The Supreme Court, recently rejected the request of Independent investigation into allegations by Hindenburg Research against Adani group of companies. The court found no ground to question SEBI’s competence. It ordered SEBI to complete the investigation within three months. The recent developments in the Adani Group and the Hindenburg case underscore the significance of delving into the topic of Short Selling. The verdict prompts crucial exploration of the concept as I embark on discussing short selling in the following article.
What is Short Selling?
If we look at the stock market through our accustomed lens, the common expectations are to see an upward growth trajectory. Investors often, anticipate positive gains and thus flourishing portfolio. The traditional functioning follows a ‘Buy Low and Sell High’. In such approach the market participant looks for buying stocks at a lower price and sell them afterwards at a higher price.
However, amidst the familiar narrative of ascent, there exist a nuanced practice that goes opposite the conventional script- the fascinating world of short selling.
SMAC (Secondary Market Advisory Committee) noted that the commonly used definition of short sales in international jurisdictions and in finance literature is ‘sale of stocks by an investor which he does not own’[1].
In other words, we can say that short selling involves borrowing stock you do not own, selling them, and then buying them when the price drops and returning the borrowed stocks, keeping the difference as profit. It is completely opposite to bullish transactions and is done to make profit in a falling market situation.
Short Selling: A Dive into the Past
The idea of short selling is not a recent development. The initial instance of short selling on record pertained to the shorting of shares in the Dutch East India Company in the early 17th century, marking the inception of the first publicly traded company[2].
In that period, engaging in short selling was perceived as a valid and beneficial strategy. It served the dual purpose of enabling investors to safeguard their positions through hedging and also contributing to market liquidity[3].
In 1720, the French market experienced a significant downturn, leading to the blaming of short sellers, who subsequently became the focal point of criticism. As a response, the practice of short selling was banned. Notably, Napoleon viewed short selling as an act of treason, recognizing the challenges it posed to financing his wars during periods of market instability.[4]
Nevertheless, controversy surrounded it in the early 20th century as certain investors exploited the practice to manipulate the stock market. In reaction to these concerns, the New York Stock Exchange implemented restrictions on short selling in 1938. These regulations stipulated that short sellers had to wait until a stock price had increased before engaging in short selling and mandated them to uphold elevated levels of collateral.[5] Presently, short selling stands as a widely adopted trading approach embraced by numerous investors and hedge funds. However, the strategy continues to be a topic of contention, occasionally accused of worsening market declines. This is because short sellers can make money when a stock goes down, adding to the downward push on its price. There is speculation that short selling played a significant part in intensifying the impact of the 2008 financial crisis, recognized as one of the most severe recessions since the Great Depression of 1929.
Covered Short Selling Vs Naked Short Selling.
The process of short selling, as already discussed means selling stocks which the market participant does not own. However the seller before selling the security borrows the said security from an entity, usually a broker at a fee, with an agreement to return them later. Such mechanism is called covered short selling as the security sold is covered by borrowed security. The process of borrowing security includes either finding the security to borrow or having a reasonable belief that it’s possible to borrow them. However, when a market participant sells a security without actually borrowing it and lacks a reasonable belief that the shares can be borrowed or found to complete the transaction, it’s referred to as naked short selling.
Except for a few cases, covered short selling is generally allowed in the majority of international markets. On the other hand, naked short selling is either strictly regulated or predominantly prohibited. Legislators believe that naked short selling has the potential to adversely impact the market by artificially inflating the supply of securities and causing a decline in prices.
Keeping in lines, India too imposed a blanket ban on naked short selling, thus prohibiting the participants from engaging in the said activity.[6]
Short Selling Regulations in India: An Examination of Past and Present.
