By Jayant M. Thakur
Chartered Accountant
BACKGROUND
Persons desiring to do business in the securities markets are usually required to obtain a license of sorts – a registration – from the Securities and Exchange Board of India (‘SEBI’). This is especially so for those who are known as ‘intermediaries’ and who render various forms of services. They may be stock-brokers, portfolio managers, those handling mutual funds, etc. Each category has a different set of requirements for being eligible to be registered which may include qualifications, net worth requirements, etc. Once registered, they also have to follow prescribed rules and usually a Code of Conduct. Failure to follow such rules / Code may result in action which may include penalties, suspension or even cancellation of certificates.
However, there is one overriding requirement and test common across almost all intermediaries. And that is the ‘Fit and Proper Person’ test. A person needs to be ‘fit and proper’ to obtain registration. Unlike other requirements which are well defined and strictly applied, the ‘fit and proper’ requirement may appear at first glance as vague, broadly defined and subjectively applied. In several cases, entities have been debarred or refused entry in the securities market on the ground that they failed this ‘fit and proper’ test.
So what is this test and requirement? Is it as arbitrary as it appears to be? There have been several rulings of the Securities Appellate Tribunal (‘SAT’) and orders of SEBI over the years in this regard. This article describes the legal provisions and discusses, in the light of several precedents, how this test has been applied. While some areas of doubt and concern still remain, the rulings have been generally on similar lines applied consistently.
THE LEGAL DEFINITION OF ‘FIT AND PROPER’ UNDER SECURITIES LAWS
This term has different connotations and definitions under different laws. The Reserve Bank of India, for example, has a different connotation of this test for appointment of directors in public sector banks. Further, without using this term, other laws, too, apply similar principles while granting or rejecting licenses / registration. However, we shall focus here on the definition under Securities Laws.
The definition has seen significant change over the years and the current definition and criteria are given in Schedule II to the SEBI (Intermediaries) Regulations, 2008 (‘the Regulations’) which reads as under:
CRITERIA FOR DETERMINING A ‘FIT AND PROPER PERSON’
For the purpose of determining as to whether an applicant or the intermediary is a ‘fit and proper person’ the Board may take account of any consideration as it deems fit, including but not limited to the following criteria in relation to the applicant or the intermediary, the principal officer, the director, the promoter and the key management persons by whatever name called –
(a) integrity, reputation and character;
(b) absence of convictions and restraint orders;
(c) competence, including financial solvency and net
worth;
(d) absence of categorisation as a wilful defaulter.
Earlier, there were full-fledged and separate Regulations focused on this aspect – the Securities and Exchange Board of India (Criteria for Fit and Proper Person) Regulations, 2004. The wordings in the earlier Regulations were similar but lengthier. The general pattern and essence remain the same in the new criteria and, hence, the rulings thereon can be generally relied on and are indeed followed for the Intermediaries Regulations.
BROAD AND VAGUE WORDING OF THE CRITERIA
The test applies not just to the applicant / intermediary but also to its director, promoter, key managerial person, etc. The criteria are striking in their wideness and even vagueness in wording. The ‘integrity, reputation and character’ of the person is examined, but no specific benchmark has been provided as to how it would be measured or judged. And whether it would be limited to the person’s work or even his personal life can be considered.
‘Absence of convictions and restraint orders’ may sound clear at first glance but becomes complicated when looked at closely. If there is a conviction for which punishment or a restraint order is continuing, it would be obvious that he cannot be registered in violation of such orders. However, does the conviction / restraint have to be on acting as such intermediary? Or is it, and which is more likely, that the conviction / restraint may be on any area that may reflect adversely on the character of the person? In any case, it is not clear whether the conviction or restraint needs to be subsisting in the sense that it is being undergone or is a past one. If a past one, whether even a conviction / restraint from the distant past is also to be considered?
Competence, including financial solvency and net worth, is to be considered. But, again, no benchmarks are given – whether any specific qualification or area of experience would be considered. The term ‘financial solvency’ is easy to understand in a negative way as not being insolvent. But considering that it is used with the term ‘net worth’, perhaps the intention, to judge from context, may be that the net worth may be commensurate with the nature of registration sought.
As we will see later, there is a reason why the criteria are broadly worded with lack of specific, measurable parameters. The intention seems to be to judge the person in a subjective manner on such parameters. However, subjectivity is compensated in a different manner by ensuring that only those adverse aspects that are serious are considered.
PRECEDENTS
This subject has again come to the fore due to a recent Supreme Court ruling (reported in the media) on certain on-going appeals before SAT on decisions of SEBI on brokers in the NSEL matter. However, there is a longer history of precedents and generally there has been consistency in them following the principles laid down in an early SAT ruling of 2006.
Jermyn LLC vs. SEBI [2007] 74 SCL 246 (SAT – Mum.)
