Market regulator SEBI has indicated to the Supreme Court that it is not in favour of banning short-selling or sale of borrowed shares, and said it is investigating allegations made by a tiny short-seller against the Adani Group as well as its share price movements.

The Securities and Exchange Board of India (SEBI) in written note before a bench headed by Chief Justice DY Chandrachud, which was hearing two PILs relating to the recent Adani Group shares crash, described what short-selling is and what the Hindenburg Research did but did not once name the Adani Group in the 20-page document.

The regulator, the note said, was "already enquiring both the allegations made in the Hindenburg report as well as the market activity immediately preceding and post the publication of the report." US-based short-seller Hindenburg in a January 24 report alleged that the Adani Group pulled "the largest con in corporate history" using offshore tax havens and stock manipulation.

The allegations, which the group has repeatedly denied, roiled shares of group's listed companies which have together lost over USD 120 billion in market value in three weeks.

SEBI said short selling usually involves investors borrowing shares and selling them, expecting to buy them back later at a lower price before returning them to the lenders. They make profits on the difference between the higher sale price initially and the lower purchase price subsequently.

"Short selling is considered by some to be a desirable and an essential feature of the securities market, as it provides liquidity and also helps price corrections in overvalued stocks.

"Thus, any restrictions on short selling, per se, may distort efficient price discovery, provide promoters unfettered freedom to manipulate prices, and favour manipulators rather than rational investors," it said, adding others consider it an undesirable activity that flourishes on distressed selling and is vulnerable to its own form of manipulation.

Securities market regulators in most countries, particularly in all developed securities markets, recognise short selling as a legitimate investment activity.

"Thus, in all major jurisdictions, instead of prohibiting short sales per se the regulators have permitted it to take place within a regulated framework," SEBI said.

The International Organisation of Securities Commissions (IOSCO) has also reviewed short selling and securities lending practices across markets and has recommended transparency of short selling, rather than prohibiting it.

"India follows this policy of regulated short selling and has framed its regime accordingly," it said, detailing the framework for regulating short selling in Indian capital markets.

Even during turbulent times such as at the start of the Covid pandemic when Nifty fell by around 26 per cent in 13 trading days in March 2020, SEBI did not ban short selling despite demand, the note to the court said.

"The markets continued to function in a robust manner, recovering far faster than other global markets," it said, adding there was no significant impact on the run on Adani Group shares at a wider market level or at a system level that might warrant a review.

Referring to the conglomerate run by billionaire Gautam Adani without naming it directly, SEBI in the note said "the Group under discussion has several listed companies in India other than two recent acquisitions." During the time that there was significant rise in share prices of the companies of the Group, the SEBI market framework, which is designed to control excessive volatility in stocks (both price increase and decrease) was triggered on numerous occasions.

"It may also be noted that the Group has a number of USD denominated bonds listed in the overseas market," it said. "Hindenburg in its report has stated that its short positions in the Group are in USD bonds in overseas markets and non-Indian traded derivatives." The SEBI said as the matter was in early stages of examination, it may not be appropriate to list details about the ongoing proceedings at this stage.

While listing out available legal and other frameworks to deal with wrong-doings in the securities market, it said, "SEBI has a robust set of frameworks and market systems to ensure seamless trading and settlement including frameworks for volatility management and restrictions on short selling including by foreign institutions." "SEBI has a strong framework for enforcement of market misconduct as well as other violations of its regulations," it said.

Referring to the facts of the recent events, the regulator said Hindenburg is a short seller research company among other such firms in the US that do research on companies that they believe have governance and/or financial issues.

"Their strategy is to take a short position in the bonds/shares of such companies at the prevailing prices, (i.e., sell the bonds/shares without actually holding them) and then publish their reports. If the markets believe the reports, the prices of the bonds/shares start to fall. Once the fall starts, other institutions who have 'stop loss limits', also start selling their holdings of bonds/shares irrespective of whether they believe the report or not thus triggering a downward spiral in the bond/share prices.

"The short sellers then buy the shares/bonds at the lower prices, thus making a profit. The more the market believes their reports, and the more that 'stop loss limits' get triggered, the more the prices of the bonds/shares fall and the more money they make," it said.

The top court is scheduled to hear the two PILs alleging exploitation of innocent investors and "artificial crashing" of the Adani Group's stock value on February 17 when it will consider setting up a panel to consider strengthening the regulatory framework.

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