Capital Markets and Securities Law

[By Tanuj Agarwal] The author is a third year student of Institute of Law, Nirma University, Ahmedabad.  Introduction Covid-19 pandemic has raised serious apprehensions surrounding health and safety causing a lockdown in India.  The pandemic has caused a worldwide recession and has spooked investors’ sentiment. Prior to the coronavirus outbreak, Indian stock market was in full positive swing as Sensex and Nifty had reached their all-time intraday peak of 42,273.87 and 12,430.50 respectively in the month of January, 2020. Even after attaining such progress, Indian stock market is witnessing the most difficult period for the past few weeks. The stock market has observed lower circuit levels after 12 years on March 13, 2020. Afterwards, the equity index discerning a continuous downfall. On March 19, 2020, Sensex crashed below 27,000 and Nifty breached the level of 7,900, thereby attained their five-year closing low levels. Consequently, an approximate downfall of 37% is evident in both the equity indices within a period of just 2 months. The stock market has seen a considerable collapse due to high market volatility. This downfall has degraded the financial market and faded interest of investors and corporates. Thereby, the concern is whether such market downturn can be controlled by restricting short-selling. Short-Selling and its Impact on the Stock Market Short-selling means selling a stock which the seller does not own at the time of trade. It is a practice in which financial traders hold bets on specific shares that they expect a fall in price. A modest fee is paid to borrow some stock in the company to sell them. Further in case the market obliges, the financial trader will buy the shares at the lower price and book the profit. All classes of investors including retail and institutional investors are permitted to do short-selling. The mechanics of short-selling are such that it inflows supply of specific shares in the stock market. These are the shares which are not even owned by the supplier. Consequently, such a scenario creates an excessive supply in the stock market. Thereby, this excess supply leads to a decrement in the price of these shares to settle for an equilibrium with the demand in the market. The mechanism is at times also useful for real price discovery of overpriced share. However at the same time, excessive short selling may decrease the price more than the actual worth of the company, as apart from the business competence, the prices in stock market are highly determined by market forces.  Covid-19 and Short-Selling With the advent of Covid-19, there is shutdown of almost all cities in India. This raises serious business concerns and results in depression of various industries. Thereby, there is an apparent market expectation of fall in stock market too. In pursuance of such expectation, the market speculators are expected to do massive short-selling with a view to pocket profit in case of fall in price of shares. Consequently, the huge amount of shorting by big market players leads to decrease in price of shares in excess of what it naturally (through market forces) might have observed because of business downturn. The fall in price of shares because of business disgrace due to coronavirus is very much conceived, however the question is regarding the excessive decrease in price due to excessive short-selling. In view of corona-pandemic, market players would be very much tempted to capitalise the downfall of share price caused by business loss. Indian stock market has observed a huge short-selling in future segments of index such as Sensex, Nifty and Bank Nifty. During the last week, the net shorting in equity index reached 173,000 contracts. Moreover, foreign portfolio investors have also piloted enormous shorting in India. These investors have perceived Rs. 26.32 lakh crore of speculative volume in derivatives. Such a scenario of extreme shorting resulted in incessant fall in stock market. Ban on short-selling: A temporary yet effective solution The permanent solution to improve the market condition is to get rid of coronavirus which seems to be difficult considering the present set-up. However, effective steps are required to be taken to control the ongoing menace in the capital markets. As demonstrated that short-selling plays a vital role in downturn of equity index and leads to abnormal fall in share prices in such panic business conditions, ban on short-selling practice for the time being can be an effective solution to control the continuous drop in stock market. Short-selling market speculators worsen the general market scenario. Amid excessive panic triggered short-selling, the capitalisation on the reduction of a share value intensifies market fluctuations. Such stock market instability impersonated a serious threat to confidence of retail market players in India as shorting can surge price swings which lead to deterioration of financial markets. The ban on short-selling will help to restore steadiness in the distressed financial market. Notably, the ban can diminish the speculative hammering of the shares and consequently, to some extent, would aid in alleviating the market. Many countries such as Italy, Spain, France, and Belgium banned short-selling with a view to control the fall in their equity index. On the other hand, the U.S. has not suspended the practice of short-selling, even after observing huge market crash. The U.S. short-sellers have made a profit of $343.67 billion in a month, at the cost of public investment in such an ongoing darkened stock market. India should not adopt the U.S. approach which permits short-sellers to make profit by using excessive market volatility due to coronavirus pandemic. Increase in short-selling doesn’t indicate improvement in bearish market. This would be detrimental to public shareholders and may expose Indian stock market at risk, likewise of 2008 financial crisis. China has also wisely handled the corona-outbreak with respect to its volatility of stock exchange. China is miserably shaken by the colossal flood of cases of coronavirus, yet Shanghai Composite Index (SCE) has observed a deterioration of mere 2.53% since the first case was reported in the country. To stabilise the effect of such panic

