1.0. A Committee, under the Chairmanship of Shri B.D. Shah (former Chairman and Managing Director, New India Assurance Company Limited and former Managing Director, General Insurance Corporation of India) was appointed by the Securities and Exchange Board of India (SEBI) on November 22, 1996 to examine and recommend suitable modalities for the proper regulation of ‘short-selling’ in the stock exchanges in India. The Committee was also requested to consider and recommend modalities for the introduction of a ‘Stock Lending Scheme’. The Committee was expected to submit its recommendations within a period of three weeks. The Committee consisted of the following members:

1. Shri B.D. Shah -Chairman, Invesco India Research & Financial Services Pvt. Ltd.
2. Shri M.G. Damani  -President, The Stock Exchange, Mumbai
3. Dr. R.H. Patil  -Managing Director, National Stock Exchange of India Ltd. (NSE)
4. Shri D.K. Singhania,  -President, Calcutta Stock Exchange Association
5. Shri S. Ramanathan,  -Executive Director, Madras Stock Exchange
6. Shri K.N. Atmaramani,  -Managing Director, Tata Asset Management Company
7. Shri M.M. Kapoor  -Executive Director, Unit Trust of India
8. Shri A.K. Narayan  -Vice President, Tamilnadu Investors’ Association
9. Shri R. Chandrashekaran  -Managing Director, Stock Holding Corporation of India Ltd.
10. Shri L.K. Singhvi  -Sr.Executive Director, SEBI
11. Shri O.P. Gahrotra  -Sr.Executive Director, SEBI (Member Secretary)

In the first meeting of the Committee held on November 27, 1996, it was decided by SEBI to include Shri R.C. Mathur -Executive Director, The Stock Exchange, Mumbai and Shri Ravi Narain -Dy.Managing Director, NSE, as Members of the Committee.

2.0 The Committee’s mandate was to recommend measures for regulating the excessive short-selling in the stock markets which have been  witnessing one of the longest bear phases, lasting over two years. The worsening of market sentiment and psychology of investors may be attributed among other things to various factors including signs of slowing down of the economy, lower corporate earnings and the  absence of fresh funds being injected by  investors -particularly  institutional investors.

The Committee is of the firm view that in as much as short sales provide liquidity and competitive prices in the stock markets, there is no case for putting a blanket ban on the short sales. However, it  also recognised that excessive short sales have  serious negative effects in depressed market conditions and generally work to the disadvantage of the investors at large.

Excessive short sales in volatile scrips provide a mechanism for  bear hammering and bear raids which bring further and deeper depression in the stock market. Taking full advantage of depressed market sentiment speculators are able to indulge in excessive short selling of volatile scrips to depress prices much further to the disadvantage of other investors who continue to suffer increasing negative returns, due to (unchecked) and (unrealistic) decline in share prices. The excessive speculative activity provides an opportunity to  speculators to benefit from short sales by progressively depressing share prices.

Such excessive short sales are not desirable and require proper regulation. In this context, the Committee noted that short sales are regulated in developed markets such as the United States. Even Malaysia which is a relatively  small and emerging  capital market has also issued guidelines for regulating short sales.

The Committee observed that regulating short sales may not necessarily lead to an immediate recovery in share prices or revival of the stock market. However the  present amplification of this bearish trend in the stock market by short sales calls for a  tightening of the conditions for short sales. There is also a need to  bring about further transparency in  stock market operations. The Committee also observed that in  reverse conditions when the stock markets are in a bull phase and are relatively overheated there would be a need of a transparent regulatory  framework to similarly tighten conditions for long purchases also.

The Committee took notice of concerns that  regulating  short sales with more stringent conditions may lead to decline in volumes of business on the stock exchanges which may further depress the overall sentiment in the market. In view of this, the Committee felt that while appropriate regulatory measures are required to be adopted at this juncture to reduce excessive short-selling , the measures adopted should be carefully designed and implemented so that market sentiments and business are not adversely affected.

2.1 The Committee, at its first meeting held on November 27, 1996, after deliberations about the present lack of transparency in the Indian stock exchanges about short sale positions, recommended that as an immediate interim measure, all the stock exchanges would mandatorily require their member brokers to submit his scrip-wise net ‘short-sale’ position to the exchange at the end of each trading day. ‘Short-Sale’ for this purpose would mean “selling of shares without having the physical possession thereof unless it is for squaring-up of an earlier purchase made in the same settlement and on the same stock exchange”. This information would be required in respect of  60 actively traded scrips as per Annexure-A.

