By Jayant M. Thakur
Chartered Accountant
BACKGROUND
One of the
important enforcement tools that SEBI has against wrong-doers in capital
markets is disgorging their ill-gotten gains. This means taking away by SEBI
those gains that such persons have made from their wrong-doings. For example,
an insider may trade based on unpublished price-sensitive information and make
profits. SEBI would take away, i.e., disgorge, such profits and deposit them in
the Investors’ Protection and Education Fund. There can be numerous other
similar cases of ill-gotten gains such as through price manipulation, excessive
remuneration, fraudulent schemes of issue of securities, etc.
Disgorgement is
not a punitive action and thus is limited to the gains made. Penalty and other
actions may be over and above such disgorgement. The idea of disgorgement is
that a wrong-doer should not retain the profits from his wrong-doing.
While this power
is expressly available to SEBI under law (thanks to a curiously worded
‘Explanation’ to section 11B), there are many areas on which there is ambiguity
and lack of clarity. Recently, however, there have been two developments that
finally have highlighted these areas of concern in relation to disgorgement.
The first is a judgment of the Supreme Court of the USA (in Charles C.
Liu et al vs. SEC, Supreme Court dated 22nd June 2020, No. 18-501
– referred to here as Liu), and the second is the report of the
high-level committee under the Chairmanship of Justice A.R. Dave (Retired
Judge, Supreme Court of India) dated 16th June, 2020 (‘the Report’).
The US judgment
in Liu has highlighted three qualifications to the absolute power
of disgorgement of the Securities and Exchange Commission (SEC) in the context
of the prevailing law. The Report, on the other hand, makes recommendations for
amendments in these areas, although to some extent different from what the US
judgment in Liu has held. These developments need discussion
because disgorgement happening at present in India (and even in the US) is
often ad hoc, arbitrary and even unfair.
For example, the
Securities Appellate Tribunal in Karvy Stock Broking Ltd. vs. SEBI
[(2008) 84 SCL 208] pointed out the arbitrary manner in which
disgorgement was ordered by the Securities and Exchange Board of India. Persons
who rendered services, and thus were part of the alleged scam, were required to
disgorge the entire illegal gains. Similar orders of disgorgement were,
however, not made against others in the same matter who had made the major
gains.
There are no
legal or judicial guidelines regarding the manner of disgorgement except some
generic remarks in SEBI orders or SAT decisions. Some of the issues raised in Liu
and the Report can be strongly raised before SEBI and appellate authorities in
the hope that they would be ruled on, thus creating clarity and precedents. In
some or all areas, the law itself could be amended, thus creating a strong, transparent
and comprehensive base that SEBI and parties can rely on.
PRESENT PROVISIONS RELATING TO
DISGORGEMENT IN INDIA UNDER THE SEBI ACT, 1992
SEBI has ordered
disgorgement of ill-gotten gains in numerous cases over the years. While
disgorgement is accepted as an inherent power based on equity, the basis in
terms of specific legal provisions in the Act is almost a belated
after-thought. It is in the form of an ‘Explanation’ to section 11B of the SEBI
Act inserted in 2013. The Explanation declares that SEBI has the power to
disgorge any profit made / loss avoided by any transaction or activity in
contravention of the Act or Regulations made thereunder. Such ‘wrongful gain
made or loss averted’ can be disgorged. No further guidance or details are
given in the provision or in any Rules / Regulations / Circulars.
Thus, while
power has been granted in the law, many aspects remain unclear and thus result
in arbitrary actions in many cases that have now been highlighted, particularly
through the US judgment and the Report.
Who should be
made to disgorge the profits? Should every person who has contravened the law
be made to disgorge the full profits, or should each person be made to disgorge
the profits that he has made? In particular, can a wrong-doer be made to pay
even the profits earned by another wrong-doer in the same wrong but who cannot
or does not pay the amount? In short, should the liability be joint and
several? If yes, are all wrong-doers to be subject to such joint and several
liability, or only certain specific categories of such wrong-doers should be so
subject?
Should the gross
gains earned by a wrong-doer be fully disgorged or only his net gains
that have gone into his pocket? In other words, should any deductions be
allowed for expenses, taxes, etc. incurred while earning such profits?
Should any
account be taken of losses incurred by the victims or should the disgorgement
be only of the gains made?
Who should keep
such disgorged profits? Should they be paid to those who incurred the losses,
or can SEBI / Government keep them? Can an employer disgorge profits earned by
an employee through violations of Securities Laws?