[By Urja Dhapre] The author is a second year student of Institute of Law, Nirma University, Gujarat. Introduction Recent trends in corporate control [i]have shown an increase in the use of unregulated Total Return Equity Swap Agreements (“TRESA”) to eschew disclosure norms while covertly building up stakes in listed companies. Regulators from around the globe are now recognizing the challenges in governance and market distortions that potentially arise from these agreements which may bestow hidden and morphable ownership in the shareholdings of a listed company. Effectively, TRESA gives the investor an upper hand in dropping a bombshell on the target company by launching a hostile takeover out of the blue. The effect of TRESA seems to be contrary to the objective behind the disclosure regulation which is not only to ensure transparency that “the target company is not taken by surprise”, but also to acquaint the shareholders of the target company about any potential change in control. This article highlights the approaches in different countries while dealing with TRESA and also visits the lacuna in Indian law pertaining to the disclosure regulation. The instrumentality of TRESA  These equity swaps are over the counter equity derivatives wherein one counter-party (“short party”) pays the other counter-party (“long party”) the total return of an underlying asset/shares including income that is generated from it along with the benefits in case the price of the asset appreciates over the life of the swap. In return, the long party is obligated to pay fixed floating payments and the amount by which the asset’s value has depreciated if its price reduces over the life of the swap. Effectively, the long party gains the economic exposure of the reference asset/shares without actually owning it. Similarly, hedge funds or Foreign Institutional Investors (“FIIs”) benefit from the avoidance of transactional costs associated with equity trades along with hedging their negative returns. These swaps can be either cash-settled, i.e., any value differences at the end of the relevant period of the swap are settled in cash or can be settled-in-kind, i.e., the short party has an obligation to transfer the reference asset to the long party upon termination of the arrangement. Treatment of TRESA in other jurisdictions Conventionally, market participants in the equity derivatives markets have not held TRESA as constituting a beneficial ownership in the underlying shares, since its aim is to merely decouple the voting control and the economic exposure in respect of the underlying shares. It is not an obligation but a market reality [ii]that the short party will further buy the reference shares as a hedge against its short position. Conversely, even if the holder of TRESA does not have any legal rights to acquire the shares or control the votes of the reference shares they are still able to influence the short party. This influence is witnessed by the long party’s ability to convert these underlying shares into actual shares by unwinding the swap. The regulators on either side of the Atlantic have approached disclosure norms very differently. Taking into account the global nature of the derivative market, a more uniform approach to disclosure of these instruments is highly desirable. In the past years, this decoupling has affected takeover battles and control of public companies in inter alia the U.S., the U.K., and New Zealand. The UK amended its Disclosure and Transparency Rules [amended (“DTR”) 5R] [iii]which triggers disclosure norms when an individual holds a financial instrument which renders an economic interest over the underlying shares. The new rules require that the holding of shares and relevant financial instruments be aggregated and disclosure be made when the aggregated holdings reach, exceed or fall below 3%, 4%, 5% and each 1% threshold thereafter up to 100% (amended DTR 5.1.2R).[iv]  Further, The U.S Securities and Exchange Commission’s (“SEC”) stance on beneficial ownership was brought out by the US district court’s ruling in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP [v],wherein the Southern District declined to take a firm stand on whether the cash-settled, total return swaps constitute beneficial ownership, as a general matter, under Rule 13(d)-3(b) of the Securities Exchange Act, 1934, which “deems a person to be a beneficial owner if he uses any contract, arrangement, or device as part of a plan or scheme to evade the beneficial ownership reporting requirements.” Albeit, the court relied on a provision of that rule which attributes beneficial ownership of a security to any person who enters into an arrangement as part of a “plan or scheme to evade the reporting requirements of the disclosure norms”. The same was later re-affirmed by the circuit court of appeals.[vi] A diametrically opposite approach was followed in New Zealand as per the Ithaca (custodians) v. Perry Corporation’s[vii] case. The court here discussed in detail about the market reality of the short parties hedging their position which can bring the target company within the reach but not under the control of the long party. It held that such a reality does not constitute an agreement or understanding between the two parties and therefore, the long party will not come under the purview of disclosure norms. However, due to the paucity of evidence, the magnitude of this problem in New Zealand has not yet been raised, but the panel is still considering amendments in the present disclosure norms. TRESA in the Indian context  Under the Indian securities laws regime, disclosure norms are triggered under the helm of Regulation 29(1) [viii] of SEBI Substantial Acquisition of Shares and Takeovers, 2011 (“Takeover Code”). Regulation 29(1) of the Takeover Code requires the acquirer with an individual or combined shareholding with Persons Acting in Concert (“PAC”) of 5% or more in the target company to disclose these shareholdings. This regulation can be traced back to the Takeover Regulation Advisory Committee (“TRAC”) report [ix]which laid the foundation of the Takeover Code, 2011. The committee’s intent was to distinguish between the disclosure requirement of an individual holding and a group/concerted holding of any security or instrument that would entitle the acquirer to receive shares in

