Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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
  • (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

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.


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