THE DECISION OF THE US SUPREME COURT IN
LIU
Summarised and simplified, these were the
facts: A married couple formulated a scheme to defraud foreign nationals,
inviting them to invest in certain commercial enterprises. This, it was
promised, would enable them to obtain permanent residence in the USA. It turned
out that this was allegedly a scam and only a small part of such amounts raised
(about $27 million) were invested for such purposes. A substantial portion of
the rest was diverted to personal accounts. Such acts were found to be in
violation of the relevant laws and SEC ordered disgorgement.
SEC, for the
purpose of disgorgement, applied a provision that enabled grant of ‘equitable
relief that may be appropriate or necessary for the benefit of investors’. The
core question before the Court was whether such disgorgement satisfied this
condition of ensuring equitable relief.
The Court
upheld the right of SEC to disgorge the ill-gotten gains. However, three
conditions were placed: First, joint and several liability cannot be placed on
all the guilty persons, except in cases where the parties are partners in the
wrong-doing. Second, the condition that it is for the benefit of investors
should be satisfied. In the ordinary course, if the disgorged proceeds are used
to compensate the loss caused to investors, the condition would be satisfied.
In other cases, compliance of this condition would have to be demonstrated.
Third, it was held that it would not be correct to disgorge all the profits
without giving appropriate deductions. While monies that go into the pocket of
the wrong-doer cannot be allowed as deductions, fair deductions on legitimate
expenses related to the activity that was in violation of law could be allowed.
Indian
Securities Laws do have parallels with those in the USA and thus judicial
developments there are considered by SEBI and Courts here. The judgment is not
only on certain general legal principles but also lays down issues that have
relevance even in the Indian context. However, the language of the law in India
is specifically different in some respects and hence it cannot be directly
applied to India in all aspects. For example, there is no condition in the
Explanation to section 11B that the disgorged amount should be for the benefit
of investors. It is also specifically stated in section 11(5) that the amount
disgorged should be credited to the IPEF fund, the uses of which have been
prescribed in the regulations. Thus, the decision in Liu, while
raising interesting questions, would have to be applied after considering the
niceties of specific and different provisions in India.
REPORT OF JUSTICE A.R. DAVE COMMITTEE
The Report is
fairly detailed and covers suggestions for reforms in certain major areas. In
one of the sections, where suggestions have been given relating to
quantification of penalties and the like, the subject of disgorgement has been
discussed in some detail. Notably, the Report was released before the decision
in Liu was rendered. Nevertheless, the issues that came up in Liu
have also been discussed to an extent.
The Report notes
the language of the Explanation and its possible interpretations. A literal
view could be that a wrong-doer could be held liable to disgorge only the gains
that have gone into his pocket and he would not be made to pay what other
wrong-doers gained. However, the Report opines that the better view is that the
gains made by all wrong-doers can be recovered from each person. The Committee,
however, suggests that the language should be made more clear and specific to provide
for joint and several liability of all persons who indulged in such
wrong-doing.
It also opines that disgorgement should be
of net gains and not of gross gains. It suggests detailed guidance on what
deductions should be allowed from the gains, so that only the net gains are
disgorged. Interestingly, income-tax is allowed as a deduction where it has
been incurred on gains from certain insider trading but not, say, where there
are identifiable investors who have lost money.
The Report also
notes that SEBI has no powers of compensating investors by helping them recover
their losses from the wrong-doers. For recovering their losses, the victims
have to approach civil courts. It also notes that it is the gains made that can
be disgorged and not the losses caused to others. Such losses can, however, be
taken into account for levy of penalty.
The Report makes
detailed and specific amendments to the law. It has been released for public
comments after which SEBI may implement it by amending the law.
CONCLUSION
Wrong-doings in
securities laws usually have a motive of financial gain. If the gains are
disgorged consistently, the motive is frustrated and wrong-doers lose their
incentive. That, coupled with penalty and other enforcement and even prosecution,
should help curb the ills in our securities markets.
The law relating
to disgorgement, however, continues to remain vague and opaque, leading to
arbitrary actions. The absence of guidelines also leads to inconsistent
actions. Appellate authorities also face the same problem of absence of a base
in law in terms of clear provisions.
Even the
decision in Liu is general in nature though broad guidelines are
given. Fortunately, we have the detailed and scholarly report of Justice Dave
and one hopes that it is quickly implemented after due consideration.
