Short-selling Laws in India: A Study in the Light of Adani-hindenburg Issue

[By Nirukta Krishnan and Aditi Kotecha]

The authors are students of Hidayatullah National Law University.

 

OVERVIEW:

In light of the Public Interest Litigations filed by four social activists after the recent shorting of the Adani Group Stocks, questions are being raised once again concerning the ban on short selling and whether the regulatory authority is adequately equipped to deal with the potential negative consequences of short selling on the market.

Short selling has for a long time been the subject of polarising opinions. On one hand, supporters consider it a fundamental practice of the market which keeps the market alive while critics believe that it is a highly volatile practice.  This article thus presents a critical analysis of the short selling laws in India operating at present and also attempts to provide certain recommendations with respect to changes that can be made to the existing regime keeping in view the recent Hindenburg report and the short selling of Adani stocks.

MEANING-

In simple terms, short selling is a practice where the short seller borrows the stock in terms of derivatives from a broker at a certain price and sells it in the market. When the price of the stock goes down, they proceed to buy it back at the lowered price and keep the difference. SEBI thus defines it as “a sale of a security that the seller does not own”. On a purely technical ground, there is nothing wrong with the practice. Buying and selling stocks in this manner through derivatives like futures and options is not wrong per se but the issue arises when this shorting is done to manipulate stock prices. In this case speculations are being made by experts that Anderson purposely partook in short selling because he knew the instability that would be caused by his report, which would jeopardize investor confidence and cause mass panic thus also leading to a sharp decline in price. This, according to them, is a clear attempt at manipulation. This is precisely the matter surrounding the Adani-Hindenburg debacle.

NATHAN ANDERSON- MANIPULATION OR COINCIDENCE?

The biggest reason why short selling came into question again is because of the report published by the Hindenburg Research group which caused complete mayhem amongst investors of the Adani Group amid allegations of fraud and manipulation among other things. After the dust settled with regard to the contents of the report itself, eyes turned to the person at the very center of it all – Nathan Anderson– who founded the organization and had previously conducted similar crusades against many large entities.

While the report refused to publish the specifics of how they pulled it all off, they mentioned that they had obtained a “short position through US-traded bonds and non-Indian traded derivative instruments”. In direct terms, Anderson purchased and shorted US bonds of Adani after which he proceeded to release his report. With the magnitude of allegations contained in the report, the credit went down which then adversely affected the value of the bonds and securities of Adani. During this time when the market was distressed, he then purchased the bonds again at a lower price thus making a profit from the difference in the purchase and sale.

The other method is mainly speculative, but many critics who have been trying to analyze how Anderson achieved this result, have suggested that he probably approached entities like global banks that trade in India and entered into a stock futures contract with them, who then entered the Indian market and shorted the stocks.

WHAT DO INDIAN LAWS SAY ABOUT SHORT-SELLING?

The discussion on short-selling first took place in 1996 when SEBI constituted a committee under Shri BD Shah. The committee suggested rules and regulations be put in place to regulate the trading practice in India. It was temporarily banned in 1998 and 2001. However, it was finally reviewed in 2003 by the Secondary Market Advisory Committee (SMAC) which took into consideration the practices followed in other states and permitted it on certain conditions.

Short-selling poses a potential risk to the market and may lead to a rampant decline, if not regulated. SEBI and the stock exchanges in India have collectively released specific rules and guidelines to be followed while short-selling a stock. India and several other developed countries have not banned short-selling, and the International Organization of Securities Commissions (IOSCO) has also suggested that the practice be regulated rather than prohibited.

Currently, in India, retail investors and institutional investors (such as mutual funds, FIIs, banks, insurance companies, etc.) are free to short-sell, provided derivative products are available of that stock. They (institutional investors) are required to disclose at the time of placement itself whether the stock is a short sale and their ability to borrow those stocks to the satisfaction of the broker, the same is not the case with retail investors. They can disclose this at the end of the trading hours on the day of the transaction. In addition to this, naked short-selling and day trading is prohibited. The present lending and borrowing scheme in India operates on clearing corporations/houses (CC/CH) of the stock exchanges, leaving very little scope for the investors to capitalize on the demand for securities. A  lending and borrowing system with CC/CH acting as Approved Intermediaries can be brought in. . However, appointing AIs must be done carefully, starting with appointing Banks as custodians in the first stage and so on. FPIs and Foreign Institutional Investors are explicitly prohibited from short selling as per the guidelines.

However, foreign entities still trade in India through some other corporations or organizations which are still allowed to trade. The regulations do not go up to the source and limit themselves to regulating the direct intermediaries which do not solve the problem.

