[By Srajan Dixit & Abhijeet Malik]
The authors are students of Gujrat National Law University.
The alleged overvaluation of stocks dubbed as the ‘‘Largest con in corporate history’’ by the Hindenburg Research may have sustained the scrutiny of courts over time; however, the Adani conglomerate which rose almost 2500% in last 5 years proved to be in-immune to the massive stock plunge when the 413-page report alleging “brazen stock manipulation and accounting fraud scheme over the course of decades” by the US-based infamous short seller firm took the financial markets across the world by storm. The Adani group has reportedly suffered a cumulative loss of $100 Billion post the report’s publication. However, the skeptics have termed the report as a mere financial tactic to deliberately undervalue the Adani entities for the purposes of shorting or short selling. This has prompted the serial litigant Advocate ML Sharma to file a PIL in the Supreme Court of India where he seeks to declare manipulating the stock market for ‘short-selling’ as the offense of fraud sections 420 (Cheating and dishonestly inducing delivery of property) & 120-B (Punishment for criminal conspiracy) of IPC r.w. 15 (HA) SEBI Act 1992 (Penalty for fraudulent and unfair trade practices), in addition to the investigation against the founder of the Hindenburg Group- Nathan Anderson, for “exploiting innocent investors via short selling under the garb of artificial crashing.”
What is short selling?
To understand ‘Short and distort,’ one must understand ‘short selling’ first. It is defined as a trading strategy where an investor borrows shares of a stock they believe will decrease in value, sells them, and then hopes to repurchase the shares at a lower price to make a profit. The investor profits from the difference between the selling and lower prices when repurchasing the shares. In layman’s terms, Suppose I, an investor, believe (by way of research and other complex tools) that the stock of the company ABC would fall in value in the near future. I will then borrow 100 shares of ABC from a broker and sell the same for Rs.100/share in the market. Suppose, the next day, the share price falls to Rs.90. I would promptly buy back the 100 shares from the market and return them to the broker. In this process, I’ll make a profit of Rs.1000. This whole process is called ‘short selling,’ which is sometimes deemed unethical but is not illegal in India.
Legal Regulations Surrounding Short Selling in India
The central government is reportedly awaiting a report from the Securities and Exchange Board of India (SEBI) on the use of tax havens and concerns about high debt levels by the Adani group. In India, short selling is regulated by the Securities and Exchange Board of India (SEBI) through regulations, guidelines, circulars, and notifications issued from time to time. Short selling was banned in India from September 2008 to March 2009 in response to the global financial crisis but has since been permitted with heavy restrictions under the bundle of regulations such as SEBI (Prohibition of Insider Trading) Regulations, 2015, SEBI (Issue and Listing of Debt Securities) Regulations, 2008, SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992.
Following are the general regulations which are adjusted from time to time in order to keep up with current economic and commercial trends:
- Eligible securities: Only specific securities that meet defined criteria are eligible for short selling. The criteria include but are not limited to market capitalization, trading volume, and price of the security.
- Margin requirements: short sellers must have a margin account with their broker and meet the margin requirements set by SEBI, ensuring that they have sufficient funds to cover any potential losses.
- Circuit breaker: SEBI has implemented a circuit breaker mechanism for short selling to limit the potential losses from excessive short selling. If the price of a security drops by a certain percentage within a certain time frame, short selling will be restricted or temporarily banned.
- Reporting requirements: short sellers must report their short positions to SEBI on a regular basis aiding in to monitoring the level of short-selling activity in the market and detect any potential market stability threats.
When short selling constitutes fraud?
Unethical becomes illegal as per the Securities and Exchange Commission (SEC) the United States counterpart of SEBI, when an individual or group of individuals spreads false or misleading information about a publicly traded company with the intention of lowering its stock price; this market manipulation practice is called ‘short and distort’.
