did convince some smaller ones to buy ₹131 crore ($16 million) or 25% of the total bonds sold.

One can imagine that there were some more of these investors who were sort-of interested but only if they got a better deal. Now, JM Financial couldn’t just change the yield on these bonds. That would mean going back to get Piramal on board, and you don’t really want to have a tough conversation with your client. So JM Financial probably figured that it could buy these bonds from its own retail investors and sell them to the few fussy investors who wanted a better price. It didn’t have to normalise the price for all investors, while still getting the investors who wanted to buy the bonds at a lower price.

The NBFC sold ₹80 crore ($10 million) of the bonds worth ₹141 crore ($17 million) which it bought from the retail investors at an average price of ₹994, which is ₹6 less than the original price of ₹1000. That’s a 9.32% yield—a good, ~0.3% more than the original yield. [4[

Was all this legal?

Was all this legal? Absolutely not.

SEBI asked JM Financial what’s up—why was JMF’s NBFC buying high and selling low? Here’s its response:

JMFPL-NBFC is “constantly looking at debt papers in the market to do active market making for the purpose of creating liquidity in such debt instruments. Accordingly, JMFPL-NBFC bought the NCDs … from the investors, who wanted to exit to avail other opportunities. The price at which JMFPL

NBFC bought these NCDs ranged from Rs. 100.21 to 100.27 per NCD.
For your information, JMFPL-NBFC has been able to sell a part of the NCDs … bought by it, while it is holding the balance quantity in its books. Typically, the trading desk at JMFPL-NBFC, like in any other trading call, makes decision irrespective of the trading loss or gain depending on the intensity of competition and its allowable risk appetite.”

Which trading desk makes a decision “irrespective of trading loss or gain”? That wouldn’t be a very successful trading desk.

So did JM Financial just lie to SEBI? Am I allowed to say the answer out loud? The answer is yes, most certainly, yes. [5] As a financial institution I’d guess JM Financial did some risk-benefit analysis of lying versus not lying and decided that it made more sense to lie. Let’s see how that turns out.

What makes this episode more interesting is that there aren’t any obvious losers. The 1016 investors didn’t lose money, and may even have made a minuscule amount. [6] Piramal didn’t lose, it sold the bonds it wanted at the price it wanted. JM Financial, sure, lost a bit in trading the bonds at a loss but overall across the investment bank, the broker, and the NBFC earned ₹3.2 crore. Here’s what some senior guy from an NBFC is quoted saying in Mint:

It is a “pedigreed firm” and may come out “not guilty” if Sebi’s record of its orders being overturned by the Securities Appellate Tribunal, is anything to go by, said a senior executive of an NBFC.

“No one lost money, and so what’s the crime,” he asked, requesting not to be quoted.

No one lost money? Except for the medium-size investors that bought the bonds thinking that they were getting good, market-decided interest rate bonds which thousands of investors were falling over each other to buy. What they ended up with was bonds which no large investor wanted to touch and a dealer who was cutting his own deals on the side.

Footnotes

[1] More accurately, the investment bank would go with a price or coupon rate range to judge investor mood, and decide on a final figure after having all the information.

[2] A small number of investors (26) got the loan without any margin. The remaining had 2% as margin.

[3] The base size was ₹200 crore, the amount below which the debt issue would fail, and there was an option to raise an additional ₹800 crore. In theory, the additional amount is a good-to-have but in practice they would expect to raise the full amount.

[4] A minor discount on the buying price makes a significant difference in yield. A ₹1,000 bond at 9% interest bought at ₹994 would have an effective interest rate of 9.05%. More importantly, at maturity, the investors get back the original ₹1,000 as principal even though they had just paid ₹994.

[5] The perk of being an independent writer is that it’s easier to state the obvious.

[6] In theory the investors may not have made a loss, but I’d argue that borrowing ₹10 lakh to make just ₹2,000 is as good as a loss. If SEBI interviews investors and digs into just how JMF’s brokerage convinced investors to agree to such a shitty deal I wouldn’t be surprised if there are stories of incessant pestering and unfulfilled promises.