Sucheta Dalal :Pitfalls ahead in new Sebi proposal
Sucheta Dalal

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Pitfalls ahead in new Sebi proposal  

Oct 24, 2005

India has been proud of the speed with which automation has cleaned capital market systems and facilitated rapid growth. It has allowed India to become one of the hottest emerging markets. But, unless the regulatory system is constantly alert, ingenious crooks are always working to identify weak links.

A good example is Saturday’s report in a leading newspaper, that the income tax department found a single investor had opened 5,000 demat accounts to be able to multiply applications to Initial Public Offerings (IPOs) and maximise his returns. The revelation is stunning, as the increase in demat accounts was assumed to signal a return of retail investors. Is it a signal of increased manipulation?

The finding raises several other questions. Why have fully automated depository systems failed to throw up alerts when multiple accounts are linked to the same bank account or address? Also, how is the maintenance of 5,000 demat accounts financially viable, unless Depository Participants (DPs) had colluded to waive fees, charges and deposits that make dematerialisation extremely expensive for ordinary investors.  

His manipulation of the system is also pertinent in the context of other market developments. The Securities and Exchange Board of India (Sebi) chief, M Damodaran, has announced plans to permit short-selling by institutional investors. He also plans to introduce physical settlement of derivative trades, after putting in place a lending and borrowing mechanism. 


• Automation of the capital market needs an ever-alert regulatory system

• Sebi has decided to now allow short-selling by institutional investors

• Given our market and Sebi’s proven ability, serious trouble is possible


The lending and borrowing mechanism is expected to prevent rampant price manipulation and keep out naked short-sales, that led to the demise of the old badla-based system of forward trading. Will it achieve this aim?  

It is pertinent to look at the growing US controversy over illegal naked short-sales and its consequences. Financial Wire of the US posted an article in March 2005 about a Michigan man, Robert C Simpson, who acquired 100% of the issued and outstanding stock of Global Links Corp. Two days later, he found over 50 million shares of the company shares were traded on the bourses. This case came up for discussion by the Senate Banking Committee and was probably the earliest official acknowledgement of naked short-sales (without first borrowing shares, as is legally required).


Since then, Patrick Byrne, CEO of a company called Overstock has gone public with the fact that his company’s float changed hands four or five times in a day. How, in a perfectly functioning lending and borrowing mechanism? And where are all the extra shares coming from to give delivery, unless there is a large incidence of illegal naked short-sales? Byrne has publicly alleged his father failed to get delivery of 200,000 shares purchased by him through a blue-chip brokerage firm. He is quoted as saying anywhere between 5-20 million counterfeit shares are currently in the marketplace, presumably on the major exchanges alone.


The US debate is important, as their trading system has become the global standard for capital markets. It is, hence, pertinent to note that extraordinary trading volumes (yet unexplained phenomena in highly manipulated Indian stocks as well) and short delivery during settlements are increasingly being flagged as manifestations of a possible scam.


More startling, many investors have accused The Dep-ository Trust & Clearing Corpo-ration (DTCC), a holding company that clears and guarantees almost all trades in the US, of engineering naked short-selling schemes. The DTCC has faced 12 lawsuits in this connection. Most of these were dismissed, but the corporation itself has admitted, in a Q&A posted on its website, that naked short-selling occurs, but the extent to which it occurs is unclear.


The DTCC’s stock lending and borrowing programme also continues to be under regulatory scrutiny by the NASD and other government agencies. The US debate attributes naked short-selling to counterfeiting and collusion between brokers, dealers and, of course, shadowy hedge funds. In most cases, the sales, accompanied by large, unexplained trading volumes, aimed to destroy the value of small companies.

An October 13 report by Financial Wire also suggests research analysts, especially Net-based ones, also have a role to play in setting the stage for shorting. It quotes specific examples of alleged collusion between broker-dealers and independent research firms to publish negative information, to beat down the prices of target companies. The article mentions Refco Inc, the beleaguered brokerage company, whose former CEO Phillip Bennett has been arrested on charges of deliberately misleading shareholders and hiding $430 million in bad debts, hidden in another company controlled by him. Quoting a report in the New York Post, it says Santo Maggio, the recently-fired president of Refco Securities, was “in the middle of an SEC probe that would have probably gotten him suspended one year from his supervisory duties.” This pertained to Refco’s relationship with Rhino Advisors, a hedge fund that illegally shorted and destroyed the stock of Sedona Corp.  

This raging American debate over rampant price manipulation and misuse of automated trading systems is extremely relevant for us, since Sebi plans to permit short-selling by institutional investors. Indian investors, too, have noticed that a large and unexplained spurt in trading volumes always signals the start of a big price ramping operation. Our stock exchanges and regulators simply sleep over this phenomenon, even when these are pointed out to them.

Second, Indian regulators are clueless about the true beneficial ownership of the most powerful market segment, namely, foreign institutional investors. Add Sebi’s record of poor prosecution of important cases and our slow judicial system and we have a recipe for serious trouble. Sebi may end by attempting to regulate institutional short-sales, while remaining partially blindfolded.


-- Sucheta Dalal