BEFORE THE ADJUDICATING OFFICER

SECURITIES AND EXCHANGE BOARD OF INDIA

[ADJUDICATION ORDER NO. AP/AO-23/2006-07]

In respect of

 

FRANKLIN TEMPLETON INVESTMENT FUNDS

(SEBI REGD. No. IN-LU-FD-0147-94).  

 

1.0              Securities and Exchange Board of India (SEBI) received a letter dated December 12, 2002 from Custodian, Hongkong and Shanghai Banking Corporation Ltd. (HSBC) mentioning that its client Franklin Templeton Investment Fund (FTF), a FII having SEBI registration number IN-LU-FD-147-94, sold 4,500 shares of HCL Technologies Ltd., without having it in its portfolio. The aforesaid transaction, known as short selling, is prohibited. Accordingly, Mr. K.R.C.V. Seshachalam was appointed as Adjudicating Officer (AO) under Section 15 I of SEBI Act, 1992, read with Rule 3 of SEBI (Procedure For Holding Inquiry And Imposing Penalties By Adjudicating Officer) Rules, 1995 (hereinafter referred as 'Adjudication Rules') vide SEBI order dated February 18, 2003 to inquire into and adjudge under Section 15I of SEBI Act, 1992, the alleged aforesaid transaction which is prohibited under Regulation 15 (3) (a) of SEBI (Foreign Institutional Investors) Regulations, 1995 (hereinafter referred as 'FII Regulations'). This order was communicated vide

proceedings of the Chairman, dated October 03, 2003, appointing the AO. The matter was then transferred to Mr. A. Chandrasekher Rao (ACR) vide order dated December 28 2004 and subsequently to the undersigned, vide order dated December 20, 2005.

 

2.0              The then AO, issued a show cause notice (SCN) dated November 25, 2004, under Rule 4(1) of Adjudicating Rules to FTF, communicating the aforesaid allegation levelled against it. The SCN also called upon FTF as to why an inquiry in terms of Rule 4(3) of the said Rules should not be conducted against it and penalty be not imposed upon it, u/s 15 HB of SEBI Act, 1992. There was no reply to the SCN from FTF.

 

3.0              Under the aforesaid circumstances, the undersigned thought it fit to hold an inquiry in the matter. Accordingly, November 10, 2006 was fixed as the date for inquiry, vide notice of inquiry dated October, 10, 2006. This notice of inquiry, enclosing copy of the SCN dated November 25, 2004, was arranged to be served on FTF through its custodian. Ms. Pranita Gramopadhye, Asst. Vice President of Franklin Templeton Trustee Services Pvt. Ltd. appeared on behalf of FTF and made submissions. FTF also sought time to file reply and was allowed to file written submissions, which they did vide their letter dated November 24, 2006.

4.0              The details of the submission made by FTF are as under:

 

4.1              FTF apologized for not filing reply to the SCN. It relied upon the order of dated August 29, 2005 wherein the AO (ACR) dropped

4.2              the similar charge, against FTF’s group entity namely, Templeton Asset Management Ltd., after considering the cause shown by that entity. FTF stated that it consist of various sub funds with various investment objectives and Templeton Asset Management Ltd, Singapore (TAM-S, hereinafter) was the duly appointed investment manager for the sub fund pertaining to the instant proceeding. TAM-S is registered as an FII and is investing in India since 1990. Reiterating its commitment to regulatory compliance, FTF stated that TAM-S viewed India as long term investment.

 

4.3              Referring to the impugned transaction, FTF stated that TAM-S’ trading desk at Hong Kong placed an order to purchase shares of HCL Technologies Ltd (HCL Tech. hereinafter) on December 10, 2002 which was executed on the same day, with December 13, 2002 as the date of settlement. FTF further stated that on December 11, 2002, TAM-S placed an order to sell HCL Tech. shares, after obtaining confirmation, both internally and from global custodian, JPM Chase that settled shares of the scrip were available. However, FTF stated that, the aforesaid confirmation turned out to be erroneous which resulted in its trade on December 11, 2002 being deemed in default of Regulation 15 (3) (a) of FII Regulations.  