[By Arnav Maru] The author is a fourth year student of Maharashtra National Law University, Mumbai. Background Karvy Stock Broking Limited (“Karvy”), a registered stockbroker, recently found itself in the crosshairs of the Securities and Exchange Board of India (“SEBI”) for perpetrating one of the biggest cases of financial misconduct involving misuse of client securities. Karvy was founded in 1995 with its head office in Hyderabad and had a net worth of over Rs. 650 crores as of March 2019. It served over 12 lakh clients, of which at least 300,000 were active clients. The fraud affected around 95,000 of its clients and involved a massive sum of Rs. 2,300 crores. While the fraud in question is not the first of its kind, the sheer magnitude of the amount involved makes it extremely relevant. This post will talk about the fraud under three major headings: understanding the law involved, how this law was subverted in the present case, SEBI’s action, and its effect on the various stakeholders. Understanding the law involved Put briefly, Karvy misused securities lying in dormant and unpaid accounts of its clients to pledge them with five lenders to secure loans of Rs. 2400 crore. This transaction was executed through a misuse of the power of attorney granted by clients in favour of Karvy. Securities of clients availing the margin trading facility with Karvy were majorly affected. A brief overview of the law regulating the use of power of attorney and the securities held in unpaid and margin trading accounts is outlined in the following paragraphs. A power of attorney (“PoA”) is executed by the client in favor of the stockbroker/depository participant to authorize the broker to operate the client’s demat account and bank account to facilitate the delivery of shares and pay-in/pay-out of funds. This may be a general PoA (one that grants a blanket authority), or a specific one (only confers authority for limited and outlined purpose). The PoA provided to brokers is specific and is for the trade settlements. Its use is limited to the transfer of securities from the demat account of the client for authorized purposes. SEBI, in its circular dated April 23, 2019 [i] laid down guidelines for the execution of PoA by the clients in favour of the stockbroker after noting irregularities and misuse of the document. Brokers were mandatorily asking clients to execute irrevocable and general PoAs in their favour, and then using them to execute unauthorized trades in their client’s names. SEBI mandated brokers and depository participants to comply with the guidelines laid down. SEBI limited the scope of the PoA to, first, the transfer of securities held in the beneficial owner account of the client towards stock exchange related margin and delivery obligations, second, pledging of the securities in favour of stock broker for the limited purpose of meeting the margin requirements, and third, to apply for various products like mutual funds, public issues, rights, etc. pursuant to the instructions of the client. Furthermore, it explicitly prohibited PoAs that facilitated off market trades, a charge that Karvy has been found guilty of. The usage of pool accounts and margin trading facility is common practice in the securities market. A pool account is a demat account of the stockbroker, which is used to facilitate pay-in and pay-out obligations. A pool account of a brokering firm typically includes unpaid securities (brought using a margin and not yet paid for by the client) and securities brought by clients not yet transferred to their demat accounts. When a client makes a purchase of shares, the clearing corporation sends it to the pool account of the broker, who has to then transfer it to the demat account of the client as per prevailing SEBI guidelines. Lastly, a margin trading account is one where the broker lends money to the client to enable him to purchase shares. This loan is collateralized by the shares that the client purchases, and comes with a periodic interest rate. The amount that the broker lends to a client may come from a bank that lends money to the broker. Client’s shares pledged with the broker could be validly pledged with the banks as a security until recently. SEBI, vide its circular dated June 20, 2019 [ii] restricted brokering firms from pledging client securities as collaterals even with a due authorization from the client. The most serious wrongdoing on part of Karvy was an illegal pledging of this sort. Facts of the case The National Stock Exchange (“NSE”) conducted a limited purpose inspection of Karvy upon noticing certain irregularities in pledging of client securities. This inspection was conducted on August 19, 2019 for a period starting from January 1, 2019 and a preliminary report was submitted to SEBI on November 22, 2019. SEBI, on the same day, through whole time member Anant Barua, pronounced an order [iii] highlighting the findings of the report and the entire misfeasance by Karvy. The first fault noticed by NSE on part of Karvy was the non-reporting of a depository participant account in its filings. Second, Karvy transferred the funds raised by pledging client securities to six of its own bank accounts, rather than the accounts of its clients, and further did not report these six accounts as it was required to. The order stated that the securities pledged by Karvy to the lenders belonged to its clients and therefore should not have been pledged as collaterals. SEBI highlighted a series of circulars that lay down client securities are not be used for any purpose other than for meeting client margin requirements. As stated earlier, this position was further made stringent when any pledging of client securities was barred, even with an express permission from the client. How do PoAs and the use of margin trading and pool accounts fit into the above stated facts? As is the business practice, and as has been highlighted above, the securities brought by clients are first transferred into the pool accounts of the stockbroker and then subsequently into