The Illegality of Artificial Short Squeezes: A Fradulent and Manipulative Move
[Nitesh is a student at National Law University, Delhi.]
Towards the end of January 2021, the US securities market witnessed a rather unprecedented event. A “mob” of Redditors had coordinated an “attack” against the institutional investors of Wall Street by rampant buying of heavily shorted stocks belonging to a plummeting video-gaming company, GameStop Inc. The prices of the stock soared about 1,700% in a matter of days and large institutional investors took a hit amounting to billions of dollars. This phenomenon is called a short squeeze and has been extensively discussed and explained in the aftermath of this incident.
This article aims at analysing the legality of such an artificially created condition of a short squeeze in the context of Indian laws. Drawing inspiration from the GameStop saga, an Indian group of Redditors had reportedly attempted to manufacture a similar short squeeze condition with certain Indian stocks, including that of Suzlon Energy Limited. The market experts have opined that such GameStop-like short squeezes are not possible in the Indian scenario, owing to the relatively stringent regulations of the Securities and Exchange Board of India (SEBI) and the structural under-development of the Indian securities market. However, I intend to argue that even in the absence of any such stopgap measures, an act of artificially manufacturing a short squeeze condition is inherently in contravention of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations 2003 (PFUTP Regulations).
Market Manipulation Prohibition Laws
Section 12A(c) of the Securities and Exchange Board of India Act 1992 prohibits any direct or indirect fraudulent or deceitful action with respect to the securities market. Deriving from this power, the PFUTP Regulations were framed to counter the “manipulative, fraudulent and unfair trade practices”. Regulation 4(2)(d) prohibits inducing another person to trade in securities, with the object of unduly influencing the price of such securities. Regulation 4(2)(e) is a catch-all provision that prohibits any actions amounting to manipulation of the price of securities.
The judiciary has consistently embarked upon a wider interpretation as far as the PFUTP Regulations are concerned. In SEBI v. Rakhi Trading, the Supreme Court, while relying on the N. Narayanan v. Adjudicating Officer, SEBI case, has given an expansive definition to ‘market manipulation’ to include any deliberate attempt to unduly create an artificial or misleading image of prices and securities. Furthermore, in SEBI v. Kanaiyalal Baldevbhai Patel, the term ‘fraud’ has been given an inclusive and a wider meaning than under the Indian Contract Act 1872. In that case, the court held that ‘fraud’ can occur under the PFUTP Regulations even without an intention to deceive being proved, provided the other person has been induced by the acts or omission of the person accused of fraudulent behaviour.
Therefore, the judicial position in respect of PFUTP Regulations is amply clear. While SEBI does have the onus to prove the occurrence of market manipulation, there is no obligation to prove the existence of an intention to manipulate the market once such actus reus is proved. SEBI is only required to establish that the market would not have behaved in the way it did or be unduly influenced, had it not been for the actions or omissions of the person accused of market manipulation and/or fraud under the PFUTP Regulations.
Having said that, it is pertinent to note that the PFUTP Regulations do not completely divorce the ‘intent’ from manipulative or fraudulent conduct. They merely ease the burden of proof on SEBI by relieving it from proving the mens rea element, as long as the actus reus element has the effect of disrupting the ordinary market processes. While the PFUTP Regulations read with the judicial pronouncements ease such burden of proving intention for SEBI, they do not restrict the accused parties from proving their ‘non mala fide intention’ to establish their innocence. Any contrary reading to this would be a legislative absurdity and hence, untenable. Therefore, third-party investors, who may incidentally hold or trade in such securities but had no role to play in the manipulative or fraudulent conduct, cannot be held liable under the PFUTP Regulations once they prove their ‘non mala fide intention’.
The Indian position of law is in stark contrast with the US position of law. In the US, the Securities Exchange Commission is required to establish the intention and ability to manipulate the market to successfully press a market manipulation charge against an individual. Proving a person’s intention to manipulate the market is inherently difficult, and more so when intentions of a large, unrelated group of people has to be proved. Hence, the illegality of the GameStop saga cannot be established in the US.
In light of the wide judicial interpretation of the PFUTP Regulations, the Fair Market Conduct Committee Report had recommended the scope of various regulations to be expanded, which was accordingly effected by the 2018 amendment to the PFUTP Regulations. A noteworthy amendment is the expansion of the scope of the term “dealing in securities” to include “activities undertaken to influence decision of investors in securities”. Therefore, the intention of both, legislature and judiciary, is clearly to prioritise the larger investor interest and trust in the securities markets by prohibiting any wild, undue market swings due to manipulation.
The Illegality of Artificial Short Squeezes
An attempt to create an artificial short squeeze in the securities market involves a trader or a large group of traders influencing a larger group of retail investors to invest in a stock that has been heavily shorted by institutional investors. Such actions are backed by the assurance of great return on investments once the stock prices rise, without informing the innocent investors of the volatile and inevitable crash of the prices immediately after it hits its peak.
A mere solicitation to invest in a stock is not outrightly illegal. However, I argue that the regulators and the courts ought to view an artificial short squeeze condition from the lens of a consequentialist. An artificial short squeeze is not limited to merely soliciting a shorted stock. It impacts the retail investors as they are left stranded after the inevitable steep decline in prices of such stocks. Such large-scale undue influence over the prices of a stock must necessarily constitute ‘market manipulation’ by the wide definition provided in SEBI v. Rakhi Trading.
Furthermore, even in Ketan Parekh v. SEBI, the Securities Appellate Tribunal had held that a ‘deemed market manipulation’ occurs whenever an individual partakes in a securities transaction that artificially raises or depletes the prices of securities as such transactions would automatically induce innocent investors to take corresponding action.
The solicitation of heavily shorted stocks also constitutes fraud under the PFUTP Regulations. As mentioned above while discussing the SEBI v. Kanaiyalal Baldevbhai Patel case, there is no requirement to prove mens rea to constitute fraud. The group of traders soliciting the shorted stocks to induce innocent retail investors to invest in such stocks and keeping them in the dark about the eventual steep decline of the prices of such stocks constitutes fraud within the meaning of PFUTP Regulations. It is the consequence of the actions that are relevant for constituting ‘fraud’ under the PFUTP Regulations, rather than the intention to commit such fraud.
Although there is no explicit provision under the PFUTP Regulations that outlaws artificial short squeeze, the current framework of law is sufficiently broad to successfully establish the illegality of artificial manufacturing of a short squeeze. In the author’s view, while the legal experts in the US have expressed doubt over the absolute illegality of the GameStop saga, any attempt to replicate such market practices in India would be outrightly illegal under the PFUTP Regulations.