Another false dawn for securities lending?

By Prachi Loona and Suprio Bose, Juris Corp
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The latest amendment to the securities lending and borrowing (SLB) framework, through a notification dated 6 January demonstrates a renewed effort by the Securities and Exchange Board of India (SEBI) in kick-starting what is presently a moribund market for SLB. SEBI’s initiatives in this area began with the introduction of the SLB scheme, 1997. However, the 1997 scheme presented major shortcomings such as prohibition on participation by institutional investors and a limited seven-day tenure for the contract. As a result, the 1997 scheme never really took off.

The issue of short sales was first deliberated by SEBI in 1996 by the BD Shah Committee. Thereafter, as a response to market volatility in 1998, SEBI temporarily banned short sales and in 2001 reintroduced this ban.

Prachi Loona Associate Juris Corp
Prachi Loona
Associate
Juris Corp

Perhaps, the key reason behind a lacklustre SLB market is SEBI’s yoyo policy towards permitting short-selling in India. SLB is a key enabler (especially in a market where the regulator, generally speaking, favours transactions in securities that are backed by delivery) to a strong and vibrant market for short-selling. A robust market for short-selling can be established only if all classes of market participants are permitted to participate, so as to generate the desired liquidity.

Given the intrinsic link between short-selling and SLB, it is worthwhile to examine some of the issues that can establish a healthy market for short-selling and facilitate an effective SLB mechanism.

SEBI withdrew the restrictions on short sales with effect from 2 July 2001 by allowing short-selling by retail investors. A decade after its first initiative, SEBI further launched a new scheme with effect from 21 April 2007. This scheme is significant, since it allowed institutional investor participation. The SEBI (Foreign Institutional Investors) Regulations, 1995, as well as the SEBI (Mutual Fund) Regulations, 1996, were consequently amended to allow foreign institutional investors and mutual funds to short-sell through the stock lending mechanism put in place by the stock exchanges. SEBI also increased the tenure of the contracts from seven days to 30 days. However, the measures continued to prove inadequate to realize any tangible results.

Last month’s notification endeavours to achieve much in the SLB framework by increasing the tenure of a contract from 30 days to 12 months. As regards the lender recalling the securities and early repayment being sought by the borrower, the SLB framework has been amended to permit the same.

An interesting question is whether voting rights should be retained by a lender under the SLB framework. Presently, borrowed securities are deemed to belong to a borrower and there are no provisions restricting the exercise of voting rights.

Currently, economic interest continues to lie with the lender and is merely deferred to a later point in time given that all corporate benefits (i.e. dividends, stock splits, etc.) are required to be settled on repayment by the borrower. Hence, voting rights should continue to be exercised by the lender and not the borrower, arguably because the lender would be the true repository of the voting rights. SEBI has rightly excluded the applicability of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, on the basis that the lending of securities does not amount to a “transfer”. This lends further credence to the argument that voting rights should continue to be exercized by a lender since the underlying implication is that mere borrowing under the SLB framework does not amount to acquiring control or voting rights. Perhaps this can be achieved with provisions in the agreement to be entered into for the lending of securities without any regulatory intervention.

Suprio Bose Associate Juris Corp
Suprio Bose
Associate
Juris Corp

Further, SEBI should consider whether transactions under the SLB framework should be permitted in an open offer. One reason is that the acquirer may use the SLB framework to depress prices of the scrips of a target company. Further, during a takeover offer, a large number of securities may be offered to the acquirer and thus lead to a reduced supply of borrowable and deliverable stock. On the other hand, some market operators may use the borrowing facility to corner floating stock!

As per current norms for short-selling, institutional investors are required to disclose when placing an order whether the transaction is a short sale. However, retail investors are permitted to make such disclosures by the end of trading hours on the transaction day. This disparity should be removed and institutional investors should also be allowed extra time to make such disclosures. Otherwise, an institutional investor runs the risk of having to pay heavily as the market recognizes the need of institutional investors to borrow in order to avoid a default.

Although the measures suggested are encouraging in providing the necessary impetus for transactions under the SLB framework, it would be unsurprising if the increase in volumes in SLB is not significant. The regulator should rethink the condition of prior disclosure by institutional investors and the quantum of margins. Further, given the sea-change in the market infrastructure, the regulator needs to shed its aversion to over-the-counter stock lending.

Prachi Loona and Suprio Bose are associates at Juris Corp, a Mumbai-based firm that specializes in banking and finance, foreign investments, private equity, direct tax, bankruptcy and restructuring, M&A, insurance, energy and infrastructure, dispute resolution and International arbitration.

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