Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Tue, 24 Jun 2008

Where is London's alleged light touch?

At least when it comes to short selling in today’s troubled markets, the UK Financial Services Authority’s vaunted light touch has given way to a heavy handed approach that makes the US regulators appear light touch. The US regulators have been content to be silent spectators while outspoken short sellers attack key financial institutions. Ackman has brought the bond insurer MBIA to its knees and Einhort has put enormous pressure on Lehman without any rebuke from any regulator.

By contrast, the FSA in the UK has ham handedly pursued those who shorted the leading UK banks particularly HBOS. In April, I blogged about the FSA initiating a probe into short selling in HBOS shares. Since then, HBOS shares have fallen by almost 50% as a stream of bad news has come out of the bank. In late April, HBOS launched a rights issue at what was then a deeply discounted price of 275p. On a couple of occasions recently, the share price has dropped below the rights issue price threatening the success of this capital raising effort. The FSA stepped in earlier this month with fresh regulations against short selling in companies which are conducting rights issues. The new regulations require public disclosures of any short position exceeding 0.25% of the issued capital of a company that is conducting a rights issue. The FSA stated:

The FSA views short selling as a legitimate technique which assists liquidity and is not in itself abusive. But it is also the case that the rights issue process provides greater scope for what might amount to market abuse, particularly in current conditions. ...

In addition to the new disclosure regime, we are also giving consideration to whether it might be necessary to take further measures in this area. We are currently examining a number of options including the following: restricting the lending of stock of securities in rights issues for the purposes of enabling short selling; and restricting short sellers from covering their positions by acquiring the rights to the newly issued shares.

Much of this is silly. It is precisely when a company is raising billions of pounds of new capital from the public that investors need the genuine price discovery that is promoted by short selling. As it is, the FSA is dangerously close to complicity in a scheme to sell overpriced shares to the public on the basis of an artificially elevated share price. The FSA has been saved from this only by the ineffectiveness of its measures in propping up the share price on a sustained basis. After a short spike, the price has again been testing the 275 level.

Meanwhile, press reports state that the FSA is ending the probe that it launched in April – apparently, it is unable to put together a case against anybody in that case. If true, this vindicates all those who thought that the investigation itself was misguided.

I think what we are seeing is a clear regulatory conflict of interest. In its role as the supervisor of HBOS, the FSA seems to be putting the health of HBOS above the health of the capital market which it regulates.

Posted at 14:56 on Tue, 24 Jun 2008     View/Post Comments (0)     permanent link


Wed, 18 Jun 2008

Offmarket transactions on the exchange for tax reasons

We have been discussing order matching and market microstructure in class during the last two weeks and this morning, students brought up the report in the Economic Times today about whether Ranbaxy promoters could use bulk trades on the exchange to sell their holdings to the Japanese acquirers. The reason for doing this is that India does not levy capital gains tax on transactions done on the exchange – the Securities Transactions Tax (STT) levied on exchange transactions is supposed to be in lieu of capital gains tax.

The price that the Ranbaxy promoters have negotiated with the acquirer is at a premium of about 27% to the current market price and SEBI regulations allow block trades negotiated outside the exchange to be put through the exchange only within a price band of 1% of the market price. It is quite clear that it is possible to do a large trade on the exchange at any price if one is willing to burn through the whole order book and thus share part of the “control premium” with these orders. For example, suppose the current market price is 100 and there are sell orders at prices ranging from 100-110 for a total of say 500,000 shares. The promoter puts in a limit sell order for 100 million shares at a price of 127 and the acquirer immedately thereafter puts in a market buy order for 100 million shares. The market order would first burn through the entire pre-existing order book of 0.5 million shares and then execute the remaining 99.5 million shares against the sell order of the promoters at 127. The only problem is that 0.5 million shares would have been bought at prices above the market price of 100 and this is a small price to pay in relation to the tax that is saved.

Obviously, a transaction of this kind would be done on the least liquid exchange on which Ranbaxy is quoted and it would be done at a time when the sell side of the order book is as thin as possible. There are two problems with this however.

The first problem is that if the whole world can see that this is what is going to happen, it makes sense for anybody who holds Ranbaxy stock to put in limit sale orders at a price of 125 or 126 to take advantage of the bulk deal whenever it happens. There is nothing to be lost and everything to be gained by doing so. The acquirer has to make a tender offer at 127, but this is only for 20% of the issued shares and selling one’s entire holding at 125 is better than tendering into that open offer and taking one’s chances. If enough people put limit orders at 125 or so, then the cost of eating through the entire order book can quickly become prohibitive. This possibility is very real because people who have the ability to borrow stock can place these limit orders even if they do not own the stock. Immediately after the bulk deal, the price will drop back to normal levels and the short seller can buy back from the market and close out the position.