 

4.4              FTF enclosed copy of letter (dated nil) whereby TAM-S informed SEBI about the aforesaid trade (Annexure – I) and also copy of letter dated May 22, 2003 whereby SEBI conveyed its no objection for repatriation of the proceeds of the aforesaid trades, out of India, but without prejudice to any action it might take in this regard.

 

4.5              Stating that the interpretation of the term short sale was more stringent in India than in other markets, FTF admitted having made the aforesaid sale prior to receiving the securities in their account, inadvertently and without any intention to short sell, as a human error, in good faith on third party confirmation that settled shares were available. Mentioning that it has arranged to take preventive measures, to avoid recurrence, FTF submitted that the quantity of the shares traded was too small to have any impact on the market. Claiming that the aforesaid was an isolated event, FTF submitted that it did not indulge in short sale to gain from falling prices in the market or to manipulate it. FTF submitted that the gain from the aforesaid trade was just US $ 105.55, an insignificant amount compared to its scale of activities and the short sale was not naked one. Moreover, it co-operated with SEBI to resolve the issue, FTF argued. Further it submitted that short selling was never part of its strategy and it is also prohibited in Luxemburg, from where it is based. FTF regretted the error and drew AO’s attention to it otherwise exemplary track record and contribution while deciding on the matter. Mentioning that any penalty would be viewed as sanction by other regulators and could hamper FTF’s future investment, including in India, FTF sought a lenient view.

 

5.0              Having carefully perused the material on record I proceed to record my finding as follows, but before that, it is important to at least briefly understand the background of the FII investment in India.

 

6.0              Consequent to the crisis in the balance of payment of the external account, in 1991, India embarked on a major reforms program to liberalize its economy. As part of the reforms measure in the financial sector, the Union budget for 1992-93 announced the decision to allow FII to invest in the Indian capital markets. The main objective to allow foreign portfolio investment into India, through FIIs, were two fold: 1) to shore up the balance of payment of the external account and 2) to infuse dynamism in the capital markets, which would hence forth be the key source of funds for corporates, as the economy transited from a centrally planned economy to a market driven one. At the same time, the real sector of the economy was in need of technology, expertise, foreign tie ups, etc. besides capital, to face external competition in the ensuing global era. To address these needs, liberalized norms pertaining to non debt inflows in the form of Foreign direct investment (FDI) were also being evolved. Therefore, right from the inception, the objectives and goals of the economic policy of the Government of India pertaining to FII investment were distinct from that of FDI, as they were designed to serve different purposes.  Illustratively, FII investment is under the purview of Ministry of Finance, whereas FDI is under the Department of Industrial Policy and Promotion of the Ministry of Commerce.

 

7.0              To operationalize the decision on FIIs investments, the Union Ministry of Finance released guidelines for FII investments vide Press Note dated September 14, 1992. The key features of these guidelines, relevant to this proceedings, are that FIIs, which are entities domiciled abroad and registered with their respective regulator, can invest in securities listed in Indian stock exchanges, after obtaining SEBI registration. FII were required to appoint a domestic Custodian for custody of investments held and “would be expected not to engage in any short selling in securities and to take delivery of purchased and give delivery of sold securities”. In accordance with the aforesaid guidelines, the Board came out with the FII regulations in 1995, which included a proviso, prohibiting short sale by FII. Reirating and the importance attached to short sale by FIIs, the Reserve Bank of India also prohibited short selling by FIIs vide A.P.(DIR Series) Circular No. 53 dated December 17, 2003 issued under Sections 10(4) and 11(1) of the Foreign Exchange Management Act, 1999 (42 of 1999). Therefore, it is a basic pre requisite that an FII ought not to indulge in short selling.

