[Garv Arora and Vatsal Jain are 3rd year B.A., LL.B. (Hons.) student at HNLU, Raipur]
By way of its circular titled ‘Framework for Short Selling’ dated January 5, 2024 (the ‘Circular’), the Securities and Exchange Board of India (‘SEBI’) has laid down a definitive framework to better regulate short-selling transactions in the Indian stock market. Short selling is a trading activity that focuses on the “Sell High, Buy Low” model, wherein the seller borrows shares from a lender, sells them in the market anticipating a fall in the price of the stock, and keeps the proceeds. The borrower settles the transaction by buying shares later at a lower price and returning them to the lender, consequently earning the profit from the difference. Over a period of time, SEBI has recognised the need for short-selling transactions to provide liquidity and for price correction of overvalued stocks in the Indian stock market.
The Circular comes in the backdrop of an affirmation given by the Solicitor General of India before the Supreme Court on relevant measures to be taken by the Union Government and SEBI to regulate short selling. Additionally, the Supreme Court in its judgment dated January 3, 2024 ordered SEBI to probe into whether the loss caused to the investors due to short selling in the Hindenburg-Adani episode involved any infraction of the law.
Historically, short-selling transactions have been governed by a circular titled ‘Short selling and securities lending and borrowing’ (‘SLB Circular’) issued by SEBI in 2007. In October 2023, SEBI additionally released a ‘Master Circular for Stock Exchanges and Clearing Corporations’ (‘Master Circular’) which updated the previously rescinded circular and statutes with its notifications and eventually superseded them. Provisions of Chapter 1 of the Master Circular imposed a ban on naked short selling and laid down the framework to regulate short selling in India. Furthermore, in the January 2024 Circular, SEBI has added two more provisions pertaining to the disclosure requirements of the short selling transaction in line with the SLB circular. Firstly, the SEBI has mandated institutional investors to disclose upfront when they place the order whether the transaction is a short sale or not. Secondly, the brokers collect the details on scrip-wise short-sell positions and provide them to the respective stock exchanges. The stock exchanges are then required to consolidate such information and provide it to the public on a weekly basis.
This post critically analyses the current legal framework of short-selling transactions in India. It investigates the Circular on short selling and highlights the lacunae in the regulations taking into consideration such regulations of other stock exchanges.
Ban on Naked Short Selling and Broker Accountability Challenges
Under the Circular, SEBI has directed the stock exchanges to frame necessary uniform provisions to deter the practice of naked short selling. The stock exchanges are required to take action against the brokers for failure to deliver the securities at the time of settlement. The majority of the securities in the Indian stock exchanges are traded and kept in the dematerialised form. Hence, there may be cases where the broker may not be able to deliver the securities due to human or mechanical errors or processing delays to transfer the securities. The provision’s presumption of ill intention and non-emphasis on the reason for failure to deliver the securities may create unfound guilt on the part of the broker. To counter this it is recommended that inspiration shall be sought from the Securities & Futures Commission of Hong Kong (‘SFC’) wherein it has expressed the position that the SFC will not penalise genuine mistakes or errors in this regard.
Allowing F&O and Silence on Overseas Transactions
The Circular has reiterated that the securities traded in the future & option (‘F&O’) segment are permitted for short sales. In the F&O segment, the sellers are allowed to speculate the price of the securities without owning them and to sell them at a predetermined price on a future date. This goes against the underlying principle of short selling and may fall under the ambit of naked short selling. Furthermore, the Circular is silent on the validity of the naked short-selling transactions in overseas markets. In the Hindenburg- Adani episode, the stocks of Adani were listed on the US stock exchange and Hindenburg held a short position in Adani Group and issuance of the report by them had a domino effect in the Indian stock market. Moreover, the Ministry of Corporate Affairs has permitted the direct listing of shares of domestic companies in the overseas stock exchanges with due permissions. The validity of the short-selling transactions in such scenarios is unclear and the current framework needs to be overhauled to cover such transactions.
