This series of articles introducing securities laws for listed companies to the lay reader continues…
1) A recent and relatively minor amendment suddenly infuses life into the otherwise dead instrument, that is, scheme of stock lending. The amendment provides that now Stock Lending can be for one year, thereby increasing the period from 30 days, which, incidentally initially was, for just seven days. This short lending period was probably the main reason why there was practically no interest in using stock lending, though the scheme has existed since 1997!
2) Let us broadly understand what Stock Lending is and understand some important developments till date. I may add that, as we will see later, numerous other things in securities laws and outside have to be resolved but this latest amendment is, I think, sufficient reason to take Stock Lending seriously now.
3) Stock Lending, as the name suggests, is lending of shares by an owner to a borrower. The borrower pays charges for “using” the shares and is required to return the borrowed stock by the end of the borrowing period. The Borrower normally cannot close the transaction in cash. The arrangement provides that all other benefits of ownership go to the Lender, such as dividends, bonus issue, etc. Hence, if a company makes a 1:1 bonus issue, the Borrower would then have to return double the number of shares he has borrowed. However, all benefits of ownership cannot be protected, such as the ‘right to vote’.
4) The Borrower normally sells the shares in the market, as he is bearish on the scrip and believes that the price of the shares will fall in the ‘borrowing period’. Thus, he will be able to buy shares back at a lower price and return them to the Lender and earn profit.
5) Conceptually, thus, the Lender would have to be a person who is either a long term investor or a promoter who is bullish on the scrip and desires to earn return in the interregnum. Another reason for not selling the shares himself could be that the Promoter may be interested in retaining the shares for the long term for the benefit of control through the shares.
6) In theory, private parties could carry out Stock Lending amongst themselves. The Lender would lend the shares to the Borrower by a private arrangement. The Borrower would sell the shares, buy them back at a later date and return the shares. However, there would be several complexities. The Lender would also have concerns about default in recovery of his shares. Further, the Lender/Borrower would have to search for counter parties and there would not be the benefits of an open market of Stock Lending where parties could find many counter parties. In an open market, the Stock Lending rates would be market determined owing to wider participation.
7) The advantages of a statutory lending scheme are many and in theory, many of the above disadvantages can be overcome. However, SEBI has been struggling, since 1997, to lay down a scheme that retains the aforesaid advantages while ensuring that the terms and conditions do not create problems. However, it has not been successful so far.
8) SEBI had introduced in 1997 a Scheme of Stock Lending. The principal concept was of approved intermediaries, who would act as intermediaries for parties on both sides, i.e., lending and borrowing. Strict approval norms were laid down for approval of intermediaries so that the intermediaries were strong in terms of net worth, which may lend confidence to the Lender. The intermediaries would also be under regulatory control of SEBI. For various reasons, including tax uncertainty (which since 1997 was partly resolved), the Stock Lending Scheme did not take off at all.
9) A decade later, around 2007, SEBI took steps to revive it. A principal change made was that that the stock exchanges themselves would be the intermediaries. It appears that the objective was also of allowing Stock Lending transactions to be effected through the stock exchange. Thus, one could theoretically borrow and lend in a manner similar to buying and selling shares or derivatives. The stock market would also protect the parties for due honour of the terms such as return of the shares and corporate benefits.
10) However, SEBI was unduly cautious. Stock Lending is actually intended to facilitate
short-selling. And short-selling is incorrectly and unfairly seen as a stigmatic act. So much so that the recent recession in the US is blamed on short-sellers. Even in India, a few years earlier, short-sellers were claimed to be behind the huge fall in the stock markets. However, short-selling and speculative buying are two sides of the same coin. If markets are undervalued, a spirited speculator is seen as heroic when he buys, raises the market and then sells the same. The same speculator who feels that the market is overpriced, becomes a villain if he short sells. Speculation is part of the market. But if speculation is indulged in for price manipulation, then, and only then, it should be punished. However, short-selling continues to be stigmatic, at least in perception.
a) Having stated this, Stock Lending is better than naked short-selling in which any quantity of shares could be sold. In Stock Lending, every short sale has to be backed by available shares.
11) Hence, as said earlier, SEBI was unduly cautious. It initially allowed barely 7 days of lending, as if prices would move towards a particular value in such short period. Such a Scheme was bound to fail and it did. It remained a failure when the lending period was increased in 2008 from 7 to 30 days. Now, SEBI has, in one stroke, increased the period to 12 months and there is some excitement in the market. This move has the potential to be the proverbial Tipping Point, when there is a major take-off on account of a small change, though some minor issues in the Scheme and tax and other uncertainties remain.