2.2 All the stock exchanges would compile the scrip-wise cumulative ‘short-sale’  positions and would make them public latest by the next trading day. The stock exchanges which are computerised would give this information both on the Notice Boards and on the members’ trading screens before opening of the next trading session, and the stock exchanges which are not yet computerised would display this information on the Notice Boards before the commencement of  trading on the next trading day. This information would also be made available to the media.

3.0 The Committee also decided to meet and solicit opinions/ views of different  market participants such as stock brokers, office bearers  of leading stock exchanges and representatives of Financial Institutions and Mutual Funds before making the final recommendations. Accordingly, the Committee held meetings with the representatives of the Inter-Exchange Co-ordination Group (IECG) and with stock brokers on December 02, 1996 and with the representatives of Financial Institutions and Mutual Funds on December 06, 1996.  The following issues relating to the regulation of short selling were discussed :

a) Disclosure of short sale position of the broker and his clients separately
b) Time frame for changes in computer software and implementation of short sale recommendations by the stock exchanges which are not computerised
c) Verification procedure for disclosed information and levy of penalties for non/ false/ under-declaration of short sales
d) ssues relating to ‘arbitrage’
e) Possible modalities to regulate short sales:

whether short sales would only be required to be declared
whether short sales might be banned  in cases where they were made on a down-tick
where the margins might be imposed in addition to the requirement of declaration

f) Number of scrips to be covered by the scheme
g) Stock lending mechanism and its operational modalities

After detailed deliberations on the above issues relating to regulation of excessive short sales, the Committee unanimously recommends suitable measures to regulate the short sale. The Committee also recommends that similar regulatory measures for ‘long purchases’ can be adopted in future when the stock markets enter into a bull phase and become overheated.
The gist of these discussions and the recommendations of the Committee with respect to each of the above mentioned points are as under:

3.2 DISCLOSURE OF SHORT SALE POSITION OF BROKER & HIS CLIENTS SEPARATELY

The discussions led to an unanimous view that the disclosure of ‘short sale’ position was necessary for transparency in the stock markets. The Stock Exchange, Mumbai (BSE) requires its Type-1 members (who have opted for the revised carry-forward system) to declare the transactions for deliveries or for carry-forward at the end of each trading day for the A-1 group scrips. It was deliberated whether short sale position could be declared up-front for each transaction or the net outstanding position of broker be declared at the end of each trading the day -in which case the squaring off transaction between his clients would be netted out. The question regarding disclosure of short sales up-front at the time of entering the order was also discussed. It was felt that under the present circumstances, it would be difficult to declare short sale transactions up-front as  investors may square-off their positions on the same day/ in the same settlement and sometimes because of practical difficulties and a  broker may consequently fail to make deliveries against his declared sale for delivery. The Committee also noted that there is no provision in the existing trading software of stock exchanges having on-line trading system to identify/ declare the net short sale/ net long purchase transaction up-front at the time of order entry. The intra-day trading i.e. squaring off the position on the same day, would be difficult to regulate even by imposition of a margin.
The representatives of IECG, Stock Brokers, Financial Institutions and Mutual Funds also felt that mere disclosure of the net short sale position may not give a clear picture of the outstanding positions and may be misleading to the investors. It was, therefore, considered necessary to disclose the net long purchase position also, so as to give a complete picture to the market. While defining ‘long purchase’ the Committee felt that a short seller had no recourse to any organised means of borrowing shares in absence of an organised stock lending system. However, a purchaser of shares arguably always has the means to borrow funds to honour his purchase commitment. After keeping in view this vital difference between the two positions (‘short sale’ and ‘long purchase’) and the need for simplicity and practicality in defining the ‘long purchase’, the Committee  was of the view that ‘long purchase’ could be broadly defined as the “purchase of securities without the intention of taking deliveries thereof, or purchase of securities for the purpose of squaring off the transaction”.
It was also considered necessary to redefine the ‘short sale’ and exclude from its definition “selling of shares against pending deliveries from the same Exchange pertaining to the previous settlements”
In the light of these discussions, the Committee makes the following recommendations:

Recommendations:

1 A ‘short sale’ is defined as “selling of the shares without having the physical possession of the shares unless it is either for squaring-up of an earlier purchase in the same settlement of the same stock exchange or against the pending deliveries from the same stock exchange pertaining to previous settlements”.

2. A ‘long purchase’ is defined as the “purchase of shares with the intention of not taking the deliveries and squaring off the transaction”.