Uncertainty and Gaps in Criteria to Review the List of Securities
SEBI’s discussion paper on Short Selling and Securities Lending and Borrowing (‘Discussion Paper’) states that for the time being short selling be permitted for only those stocks in which derivatives are available. The Hindenburg-Adani episode highlighted that various investors attacked the Adani group through the use of structured product derivatives (‘SPD’). The allowed securities posed a great risk to the stock exchange as they increased the volatility of the Indian shares. However, SEBI has failed to come up with a specified mechanism to regulate such stock derivatives even after the evident loss caused to the investors of Adani Group due to short selling in the permitted stocks.
The Circular further provides that SEBI has the power to review the list of shares that are eligible for short-selling transactions periodically. However, it does not provide any criteria on which such a list of shares can be reviewed. This might lead to perplexities and uncertainty and may result in unfettered power in the hands of SEBI. The issue of lack of transparency may arise owing to such undefined criteria. Furthermore, it does not provide for any scenario where the seller may resort to the practice of market rumours or spreading of misinformation to reduce the price of the securities and earn profit on the difference amount.
Re-introduction of Disclosure Requirements and Dynamic Challenges for Investors
The major change brought about by the Circular is the reintroduction of disclosure requirements for effecting a short sale transaction, which stands to be in line with the rescinded SLB Circular. The Circular prescribes mandatory disclosure of the transaction up front for institutional investors and, by the end of the trading hours, for retail investors. The reintroduction of such a scheme by SEBI is appreciable as it creates a strong monitoring setup for stock exchanges to take appropriate actions in case of manipulations and extreme fall in the stock value. However, on the flip-side it also creates a hindrance for investors of such scheme.
The blanket disclosure requirements for all the transactions and subsequent information being available publicly create a threat to these investors, as they are susceptible to being targeted by investors in general for the reason of an overall negative outlook towards these kinds of investors. The same phenomenon can be observed in the 2021 event of GameStop stocks, wherein the retail investors on various social media platforms joined hands to particularly target the institutional short sellers taking short positions on this stock by soaring the value of the shares to a phenomenal level than its prevailing values. This eventually created a ‘short squeeze’ situation for the hedge funds and caused substantial losses for them. Situations such as these can, therefore, eventually lead to investors resorting to illegal means such as that of ‘naked short selling,’ manipulation of markets, misinformation or fraudulent information being passed to the public; to fulfil their interests as there have been such cases before.
To protect the Indian market from such situations, SEBI needs to bring about certain reforms in the framework laid down in the Circular. To begin with, it can take guidance from various international stock exchanges such as that of Hong Kong, the United States of America or the European Union, and introduce a certain threshold limit of holding or trading of the stocks, only beyond which the mandate for disclosure shall come into picture. This shall give some relaxation to the investors on a small scale and further reduce the risk of investors resorting to alternative prohibited means to fulfil their interests.
SEBI’s recent Circular on short-selling transactions in the Indian stock market is a positive stride toward regulating the practice. While aiming to enhance transparency in the short-selling transaction, it has reiterated the ban on naked short-selling and introduced disclosure requirements. The directive on action against the brokers, if they fail to deliver the security, lacks nuance, presuming ill intention without addressing potential reasons for delivery failures. Additionally, the Circular is silent on the validity of such transactions in overseas markets, requiring an overhaul to cover scenarios involving Indian companies listed abroad through direct routes.
The criteria for reviewing shares eligible for short selling lack specificity, creating potential uncertainties and an imbalance of power. To address this, a specified mechanism is needed to regulate stock derivatives posing risks to market stability. The reintroduction of disclosure requirements aligns with past practices but introduces potential drawbacks, exposing investors to targeting by the public, as seen in the GameStop event. To strike a balance, SEBI should consider international best practices, such as setting threshold limits for disclosure mandates based on stock holding or trading volumes. In conclusion, SEBI’s efforts are commendable, but refining the framework based on identified concerns is crucial for fostering transparency and resilience in India’s stock market.
– Garv Arora & Vatsal Jain