SEBI vs Hindenburg: Separating The Law From The Noise

SEBI seems to be playing the game of ‘Where’s Waldo?’ while searching for violation of Indian securities laws in the Hindenburg report. For the uninitiated, the reference is to a popular series of children’s puzzle books where the objective is to locate Waldo, a distinctively dressed character, hidden in large, detailed illustrations.

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Today we are sharing the entirety of this notice, frankly because we think it is nonsense, concocted to serve a pre-ordained purpose: an attempt to silence and intimidate those who expose corruption and fraud perpetrated by the most powerful individuals in India.

…net of costs we may barely come out above breakeven on our Adani short. Our work on Adani was never justifiable from a financial or personal safety perspective, but it is by far the work we are most proud of

– Hindenburg’s Response

To a layperson, the optics of this case would look like a foreign research firm potentially colluded with a short seller to deflate the stock prices of Indian-traded securities with a clear arrangement to take a quarter of the profits made. But turn on the legal lens and the case doesn’t seem as straightforward anymore.

Before examining the regulator’s case against Hindenburg Research (“Hindenburg”) and whether any effective action can be taken by it, here’s a quick recap of the story so far.

Brief Background and Timeline

Brief Background and Timeline

1. Jan 25, 2023: Adani-Hindenburg saga begins. U.S.-based research firm Hindenburg issued a report in respect of the Adani Group on January 25, 2023, post which the mothership stock – Adani Enterprises Limited (“AEL”) fell by 59%. Before making this report public, Hindenburg shared a draft copy of it with Kingdon Capital, run by hedge fund manager Mark Kingdon. Certain Kingdon entities built short positions in AEL and pocketed a profit of INR 183 crores after the report was made public. Kingdon Capital had agreed to share 25% of the profits with Hindenburg on this trade. After the publication of the report, SEBI conducted an investigation for the period dated November 01, 2022, to February 28, 2023.
2. June 27, 2024 – SEBI initiated action against Hindenburg. Securities and Exchange Board of India (“SEBI”) issued a show-cause notice (“SCN”) to Hindenburg. Broadly, it made two allegations:
   • One, that Hindenburg violated the RA Regulations¹ since it issued a report on an Indian security without an agreement/tie up with a SEBI-registered entity.
   • Two, Hindenburg violated the provisions of the PFUTP Regulations² Two, Hindenburg violated the provisions of the PFUTP Regulations2.
3. July 01, 2024 – Hindenburg Responds. Hindenburg made public the SCN, and also published its response to it. Aside the obvious hyperbole, Hindenburg did not refute (on substance) any of the legal non-compliances alleged by SEBI.

First-things-first – does SEBI have jurisdiction over Hindenburg?

Does the SEBI Act³ explicitly provide extra-territorial jurisdiction to SEBI, say as in the case of our competition regulator? No. However, SEBI Act gives the regulator wide powers to protect the interests of investors in the Indian securities market. Additionally, the Supreme Court of India has recognized that if a person commits acts which affect the legitimate interest of investors in the Indian stock market, SEBI would be fully empowered to proceed against such persons.⁴

This should give SEBI sufficient jurisdiction to investigate Hindenburg’s actions.

Did Hindenburg violate the RA Regulations? Mere technical violation or a substantive one?

There are two critical aspects of the RA Regulations at play here:

a) Should Hindenburg have tied up with a SEBI registered agent before issuing the report?

Facts. As per the RA Regulations, for any document to qualify as a ‘research report’, it needs to ‘provide a basis for an investment decision’. In this case, there were 2 reports involved:

• November 2022 Draft Report. A private draft report was issued by Hindenburg to Kingdon on November 20, 2022. The SCN does not seem to allege that Hindenburg violated the RA Regulations vis-à-vis the private draft report.
• Jan 2023 Final Public Report. The final report released by Hindenburg to the public on January 25, 2023. SEBI has alleged that Hindenburg could not have published this ‘research report’ in the absence of a tie-up with a registered research agent and hence, the publication violated the RA Regulations. Hindenburg however has responded that this report carries a clear disclaimer stating: ‘the report does not constitute a recommendation on securities…’ . As a result, there should be no violation of RA Regulations since the report should not qualify as a ‘research report’ to begin with.

Our View. Is it possible to say that neither the ‘private report’ to Kingdon (although in ‘draft’ form) nor the ‘final public report’ constitutes a ‘research report’, esp. when Kingdon initiated its short trades on the basis of the report? In our view, this may be difficult.

Yes, requiring every individual expressing an opinion on securities to register as an analyst, even without making recommendations, appears impractical and could stifle open discourse in the market. However, can a simple disclaimer take away the overall substance and messaging of the report? Would it then be possible for anyone to comment freely on the ‘desirability’ of a stock without obtaining any registration?

These are challenging questions to have brightline answers to. Given the overall sequence of events, SEBI may succeed in convincing a court of law (at least on a spirit basis) that Hindenburg indeed issued a ‘research report’.

However, should failure to tie-up with a registered entity be considered a major substantive non-compliance? Should not be. In our view, this should be viewed similar to any other non-registration lapse (e.g.: failing to obtain an ‘investment advisor’ registration) and therefore be considered as a procedural non-compliance.

b) Standalone, not tying up with a SEBI registered entity may be a procedural violation. However, did Kingdon’s short sale violate any other substantive restriction of the RA Regulations?

Short answer, yes, it could have.

Facts. In addition to the tie up requirement explained above, the RA Regulations have a ‘no-trade’ period on all ‘research entities’ – i.e. 30 days prior to and 5 days after a research report is published, the ‘research entity’ and its associates should not deal in the securities⁵ which the report recommends.⁶ The question now is whether this restriction applies to Kingdon or not (which admittedly traded on the back of a profit sharing with Hindenburg).

