Indian investors need protection from manipulative short-selling practices

India’s stock market is ranked fifth in terms of market value ($4 trillion), behind the US ($47 trillion), China ($9.7 trillion), Japan ($5.9 trillion) and Hong Kong ($4.8 trillion). India is regarded as the world’s fastest growing economy which has had a surge in successful initial public offerings (IPOs).

Tata Tech is a recent illustrative IPO – worth Rs 3,042 crore, subscribed nearly 70 times – and the trend exhibits confidence of investors in markets. These investments are not all by big investors, but also substantially from small investors in Tier-II and Tier-III towns. As the interest in capital markets is growing, the stakeholder base is also increasing. Undoubtedly, there are a lot of issues concerning the sector, but true to the slogan, Securities and Exchange Board of India (Sebi) is trusted as ‘Har Investor ki Taaqat’. It is critical that whatever gaps exist, they are speedily plugged.

After several hearings, the Supreme Court recently reserved its judgment in the matter relating to PILs filed in the allegations made by US-based firm Hindenburg against theAdani Group for violations of the stock market. While the final judgement is awaited, the Supreme Court, as per media reports, observed that there is no reason to doubt Sebi’s probe and impartiality of the expert committee headed by a former Supreme Court judge. There were observations about SEBI to formulate measures to take care of market volatility and protect investors. The expert committee, in its report released in May, reportedly found no prima facie lapse on the part of the Sebi in the matter. Similarly, it made no conclusive findings of wrongdoing by Adani.

 According to media reports, the Enforcement Directorate has concluded after a preliminary investigation into the Hindenburg Research report and the subsequent market crash that a dozen companies, including foreign portfolio investors and foreign institutional investors (FPIs/ FIIs) based in tax havens, were the “top beneficiaries” of short selling. Some of these short sellers allegedly took positions two-three days before the Hindenburg report was published on January 24. Accordingly, three of the 12 short-sellers are based in India, one is the Indian branch of a foreign bank, four are based in Mauritius and one each in France, Hong Kong, Cayman Islands, Ireland and London. It was also brought out in the report of the Supreme Court appointed Committee, that the maximum loss for Indian investors between January 24 and February 27 was approximately Rs. 29,200 crore.

Short selling is a trading strategy which involves borrowing a stock to sell it in future in the expectation the price will fall and then repurchasing the shares and pocketing the difference. The European Commission defines it as the sale of a security the seller does not own at the time of entering into the agreement with the intention of buying it back at a later point in time in order to deliver it. While the practice is not illegal per se, its use by some dubious short-sellers, for manipulating stock prices for profiteering, at the cost of unsuspecting ordinary investors is questionable.

To address the harm created by manipulative short sellers, the USA’s Securities and Exchange Commission (SEC) rolled out new rules last month to strengthen investor protection and boost transparency in capital markets. The rules require investors to report their short positions to the agency, and companies that lend shares to report that activity to the Financial Industry Regulatory Authority (FINRA), a self-regulatory body for brokers.

The United States noticed the perils of motivated short sellers in the recent past. In a February 2020 petition to SEC, legal scholars and faculties at US law schools noted that there has been a rise in negative activism: The practice of motivated short selling just before disseminating an “aggressive negative opinion” about a company. The petition cited a study which found that “these attacks are followed by price declines and sharp reversals. Lastly, the data cited in the study suggests that the patterns are “likely driven by manipulative stock options trading.” Between 2010 and 2017, there were 1,720 pseudonymous attacks on mid- and large-cap firms involving over $20.1 billion of mispricing, it added.

Like in the US and EU, it is time for Sebi to also consider formulating regulations to address manipulative short sellers and make reporting more transparent so that retail investors are not left to the mercy of parties overseas, outside the reach of Indian laws.

Finance Minister Nirmala Sitharaman in an interview some time ago highlighted the role of Sebi in addressing issues of manipulative actions like motivated short selling. She expressed that effective use of regulatory tools could contribute to enhanced corporate governance.

India has strong regulatory institutions and an established rule of law; matters like short selling must be looked at from the perspective of legality and regulatory surveillance. Third party reports and comments can affect markets and shake investor confidence. When the Supreme Court is seized of the matter and has made observations, there is urgent need for the regulator to take measures to protect investors from motivated volatility of stock markets.

Dhanendra Kumar is formerly executive director at the World Bank for India, Sri Lanka, Bangladesh and Bhutan, first chairman of Competition Commission of India. Currently chairman of Competition Advisory Services LLP, he penned this piece for Business Standard. 

Views are personal and do not represent the stand of this publication.