Offmarket transactions on the exchange for tax reasons

We have been discussing order matching and market microstructure in class during the last two weeks and this morning, students brought up the report in the Economic Times today about whether Ranbaxy promoters could use bulk trades on the exchange to sell their holdings to the Japanese acquirers. The reason for doing this is that India does not levy capital gains tax on transactions done on the exchange – the Securities Transactions Tax (STT) levied on exchange transactions is supposed to be in lieu of capital gains tax.

The price that the Ranbaxy promoters have negotiated with the acquirer is at a premium of about 27% to the current market price and SEBI regulations allow block trades negotiated outside the exchange to be put through the exchange only within a price band of 1% of the market price. It is quite clear that it is possible to do a large trade on the exchange at any price if one is willing to burn through the whole order book and thus share part of the “control premium” with these orders. For example, suppose the current market price is 100 and there are sell orders at prices ranging from 100-110 for a total of say 500,000 shares. The promoter puts in a limit sell order for 100 million shares at a price of 127 and the acquirer immedately thereafter puts in a market buy order for 100 million shares. The market order would first burn through the entire pre-existing order book of 0.5 million shares and then execute the remaining 99.5 million shares against the sell order of the promoters at 127. The only problem is that 0.5 million shares would have been bought at prices above the market price of 100 and this is a small price to pay in relation to the tax that is saved.

Obviously, a transaction of this kind would be done on the least liquid exchange on which Ranbaxy is quoted and it would be done at a time when the sell side of the order book is as thin as possible. There are two problems with this however.

The first problem is that if the whole world can see that this is what is going to happen, it makes sense for anybody who holds Ranbaxy stock to put in limit sale orders at a price of 125 or 126 to take advantage of the bulk deal whenever it happens. There is nothing to be lost and everything to be gained by doing so. The acquirer has to make a tender offer at 127, but this is only for 20% of the issued shares and selling one’s entire holding at 125 is better than tendering into that open offer and taking one’s chances. If enough people put limit orders at 125 or so, then the cost of eating through the entire order book can quickly become prohibitive. This possibility is very real because people who have the ability to borrow stock can place these limit orders even if they do not own the stock. Immediately after the bulk deal, the price will drop back to normal levels and the short seller can buy back from the market and close out the position.

The second problem is the SEBI Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003 (endearingly known as FUTP). I am not a lawyer, but I think FUTP raises some very interesting issues that have not I believe been tested in this context. The question is whether executing a bulk trade in this manner would amount to market manipulation. Regulation 4(2) of the FUTP states that:

Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-

• (d) paying, offering or agreeing to pay or offer, directly or indirectly, to any person any money or money’s worth for inducing such person for dealing in any security with the object of inflating, depressing, maintaining or causing fluctuation in the price of such security;
• (e) any act or omission amounting to manipulation of the price of a security;

I am not sure how regulators would look at this issue, because on the one hand, the trade of 100 million shares is a genuine and legitimate trade. On the other hand, it does create a false market and does artificially inflate the price for a short period of time. To this extent, it does appear manipulative. I know we do not have OTC equity derivative markets in India, but imagine what the situation would be if there were large OTC barrier options at 125 that got trigerred by this trade. Would they not think that there was market manipulation?

In class today, we also considered the possibility of pushing the price only upto say 125.75 with a market order that just burns through the sell side of the order book and then using a block trade negotiated outside the exchange at 127 (within 1% of the market price). This would perhaps be even more manipulative and might not have any significant advantages over executing the entire transaction through the order book.

I think the most important lesson in all this is that the idea of treating the Securities Transactions Tax as a substitute for the capital gains tax is a huge mistake. It is not only inequitable in allowing very large untaxed incomes, but it also distorts markets and creates perverse incentives for many market participants.

Posted at 2:12 pm IST on Wed, 18 Jun 2008         permanent link

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