India has been in a state of continuous development for an extended period. Regulatory bodies and markets are consistently gaining insights from their experiences, actively pursuing initiatives for national improvement. Specifically, in the realm of Financial Markets, India lagged significantly. In 1996, a committee, chaired by Shri B.D. Shah, was formed, resulting in numerous recommendations aimed at regulating trading activities in India.[7]
The Securities and Exchange Board of India (SEBI) prohibited short selling from 2001 to 2008 due to allegations of insider trading that resulted in a drop in stock prices.[8]
In 2002, a collaborative parliamentary committee on the stock market scandal was established to investigate the matter concerning short sales.[9] In 2003, on the recommendation of the parliamentary committee, Stock Market Advisory Committee (SMAC) reviewed the practice of short selling.[10] In the 2005 discussion paper, the SEBI noted that “the votaries of short selling consider it as a desirable and an essential feature of a securities market. The restrictions on short selling distort efficient price discovery, gives promoters the unfettered freedom to manipulate prices, and favours manipulators than rational investors”[11].
Short selling is regarded as a useful mechanism in some jurisdictions as an aid to liquidity[12]
This discussion paper prompted SEBI to broaden access to short selling for a wider spectrum of market participants in 2007, contingent upon comprehensive frameworks governing short selling[13] and securities lending and borrowing.[14]
SEBI has recently reaffirmed its stance on short selling, maintaining the prohibition on naked short selling. All investors are obligated to fulfil their commitment to deliver securities during settlement. Institutional investors are prohibited from engaging in day trading, meaning they cannot square off their transactions within the same day. Additionally, institutional investors must disclose upfront, at the time of order placement, whether the transaction involves a short sale and their capability to borrow the stocks to the satisfaction of the broker. On the other hand, retail investors are allowed to make a similar disclosure by the conclusion of the trading day.[15]
Regulations pertaining to Foreign Portfolio Investors (FPIs) in India are dictated by SEBI (Foreign Portfolio Investors) Regulations, 2014 (“FPI Regulations”)[16], alongside the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”) and Foreign Exchange Management (Debt Instruments) Regulations, 2019 (“DI Regulations”). The oversight also extends to the Master Circular for Foreign Portfolio Investors (“FPIs”), Designated Depository Participants, and Eligible Foreign Investors (“Master Circular”).[17]
The FPI Regulations and the Master Circular explicitly disallow Foreign Portfolio Investors (FPIs) from participating in short selling unless adhering to SEBI’s prescribed securities lending and borrowing framework. Additionally, the Reserve Bank of India (“RBI”), through a master direction on foreign investment in India[18], has granted permission for FPIs to engage in short selling of equity shares, subject to specific conditions.
The preceding discussion has led us to comprehend the framework for securities lending and borrowing. In order to ensure the adequate coverage and honouring of investors’ short positions during settlement, SEBI instituted a comprehensive Securities Lending and Borrowing (SLB) Framework for all participants in the market. Currently, the lending and borrowing of securities are facilitated by clearing corporations of the exchanges, acting as Approved Intermediaries (AIs). These AIs provide automated, screen-based, independent order-matching platforms. Market participants seeking to borrow or lend securities can utilize these intermediaries. A dynamic securities lending and borrowing market not only complements short selling in securities but also allows investors to generate returns on their inactive securities.[19] However, in India short selling is majorly limited to futures and options. The SLB mechanism is merely on paper. It is highly difficult to practice and involves high cost.
Short Selling: A Global Perspective on Regulation
European Union (EU)
Regulation (EU) No 236/2012, known as the Short Selling Regulation (SSR), represents a comprehensive legislative framework within the European Union. Following the severe impact of the 2008 financial crisis globally, numerous countries, including the majority of EU member states, the USA, and Japan, implemented emergency measures to restrict or prohibit short selling in securities. The underlying assumption was that short selling could exacerbate the ongoing economic downturn. In response to this, the SSR was introduced to standardize and regulate the practice of short selling uniformly across the Union.
