Background Yet another case of alleged tax evasion through manipulative trading in stock markets has come to light as per a recent SEBI Order (Ex-parte ad interim Order of SEBI dated 20th August, 2015). In earlier cases, as discussed a few times in this column, the alleged tax evasion was in respect of equity shares. Equity shares were acquired at lower prices, prices were thereafter allegedly increased to very high levels by price manipulation and the shares acquired were then sold to generate tax free long term capital gains. This time, however, the alleged tax evasion (or possibly other objects as discussed later) is through trading in stock options. Certain persons on one side consistently made huge losses and certain persons on the other side made huge profits through trades in stock options at prices that were artificially and significantly different from the “intrinsic price” of the options, as per SEBI. In this order, as in earlier cases, SEBI has, pending further investigation, passed an ex-parte interim order and banned certain parties from accessing or dealing in the capital markets.
Earlier cases of alleged tax evasion through equity shares
There have been several earlier SEBI orders that have held that there has been massive manipulation in the price and trading of certain scrips on stock exchanges with an objective to evade tax. While there have been different orders in respect of different companies, the modus operandi as recorded by SEBI in those orders has been largely similar. The companies, in respect of whose shares such tax evasion was alleged, were earlier usually suspended/ inactive. They did not have any significant revenues, assets, profits, etc.
The companies were generally closely held. Shares of these companies were then acquired by certain persons either directly from the company by way of preferential allotment or through off market transfers by the promoters of such companies. Thereafter, or at a later stage, the share capital in amount and numbers both was substantially increased by way of issue of bonus shares and splitting of face value of shares. The net result was that the cost of acquisition of shares over the expanded capital thus got diluted. The next step was to systematically manipulate the share price of such companies through trading on the stock market at increasingly higher prices. The trading was within a group through circular trading. Thus, the price rose very substantially at the end, often more than 50 times the original price. A period of twelve months passed which resulted in the equity shares acquired by way of preferential allotment or off market purchases to be long-term capital assets. Thereafter, over a period, these acquirers sold their shares. The sales were allegedly synchronised i.e., the sales and purchases were matched in terms of price and time. This was done to parties allegedly connected to the Promoters/company, etc. SEBI alleged that the company, its promoters, the persons who manipulated the share price and the persons who gave an exit to the acquirers at the later stage when the price of the shares were much higher, were all related/connected. SEBI held that this whole exercise was carried out with the objective of earning illegitimate long term capital gains that were tax free. The whole exercise was also in violation of several provisions of Securities Laws being fraudulent, manipulative, etc. In view of this, SEBI passed interim orders prohibiting various parties involved from accessing and dealing in capital markets.
Trading in stock options
In the present case, the alleged manipulation was in case of stock options. As readers are aware, stock options are not created or allotted by the company but are created and traded through the stock market. A facility is offered on stock exchanges for trading in stock options of companies with certain features such as lot size, expiry period, etc. They can be then traded. The strike price of the stock option would have close connection with the price of the shares. For example, there may be an option in respect of shares of company X. The buyer of such option would thus have right to buy a certain number of shares of that company at the strike price. This option he has to exercise on or before the expiry period. However, such stock options are settled by way of reversal before such expiry period. The buyer effectively pays or receives the difference in the price paid by him.
As stated, the strike price at which the options are traded bears a close relation to the price of the underlying share. Thus, for example, if the price of the underlying share is Rs.100, the strike price will have relation with this price with the buyer/seller’s judgment about the expected fluctuations in this price plus other factors such as carrying costs being then factored in. The strike price will usually move depending upon the movements in the price of the underlying shares. Thus, if the price of the underlying shares rises to Rs.120, the strike price of the options too will move in that direction. Other things being equal, it would be rare to find strike price widely diverging with the intrinsic price.
The modus operandi in the present case of manipulations of options
SEBI has described that the particular modus operandi in the present case was as follows.
There were certain parties who dealt in stock options at a price that was unjustifiably very different from the intrinsic price. Thus, for example, they sold options at a strike price that was much higher than the intrinsic price. The options were acquired by a certain group of persons on the other side. Curiously, these sellers reversed the transactions at a low price. The counter parties who were sellers were again the same parties who had originally purchased the options.
