SEBI Decision in Reliance’s Case – Allegations Of Serious Violations Including Fraud & Price Manipulation

Background

SEBI
has passed an order holding Reliance Industries Limited (“Reliance”) and 12
other entities to have violated certain provisions of Securities Laws including
those relating to fraud and price manipulation. This finding has been recorded
in its order dated 24^th March 2017 (“the Order”), in respect of its
dealings in the shares/futures of Reliance Petroleum Limited (“RPL”). SEBI has
ordered that the profit of Rs. 447.27 crore from such transactions be disgorged
along with interest @ 12% per annum from 29^th November 2007 till the
date of payment. The events as laid down in the Order are complex and certain
interesting issues and concerns have been raised therein. Concepts like hedging
have been discussed and applied. The decision has relevance also to any case
where a large quantity of shares are purchased or sold.

This
article narrates the findings and assertions made in the SEBI order. Needless
to add, considering the reportedly proposed appeal against the Order, it is
possible that there may be developments in the near future.

The
facts as narrated in the said SEBI Order including its reasoning as also
certain further comments are given in the following paragraphs.

Context of the proposed dealings in shares of RPL

Reliance
was the holder of 75% of the equity share capital of RPL. Reliance needed to
raise monies for its large new projects. To part meet such needs, it had
decided at its Board Meeting held in March 2007 to sell about 5% shares (about
22.50 crore shares) in RPL. It is the manner in which the sales were carried
out that raised concerns and eventually, after being seized of the matter for
nearly 10 years, SEBI has passed this Order.

Method adopted for sale of the equity shares in RPL

It
can be expected that when a relatively large quantity of shares are to be sold
in the market, the price of the shares may fall in the interim. This may result
in the seller getting a lower price. According to Reliance, to help make up for
such potential loss in the cash market, it decided to hedge in the futures
market. Accordingly, it argued, it sold futures in the shares of RPL. However,
as will be seen later, this contention that trades in futures were for hedging
was rejected by SEBI. SEBI also held that the whole purpose of and manner of
carrying out the futures trades through certain agents was to profit through
price manipulation and fraud.

Client wise limits in futures

Relevant
provisions under circulars of SEBI/National Stock Exchange and other relevant
bye-laws/regulations prescribe limits of quantum of futures trade that a single
client could enter into. Such limits are intended for purposes of market
integrity, ensuring wider market, etc. It was found, however, as will be
seen later, that Reliance, with the help of agents/front entities, carried out
future trades far in excess of the prescribed limits.

Future trades with the help of 12 ‘front entities’

Reliance
entered into agreements with 12 entities (“the front entities”) who would enter
into futures trades for the benefit of Reliance. This meant that the
profits/losses on account of such trades would accrue to Reliance while the
front entities would earn commission. Each of the entities, except one, entered
into future trades that were slightly lower than the permissible limit per
client. In one case, where this limit was exceeded, the said entity was
penalised by the stock exchange.

The
futures trades that the front entities entered into were to expire on 29^th
November 2007. Accordingly, a party who had entered into such trades
could square off such trades on or before closing on 29^th November
2007. Alternatively, it could keep the trades as outstanding in which case they
would be compulsorily squared off at the weighted average price during the last
10 minutes of the closing day in the cash market.

The
front entities entered into future sale trades in the aggregate of 9.92 crore
shares. During this period, 1.95 crores of such trades were squared off leaving
a net of 7.97 crore of trades.

Sale in cash market

SEBI
recorded a finding that Reliance sold from 6^th November to 23^rd
November 2007 18.04 crore equity shares in the cash market. From 24^th
November 2007 to just before the last 10 minutes of trading of last day of
trading, it did not sell any shares. However, in the last 10 minutes of such
last trading day, it offered for sale 2.43 crore shares of RPL and actually was
able to sell 1.95 crore. SEBI alleged that this was done with an intent to
manipulate the price since heavy sales in the last 10 minutes would result in
reduction in price. This, as explained earlier, would affect the settlement
price for futures resulting in higher profit for Reliance.

Violation of client wise limits

The
first finding regarding violation of law was relating to effectively exceeding
of client limits. As seen earlier, the futures trades were carried out through
12 front entities. Each of such entities had entered into an agreement with
Reliance whereby the profits/losses of the futures would accrue to Reliance
while such front entities will earn commission. The quantity of trades of each
such entity, except one, was just below the client-wise limits as prescribed
under relevant circulars of the stock exchanges/SEBI and other regulations,
bye-laws, etc. SEBI held that this arrangement with such entities was
done to circumvent the prescribed limits.

