A Weak Start to Short Selling

Although short sales were allowed to commence last week (on April 21, 2008), the response thus far has been lukewarm. Various reasons have been offered for this result. The Hindu Business Line reports that market players attributed the poor response to bad timing, to relatively higher margin requirements for securities lending and borrowing (SLB) as compared to the future and options (F&O) segment of trade, and to the lack of operational readiness on the part of institutions. On the other hand, an The Economic Times report states that foreign institutional investors (FIIs) (who hold the key to the success of short selling) continue to use the participatory notes (PNs) route for shorting on Indian securities rather than to go through the mechanism established by SEBI. From these, it appears that there are several loose ends to be tied before the short selling mechanism can be implemented on a large scale.

In the meanwhile, there are more fundamental questions being raised about the desirability of short selling. [email protected] carries an article that notes:

“When Bear Stearns collapsed in March, some insiders argued it was wrong to blame the firm’s risky bets on mortgaged-backed securities. They had another culprit: malevolent traders working together in the upside-down world of short sales – making money by knocking down Bear’s stock.

No one openly admits to conducting a “bear raid,” since deliberately manipulating stock prices is illegal. But Wall Street has long believed bear raids can and do take place. There has, however, been little academic research to explain the forces at work. Now two finance experts have shed some light on the process. “We basically describe a theory of how bear raid manipulation works,” says Wharton finance professor Itay Goldstein. He and Alexander Guembel of the Said Business School and Lincoln College at the University of Oxford describe the procedure in their paper titled, “Manipulation and the Allocational Role of Prices.”

Their key finding illuminates the interplay between a firm’s real economic value and its stock price, showing how traders who deliberately drive the share price down can undermine the firm’s health, causing the share price to fall further in a vicious cycle.”

Apart from this, short selling may also induce a tendency towards price manipulation. For instance, the Securities and Exchange Commission (SEC) recently issued a press release where it charged a Wall Street trader with fraud for spreading false rumours. The release states:

“The U.S. Securities and Exchange Commission today filed a settled civil action in the United States District Court for the Southern District of New York, charging Paul S. Berliner, a Wall Street trader formerly associated with Schottenfeld Group, LLC, with securities fraud and market manipulation for intentionally disseminating a false rumor concerning The Blackstone Group’s acquisition of Alliance Data Systems Corp. The Commission’s complaint alleges that on November 29, 2007 — approximately six months after Blackstone entered into an agreement to acquire ADS at $81.75 per share — Berliner drafted and disseminated a false rumor that ADS’s board of directors was meeting to consider a revised proposal from Blackstone to acquire ADS at a significantly lower price of $70 per share. The Commission alleges that this false rumor caused the price of ADS stock to plummet, and that Berliner profited by short selling ADS stock and covering those sales as the false rumor caused the price of ADS stock to fall.”

While short selling has begun in the Indian markets, the regulators ought to be watchful of such situations. Vigilance and monitoring of market activity is crucial. The SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 do contain detailed provisions prohibiting fraudulent and manipulative trading, and these regulations can potentially be used to curb such activity.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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