The introduction of these regulations aims to address identified risks associated with short selling while ensuring that its beneficial aspects are not compromised. Articles 5 and 6 of the SSR mandate that individuals with short positions must notify the competent authority and the public, respectively, if the position reaches a specified threshold. This requirement is in place to enhance transparency in short selling activities.[20]
Article 11 stipulates that competent authorities relay information regarding short positions to the European Securities and Markets Authority (ESMA). The Regulation also confers a wide set of supervisory powers on the European Securities and Markets Authority (‘ESMA’). [21]
Moreover, Articles 12 and 13 impose bans on naked short selling of shares and sovereign debt, respectively, emphasizing the importance of locating securities before initiating a short selling position.
In situations where adverse events pose serious threats to financial stability, the SSR grants intervention powers to competent authorities in member states (Article 18) and ESMA (Article 20) to implement effective measures. One of the primary concerns associated with short selling is its potential contribution to disorderly declines in the prices of financial instruments. To address this, Article 23 of the regulation empowers authorities to temporarily suspend short selling when deemed appropriate.[22] However the market makers are exempted from such rules to ensure liquidity and drive in the markets.
United Kingdom (UK)
The UK incorporated the EU SSR ( discussed previously) into its regulatory framework post-Brexit. Nevertheless, the overall system has consistently diverged from the UK’s traditionally more open-market approach and has emerged as a focal point for reform in the aftermath of Brexit.[23]To fulfil its targeted liberalisation , UK has recently published its draft Short Selling Regulations, 2024.[24]
In cases where the FCA is informed about short positions in a company, the proposed SSR 2024 mandates the FCA to publicly disclose the cumulative net short position for the issued share capital of a company on a daily basis as long as positions are maintained. This is a departure from the individual disclosure requirement under the EU SSR. Additionally, the threshold for notification is raised from 0.1% to 0.2%.
The SSR 2024 in draft form confers emergency powers upon the FCA. These include the authority to prohibit short sales or impose restrictions on them, particularly in response to a substantial drop in the price of a financial instrument. The FCA is also empowered to demand the notification of short positions and information regarding lending fees[25].
United States of America (USA)
USA has allowed short selling since its adoption of short selling regulation in 1938. As a result the uptick rule[26] was introduced. Further regulation SHO was adopted to update short selling regulation because of the changing dynamics.[27]
Rule 200, pertaining to Marking Requirements, mandates that any orders you submit to your broker-dealer must be clearly designated as “long,” “short,” or “short exempt.”
Rule 201 puts restrictions on how low short sales can go when a stock’s price is dropping significantly. It’s meant to stop short selling, especially if it could be manipulative, from making the price of a security drop even more after it has already gone down a lot during the day. Simultaneously, the rule aims to enhance the opportunity for long sellers to initiate selling actions promptly in response to such a decline.
Rule 201, the Short Sale Price Test Circuit Breaker, requires trading centres to establish and enforce written policies and procedures. These measures should be reasonably designed to prevent the execution or display of short sales at inappropriate prices, specifically triggered when a stock experiences a 10 percent or more price decline in a single day, activating the circuit breaker. Once this circuit breaker is triggered, the associated price test restriction will be applicable to short sale orders in that security for the remaining portion of the day and the following day, unless an exception is met.
Rule 203(b)(1) and (2), referred to as the Locate Requirement in Regulation SHO, mandates that a broker-dealer must possess reasonable grounds indicating the ability to borrow the security.
Rule 204, the Close-out Requirement, mandates that brokers and dealers participating in a registered clearing agency must initiate measures to resolve and close out positions with failures to deliver.
In the case of Harrington Global Opportunity Fund Ltd v. CIBC World Markets Inc[28]., Judge Schofield concluded that broker-dealers could bear primary responsibility for manipulative trading conducted by their clients. This is due to their role as “gate-keepers” in facilitating trading on securities exchanges.[29]These broker-dealers are tasked with an ongoing responsibility to verify that their customers’ order flow adheres to all relevant rules, regulations, and laws, and to identify and prevent any instances of manipulative or fraudulent trading.[30]
Benefits of Short Selling: Why Does It Still Evoke Dubious Perceptions?