 

8.0              As stated earlier, HSBC, the custodian of FTF, vide its letter dated December 12, 2002 informed SEBI that it received a contract note from broker UBS Warburg Securities India Pvt Ltd. for a sale of shares of HCL Technologies Ltd. by FTF. HSBC further stated that FTF did not have sufficient stock in its portfolio. The details in this regards are as under:

 

SEBI Registration No.	IN-LU-FD-147-94
Trade No.	200234809
Trade Date	11 December 2002
Settlement Date	16 December 2002
Security	HCL Technologies Ltd.
Quantity of Trade	4,500 shares
Trade rate	INR 188.25396
Settlement Amount	INR 847,142.82

 

 

The custodian, further mentioned that “The above FII has executed a purchase trade for the above scrip that is expected to settle on 13 December 02. We have advised the client and broker of the insufficient stock in the client’s portfolio and shall keep you apprised of further developments”.

 

9.0              I find that TAM-S, vide its letter (dated nil) to SEBI, admitted having made the aforesaid sale prior to receiving the securities in their account, inadvertently and without any intention to short sell as administrative processing error. Mentioning that the issue has been addressed, TAM-S regretted the error and sought condonation. FTF also stated that it instructed its custodian to settle the trade to avoid an auction and undertook to utilize the sale proceed for fresh purchases/repatriations only after receiving SEBI approval.

 

10.0          From the aforesaid and from the submission made vide letter dated November 24, 2004, it is clear that FTF has conceded the default - it is undisputed that TAM-S, on behalf of FTF sold 4,500 shares of HCL Tech. worth Rs. 847,142.82 on December 11, 2002. It is also undisputed that as on December 11, 2002, FTF did not have any shares of HCL Tech. in its portfolio. Although the term short selling is not defined in the regulations, as per market conventions it is generally understood that short selling is the sale of security that the seller does not own.   Regulation 15 (3) (a) of FII Regulations Regulation prohibits short sales by FIIs and reads as under:

15. (3) In respect of investments in the secondary market, the following additional conditions shall apply:-

(a) the Foreign Institutional Investor shall transact business only on the basis of taking and giving deliveries of securities bought and sold and shall not engage in short selling in securities: 

[Provided that nothing contained in clause (a) shall apply in respect of transactions in derivatives traded on a recognised stock exchange;]

 

11.0          The impugned transaction on December 11, 2002 is a ‘naked’ short sale from December 11-12, 2002 and a ‘covered’ short sale from December 13-15, 2002, for the following reason. It is undisputed that FTF did not have sufficient shares of HCL Tech. in its portfolio as on December 11, 2002, when it sold 4,500 shares. On the other hand, it is also on record that FTF bought shares of the same scrip on December 10, 2002, which was to settle on December 13, 2002. However the quantity of shares purchased, is not mentioned. In other words, FTF was to receive shares of HCL Tech. on December 13, 2002, which it bought on December 10, 2002, before it was required to deliver 4,500 shares of the same on December 16, 2002, which it sold on December 11, 2002. Therefore, subject to the quantity of shares bought on December 10, 2002, FTF’s sale transaction on December 11, 2002 was a covered short sale from December 13-15, 2002. However, the same was a naked short sale from December 11-12, 2002, as FTF, indisputably, did not have the requisite number of shares of HCL Tech. in its portfolio. Irrespective of interpretation of the term short selling in other markets, the aforesaid transaction on December 11, 2002 is prohibited under Regulation 15 (3) (a) of FII Regulations. The charge against FTF is, therefore, established.

 

12.0          For the aforesaid default, penalty can be imposed u/s 15 HB of SEBI Act 1992, which reads as under:-

 

"Penalty for contravention where no separate penalty has been provided.

 

15HB. Whoever fails to comply with any provision of this Act, the rules or the regulations made or directions issued by the Board thereunder for which no separate penalty has been provided, shall be liable to a penalty which may extend to one crore rupees.)"

 

13.0          The undersigned considered the following factors as provided in the section 15J of SEBI Act to determine the quantum of penalty that can be imposed under Section 15HB of SEBI Act, 1992 viz. (a) the amount of disproportionate gain or unfair advantage, wherever quantifiable, made as a result of the default; (b) the amount of loss caused to an investor or group of investors as a result of the default and; (c) the repetitive nature of the default. In the absence of any data, the disproportionate gain or unfair advantage, or loss to the investors is not quantifiable in the instant case. On the other hand from the material on records, the default appears to be one off in nature. It is not the case against FTF that it indulged in short sales in many scrips and over a period of time; instead, it was done just in one single scrip on one single day. In the absence of any material to the contrary, FTF’s contention that the default was an inadvertent error, needs to be given due credence.

