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Reliance’s Chances On Appeal Against SEBI’s Order

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The Rs 1,000-crore penalty imposed by market regulator Securities and Exchange Board of India (SEBI) on Reliance Industries Ltd. (RIL) is based on ‘surmises, conjectures and hindsight view of the transactions and on untenable reasoning.’

This is Reliance’s response to the SEBI order that found the company, along with 12 related entities, acted in a fraudulent manner in the derivatives market and manipulated the cash market. The case dates back to 2007 and relates to Reliance’s sale of a nearly 5 percent stake in subsidiary company Reliance Petroleum Ltd (RPL).

Reliance says it will challenge SEBI’s decision before the Securities Appellate Tribunal.

The ‘Hedging’ Defence

SEBI’s order shows that having informed stock exchanges of its intent to sell 5 percent of RPL’s equity in the open market, Reliance took up short positions in the futures market via the 12 entities, to benefit from any drop in the price of RPL’s shares that would occur on the sale.

The 12 entities together held 9.92 crore shares, constituting 61.15 percent of the open interest in November futures. This, SEBI’s order points out, breached the maximum permitted client position limit under its circulars on derivatives trading. The order notes that the 12 entities related to Reliance together had a nearly 7 times higher exposure to RPL futures, thereby substantially exceeding the limits permitted by SEBI. The regulator concluded that Reliance’s aim was to reap huge speculative profits by cornering futures positions.

Position limits are created for the purpose of maintaining stable and fair markets, pointed out Sumit Agrawal, a partner at law firm Suvan Law Advisors and former legal adviser at SEBI. “They regulate speculation, liquidity and act as a filter process for regulatory surveillance, based on trading volume and underlying share quantity.”

Reliance had argued that by taking appropriate positions in the derivatives segment, it had adopted a prudent strategy to hedge the loss that it was expecting due to the impending sale in the cash segment.

Umakanth Varottil, assistant professor at the National University of Singapore said Reliance’s hedging defence is on a shaky ground. He said irrespective of the argument that the trades involved hedging, the key question is whether Reliance breached the various limits specified in SEBI regulations.

Varottil pointed out that even if hedging were accepted as an adequate defence, other aspects of the trades may help establish violation of other SEBI regulations.

In the present case, the fact that Reliance traded through various agents rather than directly, and that too in order to overcome the position limits, would be suggestive of a device that was created to affect market integrity. Hence, while breach of position limits may be an end in itself (and hence attract consequences such as voidability of the contract or monetary penalties), it could also constitute a means to establish other securities law violations (such as market manipulation). – Umakanth Varottil, Assistant Professor, National University of Singapore

Cash Segment Trades: Fraudulent And Manipulative?

SEBI’s order establishes another instance of market manipulation by Reliance. As per the order, Reliance sold 18.04 crore RPL shares in the cash market between November 6 and 23, 2007 for Rs 4,023 crore. On November 29, the last day of expiry of November contracts, it sold 1.95 crore RPL shares in the last 10 minutes of trade in the cash market.

The sale of RPL shares in the last 10 minutes, the order states, drove the stock to as low as Rs 209.80 per share. RPL November futures contracts settled at Rs 215.60 and according to SEBI, this helped the 12 entities gain on their short positions. The market regulator said Reliance had intentionally placed its sell order at below the last traded price in the cash market to profit in the futures market.

Reliance had argued that the demand for the shares existed only at lower prices and hence the orders were placed below the last trading price.

There was neither a manipulation nor an artificial depression of share prices. Matching the demand in terms of price and quantity is not manipulation. Selling at marginally below the last traded price to meet market demand and delivery cannot be fraudulent and manipulative practice.

Reliance’s argument in SEBI order

But SEBI concluded that the trading time-frame was selected to benefit from or influence the closing price in the cash segment which would immediately convert into returns in the futures segment. And so, the regulator held the trades to be fraudulent and manipulative.

Varottil said the circumstances of the transaction and the choice of timing would indicate that the trades were indeed fraudulent and manipulative. Agrawal said Reliance may have a stronger argument on this front.

From an economics of trade argument, are you not likely to place orders lower than the bid if you want to sell 2.29 crore shares and all you have is 10 minutes? SEBI could have deemed it more manipulative if it was a market order or synchronised trade in last 10 minutes. – Sumit Agrawal, Partner, Suvan Law Advisors

Determination Of Reliance’s ‘State Of Mind’?

Experts quoted in this story said that SAT is likely to weigh Reliance’s hedging argument and cash market strategy against its intent.

The principal bone of contention before SAT is likely to be whether the required state of mind for the establishment of a violation of the SEBI (PFUTP) Regulations for market manipulation exists, Varottil said.

Reliance is likely to contend that higher burden of proof is necessary to establish fraudulent intent. Even if there is a breach of the position limits, it may be argued that it necessarily does not amount to market manipulation due to the lack of fraudulent intent. Ultimately, it may boil down to the appropriate test to determine the mental element, and a consideration of whether the facts bear out the same. – Umakanth Varottil, Assistant Professor, National University of Singapore

Agrawal added that a lack of distinction between ‘fraudulent trade practice’ or ‘unfair trade practice’ or ‘manipulative trade practice’ will be debated in this case. The standard of evidence required for all three is different and the SEBI FUTP Regulations only define fraud. Since SEBI has used all these terms interchangeably, Reliance may argue that the evidence used by the regulator is not enough to prove fraud.