Short selling is considered to be a volatile activity. It ensures price discovery for the stocks as the short sellers bet against the overpriced stock. It helps in reducing the hype in the market that is growth without tangible reasons. Limiting the capacity of short sellers to engage in market transactions would introduce a bias in securities prices, as these sellers would face constraints in executing trades based on their information.[31] Shorting activity could potentially lead to destabilization by contributing to a rapid downward spiral in prices. Nevertheless, Bailey and Zhang discover an opposite effect. They say, short positions do not increase when stock prices fall (which may lead to spiral falls) but when prices rise.[32]
Short selling also positively affects the market liquidity. Its presence brings liquidity in the market. It ensures that there is continuous trading.
Short selling also ensures that firms operate in accordance with laws. Short sellers bet against the shares, because of their knowledge about laxity on part of the management of the company. They are motivated to uncover the wrongdoing of the management. Thus, promoting corporate governance.[33]
Short selling is engaged in by individuals considered rogues, thieves, and notably pessimists, often regarded as the least favourable group. It is perceived as a highly negative activity that should be put to an end during our lifetime. Many share the sentiment of stopping, limiting, or condemning those who pursue short selling as their profession. These sentiments, regrettably, are not fictional or infrequent; they genuinely mirror a significant portion of the investing public’s perception of short selling.[34] This might be attributed to the prevalent expectation of witnessing growth and markets ascending. A considerable number of investors lack the skill to sell high initially and repurchase at a lower price later, often influenced by human psychology.[35] Short sellers, characterized by their pessimistic approach, typically do not garner favourable media attention. In times of market decline, short sellers become easy targets as they are perceived to profit from the downturn.[36] Another behaviour that could cast short sellers in a negative light is the potential to erode confidence in a company during times of crisis, subsequently making shares available at a reduced price later on.
Recent Impactful Short Seller Reports: Affecting Stock Prices
The Wirecard Scandal:
In 2019 and 2020, wirecard a German Payment company faced allegations of accounting irregularities by various reports, including The Financial Times. The report led to serious investigations by the authorities. Wirecard eventually filed for liquidation in 2020. It was the short sellers whose research and reports brought to light the Wirecard misdoings.
Luckin Coffee:
In the year 2020, Luckin Coffee, a coffeehouse chain based in China, faced allegations of falsifying sales figures. Muddy Waters Research, a renowned short-selling firm, released a report exposing anomalies in Luckin Coffee’s financial statements. Subsequently, these revelations triggered a significant decrease in the company’s stock value and prompted regulatory authorities to launch investigations.
Adani and Hindenburg fiasco:
In 2023, Hindenburg Research a well-known short-seller published reports alleging irregularities in Adani group of companies. It alleged accounting fraud and stock manipulation. It claims that Adani stocks were inflated by almost 85%. Following this a probe by SEBI as initiated as to allegations of targeted defamation against Hindenburg research and short selling to make profit out of Adani’s share price fall. The report is still pending.
Conclusion
The preceding discussion concludes at this point. Engaging in short selling represents a legitimate practice within the market. It is imperative to recognize that a declining market cannot solely attribute its downturn to short selling. Eliminating short selling would result in a unidirectional market movement characterized by inflated prices and misguided optimism, ultimately leading to a burst fuelled by a lack of fundamental strength. Instead of censuring and prohibiting short selling, it should be embraced as a corrective element inherent in the market. However, it is crucial to emphasize that it should not be left unchecked.
Rather than focusing on banning short selling, attention should be directed towards regulating it. The primary concern should be the losses incurred due to intentional market manipulation employing such tactics. Taking the recent example of Adani and Hindenburg, despite existing regulations, they managed to circumvent them, causing significant losses to retail investors. Proactive measures should be implemented to keep investors well-informed about market changes, and transparency must be upheld.