3. All the stock exchanges would require their members to mandatorily declare cumulative scripwise ‘net short sale position’ and cumulative scripwise net long purchase position’ of identified scrips at the end of each trading day. Further, the break-up will be provided for the net outstanding position on clients’ account and on broker’s own account.

4. Software changes would be made to incorporate the declaration of short sale position and long purchase position at the time of order entry itself so that the outstanding position could be obtained through computers on the basis of trading data.

5. The stock exchanges would verify the declaration made by the members and would compile scrip-wise cumulative outstanding positions and will make this information public on the notice board and through the trading terminal screen before the commencement of the next trading day and will also make it public through the press media. The broker-wise outstanding position would not be disclosed and confidentiality of the broker-wise position will continue to be ensured by the stock exchanges and other authorities.

3.3 TIME FRAME FOR CHANGES IN COMPUTER SOFTWARE AND IMPLEMENTATION OF SHORT SALE RECOMMENDATION IN STOCK EXCHANGES WHICH ARE NOT COMPUTERISED.

The representatives of the stock exchanges were of the view that the required changes in the software where trading was computerised could be made within a period of three months. The Committee was also informed that a majority of the other (non-computerised) stock exchanges would implement ‘on-line trading system’ by the end of March 1997. In light of the above, the Committee makes the following recommendation:

Recommendations:

 The stock exchanges having on-line trading system would modify their trading software within a period of three months and the other stock exchanges which are to begin on-line trading  would incorporate the necessary features in their software as suggested in the Committee’s recommendations. Till on-line trading begins, compliance with the Committee’s recommendations would be on a manual basis.

3.4 VERIFICATION PROCEDURE FOR DISCLOSED INFORMATION AND LEVY OF PENALTIES FOR NON/ FALSE/ UNDER DECLARATION:
The various possibilities of non-declaration and false declaration by the members of their short sale position was discussed. Sometimes, the declaration may turn out to be false because of the reasons beyond the control of the broker. The possibilities of not allowing the broker member to square-off his transaction of ‘sale for delivery’ was also examined. A client/ broker first making a purchase transaction and squaring it off later would be permissible, but a client/ broker who first makes the ‘sale for delivery’ and later squares it off or fails to deliver the shares in the settlement, would be required to pay a penalty for false/ non/ under disclosure. The possibilities of the client/ broker having physical possession of the shares who first sells shares for delivery, but subsequently changes his position and squares-off the transaction during the same settlement was also considered. It was agreed that it may be left to the broker to pay the additional margin by declaring short sale and square-off the transaction. In case he  misdeclares and evades the payment of additional margin, he would have to pay the penalty in the event of squaring off of the transaction/ non-delivery of shares in the settlement. The penalties considered included impounding of profit in the event of auction/ close-out, compulsory physical deliveries in respect of gross purchase and sale position and imposition of penalty over and above the auction price. In the light of the above, the Committee makes the following recommendation:

Recommendations:

In the event of a broker having declared a transaction as ‘sale for delivery’ and subsequently fails to give deliveries or squares off his transaction -thereby evading the payment of additional margin, a penalty of 2% of the weighted average auction price or close-out price of that scrip would be charged on the broker for the quantity squared-off/ undelivered.

3.5  ISSUES RELATING TO ARBITRAGE:

It was discussed whether a broker/ client having a ‘buy’ position at one stock exchange can sell ‘short’ at another stock exchange? It was felt that it would be extremely difficult and impracticable for a stock exchange to verify ‘buy’ positions of its members on the other stock exchanges. As per the definition of short sale, such transactions would be considered as short sale as the member does not have the physical possession of the shares,  has not  made the transaction for squaring off his earlier purchase position in the same settlement at the same stock exchange and nor  is it against the pending deliveries from the same exchange pertaining to the previous settlement(s). The Committee’s recommendation in this regard is as follows :

Recommendation:

The client/ broker selling the shares at one stock exchange against his outstanding purchase position at another stock exchange(s) will be considered as ‘short-sale’.

3.6  POSSIBLE MODALITIES TO REGULATE SHORT SALES:

The possible modalities of regulating short sales were discussed. The representatives of the IECG, Stock Brokers, Financial Institutions and Mutual Funds were of the opinion that mere disclosure might not be enough to regulate the short sales as market players indulging in speculative activities may already have access to the information through their own sources. The Committee was informed that the majority of the stock exchanges are charging equal margins on both purchases and sales transactions. It was considered appropriate to charge a differential margin on purchases and sales depending upon whether the prices were rising or declining. A view was also expressed that imposition of margin would adversely affect the liquidity in the stock market and the overall volumes may decline considerably. However, it was considered necessary to curb the excessive short sale by imposition of appropriate margin even if there was some decline in liquidity and volume in the short term. This  was because excessive short sales amplify  downtrends in the markets and depress investors’ sentiment. As for regulation, the unanimous view was that for the time being, declaration of short sale positions and still further imposition of margins thereon would be adequate. Banning of short sale on a down-tick  which is imposed in the U.S., was not considered advisable or feasible until a proper stock lending scheme was in place.