Our View. If SEBI is able to demonstrate that Hindenburg was indeed required to ‘tie-up’ with a SEBI registered ‘research entity’ before issuing the public report, on a substance basis, the regulator should have a good case to say that the ‘no-trade restriction’ explained above has been breached.

Hindenburg’s best defence again would be to explain that the question of a ‘no-trade restriction’ does not arise since it is not regulated under the RA Regulations to begin with. In addition, some provisions of the RA Regulations are not very helpfully worded for SEBI [e.g.: Reg. 16 (5)]⁷ – so Hindenburg could also use these to weaken SEBI’s case (although the impact may not be highly significant).

Allegation of fraud, but where are the facts to support it?

Facts. SEBI has alleged that there were statements in Hindenburg’s report which built up a narrative to mislead investors, and this amongst other things violated the PFUTP Regulations and the SEBI Act.⁸ Broadly, the SCN alleges the following:

• Hindenburg sensationalized, distorted and cherry-picked facts. For example, misrepresenting that an appellate tribunal, while passing an order against the Adani group, ignored evidence on circular trading and fraud. In reality, the order was in fact a detailed and reasoned one.
• SEBI cites a misplaced hyperlink, objection to the use of the word ‘scandal’ and allusions to unspecified ‘unreliable sources’ – all while referring to the data and sources used by Hindenburg.
• SEBI has also contended that Hindenburg misled the public by failing to adequately disclose its profit-sharing arrangement with Kingdon and its relation to the AEL’s Indian securities.

Our View. In our view, SEBI is fighting an uphill battle against Hindenburg. SEBI does not seem to have indicated that any of the facts presented by Hindenburg are incorrect or inaccurate. Instead, SEBI seems to have a problem with selective presentation of facts by Hindenburg and its approach of using hyperbole to state facts instead of presenting them as-is.

Did Hindenburg exaggerate and over-emphasise on bad facts selectively? Yes. However, would that be sufficient to trigger a PFUTP violation if the underlying facts are indeed true? May not be. SEBI at some stage will have to roll up its sleeves, sift through all the allegations made by Hindenburg, and establish that Hindenburg purposely presented incorrect/ fraudulent facts to mislead investors in order to profit from the resulting stock dive. Holding Hindenburg responsible under the PFUTP regulations for its seemingly ‘reckless’ choice of language may be difficult for SEBI if the facts presented by Hindenburg are true.

SEBI may also need to work overtime on the non-public information allegation, since both Hindenburg and Adani group seem to suggest that most parts of the report are nothing more than a mere aggregation of publicly available/ accessible information.

Finally, on SEBI’s concern on incorrect disclaimers, there appears to be some degree of inconsistency on Hindenburg’s part. The general disclaimer suggests that Hindenburg has a short position in all the stocks mentioned in the report, but the more specific one limits their short positions only to US-traded bonds and non-Indian derivatives. However, to term this inconsistency as ‘fraud’ may be stretching it a bit too far, and this once again may not be a clincher by itself for SEBI.

Conclusion

It’s neither Hindenburg nor Adani under the spotlight now. It’s India’s market regulator who had to join the party, albeit a bit too late, and unfashionably so.

The optics clearly go against Hindenburg, particularly the 25% profit share agreement. One cannot deny a slight degree of perception bias against short-sellers and their supporting research arms. But let’s play it the other way around – if Hindenburg had aggregated all publicly available information to bump-up the stock (instead of shorting it), would the regulatory perspective have been different? When the matter was being heard by the Supreme Court, SEBI itself had submitted that shortselling is a desirable and essential feature to provide liquidity and price correction in overvalued stocks. Optics aside, SEBI’s case is not about short-selling. It’s about information asymmetry (not UPSI admittedly), which allowed both the research firm and its client to make disproportionate gains. Unfortunately, what appears wrong may not always be illegal. Reminds us of a US billboard that once said, ‘just because you did it, doesn’t mean you’re guilty’.

To be clear, the regulator’s inability to pursue any action against Adani does not whitewash Hindenburg’s potential breaches and must be seen independent of SEBI’s action against Adani. On its part, SEBI will need to bolster the legal basis in bringing charges of ‘fraud’ against Hindenburg. Given the limited enforcement ability SEBI may have against a US-based researcher, the question is more of reputation and doing what’s right than of disgorging gains, which Hindenburg proudly claims it never made.

¹ SEBI (Research Analyst) Regulations, 2014.
² SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.
³ Securities and Exchange Board of India Act, 1992.
⁴ SEBI vs Pan Asia Advisors Limited, (2015) 14 SCC 71.
⁵ See Reg. 16(2) r/w Reg. 16 (5) of the RA Regulations.
⁶ Section 12A (a), (b), (c) and (e) of the SEBI Act, 1992 r/w regulations 3 (a), (b), (c), (d) and 4 (1) of the PFUTP Regulations, and regulation 4(1), 4 (2) (k) and (r) r/w regulation 2(1)(c) of the PFUTP Regulations.
⁷ Reg. 16 (5) of the RA Regulations states: “Provisions of sub-regulations (2) to (4) shall apply mutatis mutandis to a research entity unless it has segregated its research activities from all other activities and maintained an arms-length relationship between such activities.”
⁸ Section 12A (a), (b), (c) and (e) of the SEBI Act, 1992 r/w regulations 3 (a), (b), (c), (d) and 4 (1) of the PFUTP Regulations, and regulation 4(1), 4 (2) (k) and (r) r/w regulation 2(1)(c) of the PFUTP Regulations.