The result was that one group of parties made huge losses while another group made huge profits.
SEBI recorded several other findings. These parties were often the only parties who traded in these stock options. They traded with each other very often in close synchronisation. The movement in the price of the options was unreasonable for such short time and also in relation to the underlying price of the shares. The parties often had no other trades.
SEBI was of the view that the transactions were suspicious and with ulterior motives. SEBI believed that the motives could be tax evasion, creation of net worth or other similar motives. In any case, it said that there was clear manipulation of the prices and volumes in violation of several provisions of the Securities Laws. The matters required further investigation, but in the interim, to prevent further violations, SEBI banned the parties from accessing or dealing in the capital markets.
Some of the observations/conclusions of SEBI are worth reviewing.
“The repeated sell of illiquid stock options by the loss-making entities to a set of entities at a price far lower than the theoretical price/intrinsic value and subsequent reversal trades with the same set of entities within a short span of time with a significant difference in buy and sell value of stock options, in itself, exhibits abnormal market behavior and defies economic rationality, especially when there is absolutely no corresponding change in the underlying price of the scrip. On the other hand, trading behavior of profit-making entities exhibited through opening specific trading accounts and operating them exclusively to execute reversal trades in illiquid stock options with a set of entities clearly indicates their role in facilitating loss-making entities in executing their ulterior motive.
Considering the facts and circumstances discussed herein above, I, prima-facie, find that the loss-making entities were deliberately making repeated loss through their reversal trades in stock options which does not make any economic sense, and the profit-making entities were facilitating them by becoming their counterparties and were acting in concert with a common object of intended execution of these suspicious and non- genuine trades. The reasons for executing such trades by these entities could be showing artificial volume and trading interest in these instruments or tax evasion or portraying artificial increase in net worth of a private company/individual. Be as it may, it is amply clear to me that the rationale for such transactions is not genuine and legitimate as the behavior exhibited by these entities defies the logic and basic economic sense. No reasonable and rational investor will keep making repeated loss and still continue its trading endeavors. On the other hand, an entity/ scheme may not forever be able to make only profit and become equivalent to an assured profit maker/scheme. I am of the considered view that the scheme, plan, device and artifice employed in this case of executing reversal trades in illiquid stock options contracts at irrational, unrealistic and ? unreasonable prices, apart from being a possible case of tax evasion or portrayal of artificial net worth to certain entities, which could be seen by the concerned law enforcement agencies separately, is prima facie, also a fraud on the securities market in as much as it involves non-genuine/manipulative transactions in securities and misuse of the securities market. “
Considering that SEBI believed that the reason for such transactions may be with an objective of tax evasion, it also said it would refer the matter to Income-tax and other authorities. It observed:-
“As the purpose of the above mentioned transactions may be to generate fictitious profits / losses for the purpose of tax evasion / facilitating tax evasion, the matter may be referred to Income Tax Department for investigation and necessary action at their end. The matter may also be referred to Financial Intelligence Unit and Enforcement Directorate for necessary action at their end.” ?
Conclusion
SEBI is rightly coming down hard on such cases where it believes that there are rampant and there are manipulative and fraudulent acts. Such acts affect the markets in man ways. The artificial volumes may influence investors not only in the shares and options being manipulated but even in other shares/options. Unsuspecting investors may thus suffer losses. The credibility of the markets would also suffer and thus harm the interests of bonafide companies who end up having to suffer in many ways including getting a lower price for their shares. The image of the country too suffers. The culture of violating laws and even expecting to get away also gets entrenched. Clearly, strong action is necessary.
However, it is also seen that these orders are at a very preliminary stage. SEBI has stated that the full investigation is yet to be over. The allegations are serious. It would have to be backed up by foolproof investigation supported by impeccable logic and evidence. For upholding severe actions and punishment, law and courts require such clear and conclusive evidence. In any case, a message has certainly gone across that SEBI and stock exchanges are closely monitoring such cases. The investigative resources and powers SEBI has are helping it gather considerable information. Time will of course show whether and to what extent wrong doers are punished and how much impact it has on malpractices in capital markets.