Internationally, it is mostly seen that the securities market does not directly regulate the lending and borrowing processes because they are essentially held over the counter. The custodians and depositors run these lending and borrowing institutions. So, if India goes for bringing such a scheme, the short-selling regulation would be simultaneous to that.

IS SHORT SELLING PERMITTED IN OTHER COUNTRIES?

The Financial Services Agency of the UK sees short selling as a valid practice in investment until it is misused. They have two major methods of practising it- (i) spread betting, where the investors bet on the direction market is about to move and short stocks without even borrowing, and (ii) CFD (contract for difference), where investors contract to exchange the difference between the stock opening and closing values. However, after BREXIT, the UK is planning to reform short-selling laws to make it more investor-friendly and flush money into the market. The USA allows naked short selling, where the investors need not even borrow the stock before short-selling it. The Securities and Exchange Commission (SEC) of the USA allowed short-selling in 1937 based on the condition of the uptick rule which implies that the practice should not strategically and artificially drive down the market. These countries have also banned short-selling from time to time when the market sees a disadvantageous outcome of it. Emerging markets like Hong Kong, Korea, and Japan have not banned short selling.

HOW IS IT BENEFICIAL?

Short-selling as a volatile practice contributes a lot to the market liquidity and keeps it alive with the continuous trading taking place. It gives an opportunity to the traders and investors to get profit even at the time of downturn of the market or a stock. Banning it will serve no purpose and in turn, restrain the freedom of the market. In order to keep things in place, we need to regulate them and not ban them altogether.

THE REGULATIONS IN PLACE

From the point of view of investors, the regulations put an  additional responsibility of maintaining sufficient documentation as to whether their client would be able to deliver the borrowed securities at the time of settlement. In the case of institutional investors, they have to make sure that sufficient arrangements are made for borrowing securities before actually performing the operations in its furtherance. They are also mandated to collect scrip-wise short-sell positions and upload them on the respective stock exchanges site before the trading has begun to make it available in the public domain. However, that doesn’t mean that they do not benefit  from this practice. In the case of the market as a whole, they are required to consolidate the information provided by the brokers and make it available on the website after the closing hours of the market the next day.

IMPACT ON STAKEHOLDERS

Overall, no major impact is created on the market solely by short selling which is already not created by the market itself. That is to say that risks to stakeholders exist even with short selling prevailing as a practice because of the volatile nature of the market. . In fact, it is the opinion of many critics that removing it would put the market in a linear direction. At the end of the day even if there is a fall, money is always circulating in the market and some entity at a given time is making some form of profit. For a company, if its stock prices go down due to any unforeseen situation, they are anyways in a loss, and since derivatives derive their value from the underlying security, which in this case is the stock, any fall in value is going to affect them just the same. Thus short selling does not impact them to a large extent. What we need to focus upon is the loss caused by such deliberate manipulation of stocks. Because the only group who is getting negatively affected by a situation like the Adani crash are the retail investors who are participating in daily trading and who will suffer great losses when the value will suddenly crash. As they are the most vulnerable group of investors, over the years SEBI has greatly emphasised on protection of these retail investors and this is seen in the various regulations that have been set in place. For example the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, both put heavy burden on public listed companies to make all the necessary disclosures with respect to their finances when an issue is made, particularly in the case of Initial Public Offerings (IPOs). The first step in protecting retail investors is to keep them aware and up-to-date with regards to all the changes in the company and disclosures and transparency play a big role in this. These safeguards do protect the investors to a great extent however, they are still not able to adequately deal with the volatile nature of retail investors. Thus there is no particular need to do away with short-selling.

WAY AHEAD

There are already a lot of regulations in place in order to deal with any possible malpractices on the part of traders and agents as has been discussed in the previous section. . But this experience was a lesson that taught us that indirectly as well such crashes can be triggered and the main culprit behind it can easily brush off any allegations of manipulation by hiding behind institutional investors. In this regard, SEBI can release a guideline where they impose a kind of restriction on the quantum or amount of shares that institutional investors can invest in since SEBI has the power to take such action in the interest of the retail investors who would suffer a bigger loss if such an instance of shorting happens again. Although this would also cause certain rigidity in the market and restrain the freedom of the market itself, it would definitely contain the magnitude of the loss caused to a certain extent. However, on the other side, SEBI has been trying to create a level playing field for all groups of investors, but if they impose a guideline like this it would nullify the efforts since there will be no level playing field left between institutional investors and other classes of investors. Another addition that could be made to regulations is a vibrant securities lending and borrowing scheme which could be made in order to regulate the lending and borrowing activities in the market. However, it should be kept in mind that any such regulation must not affect the freedom of the market.

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