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.