Imagine a financial storm, not one of rain and wind, but of plummeting prices and shattered confidence. This was the scene that engulfed the Indian stock market in 2023, triggered by a single act: a short-selling report by Hindenburg Research targeting the Adani Group.

What followed was a maelstrom of accusations, investigations and billion-dollar losses, casting a long shadow over the very foundations of fair market practices.

The Adani-Hindenburg controversy has brought to the forefront a contentious issue: short-selling. This financial strategy, which thrives on falling stock prices, has intensified the fallout from the accusations against Adani. It has also raised questions about market manipulation and investor security. As the storm raged, the Indian Supreme Court stepped in, demanding a thorough probe into the role of short-selling. This marks a crucial moment for the Securities and Exchange Board of India (SEBI) as it grapples with how to maintain market stability and investor trust amidst complex financial practices.

The Supreme Court in Vishal Tiwari v. Union of India and connected cases (Adani-Hindenburg case) upheld the regulatory powers of SEBI and directed the market regulator to probe the manipulative activities. Under the watchful eye of the Supreme Court, SEBI introduced a revised framework for short selling in January 2024. This framework, designed to address concerns about market manipulation and safeguard investor interests, stands as testament to SEBI's commitment to transparency and fair market practices. It promises to shine a light on the shadowy corners of the market, deter potential manipulation and safeguard the interests of investors.

In this article, we will delve into the intricacies of SEBI's new framework, analyze its potential impact on market dynamics, and examine the challenges that lie ahead in the quest for a truly well-regulated and transparent financial system.

Sell before you buy? The practice of short-selling explained

Imagine borrowing a friend's prized baseball cap, selling it to another friend at a high price, and hoping to buy it back later at a discount to return it. That's essentially the short-selling game in the stock market. Investors borrow shares they believe will plummet in value, sell them at the current high price, and aim to repurchase them later at a lower price to pocket the profit. Think of it as betting against the market's optimism.

Short-sellers serve as a vital check in the market by preventing overvaluation and market bubbles. Just like a friend who helps you avoid hype, they provide a counterbalance to the optimism surrounding a stock.

However, a dangerous shadow lurks within the short-selling realm: naked short-selling. In this forbidden act, the investor sells shares they haven't even borrowed, like selling your friend's cap without their permission! This reckless gamble creates a major problem – if the price indeed plummets, the seller might not be able to find or afford the shares to return, leaving the buyer (and potentially the entire market) in a sticky situation. Imagine your friend demanding their cap back, only to find out you never had it!

The Adani-Hindenburg case: A corporate saga unfolding

In January 2023, a storm of accusations ripped through India's financial landscape as US-based short-seller Hindenburg Research unleashed a scathing report on the Adani Group, a sprawling conglomerate helmed by billionaire Gautam Adani. The report painted a picture of a meticulously orchestrated "brazen accounting fraud scheme" spanning decades. It detailed alleged stock manipulation, inflated prices, questionable related-party transactions, and unsustainable debt levels, casting a dark shadow over Adani's empire.

The market reacted with seismic tremors. Adani stocks plummeted, erasing over $140 billion in market value and forcing the cancellation of a mammoth share sale. Panic and confusion gripped investors, raising concerns about systemic risk and the efficacy of regulatory mechanisms. The crisis quickly transcended the realm of corporate drama to become a national spectacle, drawing in the Indian government, SEBI and a voracious media frenzy.

Legal battles erupted with Hindenburg suing Adani in the US and receiving a countersuit claiming sabotage. Meanwhile, SEBI independently investigates. Beyond legalities, the saga ignites concerns about corporate governance, transparency and short-selling's role in India's growing financial market. Investors worry about data validity, systemic risks and robust regulations. Political scrutiny intensifies due to potential conflicts and big business influence.

The Supreme Court's balancing act

The Indian Supreme Court has played a central role in navigating the tangled web of the Adani-Hindenburg saga, stepping in as a critical arbiter amidst market turmoil and public scrutiny. Here's a snapshot of its key interventions:

● Upholding SEBI's authority: Refusing to transfer the ongoing investigation from SEBI to other bodies, the Court reaffirmed its trust in the regulator's capabilities. This decision helped maintain stability within the financial system and avoided the creation of parallel investigative structures.

Earlier, the Supreme court in IFB Agro Industries Ltd v. SICGIL India Ltd examined the role of independent regulatory bodies such as SEBI in public administration and upheld the primacy of SEBI as the forum to adjudicate violations of its regulations. Further, the Court detailed the delegated legislative, administrative and adjudicatory powers of SEBI arising from the SEBI Act.

