CAESAR’S WIFE SHOULD BE ABOVE SUSPICION

BACKGROUND

On 30^th April,
2019, SEBI passed orders in the matter of the National Stock Exchange. The
principal issue was the alleged preferential access accorded to some parties to
the stock market order mechanism whereby they could profit and also allegedly
giving them preference over other investors, brokers, etc. Further, there are
two other orders passed by SEBI that deserve consideration. They effectively
exhibit SEBI’s new approach to widen the scope of the liability of persons
associated with the capital market, especially of those connected with listed
companies such as directors, auditors, key executives, etc.

These two orders deal with
the alleged abuse of position by some people close to NSE whereby they profited
from certain data preferentially and exclusively obtained from NSE which was
used to develop products that were sold in the market. Worse, the implication
that appears to be brought out is that these products enabled the users to
profit at the cost of other investors.

The orders make stringent
adverse comments and issue directions against the two groups of investors. The
first group comprises those who were close to the NSE and which closeness was
used to obtain and use NSE data exclusively. The second group consists of the
exchange itself and its two key officials at the relevant time. SEBI found that
the officials did not carry out the required diligence expected of them. The
adverse directions are fairly stringent and harsh and if they acquire finality,
have the potential to harm careers and reputations, especially of the involved
key persons.

However, on appeal to SAT,
the operation of these orders has been stayed as regards some of the key
management persons. Despite the fact that the issues are in appeal because of
the new approach of SEBI, we are reviewing these decisions because a very
interesting approach has been taken in relation to the duties and liabilities
of key management persons. The orders have wider implications and in a manner
are cautionary for several groups who may be in a similar situation; they are,
independent directors, non-executive directors, promoter directors and other
entities associated with the capital markets. These entities often enter into
profitable associations with their companies. Key and even mid-level executives
should examine these transactions. A fairly broad level of performance is
expected from these persons, which are far beyond the literal requirements of
the law. For the purposes of this academic analysis, the statements in the SEBI
orders are taken to be true, though, on facts / law, it is possible that they
may be reversed.

THE ALLEGATIONS

SEBI alleged, in the first
order, that there were 5 persons (4 individuals and 1 company) close to the
NSE. This closeness arose primarily because of the closeness of one person over
a long period of time and who, it is stated, was very influential and respected
in NSE. SEBI alleged that he used his position to get certain contracts in
favour of a company associated with his extended relatives. It was alleged that
under this arrangement certain data of NSE was preferentially / exclusively
given to this company. This data was used to develop software products that
could be sold to market operators whereby they could profit and also perhaps
have an edge over other operators in the market. In view of these facts,
allegations of having violated several provisions of Securities Laws, including
those relating to fraud and unfair trade practices, were made.

In the second order, based
broadly on the same facts, SEBI has alleged that NSE and its two top officials
failed to exercise due diligence in relation to such contracts, especially
where the parties involved were close to the exchange.

THE DEFENCES OFFERED

SEBI relied on certain
emails exchanged between some of the persons covered by the order. According to
SEBI the emails record confidential information which was preferentially given
by NSE. The parties responded that the emails were being taken out of context.

The parties also generally
and specifically denied any wrong-doing, particularly relating to profiting
unduly from such information, and also contended that the software products did
not harm the interests of other investors.

NSE and its officials also
denied any wrong-doing. They, inter alia, stated that the contracts were
of such size and nature that they do not deserve close attention of the top
officials of the Exchange. They stated that the alleged effects of the
contracts were effectively inconsequential. Further, the contracts did receive
the attention and diligence they deserved.

CONCLUSIONS OF SEBI

SEBI rejected these
defences and described how the parties were very close to the Exchange and thus
influenced NSE’s decision-making process. Further, SEBI

• brought out and emphasised the personal
  relations between some of the parties;

• it particularly highlighted that the manner
  in which the information was provided was exclusive and hence irregular;

• concluded that proper safeguards were not put
  in place for protecting the data from being shared;

• SEBI also pointed out that mere disclosure by
  a party that it is interested in a contract is not sufficient and not a
  substitute for diligence by NSE’s key personnel.

ORDERS PASSED

Two orders have been
passed. These debar the individuals from, inter alia, holding positions
in prescribed entities. NSE has been issued several directions relating to
strengthening of its internal systems. Further, SEBI has directed legal action
against specified individuals and companies for abuse of the data, etc. As
stated above, on appeal, the operation of SEBI’s orders has been stayed.

IMPLICATIONS FOR INDEPENDENT DIRECTORS,
OTHER DIRECTORS AND SENIOR OFFICIALS OF VARIOUS ENTITIES ASSOCIATED WITH
CAPITAL MARKETS, AUDITORS, ETC.

The orders deal with certain
specific facts and also relate to the case of a stock exchange that has certain
duties to the market. However, the principles involved also have relevance to
other entities, for example, independent directors, executive and non-executive
directors, CFOs, key personnel such as company secretaries, lawyers, auditors,
etc.

It is very common, for
example, to have contracts and arrangements with directors and / or persons
connected with them. There are requirements under law whereby directors and key
management personnel have to disclose their interest in the contracts and
arrangements with the company. There are also provisions relating to
related-party transactions. However, the orders suggest that complying with
even such broad and comprehensive requirements may not be enough. As a matter
of fact, where such connection exists, arrangements with persons close to the
company ought to require a higher degree of diligence on the part of the
company, its CEO, etc. If it is found later that the contracts bestowed undue
favour or better terms than others or there is non-compliance of law, lack of
action against the party, etc., then the company, its officials and the parties
involved could face scrutiny and possibly action from SEBI.

The orders also deal with
confidential and valuable information about the company and the safeguards the
company and the parties who have access to the information would have to take
to ensure that there is no abuse. Conceptually, this is similar to unpublished
price-sensitive information for which there are extensive regulations relating
to insider trading. Abuse of such information may result in loss to the company
and / or loss to investors or may impact the credibility of entities in the
markets.

The fact that top
executives (both former Managing Directors) have been debarred from holding
office for a period of three years (though these actions have been stayed by an
appellate order) is another area of concern. The contracts in question were,
relatively speaking, of small amounts in the context of the size of NSE. There
is, I submit, validity in their defence that such contracts are largely handled
at the functional level. However this defence was not accepted.

SEBI has expressed that
even if the contracts are small in value, if they are with parties close to the
company, then the contracts / arrangements need a closer watch at a senior
level; because issues, especially those related to confidential data, could
have wider ramifications if abused. Hence, I now perceive that key management
executives will henceforth be expected to look at and monitor closely contracts
with persons close to the company. SEBI has alleged that NSE did not take due
action for violation because the parties who violated the contracts were close
to and influential in NSE.

The other point to
emphasise is that the usual concepts and definition of “persons interested in
contracts” have been given a broader interpretation. Hence, mere disclosure of
interest or even complying with the procedural / approval requirements may not
be enough. Further, even if a person involved is not deemed to have interest as
defined in law or is not a related party as defined in law, the management will
have to demonstrate that due “care and diligence” was carried out at the time
of entering into a contract / arrangement with such person/s.

To conclude, the adage Caesar’s wife should be above
suspicion applies today even more than ever.