This was one of the earliest rulings (affirmed by the Supreme Court in the second appeal) that laid down the basic principles for application of the criteria. The matter related to the alleged Ketan Parekh scams. Simplified a little bit, the broad issue was whether persons who have been subjected to bans and investigations of serious violations could re-enter the market through a different name. The question was about determining whether a non-resident entity registered with SEBI was indeed associated with the KP group that faced serious allegations. It was alleged that there was commonality / association with persons allegedly connected with the KP group and several factors were placed on record. The entity contended that the allegations against the KP group were not finally proved, that many investigations were still going on, and so on. SAT took a broader view of the requirements relating to ‘fit and proper person’. It held that it was fair to consider serious allegations as relevant even if the proceedings do not yet have a final outcome. It also held that subjective judgment was acceptable. The following words can be usefully referred to since they have been applied in later cases (emphasis supplied):
‘9. A reading of the aforesaid provisions of the Regulations makes it abundantly clear that the concept of a fit and proper person has a very wide amplitude as the name “fit and proper person” itself suggests. The Board can take into account “any consideration as it deems fit” for the purpose of determining whether an applicant or an intermediary seeking registration is a fit and proper person or not. The framers of the Regulations have consciously given such wide powers because of their concern to keep the market clean and free from undesirable elements… In other words, it is the subjective opinion or impression of others about a person and that, according to the Regulations, has to be good. This impression or opinion is generally formed on the basis of the association he has with others and / or on the basis of his past conduct. A person is known by the company he keeps. In the very nature of things, there cannot be any direct evidence in regard to the reputation of a person whether he be an individual or a body corporate. In the case of a body corporate or a firm, the reputation of its whole-time director(s) or managing partner(s) would come into focus.
The Board as a regulator has been assigned a statutory duty to protect the integrity of the securities market and also interest of investors in securities apart from promoting the development of and regulating the market by such measures as it may think fit. It is in the discharge of this statutory obligation that the Board has framed the Regulations with a view to keep the marketplace safe for the investors to invest by keeping the undesirable elements out… One bad element can not only pollute the market but can play havoc with it which could be detrimental to the interests of the innocent investors. In this background, the Board may, in a given case, be justified in keeping a doubtful character or an undesirable element out from the market rather than running the risk of allowing the market to be polluted.
We may hasten to add here that when the Board decides to debar an entity from accessing the capital market on the ground that he / it is not a fit and proper person it must have some reasonable basis for saying so. The Board cannot give the entity a bad name and debar it. When such an action of the Board is brought to challenge, it (the Board) will have to show the material on the basis of which it concluded that the entity concerned was not a fit and proper person or that it did not enjoy a good reputation in the securities market. The basis of the action will have to be judged from the point of view of a reasonable and prudent man. In other words, the test would be what a prudent man concerned with the securities market thinks of the entity.’
This ruling and the principles it laid down were followed in many later cases such as:
1. Mukesh Babu Securities Limited vs. SEBI (Appeal No. 53 of 2007, dated 10th December, 2007, SAT);
2. SEBI’s order in case of Motilal Oswal Commodities Broker Private Limited dated 22nd February, 2019;
3. SEBI’s order in case of Anand Rathi Commodities Limited dated 25th February, 2019;
4. SEBI’s order in case of Phillip Commodities India Pvt. Ltd. dated 27th February. 2019.
ISSUES AND CONCLUSION
The series of decisions shows that the application of the criteria to determine whether a person is a fit and proper person is seen from a different perspective. The core objective is that persons with dubious reputation and image should not be allowed entry in the capital market. A person may have several cases against him about alleged scams, serious wrongdoing, etc. The final outcome of these cases may take years, even decades. Can such person enter or continue in the securities markets? Would it be sufficient that he discloses on-going cases? The governing principles as laid down suggest that SEBI can take into account such allegations even if there is no final outcome. In its subjective view, it can refuse entry to such persons. For this purpose, SEBI may take into account developments which may occur at various intermediary stages – observations of courts, reports of investigative agencies, etc. Many of the principles of natural justice such as right of cross-examination, providing of all underlying information / documents, etc., may not be strictly applied. The material SEBI has relied on is seen in a more substantive manner.
That said, this does not mean that SEBI has indiscriminate and unquestionable powers. Each of the cases has shown that the allegations on record have been fairly serious and multifarious. Such serious allegations are enough to put a person in a bad enough light to be refused entry in securities markets at least in the interim. SEBI as a gatekeeper thus has broader powers.
The test of ‘fit and proper person’ at present has application to intermediaries under the Regulations. However, it may not be surprising if such test, or at least the principles thereof, may get wider application to other persons associated with the capital markets and who play a key role. One example that can be thought of is Independent Directors.
