TAKE ACTION, BUT TREAD CAUTIOUSLY

SEBI oversees and regulates
dealings in shares and other securities traded on the stock exchanges. However,
for several years now it has also been regulating trading in commodity
derivatives on commodity exchanges. It has replaced the Forward Markets
Commission and the SEBI Act and Regulations / Circulars issued thereunder have
effectively replaced the Forward Contracts (Regulation) Act, 1952.

While the regulator is
common between the two markets now, and although there are fundamental
similarities between trading in securities on stock exchanges and on commodity
exchanges, there are fundamental differences, too. The contracts in derivatives
have broad similarities in both the markets. The regulator also recognises a
fundamental similarity, that is, ensuring fair price discovery in a
regulated market that is free of wrongful influences. Thus, for example,
price manipulation is as much a cause for worry for commodity markets as it is
for stock markets.

The volumes of trades in
commodity exchanges are fairly high. However, other than the much-discussed
matter of NSEL, there have been few orders by SEBI relating to the commodity
market. A recent SEBI order (“the Order”), which has been promptly reversed on
appeal to the Securities Appellate Tribunal (“SAT”), thus becomes a good case
study to review some broad aspects pertaining to the commodity market.

However, apart from
considering issues specific to commodity markets, this order also raises some
important issues relating to the type of orders that SEBI can pass; for
example,

• What are the situations where SEBI can pass ex
  parte interim orders?

• Under what circumstances can SEBI debar parties
  from dealing in the markets?

These questions are
important because an ex parte interim order debarring a person may not
only result in huge losses to him but may even sound the death knell for his
business.

THE BACKGROUND

One of the primary concerns
in the commodities market is the cornering of stocks in a particular commodity.
A person cornering a very large percentage of the stock of a particular
commodity can be in a position to dictate its price. Thus, SEBI has specified
limits on trades by persons and these limits apply to a single person or a
group of persons acting in concert.

To ensure that groups
acting in concert are also brought under this rule, SEBI has specified generic
and specific tests to determine whether a group of persons is acting
independently of each other or is acting in concert. Hence, having certain
specified relations or commonalities would show such persons as acting in
concert. However, the exchanges can use generic criteria based on facts of
individual cases to determine whether ‘persons are acting in concert’.

Cornering market beyond the
specified limits, though a violation in itself, can potentially lead to
additional violations.

The case in question, as
seen below, allegedly had both the concerns specified above.

THE FACTS AND THE SEBI ORDER

Vide an order dated 28^th
February, 2019 SEBI passed an ex parte interim order against 26 persons
for certain violations while acting in concert. SEBI initiated this action
based on the advice of the commodity exchange concerned. SEBI was informed that
three persons were holding more than 75% of the total exchange deliverable
stock of mentha oil. The exchange had applied the tests specified by SEBI to
determine whether these three persons were acting in concert. These three
persons were found to have been funded by a certain person.

The large holding was
accumulated not only by purchases on the exchange platform, but also through
off-market transactions. They had transferred their purchases to the specified
three persons. These parties were also alleged to be connected with each other
on the basis of findings made by the exchange.

The acquisitions and
holdings of these parties were tabulated by SEBI over nearly a year and it was
found that the deliveries taken by them as a percentage of total deliveries
showed that the cumulative deliveries were almost 75% of the total deliveries.

The order then analysed in
detail the relationship between the parties as well as the flow of funds
between them to demonstrate that they were acting in concert.

Further, the order
highlighted an aspect that strengthens SEBI’s case. It pointed out that some of
these parties traded for the first time. A few opened their trading accounts
during this period itself. Many traded beyond their capacity (i.e., net worth)
– for example, in an extreme case, a person whose declared net worth was Rs. 15
lakhs had taken delivery of goods worth Rs. 34.94 crores, which was 23,293% of
his net worth!

The order also considered
the numerical limits specified for the commodity and noted that such persons, allegedly
acting in concert, violated these limits on most of the days.