The Committee also examined the need of providing a threshold volume limit for the levy of margins and the representatives of the IECG, Stock Brokers, Financial Institutions, Mutual Funds were of the view that a threshold volume limit ranging between Rs.10 lac to Rs.50 lac may be kept. In order to minimise the operational problems for the stock exchange, the committee considered the provision of a threshold margin limit. In the light of the above, the Committee makes the following recommendations:

Recommendations:

1 The stock exchanges may be advised to charge different margins on purchase and sales depending upon market conditions.

2 In case of 15 high volume identified scrips, all the stock exchanges would uniformly charge a differential margin of 15% on the aggregate short sales position on cumulative basis of each stock broker i.e. that the percentage rate of the margin payable on the short sale would be  15 percentage points more than the percentage rate of margin imposed on purchases. The same should also apply to short sale transactions made under the revised  carry forward system approved by SEBI. The margin should be collected in cash or by way of a bank guarantee. The margin should be collected only if it exceeded the threshold limit as stated below.  This margin  will be in addition to the ‘mark-to-market’  margin. The margin collected by the stock exchange from the stock brokers would be adjusted against his pay-in liability on settlement day as per the prevalent practice.

3 For the members of the stock exchanges having a base minimum capital of Rs.10 lac or more, there will be a threshold margin limit of upto Rs.5 lac, and for the members of stock exchanges having a base minimum capital of less than Rs.10 lac, there will be a threshold margin limit of upto Rs.3 lac.

4 For the purpose of calculating the gross exposure of the broker to determine the other margins payable by him, his short sale exposure relating to the 15 high volume identified scrips would be excluded.

5 SEBI may review any increase/ decrease in the margins as also the threshold limits in future depending upon the market conditions.

3.7  NUMBER OF SCRIPS TO BE COVERED BY THE SCHEME

The question of the number of scrips for which recommendations on the regulation of short selling would be made applicable was deliberated by the Committee. There was a general consensus that to begin with, the list of 60 scrips identified would be adequate. Further, the scrips chosen  for the regulation of short sales should be uniform across all the stock exchanges. Additions/ deletions to the list of scrips could be reviewed by SEBI depending upon the market conditions. The disclosure requirements would be applicable to all the 60 scrips, whereas the margin requirement could be made applicable to the 15 scrips identified out of the total 60 scrips. The recommendations of the Committee in respect of the coverage of scrips were as follows :

Recommendations:

1 The disclosure recommendations may be made applicable to the 60 actively traded scrips as per the list enclosed (Annexure-A)
2 For the purpose of imposition of additional margin on short sales (in addition to mark-to-market margin), following 15 high volume scrips (equity shares)  are identified for the present :

(1) State Bank of India
(2) ITC
(3) Reliance Industries
(4) Tisco
(5) MTNL
(6) Larsen & Toubro
(7) Telco
(8) BSES
(9) Bajaj Auto
(10)ACC
(11)Gujarat Ambuja Cement
(12)IPCL
(13)Tata Power
(14)Hind.Lever
(15)Oriental Bank
 

3. Any addition or deletion in the list of the identified scrips for the purpose of disclosure or for imposition of margin could be reviewed by SEBI depending upon the market conditions.
 

3.8  STOCK LENDING MECHANISM & ITS OPERATIONAL MODALITIES

The Stock Lending Scheme was conceptualised  almost 3 years ago and needs to be modified in the light of the recent changes/ developments such as on-line trading system, settlement through clearing corporation/ clearing house and the dematerialisation and book entry transfer of securities in the depository. The Government clarification  exempting stock lending transactions from the levy of income tax is expected shortly. The Committee feels that operational modalities of the stock lending scheme needs to be redefined to take care of the following important factors:

Stock Lending mechanism to be implemented
Eligibility of the participants
Stock lending in case of dematerialised scrips in the Depository
The guarantee to the lender
Tax issues
Confidentiality of information
Eligible scrips for lending
Limit of lending of stocks by Financial Institutions, Mutual Funds, and other Institutional Investors, etc.

The Committee is examining relevant aspects and would suggest the modalities regarding the introduction of stock lending scheme in the next two months.