Improving the securities lending and borrowing (SLB) mechanism is another aspect that requires attention. Establishing an efficient and cost-effective SLB system would contribute significantly to proper oversight. While market growth is essential over time, it is equally crucial for the market to respond effectively to any wrongdoing or improper functioning. Therefore, short selling should be subject to regulation rather than eradication.
[1] Securities and Exchange Board of India (SEBI), ‘Broad Framework for Short Selling’ (Annexure) available at: https://www.sebi.gov.in/sebi_data/commondocs/ssframe_p.pdf (accessed 08 January 2024).
[2] NPR, ‘The Spicy History of Short Selling Stocks’ (29 January 2015) https://www.npr.org/2015/01/29/382463501/the-spicy-history-of-short-selling-stocks (accessed 08 January 2024).
[3] Lodewijk Petram, ‘Going Short in 1608’ (27 November 2020) https://www.worldsfirststockexchange.com/2020/11/27/going-short-in-1608/ (accessed 07 January 2024).
[4] ‘History of Short Selling’ https://www.capitalideasonline.com/wordpress/history-of-short-selling/?pdf=13324 (accessed 10 January 2024).
[5] Merritt, Lawrence and Paul), ‘Short Selling and the News: A Preliminary Report on an Empirical Study’ (SSRN, 28 January 2010) http://ssrn.com/abstract=1543855 (accessed 10 January 2024).
[6] Supra note 1
[7] Securities and Exchange Board of India (SEBI), ‘Discussion Paper on Short Selling and Securities Lending and Borrowing’ available at: https://www.sebi.gov.in/sebi_data/commondocs/rep40_p.pdf (accessed 01 January 2024).
[8] Investopedia, ‘Short Selling in India’ available at: https://www.investopedia.com/ask/answers/09/short-selling-india.asp#:~:text=Key%20Takeaways,a%20decline%20in%20stock%20prices (accessed 11 January 2024).
[9] Joint Parliamentary Committee on Stock Market Scam, ‘Report on Stock Market Scam and Matters Relating Thereto’ para 9.158, available at: https://eparlib.nic.in/bitstream/123456789/783370/1/JPC_13_Stock_Market_Scam_2002_Vol_I.pdf (accessed 28 December 2023).
[10] Securities and Exchange Board of India (SEBI), available at: https://www.sebi.gov.in/sebi_data/commondocs/rep40_p.pdf (accessed 11 January 2024).
[11] ibid
[12] International Organization of Securities Commissions (IOSCO), Public Document No. 96, ‘Securities Lending Transactions: Market Development and Implications, Joint Report by the IOSCO Technical Committee and the Committee on Payment and Settlement Systems of the Bank for International Settlements’ (July 1999), available at: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD96.pdf (accessed 10 January 2024).
[13] Supra note 1
[14] Securities and Exchange Board of India (SEBI), ‘Broad Framework for Securities Lending and Borrowing’ available at: https://www.sebi.gov.in/sebi_data/commondocs/slbframe_p.pdf (accessed 03 January 2024).
[15] Securities and Exchange Board of India (SEBI), circular SEBI/HO/MRD/MRD-PoD-3/P/CIR/2024/1 dated 5 January 2024, available at: SEBI Circular on Framework for Short Selling in Indian Securities Market (accessed 11 January 2024).
[16] Securities and Exchange Board of India (SEBI), ‘SEBI (Foreign Portfolio Investors) Regulations, 2014,’ available at: SEBI (Foreign Portfolio Investors) Regulations, 2014 (accessed 27 December 2023).
[17] Securities and Exchange Board of India (SEBI), ‘Master Circular for Foreign Portfolio Investors, Designated Depository Participants, and Eligible Foreign Investors’ available at: SEBI Master Circular for FPIs, DDPs and EFIs (accessed 11 January 2024).
[18] Reserve Bank of India (RBI), FED Master Direction No.11/2017-18, Notification No. RBI/FED/2017-18/60 available at: Master Direction – Foreign Investment in India (accessed 10 January 2024).