12) As the revised scheme is now in place, let us note some important features which make the Scheme attractive:-
a) Any person can carry out stock lending and thereby short-selling. The Borrower and the Lender can be any person, individual, corporate, institutional investor, etc.
b) Initially, Stock Lending will be allowed in shares in which futures and options are allowed. SEBI will review this list from time to time.
c) The lending/borrowing period is upto one year.
d) The Lender can request an early termination and the Approved Intermediary can, on a best effort basis, seek to get shares from another lender and give them to the original Lender.
e) The Borrower can also return the shares earlier and the Approved Intermediary can attempt to find another borrower.
f) Timely disclosures will have to be made of the shares that are sold using the Stock Lending mechanism.
g) The clearing corporation/clearing house of the stock exchanges having nationwide terminals will be registered as Approved Intermediaries, through which the Stock Lending would be carried out. The Borrowers and Lenders would approach authorized Clearing Members for their transactions.
h) The Stock Lending would be through the screen-based, order-matching platform. Thus, like derivatives, parties can find out orders available on either side and carry out “trades” of borrowing/lending.
i) There will be a contractual/statutory framework between the parties involved, viz., the Borrowers, Lenders, Approved Intermediaries and the Clearing Members. However, there will not be any direct agreement between the Borrower and the Lender.
j) The contracts would effectively be standardized and thus comparable and capable of being valued uniformly.
k) The Approved Intermediaries will lay down the risk management mechanism so as to ensure that shares lent are recovered or due compensation is otherwise received from the Borrower. This is an important pillar of the Scheme, which would give comfort to the Lender.
l) There are overall limits of shares that can be lent as a percentage of capital. At least in this respect, SEBI has been realistic and has allowed a fairly high percentage of the share capital—10%—though one could argue that even this is arbitrary. There are sub-limits though, at various lower levels.
m) The lending and borrowing would not be deemed to be sale and purchase of shares for various purposes such as for Takeover Regulations. However, one will have to look at actual amendments in the law, if there would be any.
13) Note that while the Stock Lending scheme is approved, steps would have to be taken by stock exchanges and others concerned to lay down the systems and procedures for the same to make it operational.
14) While the Scheme is attractive generally, there are various concerns.
15) The tax law remains uncertain, and though there is a specific but old Section 47(xv) that deals with Stock Lending, some questions worth considering are:-
a) Will lending be deemed to be a sale and borrowing deemed to be a purchase in the revised statutory framework, particularly where there
are no direct agreements between Borrower and Lender? Similarly, what will be the treatment of the reverse transactions when shares are returned from the Borrower to the Lender through the Approved Intermediaries?
An incidental question would be how would the period for which the stock is lent be treated? Will it be part of the continuous period for which the shares were held by the Lender?
b) The Borrower would be in a peculiar position. Assuming that he is not deemed to be a purchaser, he would be selling the shares first and then buying them back. How would the surplus/loss be treated? How would he account for his position for tax purposes at the yearend when he has sold shares but he has not yet bought them back? Will he be able to book a provisional loss if the market price is higher than the price at which he sold? How much of such loss will he be able to book?
c) How would the income from Stock Lending be treated? How would the Stock Lending charges paid be treated? How will the treatment differ for those who hold the shares as stock in trade and for those who hold it as capital assets?
d) If there is finally a default in return of the shares and the Lender is compensated in money, what would be its tax treatment? When would the “transfer”/sale be deemed to have taken place?
I must confess that I have only scratched the surface and I am sure readers will think of more issues.
16) Apart from tax, there would be other issues such as:-
a) Can Stock Lending be deemed to be insider trading? In other words, would a Stock Lend-ing by an insider be deemed to be insider trading if he had access to unpublished price sensitive information?
b) How would the lending and borrowing be treated for accounting purposes? How will it differ for shares held as investments and shares held as stock in trade? How will the potential loss on account of rise in price be accounted by the Borrower at the yearend?
c) Will Stock Lending be treated as borrowing for the purposes of Section 58A of the Companies Act, 1956?
d) Will stock lending be deemed to be a financial activity for the purposes of regulations relating to NBFCs?
17) Then there are other aspects. Should an act of a Promoter who lends shares be viewed negatively? Should it show an indication that he is himself bearish on his shares and thus he is protecting himself? By lending, is he not encouraging fall in the share price since there would be selling pressure? Or should a view be taken that the fact that the Promoter is only lending and not selling shows that he is actually confident of his company since he would want his shares back eventually? Whatever the theoretical arguments, on either side, may be, a Promoter who lends his shares may face publicity and, often, publicity relating to such transactions is automatically negative publicity!
18)To conclude, Stock Lending offers a new and attractive instrument but with complex issues that Chartered Accountants, whether in industry or in practice, will have to address.
