By a small tweak to its stock lending scheme last month, the Securities and Exchange Board of India (Sebi) has suddenly made stock lending a serious and useful instrument—something 13 years of efforts since 1997, when Sebi first started stock lending, failed to achieve. At one stroke, lending stock has become attractive not just to speculators but also to company promoters and other long-term investors who can “rent” out their shares and earn income—since, now, any shareholder is allowed to do so. What’s more, this process becomes more attractive now that an amendment allows stock to be lent for a period of one year, and not just 30 days. All of this thankfully brings this practice into deeper focus.
Until 2007, a person bearish on a scrip could not even short sell in India—that is, borrow shares, sell them, and then buy them back when the price falls to return to the lender. In 2007, Sebi allowed short selling through stock lending, but only by borrowing for seven days (which later became 30 days), rendering it ineffective. However, he can now borrow shares for up to one year. The lender, since he is only “lending”, retains all the corporate benefits such as dividends. On a policy level, shorting through stock lending is obviously better than “naked” short selling since it’s backed by actual shares and is, therefore, automatically limited; in a naked short sell, you sell shares without physically borrowing them. In fact, the scheme restricts stock lending to 10% of the company’s total stock, with further sub-limits.
What are other attractive features of stock lending? It would be done literally through electronic online trading through stock exchanges. Thus, the potentially large number of sellers and buyers will lead to better pricing. Having stock exchanges as intermediaries also assures lenders and borrowers of high-level security that all contracts will be observed properly, without any default.
A debatable policy issue is whether stock lending by promoters would amount to insider trading. Stockxpert
Particularly, promoters and other long-term investors should find stock lending remunerative. However, one negative aspect for promoters is that they lose the right to vote on the lent stock during the lending period.
However, there are some concerns. The tax law, for example, is woefully inadequate. Would stock lending attract a capital gains tax for the lender, since it could be interpreted as the sale of stock? An old provision states that stock lending is not “transfer”, provided the lending is “under an agreement or arrangement, which the assessee has entered into with the borrower”. Sebi’s scheme, in stark contrast, provides “there shall be no direct agreement between the lender and the borrower”. The tax law is also silent on the treatment of lending fees, both for the borrower and the lender.
Even otherwise, this could be tax ineffective for the lender. Say, a person lends shares, which had initially cost him Rs40, when the price is Rs150—and he earns Rs35 as lending charges. The price falls and he gets his shares back and sells them at Rs100. He earns Rs60 as capital gains which, assuming they are long-term, would be generally tax-free. However, the Rs35 stock lending charges would almost certainly be taxed at full rates. He may have been better off directly selling the shares at Rs150.
Worse, if his stock-lending contract is squared up by receiving other compensation instead of getting the actual shares back, he may not get any tax-free gains at all.
A debatable policy issue here is whether promoters should be allowed to lend their shares. As stated earlier, being long-term investors, particularly holding the shares for control, promoters could benefit significantly from stock lending.
However, would stock lending by promoters—who usually possess unpublished price-sensitive information—amount to insider trading? Say, a promoter, obviously privy to inside information, lends the shares when the price is Rs150 and earns Rs35 as lending charges. When the price falls, as he anticipated, he gets back his shares, pocketing some profit when otherwise he would have only lost on the price fall. The current Sebi regulations prohibiting insider trading have obviously not even conceived of this stock lending and thus may not cover this practice.
Then there is another concern: the issue of these very same promoters pledging shares, that is, using these shares as collateral to take loans. Readers may recollect from the aftermath of the 2009 Satyam scandal that the practice of share pledging was abused. Promoters— including, allegedly, the promoters of Satyam—had apparently “pledged” their shares. But these pledges were actually disguised sales, so that once the shares realized their full value, the promoters escaped the downfall in price in which the public shareholders suffered. Stock lending can also be similarly and easily abused, unless there are disclosure requirements similar to those for share pledges—which Sebi instituted a year ago.
Would borrowing of shares be treated as acquisition and attract takeover regulations, where one entity acquires enough shares to challenge the promoter for ownership? The scheme argues that it is not. However, the guidelines do not mandate that a borrowing must immediately be followed by a sale. In such a case, there could be potential for misuse: A so-called borrower may be an acquirer in disguise.
Unless such concerns are resolved, Sebi’s efforts for 13 long years could go fruitless.
Jayant Thakur is a Mumbai-based chartered accountant. Comment at firstname.lastname@example.org