Reliance
argued that the relevant provisions provided that each entity should be
considered separately for the purposes of calculating this limit and hence it
was not in violation of the circulars. SEBI however rejected this argument. It
held that it was Reliance who, through such agreements, was the entity that was
carrying out such trades and hence there was effectively only one party. It
also observed that all the front entities were represented by one single
individual who also happened to be an employee of a wholly owned subsidiary of
Reliance. Such person also placed orders in the cash market for the sales made
by Reliance. The trades were thus in violation of the limits. More importantly,
SEBI held that considering the large volumes of futures trades that had a high
percentage of market share, they were entered into “with the intention to
corner the F&O segment and were therefore fraudulent and manipulative in
nature”.

Finding by SEBI

SEBI
alleged that Reliance and the front entities had carried out manipulation and
fraud and thus was in violation of the relevant provisions of the SEBI Act and
Regulations. It also held that Reliance had violated the limits of client wise
trades and thus was in violation of the relevant circulars of the stock exchanges
thereby violating the provisions of the Securities Contracts (Regulation) Act,
1956.

Directions by SEBI

In
view of such finding of violation of laws, SEBI issued two directions which are
contained in its order.

Firstly,
it debarred Reliance and the 12 front entities from dealing in equity
derivatives directly or indirectly for a period of one year in the ‘Futures and
Options’ segment of stock exchanges. It, however, permitted them to square off
existing positions on the date of the Order.

Secondly,
it directed Reliance to disgorge the excess profits made out of the futures
trades in violation of law. For this purpose, the proportionate profits of the
futures trades over and above the permitted limit for one client were
calculated. Further, interest @ 12% per annum was required to be paid from the
date of earning of such profits till the date of payment. The profits thus
worked out to be Rs. 447.27 crore. To this, interest @ 12% per annum with
effect from 29^th November 2007 till the date of payment was to be
added.

Comments and conclusion

As
this article is being written, it has been reported that this Order will be
appealed against and Reliance has rejected such findings. Considering the
findings of fraud/manipulation are of a serious nature and considering also the
large amount, it is possible that the matter may even go for final decision to
the Supreme Court. The standards of proof required for serious allegations of
fraud/manipulation are high in law and it will be interesting to consider what
the appellate authorities have to say on the facts of this case and reasoning
applied by SEBI. This would add to the jurisprudence in Securities Laws through
the observations of the appellate authorities on the law.

The
decision is also interesting considering how SEBI has used data such as
quantity of futures/shares sold, the price at which trades took place
particularly relative to last traded price, the futures trades squared off and
generally how it made periodic comparison between the quantity of shares sold
in the cash market vs. the futures trades.

The
observations relating to hedging by SEBI are relevant too and considering that
it is an important defence offered, it is likely that there may be finding on
this issue by the appellate authorities. In passing, it may be observed that
such client-wise limits effectively defeat one of the objectives futures and
that being hedging.

The
present case was of a proposed sale of a large quantity of shares which
could have lowered the market price and hence the desire of hedging. A similar
situation can arise in case of proposed purchase of a large quantity
shares that may result in increase, at least in the short term, of the price of
the shares as quoted on stock exchanges. Such situations are dealt with in different
ways such as hedging or even warehousing where other parties are asked to
purchase shares that would eventually be transferred to the buyer. The present
order and its outcome would be of interest to such and other similar
transactions. Needless to say, it would be the facts of each case that would be
decisive. However, an element of wariness and proper planning would become
imperative by parties so as to avoid such action by SEBI.

In
the opinion of the author, there are some areas of concern in the Order. SEBI
has held that the fact that 12 front entities were used is a pointer of an
intent to manipulate/defraud. Whether this finding can be held to be
independently correct or has the benefit of hindsight of last 10 minutes of
heavy sales is, I submit, an area requiring more examination. Then there is the
fall in price in the last 10 minutes on account of the large sales in the cash
market. Even if it can be held that such fall was intended/manipulative,
whether the profits on account of only such fall can be treated as ill-gotten
profits? Or whether, as SEBI held, the whole of the profits on account of the
open futures trades should be held to be ill-gotten profits?