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The authors are Tarun Thakur and Navya Bassi, second and third year students respectively at National Law University, Odisha.
Introduction
The Securities and Exchange Board of India (“SEBI”) on January 5, 2024 in its exercise of power under Section-11(1) of the Securities and Exchange Board of India, Act 1992 has issued a circular that provides a comprehensive framework for short selling in the Indian market.
In a normal market, a stock is purchased at a low price and then sold at a higher rate. For instance, X buys a stock for Rs. 100, and then sells it off for Rs. 120, the profit margin being Rs. 20. However, tactics are used to earn profits even in a falling market by selling something that you did not even have in the first place. This is allowed by the regulator SEBI itself. Short-selling is the sale of a security that the seller has borrowed. The short seller does this believing that the borrowed security’s price will decline, which will enable it to be bought back at a lower price for profit. Short selling is permissible under this circular. However, it expressly prohibits naked short-selling, which refers to a practice when the shares in some asset are sold by the trader without first borrowing them. By buying the shares at a lower cost, the aim is to profit from a decline in the asset’s price.
The impetus to introduce a new framework was given by the Supreme Court (“SC”), which in its recent order in the Adani-Hindenburg case mandated SEBI and the Central Government to take into account recommendations which were made by an expert committee , pertaining to bolstering the current regulatory framework. This whole saga started in January 2023 when Hindenburg published a report on the Adani group due to which the latter’s stocks plummeted drastically. This report alleged the Adani group of “brazen stock manipulation and accounting fraud”, due to which the conglomerate suffered a loss of more than $120 billion. This circular came two days after the SC order to reiterate the rules on short selling and to also introduce some key changes.
Key Changes Introduced by SEBI
Although the new framework is not a major departure from the existing rules since it is a verbatim reiteration of the original rules on short selling framed in October 2007, it introduces some key new points which could act as a major game-changer for the Indian stock market. Point eight of the circular stipulates that institutional investors will have to disclose upfront at the time of placement if a transaction is a short sale. Now, this is a shift from the previous norm where the disclosure was not mandatory, but the same has now been made mandatory for institutional investors with an aim to prevent market manipulation. Manipulation of a stock by short selling is done by artificially affecting the price of securities by stock market entities, by falsely increasing or decreasing the demand for the securities. this is done to conceal a flawed security by projecting it as a profitable investment and then selling it using various techniques such as wash trading, pump and dump, short and distort, spoofing, etc. The main rationale behind the new disclosure requirement is therefore to increase transparency. Then, point nine of the circular mentions that stock exchanges shall integrate information on short selling and disclose the same to the public on a weekly basis. By this, the retail investors will become aware which stock has been subject to shorting by institutional investors and be able to safeguard themselves from manipulation, if any. In the Adani-Hindenburg row, the retail investors were not aware that short selling was being done on the Adani stocks, due to which many investors sustained losses. But now this will not be possible in the new disclosure regime under the 2023 circular as the investors will have information regarding shares in which short selling has occurred.
In the new framework, SEBI has also notified a Securities Lending and Borrowing scheme (“SLB”) which is expected to bolster the short selling framework. The scheme does not come as a surprise since the same was notified by SEBI in October 2023. This scheme enables investors to borrow stocks for short selling and is expected to increase liquidity by creating a platform where borrowing can be facilitated between borrowers and lenders engaging in short selling.
The new framework is also in consonance with the US rules on short selling, where in October 2023 the US Securities and Exchange Commission (SEC) inserted rule 13f-2 so as to increase transparency in the market. It mandates institutional investors involved in short selling to report its information to the Financial Industry Regulatory Authority (FINRA), which will consolidate the data and make it available to the public. The same framework has been adopted by SEBI as mentioned in point nine of the circular.
The new framework notified by the SEBI looks promising and gives a glimmer of hope to the retail investors which are affected by manipulation owing to short selling.
SEBI’s Nuanced Stance on Short Selling
Over the course of time, SEBI’s stance on short selling has been evolving. In 2001, SEBI for the very first time banned short selling, the impetus to which was given by the Ketan Parekh scam where Ketan Parekh, also known as the “Pied Piper of Dalal Street”, siphoned off a whopping amount of more than Rs. 1200 cr. resulting in a market crash. SEBI soon took cognizance of the scam and banned short selling as there was no other measure to prevent further manipulation in the market that was hammered by the scam. Later, in 2008, the ban on short selling was lifted by the SEBI and all classes of investors were given the green light on short selling. In 2020, SEBI again temporarily banned short selling to deal with economic turmoil which was caused by the COVID-19 pandemic.
SEBI’s stance on regulating short selling is better than enforcing a complete ban on it. Short selling is an important feature of a market and banning it can put the market in jeopardy. In the Adani-Hindenburg case, the short selling did put the retail investors in danger but banning short selling is not the appropriate measure to tackle market manipulation as risk is an inherent feature of the stock market, and no SEBI framework or RBI guidelines can fully mitigate that risk. What can be done to mitigate manipulation is that risk can be minimised to a level that an investor does not sustain losses on account of manipulation. Furthermore, if short selling is banned, it will have a negative impact on market liquidity. In 2008, when the US banned short selling after the market crash, the SEC chairman regretted the said decision as “banning costs appear to outweigh the benefits.” Furthermore, putting a blanket ban on short selling has other repercussions too. For instance, a ban on short selling can result in lack of hedging, which is employed as a risk reduction tool by the companies as it helps in reducing exposure to the potential market risks. For example, in case of a company that relies majorly on its stocks for financing, if short selling is banned, the company may not be able to hedge against the potential decline in its stock prices and would be subject to greater financial strain. Furthermore, a study conducted on effects of a ban on short selling imposed in 2001 to 2008 reflects that even after a ban on short selling, the stocks continued falling. So, it can be concluded that a complete banning of short selling is of little aid and does not yield fruitful results.
SEBI’s circular does succeed in effectively regulating short selling. But, one problem with the framework is that the lack of definition in the standards for evaluating shares that qualify for short sales could lead to ambiguities and an imbalance of power. A defined system is therefore required to control stock derivatives that pose threats to market stability in order to resolve this.
Conclusion
In conclusion, the recent circular issued by the SEBI represents a significant step towards reinforcing the regulatory framework for short selling in the Indian market. The circular builds upon existing regulations and introduces key changes aimed at enhancing transparency and preventing market manipulation. The Adani-Hindenburg case serves as a backdrop to this development, emphasizing the need for measures to safeguard the interests of retail investors and maintain market stability.
Short selling has been prevalent in the whole world for a long time and there is a long-standing debate on it. SEBI has adopted a nuanced approach where it tries to maintain a balance instead of putting a blanket ban on short selling. The primary goal is to curb the market manipulation caused owing to short selling and SEBI’s new framework is a step towards achieving that. Overall, the new framework presents a promising outlook for the Indian stock market.
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