 

14.0          The SAT in its ruling in the matter of HDFC in its order dated November 10, 2000 in the appeal No. 21 of 2000 stated that “Default per se is not the dominant guiding principle for imposition of penalty. It is the consequences of the default that weighs in taking the decision to impose penalty and its quantum”. Accordingly, it will be pertinent to examine the consequences of short selling, more so, specifically by an FII.

 

15.0          Perusal of literature and market views on the subject reveals that the arguments for and against short selling are equivocal. On one hand the demerits attributed to short sales are 1) potential to destabilise the market 2) exacerbate declining trend and lowers prices of securities 3) promotes speculation 4) amenable to price manipulation 5) allows leveraged trading (especially where the identity of the source of funds through PN is not known) 6) escalates volatility 7) allows FII to earn risk free income (by lending through approved intermediary), 8) complicates monitoring investment limits of FII in companies (10 % individual and 24% aggregate limit) 9) tantamount to borrowing rupee equivalent by the FII (which is the anti thesis of the objective of allowing FIIs to invest in India) etc. On the other hand the merits attributed to short selling are 1) it reduces volatility 2) facilitates price correction of over valued stocks 3) permits arbitraging 4) increases liquidity and dept in the market 5) brings stability in the market 6) prevents price manipulation etc; the aforesaid factors are collectively help the market price align with the fundamentals.  Keeping in view of the merits & de-merits of the short sale it is not possible generally to comment on the policy of short sale but the matter will have to be examined on case specific basis because the existing law does not allow FII to short sale. 

 

16.0          As already mentioned, the short position of FTF in the scrip of HCL Tech. was only for two days, subject to the number of shares purchased on December 10, 2002. The value of the trade was about Rs. 8.47 lakhs. It is well known that in the balance of payment account, which is measured in millions of US$, the figure of Rs. 8.47 lakhs is very small, if not insignificant. Here again, the balance of convenience is in favour of FTF. Moreover, from the fact of the case it is clear that FTF did not take short position in HCL Tech. to profit from falling price, as it already had a buy position on December 10, 2002, prior to the sale on December 11, 2002.

 

17.0          In this regards it may be pertinent to highlight the ruling of the SAT in the matter of Yogi Sungwon (India) Ltd. Vs. SEBI in the order dated May 04, 2001 in the appeal No. 36 0f 2000, the relevant portion of which is as under:       

On a perusal of section 15I it could be seen that imposition of penalty is linked to the subjective satisfaction of the Adjudicating Officer. The words in the section that "he may impose such penalty" is of considerable significance, especially in view of the guidelines provided by the legislature in section 15J. "The Adjudicating Officer shall have due regard to the factors" stated in the section is a direction and not an option. It is not incumbent on the part of the Adjudicating Officer, even if it is established that the person has failed to comply with the provisions of any of the sections specified in sub section (1) of section 15I, to impose penalty. It is left to the discretion of the Adjudicating Officer, depending on the facts and circumstances of each case.

 

It is also held by SAT that Adjudicating Officer has to satisfy himself whether violation deserves punishment.

 

18.0          I have also noted from the submissions of the noticee that in the identical matter (ACR/81 of 2005 dated 29/10/05), my predecessor has imposed no penalty.  I have gone through the said order of Adjudicating Officer and observed that the facts and circumstances are quite identical to this case.

 

19.0          Therefore, considering the totality of facts and circumstances of the instance case, including non repetitive nature of the default, insignificant consequence of the default and with due regard to consistency of approach and uniformity of actions, I do not find it to be a fit case for imposition of penalty. At the same time the noticee should be cautious in its dealings in the securities and the violations of like nature, if noticed, shall be viewed very seriously.

 

20.0          This order of adjudication is made and passed on 5^th day of December 2006 at Mumbai.

 

 

AMIT PRADHAN

ADJUDICATING OFFICER