Integrity risk: A new danger that faces investors in stock markets

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New Delhi | Published: February 6, 2019 2:45:17 AM

Every business has its own associated risks but vanishing companies pose integrity risk

stock markets, capital market, Companies Act, IPO, IPO grading, director identification numberThe Companies Act, 2013 provide some safeguards against vanishing companies.

Vanishing companies are a major concern not only for the regulators but also for the investors who invest their hard-earned money in those firms. By definition, vanishing companies are those companies who fail to file their annual returns and other documents to the regulator after raising capital from the public and the whereabouts of their directors and registered office are not know. So, investors should be very carefully while making their investment.
Let us discuss how to keep away from investing in such companies.

Integrity risk

As per the Ministry of Corporate Affairs website, the list of vanishing companies, derived from e-records, name around 115 companies across the country and these companies mopped up around Rs 252 crore from the public. Nowadays, investors are exposed not only to business risk but also to integrity risks. Many companies come to the capital market with unsustainable business models and lure the ignorant investors.

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Effectiveness of the Companies Act, 2013

The Companies Act, 2013 provide some safeguards against vanishing companies. The Act mandates that all directors including independent directors should have director identification number (DIN) to become directors and entails physical verification of the registered office address of the company. But the current legal framework is insufficient to address the problem of vanishing companies. There are no immediate automatic alerts and red flags to find out the defaulting companies. There are many companies who have not complied with compliance requirements for more than two years.

Precautions that investors should consider

If you observe the vanished companies and their IPO size, they were ultra-small, ranging from Rs 49 lakh to Rs 12 crore. Generally, they target first-time investors and lure them through broking houses and other channels with the idea that penny stocks will be multibagger soon. So, one way out is for investors to avoid such kind of IPOs which are small in size.

Look at the IPO grading

The concept of IPO grading was introduced by the stock exchanges as an option to companies in April 2006, and made mandator in May 2007. Again, it was made voluntary in 2013. IPO grading is done by the credit rating agencies by considering the company fundamentals, promoters and management quality, financial and business risk and other relevant factors. Accordingly, firms with an IPO grade of five indicates strong fundamentals, four indicates above average fundamentals, three denotes average fundamentals; two denotes below average fundamentals and one states poor fundamentals. Though IPO grading is not mandatory, many good companies do obtain the same from credit rating agencies and report the same. So, to some extent, it is a good indicator to the investors.

Assess sustainability of the business model

This is one of the key parameters that investors should look into. For instance, as an investor you should check what is the business model, how the revenues are generated, profit margin, how this firm is positioned compared with other players in the industry and check whether the current business model is sustainable in the long term. Also, check whether the business model can withstand any technical disruption.

To conclude, every business has its own associated risks but vanishing companies pose a new risk, namely integrity risk. So, investors should check the integrity of the firms and other allied aspects by running the above checks and balances before investing.

The writer is a professor of finance & accounting, IIM Tiruchirappalli

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