Integrity and Indian capital markets
To improve Sebi's tarnished image, junior staff should be appointed through a competitive exam and encouraged to reach the top
In the last week of March 2017 the Securities and Exchange Board of India (Sebi) ordered Reliance Industries Limited (RIL) to disgorge about ~1,000 crore. Concurrently, RIL and 12 other companies were prohibited from trading in the stock futures and options (F&O) segment for one year. According to the Sebi order, “RIL was not genuinely hedging risk” and its actions were “well-planned, fraudulent and manipulative”. The shocking aspect of what appear to be a case of insider trading is that it took Sebi close to 10 years, since November 2007, to come to these conclusions. RIL has announced that it will appeal against Sebi’s order with the Securities Appellate Tribunal (SAT).
RIL was best placed to know ahead of others that the stock price of Reliance Petroleum (RPL) would fall once markets realised that Chevron was not going to buy any RPL stock and when RIL sold RPL shares in the spot market. Short positions in equity futures make money when the underlying stock prices fall because this is equivalent to selling shares in advance and later buying back the same shares at a lower price. RIL accumulated short positions in RPL futures and by 29 November 2007, it owned 94 per cent of the total volume of RPL stock futures for the contract which expired on that day. It was logical, therefore, for Sebi to rule that RIL had profited illegally from futures contracts, the volumes of which were close to 10 times higher that Sebi’s applicable ceilings for such trades. Sebi needs to amend its regulations to disallow companies from taking short/long positions in derivatives markets on stocks of related firms.
As for the penalty imposed by Sebi it is less than a flick on the wrist. RIL has been told to merely pay the amount it gained plus interest over the past 10 years. This is a non-fine since Sebi, under its Act, can impose three times the amount the guilty party is estimated to have gained through a violation of Sebi’s regulations.
In February 2016 the Ministry of Finance (MoF) announced a revision of the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius. Under the new DTAA, by 2019, short- and long-term capital gains on investments made from Mauritius would be treated on par with similar investments made in India. Subsequently, on 13 May 2016, derivatives and debentures were excluded from the amendments in the DTAA with Mauritius. Put and call options for large-cap stocks in Indian and off-shore derivatives markets are sufficiently liquid to replicate exactly the same pay-off as from buying or selling the underlying shares. If the MoF consulted Sebi before allowing derivatives transactions to be excluded from the revised DTAA, Sebi should have voiced its opposition. If Sebi was not consulted at all, it reflects poorly on Sebi’s reputation for technical excellence.
As of now, Sebi does not seem to have personnel who understand derivatives markets well. That is, junior staff who have the academic background in finance and experience of transacting exchange traded and over-the-counter (OTC) derivatives. It could be argued that Sebi personnel do not need to be as well versed as market participants. On balance, Sebi needs to strengthen its in-house expertise in derivatives.
Reverting to the non-fine announced against RIL, it could be that it took Sebi 10 years to take this decision since there were integrity-related controversies surrounding the appointment of and decisions taken by past Sebi chairpersons between 2007 and early 2017. For instance, Indian print media reported in mid-2011 that K M Abraham, a SEBI board member, wrote twice to former prime minister Manmohan Singh in May and June 2011, alleging wrong-doing by the then Sebi chairman, the sitting finance minister, his adviser and two senior finance ministry officials to favour corporate houses. It was also reported that two Sebi Board members were harassed by income tax-authorities. The sub-text was that all this was done at the behest of the MoF.
Separately, in November 2011, a public interest litigation (PIL) filed by former Chief of Air Staff S Krishnaswamy and ex-director general of Punjab police Julio Ribeiro alleged that the MoF had interfered in the working of Sebi by manipulating the selection of successive chairpersons and senior Sebi officials. This PIL was rejected by the Supreme Court.
It is unlikely that a joint secretary level officer has ever written twice to the head of the Indian government suggesting that one of the prime minister’s senior most ministerial colleagues was acting at the behest of specific private firms. It has to be a matter of regret that there is no information in the public domain on what action former prime minister Singh took on these accusations, or whether an investigative agency including the Central Vigilance Commission (CVC) looked into any of the allegations.
Taking a step back to ponder, the contrast between SEBI and the Reserve Bank of India (RBI) is quite stark in terms of their respective reputations on professional excellence and probity. The RBI has an impeccable reputation for the integrity of its officers irrespective of whether market participants or others agree with its monetary policy decisions or the efficacy of its regulation of banks. Despite the high volumes of net non-performing assets (NNPAs) on the balance sheets of public sector banks (PSBs) there is no suggestion from any quarter about any financial wrong-doing on the part of the RBI. Commentators do refer to the lack of timely regulatory attention on the part of the RBI but it is government as the majority shareholder of the PSBs, the major debtors and the PSBs who are blamed.
To sum up, a sustainable way for Sebi to improve its personnel, practices and image is for its entry-level officers to be recruited through competitive examinations. Such tests should preferably be conducted by Union Public Service Commission and those selected should be eligible and even favoured for appointment to the senior-most positions, including the Sebi board/chairman.