Background
A recent decision of the Securities Appellate Tribunal (SAT) discusses in detail as to what constitutes “due diligence” (Keynote Corporate Services Ltd. vs. Securities and Exchange Board of India, Appeal No. 84 of 2012, dated 19th February 2014). Intermediaries, including merchant bankers, are required to be diligent in the performance of their duties and this decision is of relevance to them. For Chartered Accountants in general and Auditors in particular too, this decision has relevance for at least two reasons. Firstly, professionals like CAs are required to carry out their duties exercising care of a level higher than the “due diligence” test. Hence, what constitutes “due diligence” should be of use. Secondly, CAs connected with listed companies and the SEBI registered intermediaries, though are not being regulated directly by the SEBI, do find their work reviewed by the SEBI. Hence, generally the standards laid down in this decision have relevance to intermediaries registered with SEBI.
Brief facts
In this case, to summarise the facts as reported, a merchant banker managed a public issue. As the readers would know, the manager to a public issue (“IPO”) has the highest and broadest of responsibilities, not only in managing the issue generally but coordinating with other intermediaries. In particular, it is his prime responsibility as regards the quantity and quality of information of disclosures made in the prospectus. It was found that in an issue managed by it, certain material disclosures were not made. The Company had, immediately before the IPO, borrowed monies from certain entities and used the same for advances for capital assets and other matters. The genuineness of such outgoing/ expenditure was not accepted by Securities and Exchange Board of India. The Company, after the IPO, repaid such loans from the IPO proceeds. The SEBI alleged that this amounted to siphoning off of funds. Further, it seems that the SEBI believed that the fact that the IPO proceeds were really meant to pay off such existing liabilities would have been a material consideration for the investors. Thus, disclosure of such facts would have affected their decision in investing.
The basic facts that the amounts were borrowed, then used for certain purposes and then the IPO proceeds were utilised for repayment of such borrowings do not seem to be in dispute. Also, nondisclosure of such pre-existing borrowings was also not in dispute. The issue in question was whether the merchant banker had carried out his duty with diligence that was expected of him.
Decision and principles laid down
The SAT laid down the law relating to the duties of the merchant banker as regards due diligence. Clause 64 of the SEBI (ICDR) Regulations 2009, reads as under:
“Due diligence.
64. (1) The lead merchant bankers shall exercise due diligence and satisfy himself about all the aspects of the issue including the veracity and adequacy of disclosure in the offer documents…..”
The SAT relied on the decision of the Supreme Court in the matter of Chander Kanta Bansal vs. Rajinder Singh Anand [(2008) 5 SCC 117] where due diligence was explained in the following words:
“The words “due diligence” have not been defined in the Code of Civil Procedure, 1908. According to Oxford Dictionary (Edn. 2006), the word “diligence” means careful and persistent application or effort. “Diligent” means careful and steady in application to one’s work and duties, showing care and effort.”
The SAT then reviewed the Memorandum of Understanding between the merchant banker and the Company and the rights of the merchant banker stated in the following clause was highlighted:
“The BRLM shall have the right to call for any reports, documents or information necessary from the Company to enable them to verify that the statements made in the Draft Red Herring Prospectus or the final Prospectus are true and correct and not misleading, and do not contain any omissions required to make them true and correct and not misleading.”
The statement in the prospectus that was found to be incorrect read as under:
“Bridge Loan: We have not entered into any bridge loan facility that will be repaid from the Net Proceeds.”
The merchant banker raised several pleas in its defence, all of which (except one, which is not relevant for this discussion) were rejected.
Firstly, the merchant banker stated that it was not informed by the company about the borrowings and that such information was indeed withheld from them. The SAT did not accept this as a valid defense. It said that the merchant banker could not expect the company to provide its information on its own with the merchant banker not taking any initiative. The SAT observed, :-
“Appellant’s plea that the information regarding ICDs was withheld from Appellant by ESL cannot be accepted. BRLM, in carrying out its functions is generally expected to act in an independent and professional manner and should not rely only on issuer company to provide them with updates, if any. Due diligence on part of Merchant Banker does not mean passively reporting whatever is reported to it but to find out everything that is worth finding out.”
The merchant banker said that it had obtained undertakings from the directors of the Company that the statements made in the prospectus are true. This too was rejected as being an insufficient defense. The SAT stated that accepting statements from the Company was no substitute for proper due diligence.
Then the merchant banker explained the manner in which he carried out his duties. He said that “when he handles IPO, he carries out random checks to verify authenticity of entities mentioned in the prospectus and has submitted documents in support of same”. In particular, the verification is “with reference to objects of issue and quotations, and in respect of IPO of ESL such checks were made in respect of major quotations submitted by ESL and, in support, Appellant submitted copies of few quotations along with nothings from concerned executive at its end, confirming veracity of offer document.”.
However, the SAT did not accept this and found that the manner in which such checks were carried out was insufficient. The Investigation had revealed that a sum of Rs. 4.75 crore from the IPO proceeds was allegedly siphoned off.
The SAT also explained the manner in which an intermediary such as a merchant banker in the present case should act while carrying out its duties with due diligence:-
“It is about making an active effort to find out material developments that would affect interest of investors. It is on faith that intermediary has conducted due diligence with utmost sincerity that investing public goes forward and decides to invest in a particular company. In present case Appellant had failed to exercise due diligence in carrying out its duties as BRLM in IPO of ESL.”