SEBI also alleged that NEFM
who ultimately funded the transactions, ‘intentionally created false and
misleading appearance of trades’. Further, the act of concealment was devised
to ‘deliberately mislead the market and hold a dominant stock position’. These
actions were in violation of the SEBI PFUTP Regulations. The registered broker
through whom the transactions were channelled by the parties was also alleged
to have prima facie violated various provisions, including incorrect
reporting and not exercising due skill, care and diligence, etc.

SEBI held that the parties
had not only violated provisions of law and accumulated a dominant position but
such position could put them in a position to manipulate the price of the
commodity.

In view of the above facts
SEBI debarred the parties from dealing in or being associated with markets in
any manner till further directions. Post-order hearing was granted to the
parties since this was an interim order.

The appeal and the
order of SAT (North End Foods Marketing (P) Ltd. vs. SEBI {[2019] 105
taxmann.com 69 (SAT – Mumbai)}

The parties so debarred
appealed to the Securities Appellate Tribunal (SAT) against the interim ex
parte order debarring them from trading. SAT set aside the order on several
grounds. Interestingly, the parties sought an interim order from SAT for
immediate reliefs.

The primary appellant
contended that it was involved in the business of procurement of commodities
and warehousing of commodities for which it received orders from its clients
and, in turn, placed orders for such commodities with its agents. These agents
procured such commodities and delivered those commodities to the appellant who,
in turn, delivered such commodities to its clients. Thus, the allegation of
acting in concert was denied.

The presumptions of SEBI
were questioned. For example, it was contended that the basis of presuming the
dominance in market was incorrect. It was argued that the total volume of trades
should be taken as the basis. If that were done, then, even if all the parties
were clubbed together their delivery would be less than 2% of the total volume
of trades. Thus, there was no dominance.

It was also contended that
though the transactions were completed, none of the price manipulations that
SEBI alleged had taken place. Thus, SEBI’s fears had no basis even on facts.

The order even debarred
parties from dealing in other commodities. Many commodities had limited shelf
life and there would be financial and physical loss if these deals were not
completed.

The SAT considered the
contentions and set aside SEBI’s order.

However, SAT upheld SEBI’s
power to pass interim ex parte orders and also highlighted various
pre-conditions to be satisfied before interim ex parte orders should be
passed. There has to be urgency for passing orders without granting a hearing
to the parties and this need particularly has to be justified. Further, SEBI
has to establish that there would be serious consequences if such an order is
not passed.

SAT noted that the events
described in the SEBI order were of the past. No useful purpose would be served
by debarring the parties at this stage. The derivatives contracts entered into
by the parties had already been executed and SEBI had not recorded any finding
of manipulation that it suspected had taken place. The order debarred parties
not only from dealing in mentha oil, but also all other commodities. This
obviously was too broad and too harsh. The order had also frozen the demat
accounts and mutual fund investments of the parties which had no bearing on the
alleged violations. SAT held that no purpose would be served in preventing
their dealings through an interim order.

Thus, the order failed in
complying with the necessary basic conditions of an interim ex parte
order. SAT set aside the order, though allowing SEBI to initiate and continue
such proceedings and inquiries on the matter as it deemed fit.

CONCLUSIONS

Interim ex parte
orders are often passed and it is well settled that SEBI has powers to pass
such orders. The basic features of interim ex parte orders are:

• No opportunity to explain is given. Restrictions
  are often placed on the activities of the parties that can cause financial and
  reputational losses. Such interim orders often continue for years pending
  inquiry and investigations;

• Hence, SAT held that SEBI has to establish
  exceptional need to pass ex parte interim orders.

There is another aspect
that is common to all orders of debarment – whether interim or final. Debarment
in ordinary course should be for prevention. Freezing bank accounts and sale of
assets should be done to ensure that funds are not siphoned off in anticipation
of orders of penalty, disgorgement, etc. However, it is often seen that the
debarment operates as a punishment. An order debarring dealings in securities
can result in loss and even closure of business. Hence, unless it can be shown
that dealings by parties would harm the markets, interim ex parte orders
cannot be sustained and should not be passed.