In a consistent line of precedent, the Supreme Court has held that when technical questions arise particularly in the financial or economic realm, expert views are duly considered by the regulator in designing policies and implementing them. In this context, the Court ought not supplant the role of the expert with its own view. Courts do not act as appellate authorities over policies framed by the statutory regulator and may interfere only when it is found that the actions are arbitrary or violative of constitutional or statutory mandates. The Court said that it cannot examine the correctness, suitability or appropriateness of the policy, particularly when it is framed by a specialized regulatory agency in collaboration with experts.

In Prakash Gupta v. SEBI, the Supreme Court observed that the Court must be mindful of the public interest that guides the functioning of SEBI and should refrain from substituting its own wisdom over the actions of SEBI.

● Balancing interests: Striking a delicate balance between various stakeholders, the Court rejected demands for a separate Special Investigation Team (SIT) while directing SEBI to complete its probe within a specific timeframe. This approach addressed concerns about both swiftness and thoroughness, ensuring that the investigation progressed efficiently without compromising due process.

● Addressing short-selling concerns: Acknowledging the concerns surrounding short-selling practices in the wake of the Hindenburg report, the Court directed SEBI to investigate if any laws were violated. This move not only addressed a key aspect of the case, but also potentially set a precedent for future regulation in this domain.

SEBI's short-selling framework

SEBI's short-selling framework has stirred up a hornet's nest, sparking both excitement and apprehension within the Indian capital market. Let's delve deeper, analyzing the framework to understand its implications.

Taming institutional giants

The framework welcomes all investors - from retail newbies to institutional giants - to join the market dance. This democratization promises to boost liquidity and price discovery by infusing diverse perspectives and increasing the available pool of shares.

However, opening doors also demands vigilance. Inexperienced retail traders entering this complex arena risk amplifying volatility and falling prey to manipulative tactics. To ensure everyone benefits, SEBI must prioritize robust investor education and vigilant monitoring. Equipping retail with knowledge is key, while strict regulations and watchful eyes will safeguard them from predatory practices.

Banishing the naked menace

One critical safeguard implemented by SEBI is the mandatory delivery of borrowed securities. This directly addresses the dangers of "naked short-selling," a practice where sellers lack the necessary shares to fulfill their obligations. This reckless strategy can artificially depress stock prices and create market chaos, as infamously witnessed in the 2008 Volkswagen short squeeze orchestrated by Porsche. Without borrowed shares, Porsche could not deliver on their short positions when Volkswagen's price skyrocketed, leading to massive losses for hedge funds and significant market volatility. SEBI's mandatory delivery requirement aims to prevent such scenarios by ensuring responsible short selling and curbing predatory tactics.

Disclosure requirements

SEBI made it mandatory for institutional investors to disclose upfront at the time of placement of order whether the transaction is a short sale. Retail investors, on the other hand, will have to make a similar disclosure by the end of the trading hours on transaction day. Additionally, SEBI has made it mandatory for brokers to collect the details on scrip-wise short-sell positions. They will also have to collate the data and upload it to the stock exchanges before the commencement of trading on the following trading day.

While the Adani-Hindenburg short-selling saga has shaken the Indian market, its legal backdrop isn't a blank canvas. The Sahara v. SEBI case serves as a crucial brushstroke, affirming SEBI's power to regulate convertible debentures, a popular short-selling tool back then. The Adani case reflects SEBI's newfound authority to probe market manipulation, a shift from the regulatory focus of the Sahara case.

Conclusion

Short-selling, while not inherently destabilizing, becomes a problematic tool when used to manipulate markets, especially when targeting stocks popular among retail investors. This presents an ethical dilemma: How to protect these vulnerable stakeholders without stifling market activity.

Existing regulations like SEBI's (Issue of Capital and Disclosure Requirements) and (Listing Obligations and Disclosure Requirements) aim to protect investors through transparency. However, these safeguards fall short in shielding retail investors from their own emotional volatility and the cloak of anonymity that institutional investors often provide to manipulative actors.

To enhance investor protection in the face of short-selling, it is crucial to reinforce existing regulations. SEBI should increase oversight on short-selling practices, particularly for stocks with high retail participation and short interest, by imposing stricter penalties for manipulative tactics. Empowering retail investors with the knowledge and tools to make informed decisions and identify manipulation is essential.

Additionally, strengthening lending and borrowing frameworks can improve transparency and reduce hidden manipulation opportunities. It is imperative to prioritize vulnerable investor protection through SEBI's existing disclosure requirements, while also addressing the unique vulnerabilities of retail investors and institutional involvement's anonymity. By focusing on targeted regulations, investor education and a well-regulated lending and borrowing ecosystem, we can ensure a healthy financial environment where all stakeholders can thrive.

Srishti Sharma is an advocate practising in New Delhi.

Aarlin Moncy is an Associate at Banerjee & Grewal Advocates, New Delhi.