The Indian Securities market regulator SEBI, refers to this scheme by an alternative name, which in itself is not separately categorised as an offense under Indian laws. However, the act of spreading misinformation to gain an advantageous position for the purpose of short selling might fall under the definition of ‘fraudulent or unfair trade practices’ or simply ‘fraud’ as defined under Section 2(1)C of SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003, the section dictates an act intentionally deceptive or not, by an individual or by anyone else with their complicity or by their representative while engaged in securities transactions, with the goal of persuading another person or their representative to participate in securities transactions, regardless of whether there is any unjust enrichment or prevention of any loss is fraudulent. Furthermore, the definition also attracts sub-section 2(1)(c)(1), 2(1)(c)(2) & 2(1)(c)(8), which categorically declares any acts or omissions, suggestions or false statements which might induce another to act in his detriment, the acts of fraud.
Furthermore, under the regulation 9 Code of conduct for Stock Brokers Schedule II of the aforementioned SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992, market manipulation is categorically prohibited. The clause A (3) states that “a stock-broker shall not indulge in manipulative, fraudulent or deceptive transactions or schemes or spread rumors to distort market equilibrium or make personal gains”. Additionally, clause A (4) dictates that spreading rumors to bring down the value of the shares of the company for the purpose of short selling is well within the limits of the meaning of malpractice, which reads as “A stock-broker shall not create false market either singly or in concert with others or indulge in any act detrimental to the investors’ interest or which leads to interference with the proper and smooth functioning of the market. A stock-broker shall not involve himself in excessive speculative business in the market beyond reasonable levels not commensurate with his financial soundness.”
Under the Indian scheme, Regulation 15 HA of the SEBI act of 1992 gives for a penalty of Rs. 25 Crores or three times the number of profits made out of such practices on any person who indulges in fraudulent or unfair trade practices. It is to be noted that SEBI does not completely bans flow of information in the securities market rather Section 2(1)C of SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003, other than restricting frivolous statements, also protects statements which are made in respect to public or the economic policy of the government, the economic situation of the country, trends in the securities market and any other matter of like nature is made in good faith. However additional requirements have to be met, if such information is published by a national or International ‘Research analyst’ in good faith. Such analysts must comply with the provisions of SEBI (Research Analyst) Regulations, 2014 in order to escape liabilities under section 32 of the same regulation.
How is ‘Short and Distort’ dealt under regulatory provisions of US and UK?
In the United States, the practice of ‘short and distort’ is illegal under securities laws and regulations, including the Securities Act of 1933 and the Securities Exchange Act of 1934. In a 2018 case of SEC v. Gregory Lemelson and Lemelson Capital Management LLC, where the defendants were found guilty of market manipulation by disseminating fabricated information about the company Ligand in order to drive down its shares to reap benefits of the same by taking a short position in the market, the United States District Court for the District of Massachusetts charged them under section 10(b) and 10(b)5 of Exchange act 1934, for ‘fraud’ in the sale and exchange of securities.
Similarly, in the UK, the Financial Services Authority (FSA) considers short selling a legitimate investment practice by the FSA and, in its opinion, is simply the opposite of taking a long position; however, if misused, it has the potential to disrupt the market equilibrium through manipulation. FCA considers short selling to be market abuse and fraud if it is done in collusion with other short sellers, and the purpose is to manipulate the price of a security through the circulation of false or misleading information. This type of behavior can result in unlimited fines under the market abuse regime.
Conclusion
As discussed above, short selling an activity though seen with raised eyebrows, is not illegal within the jurisdictional limits of India; although kept under heavy surveillance and restrictions, market players are still allowed to use their market intellect and experience and make a fortune with shares taking a nose dive. However, both though interrelated short-selling differs from the practice of ‘short and distort,’ which is marked illegal and punishable under SEBI legislation. Mr. ML Sharma’s petition to declare the illegal practice of ‘short and distort’ as Fraud, is well-founded and supported within SEBI’s Legal framework. The act of spreading misinformation and manipulating the stocks to seek unjust enrichment falls well within the borders of the definition of a fraudulent act mentioned in section 2C of SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003, which in turn are made punishable under Regulation 15 HA of the SEBI act of 1992. The same proposition of tagging such practice as ‘fraud’ is supported by the regulations of the SEC of United States and FCA of United Kingdom, which have declared such activities fraudulent and abusive and have come up with strict provisions to keep such practices in check.