In Securities and Exchange Board of India’s (Sebi) books, Reliance Industries Ltd made unlawful gains worth Rs447.27 crore in November 2007, while trading in equity derivatives of subsidiary company, Reliance Petroleum Ltd (RPL).
In Reliance’s books, these were merely hedging transactions done to protect the price at which it sold its subsidiary’s shares.
After a fair amount of back and forth that lasted nearly eight years, Sebi has ordered Reliance to pay back the amount of unlawful gains, with an interest of 12% per annum.
Predictably, Reliance has said it will challenge the order in the Securities Appellate Tribunal (SAT).
Here’s the backdrop:
After the successful initial public offer (IPO) of RPL in 2006, Reliance Industries had a 75% stake in the new refinery, acquired for a net cost of Rs20 per share, while other shareholders had bought shares during and around the time of the IPO at Rs60 (see table).
Among the other investors who bought shares around the time of the IPO, oil firm Chevron Corp. had bought a 5% stake from Reliance, again at Rs60 per share. The deal with Chevron included a provision where it could buy additional shares from Reliance and increase its stake to 29%. In early November 2007, rumours that Chevron will buy a sizeable stake in the new refinery at a hefty valuation had sent RPL shares soaring to as high as Rs295 per share.
But investors were in for a rude shock.
Not only was Chevron not planning to buy additional shares at a hefty valuation, Reliance Industries was just about to take advantage of the stratospheric valuations by selling shares in the open market. It was a double whammy of sorts.
And worse still, from the unsuspecting investors’ point of view, Reliance had decided to maximize returns by also taking short positions in the derivatives market. It sold RPL stock futures between 1 November and 6 November through so-called agents. These trades resulted in total gains of Rs513 crore eventually.
The cash market sales commenced on 6 November and ended on 29 November. Reliance sold a 4.5% stake in its subsidiary at an average price of Rs221.8 per share. The gains from derivatives trading boosted the per share realization to around Rs247.1 per share.
The upshot: Reliance had effectively financed about three-fourths of its net investment in RPL through some deft trading.
Before Reliance commenced its cash market sales on 6 November, shares of its subsidiary traded at Rs268 on the NSE. In Reliance’s books, the trades in the derivatives market helped bring overall realizations as close to the prevailing market prices as possible.
It was evident that large cash-market sales will cause prices to crash, and the derivatives trades were done to protect against this loss, its argument goes.
So far, so good.
Why is Sebi complaining?
Here’s the nub. While going about its ‘hedging’ strategy, Reliance flouted client-level position limits prescribed for derivatives contracts, according to Sebi’s order. It did so by using what the regulator calls 12 front entities. Put together, the short position of these 12 entities in the RPL November 2007 futures contract amounted to 61% of the total open interest in the contract as on 6 November and as high as 93.6% on 29 November, the day on which the contract expired. In Sebi’s books, the front entities had cornered the market.
What’s more, the same employee who handled the company’s cash market sale transactions was also authorized to trade on behalf of these 12 entities. Sebi’s order calls this principal-agent construct a sham. On its own, Reliance would have been able to take a hedge position for about 10 million shares because of client-level position limits. By using agents, it took short positions worth nearly 100 million shares.
Reliance, in its arguments before Sebi, pointed out that Sebi’s circular on client-level position limits do not explicitly prohibit such aggregation of holdings, unlike, say, the takeover regulations, which talk of taking into account the holdings of ‘persons acting in concert’.
Shouldn’t it be self-evident that a client’s position limit cannot include positions of other traders who act as agents?
Not so, in Reliance books, since Sebi rules don’t specifically say so.
Sebi’s response is simply this, “If the argument of Noticee No.1 (Reliance) is adopted, the stipulation of a client-wise limit in the relevant circular itself becomes irrelevant and redundant.” In other words, Sebi says client-level limits are what they mean they are, and can’t be circumvented by using “agents” to act on one’s behalf.
That’s not all. Sebi has concluded that some of Reliance’s cash market sales were fraudulent and manipulative in nature. While a majority of the shares were sold between 6 November and 23 November, Reliance sold around 20 million shares in the cash market in the last 10 minutes of trading on 29 November, which also happened to be the expiry date for November contracts. This is relevant because the closing price of RPL in the cash segment is used as the settlement price for its futures contracts. The lower the price, the higher the gains for the short positions in the futures contracts.
Sebi’s whole-time member G. Mahalingam, writes in his order, “The unseemly hurry to press ahead with the sales in the last 10 minutes was motivated entirely by the objective to push the price down or at least prevent the price from surging.” As it happens, RPL shares were surging on expiry day—from around Rs192 the previous day to Rs208 at 3pm and, eventually, to Rs224.7 with 10 minutes left for the market’s close. Compared with the previous day’s close, mark-to-market gains on the outstanding futures position had whittled down by Rs260 crore because of surging prices.
In Sebi’s books, the flurry of sales by Reliance in the last 10 minutes was with a view of manipulating the settlement price for futures contracts, where it had already built a large position through its agents.
Sebi has other concerns and questions about Reliance’s “hedging” construct. For instance, why did the agents hold short positions worth nearly 80 million shares at the time of the contract’s expiry, even though cash market sales of only 20 million shares were pending? Needless to say, Reliance has explanations for each of these concerns.
But the weightiest matters are related to the alleged circumvention of client-level position limits and Sebi’s assertion that Reliance manipulated RPL’s share price on the day of expiry of derivatives contracts. Hopefully, it won’t be another eight years before SAT rules on these matters.
Sebi’s investigation, done during C.B. Bhave’s tenure as chairman, appears to be thorough, but it leaves much to be desired when it comes to enforcement. Apart from the inexplicably long time taken to pass an order, there are also question marks on the lack of monetary penalties.
While Sebi’s order is harsh and doesn’t mince words, all it asks Reliance to do is return the majority of its unlawful gains, apart from banning it from trading in equity derivatives markets for a year.
Of course, this, too, brings with it reputational risks.
But at the end of the day, if the worst that things can get, in terms of monetary consequence, is that you’d have to return unlawful gains, then rather than act as a deterrence, the order may well encourage those who like to live on the edge of the law.