The SAT observed that the merchant banker had merely relied on certain statements provided by the Company and others. Moreover, even some of such statements were misleading or not in context of the issue before it. In any case, the SAT observed that this approach did not amount to carrying out its duties with due diligence. The SAT observed, :-
“Reliance of such documents, which in effect do not convey anything material or are misleading, infact, strengthens the case of Respondent that Appellant has done nothing to carry out due diligence and has been a passive actor, waiting for documents/information to come to him, whereas he should have been active in looking into various aspects of functioning of ESL, scrutiny of functioning of ESL, scrutiny of all relevant documents- including bank statements and order book position etc., before certifying correctnes of various statements in prospectus and issue of due diligence certificate at various stages of IPO”.
Curiously, the merchant banker pleaded that he had
a wide experience, knowledge and recognition in
the field. It had 35 years of experience in the field
and had managed more than 100 IPOs. He was a
regular speaker at various forums on the field. It
appears that this defence was raised to imply that
the merchant banker was well versed with his duties
and thus he would not have committed any
violation. However, this was actually went against
him. It was held that this past experience actually
raised the benchmark with which he ought to have
performed its duties and the facts did not evidence
‘due care’. The SAT observed,:-
“Appellant’s pleadings in Memorandum of Appeal
that the is highly experienced, and is a regular
speaker on subject of capital markets at various
forums and that he had carried out due diligence at
every stage, of issue of IPO and that he had fulfilled
all requirements of his responsibilities as BRLM/
Merchant Banker and some material disclosures
were not in issue documents, since these were done
at his back and not brought to his notice by ESL,
come to nothing, when he himself is not serious or
vigilant and is awaiting relevant information coming
to him and he then taking action on same, this
Tribunal has no hesitation is stating that Appellant
has failed in his duty to carry out due diligence, at
any stage of IPO of ESL and had failed not only the
investors in this issue but has done considerable
harm to security markets, at large.”
“….a professional person having wide knowledge
and experience in bringing out 125 IPOs during
its existence, is expected to show better professionalism
than was shown by Appellant. In the circumstances,
this Tribunal expects better standards
of performance from professionals, who charge
reasonably good fee from clients and who bring
out documents (prospectus in this case), which are
relied on by investors, at large, to take informed
decisions regarding investments in scrips/IPO and
this standard of professionalism should be higher
than a reasonable man with ordinary prudence will
demonstrate in the matter of due diligence but in
present case no mark of professionalism can be
seen from Appellant, who was merely a certificate
issue machine on dates when it was due, without
undertaking any due diligence whatsoever.”
The SAT, thus upheld the penalty levied on the
merchant banker.
Other aspects/laws/developments
The original SEBI order, that levied the penalty
on the merchant banker, is also worth reviewing.
The SEBI reviewed several other past cases where
it was alleged that an intermediary did not carry
out its duties with due diligence. A review of such
decisions is useful to understand this concept better.
The Auditors of a listed company, apart from
of course carry out statutory audit, also carries out
limited review of financial results for disclosure. The
manner in which such limited review is carried out
can be considered by the SEBI.
“All the directors of the company
(including
independent directors) shall exercise their duties with
due and reasonable care, skill and diligence;”.
The implications of this decision thus is wide and
the principles laid down by the SAT will be useful
for intermediaries including merchant bankers,
chartered accountants and others associated with
The SEBI also expects a common and high standard
of diligence from intermediaries generally. Clause 1.3
of the Code of Conduct, which is part of the SEBI
(Intermediaries) Regulations, 2008, reads as under:-
“1.3 Exercise of Due Diligence and no Collusion
An
intermediary shall at all times render high standards
of service, exercise due skill and diligence over persons
employed or appointed by it, ensure proper care and
exercise independent professional judgment and shall
not at any time act in collusion with other intermediaries
in a manner that is detrimental to the investor(s).”
Further, while the SEBI (Intermediaries) Regulations
do provide for a common duty of due diligence by
intermediaries generally as stated above, individual
regulations too, provide make specific or general
requirements of performance of duties by the
respective intermediaries with due diligence. The
SEBI (Debenture Trustees) Regulations, for example,
require that the Trustees shall exercise due diligence
to ensure compliance of various laws, the Trust
Deed, etc.
The SEBI (SAST) Regulations 2011 require
that the manager to the open offer “shall exercise
diligence, care and professional judgment to ensure
compliance with these regulations”.
The Companies Act 2013 also provides in section
149(12) that an Independent Director, a non-executive
director or a key managerial personnel would be
held liable only “where he had not acted
diligently”.
Not carrying out his role with diligence would thus
subject him to severe adverse consequences under
the Act. Schedule IV of that Act further lays down
the Code for Independent Directors and a fairly
high standard of performance of duties is expected
from the Independent Directors. The explanation
of the duties in this decision of the SAT would be
of guidance.
Clause 49 of the Listing Agreement which lays
down requirements of corporate governance also prescribes duties of the directors in general and of
the Independent Directors and the members of the
Audit Committee in particular. Here too, though not
stated explicitly, similar standards may be applied.
Indeed, SEBI’s concept paper which proposes to
substantially expand the standards of corporate
governance specifically states as follows:-
“All the directors of the company (including independent directors) shall exercise their duties with due and reasonable care, skill and diligence;”. The implications of this decision thus is wide and the principles laid down by the SAT will be useful for intermediaries including merchant bankers, chartered accountants and others associated with listed companies.