The second problem is the SEBI Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003 (endearingly known as FUTP). I am not a lawyer, but I think FUTP raises some very interesting issues that have not I believe been tested in this context. The question is whether executing a bulk trade in this manner would amount to market manipulation. Regulation 4(2) of the FUTP states that:

Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-

I am not sure how regulators would look at this issue, because on the one hand, the trade of 100 million shares is a genuine and legitimate trade. On the other hand, it does create a false market and does artificially inflate the price for a short period of time. To this extent, it does appear manipulative. I know we do not have OTC equity derivative markets in India, but imagine what the situation would be if there were large OTC barrier options at 125 that got trigerred by this trade. Would they not think that there was market manipulation?

In class today, we also considered the possibility of pushing the price only upto say 125.75 with a market order that just burns through the sell side of the order book and then using a block trade negotiated outside the exchange at 127 (within 1% of the market price). This would perhaps be even more manipulative and might not have any significant advantages over executing the entire transaction through the order book.

I think the most important lesson in all this is that the idea of treating the Securities Transactions Tax as a substitute for the capital gains tax is a huge mistake. It is not only inequitable in allowing very large untaxed incomes, but it also distorts markets and creates perverse incentives for many market participants.

Posted at 14:12 on Wed, 18 Jun 2008     View/Post Comments (5)     permanent link


Sat, 14 Jun 2008

Takeover disclosures and cash settled derivatives

The New York District Court ruled earlier this week that the hedge fund TCI should have disclosed its cash settled derivatives (total return swaps) on CSX stock under the takeover rules of the US SEC (Rule 13d-3). Hitherto, it was believed that cash settled derivatives do not convey a “beneficial ownership of any equity security” as required by the statute. Rule 13d-3 defines the beneficial owner essentially as one who has or shares voting power and/or investment power over the security.

The New York District Court took a different line. Based largely on the expert report of Prof. Marty Subrahmanyam, the Court came to the conclusion that the only practical way for the swap counterparty to hedge its position was to buy the underlying stock. It also found that this was what they actually did:

But the evidence is overwhelming that these counterparties in fact hedged the short positions created by the TRSs with TCI by purchasing shares of CSX common stock. ... they did so on virtually a share-for-share basis and in each case on the day or the day following the commencement of each swap.

This is precisely what TCI contemplated and, indeed, intended. None of these counterparties is in the business, so far as running its swap desk is concerned, of taking on the stupendous risks entailed in holding unhedged short (or long) positions in significant percentages of the shares of listed companies. As a practical matter, the Court finds that their positions could not be hedged through the use of other derivatives. Thus, it was inevitable that they would hedge the TCI swaps by purchasing CSX shares.

The Court interpreted this as investment power. Moreover, it determined that TCI chose counterparties who were more likely to vote the shares in accordance with its wishes. The Court relied on the SEC position that “ability to control or influence the voting . . . of the securities” constitutes voting power.

The Court also referred to provisions in UK law based on economic interest rather than legal ownership and stated that “Yet there is no reason to believe that the sky has fallen, or is likely to fall, in London” as a result of such provisions.

Having come close to saying that cash settled derivatives meet the definition of beneficial ownership under Rule 13d-3(a), however, the Court refused to rule on this point at all, but proceeded to decide the case under Rule 13d-3(b) which deals with “contract, arrangement, or device ... as part of a plan or scheme to evade the reporting requirements”. The Court also allowed TCI to vote the stock after making the requisite disclosures.

The Deal Professor is of the view that everything now depends on how the the Second Circuit Court of Appeals deals with this case on appeal.

All this discussion is of great relevance in India because of the large cash settled single stock futures market in India. Indian law talks about acquisition of shares and voting rights. Shares “includes any security which would entitle the holder to receive shares with voting rights”, but this clearly does not cover cash settled derivatives. Another issue that comes to mind in the context of the US ruling is the issue of participatory notes as well as that of the non voting ADRs and GDRs issued by Indian companies.

Posted at 18:12 on Sat, 14 Jun 2008     View/Post Comments (0)     permanent link


Tue, 10 Jun 2008

Reforming the rating agencies

In my last blog on my vacation reading, I was rather contemptuous of the efforts of the New York Attorney General and of IOSCO to reform the rating agencies, but Joshua Rosner goes much further. He says that the Attorney General’s proposal will actually reward the rating agencies, and I think he is right.

Rosner also has some very sensible suggestions for genuine reforms at the end of his post. I agree with all of them and also think that they are genuinely workable:

Posted at 13:55 on Tue, 10 Jun 2008     View/Post Comments (0)     permanent link


Sun, 08 Jun 2008

My vacation reading

I am back from my vacation. I did not read email and newspapers while on vacation, but I did read some blogs and web sites selectively. I also used the opportunity to catch up on some reading material that I had not been able to finish before I began my vacation. As could be expected, my vacation reading was dominated by the global financial turmoil. Some of the more interesting stuff that I read:

Posted at 20:46 on Sun, 08 Jun 2008     View/Post Comments (0)     permanent link