[19] Securities and Exchange Board of India (SEBI), ‘Discussion Paper on Short Selling and Securities Lending and Borrowing,’ para 1.4, available at: https://www.sebi.gov.in/sebi_data/commondocs/rep40_p.pdf (accessed 11 January 2024).
[20] Author/Entity (if available), ‘Application of European Regulation on Short Selling’ available at: https://www.amf-france.org/en/news-publications/depth/short-selling#Consolidation_of_short_sale_disclosures (accessed 10 January 2024).
[21] Jacques de Larosière, ‘The High Level Group on Financial Supervision in the EU’ (Brussels, 25 February 2009), available at: https://ec.europa.eu/economy_finance/publications/pages/publication14527_en.pdf (accessed 10 January 2024).
[22] Regulation (EU) No 236/2012 on Short Selling and Certain Aspects of Credit Default Swaps, available at: https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32012R0236&from=EN (accessed 10 January 2024).
[23] Thomas, Wilf, Elias, Sandy, Chloe, ‘The UK’s Lighter-Touch, Post-Brexit, Short Selling Regime’ available at: https://www.shearman.com/en/perspectives/2023/12/the-uks-lighter-touch-post-brexit-short#:~:text=Short%20selling%20is%20one%20of,are%20regulated%20by%20the%20FCA (accessed 11 January 2024).
[24] HM Treasury, ‘Short Selling Regulations 2024 – Policy Note’, November 22, 2023, available at: https://assets.publishing.service.gov.uk/media/655bc6d7d03a8d000d07fd13/M8212_Short_selling_policy_note.pdf (accessed 11 January 2024).
[25] Supra note 23
[26] Investopedia, ‘Uptick Rule’ available at: https://www.investopedia.com/terms/u/uptickrule.asp (accessed 11 January 2024).
[27] U.S. Securities and Exchange Commission (SEC), ‘Key Points about Regulation SHO’ available at: https://www.sec.gov/investor/pubs/regsho.htm (accessed 11 January 2024).
[28] Alan, Felicia, Leron, ‘Broker-Dealers Can Be Held Primarily Liable For Failing To Fulfill Their “Gatekeeping Responsibilities” Of Monitoring Their Clients’ Trading Activities’ available at: https://www.wbny.com/Warshaw-Burstein-Prevails-Against-Major-Banks-and-Brokerage-Houses-Opposition (accessed 04 January 2024).
[29] ‘Is this the End of Naked Short Selling?’ available at: https://finance.yahoo.com/news/end-naked-short-selling-230100677.html (accessed 03 January 2024).
[30] Supra note 28
[31] Archana Jain and Chinmay Jain, ‘Fails-to-Deliver before and after the Implementation of Rule 203 and Rule 204’ available at: https://ypfsresourcelibrary.blob.core.windows.net/fcic/YPFS/Fails%E2%80%90to%E2%80%90Deliver%20before%20and%20after%20the%20Implementation%20of%20Rule%20203%20and%20Rule%20204.pdf (accessed 02 January 2024).
[32] Bailey, A., & Zhang, H., ‘Banks, Bears, and the Financial Crisis’ (2013) Journal of Financial Services Research, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1695062 (accessed 02 January 2024).
[33] Massa, M., Zhang, B., & Zhang, H., ‘The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management?’ (Oxford Academic, 2015) Review of Financial Studies 28(6), 1701, available at: https://academic.oup.com/rfs/article-abstract/28/6/1701/1610243 (accessed 03 January 2024).
[34] Sharma, N., ‘Impact Of Short Selling In Financial Markets’ (2017) Journal of Social Science Research 11, 2447-2481, available at: https://www.researchgate.net/publication/326975360_Impact_Of_Short_Selling_In_Financial_Markets (accessed 01 January 2024).
[35] ‘All about Short Selling’ (The Wire), available at: https://thewire.in/business/explainer-short-selling-futures-india-adani-stocks-hindenburg (accessed 05 January 2024).
[36] ibid
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