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Category: Securities Laws

Infrastructure Investment Trust (INVIT) – Emerging Asset Class

Infrastructure Investment Trusts (InvITs) are SEBI-regulated vehicles that pool capital to invest in operational infrastructure assets such as roads and power. They allow developers to monetize assets while providing investors with stable, periodic distributions; the regulations mandate the distributing at least 90% of net cash flows. As of March 2026, India has 28 registered InvITs, with assets under management projected to triple by 2030. Governance is ensured through strict leverage limits (70%), mandatory valuations, and unitholder rights. Despite rapid growth, InvITs face sector-specific risks and represent only ~1.5% of India’s GDP compared to mature global markets.

1. INTRODUCTION TO INVIT

Infrastructure Investment Trusts (“InvITs”) are investment vehicles established to facilitate investment in completed and revenue-generating infrastructure assets. Regulated under the SEBI (Infrastructure Investment Trusts) Regulations, 2014, InvITs enable the pooling of capital from institutional and retail investors for investment in infrastructure sectors such as roads, power transmission, renewable energy, telecom, pipelines, and logistics. They provide infrastructure developers with an efficient mechanism to monetize operational assets and recycle capital into new projects, while offering investors an opportunity to participate in long-term infrastructure assets that generate stable and periodic cash flows through distributions.

InvITs in India are broadly classified into publicly listed InvITs and privately listed InvITs. Publicly listed InvITs are listed on recognized stock exchanges and are accessible to both retail and institutional investors, thereby enhancing market participation and liquidity. In contrast, privately listed InvITs are primarily targeted at institutional investors and accredited investors through private placement.

As of 31st March 2026, the Indian InvIT ecosystem comprises 28 registered InvITs1 spanning diverse infrastructure sectors, including roads, power transmission, renewable energy, telecom infrastructure, pipelines, warehousing, and supply chain assets, reflecting the growing adoption of the InvIT structure across India’s infrastructure landscape. The growing diversification of underlying assets reflects the increasing adoption of the InvIT structure as a preferred vehicle for infrastructure financing and asset monetisation.

1Bharat InvIT Association (BIA) Primer, June 2026

2. INVIT STRUCTURE & CASHFLOW MECHANICS

In an InvIT, a party that originates the assets, the party that manages the portfolio, the party that operates the underlying projects, and the party that holds the assets on trust for the unitholders are required to be functionally different and, in the trustee, structurally separate.

A diagrammatic representation of an InvIT structure is set out below: –

Structure of InviTs

An infographic illustrating the flow of funds from the Unit holder to the SPV through the InvIT structure, and subsequent distribution back to the unitholders in the form of dividend, interest, and capital, is set out as follows:

Cash flow in Invits

3. KEY REGULATORY ARCHITECTURE

The SEBI (Infrastructure Investment Trusts) Regulations, 2014 (the “InvIT Regulations”), notified on 26th September 2014, were designed to facilitate the monetisation of operating infrastructure assets through a yield instrument vehicle. This framework enables institutional and retail investors to participate, thereby substantially reducing exposure to construction and promoter-related risk.

SEBI has been progressively aligned the regulatory framework governing InvIT with the disclosure, issuance and listing standards applicable to equity securities under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, while simultaneously lowering the thresholds that had earlier confined the instrument to a narrow institutional base.

InvITS

The InvIT Regulations have been amended repeatedly over the past two years and are supplemented by the Master Circular for InvITs, updated on 11th July 2025. Key highlights of InvIT regulatory framework include:

  • InvIT Corpus, Offer Size and Composition of Investor Base

A publicly offered InvIT requires a minimum asset value of ₹500 crore, a minimum offer size of ₹250 crore, a minimum public float of 25 per cent, and mandatory listing; The minimum application and trading lot is in the ₹10,000 to ₹15,000 range. Further, the maximum subscription by any investor, other than the sponsor(s), its related parties, and its associates, in initial offer shall not be more than 25 percent of the total unit capital. A privately placed InvIT requires a minimum of five and a maximum of one thousand investors.

  • Ticket Size

Recently, the minimum investment by any investor in a privately placed InvIT was reduced from ₹1 crore to ₹25 lakh, and the separate ₹25 crore minimum investment requirement that had applied where such an InvIT invested, or proposed to invest, not less than 80 per cent of the value of its assets in completed and revenue-generating assets was removed. The effect is to align the primary market allotment lot with the ₹25 lakh secondary market trading lot and to open the private channel to a considerably broader base of high net worth and family office capital.

  • Investment Restrictions

Investment is permitted only in infrastructure as defined in the Harmonised Master List of Infrastructure Sub-sectors issued by the Ministry of Finance, whether held directly or through holding companies and special purpose vehicles. Of this, not less than 80 per cent of the value of InvIT assets must be invested in completed and revenue generating projects. The residual permitted basket comprises under-construction projects, listed and unlisted debt of infrastructure companies; equity of listed companies deriving at least 80 per cent of their income from the infrastructure sector, as per the audited accounts of the previous financial year; government securities; money market instruments; liquid mutual funds and cash equivalents; and, pursuant to the recent amendment, also includes unlisted equity shares and liquid mutual fund schemes, etc.

  • Distribution Waterfall

Regulation 18(6) requires that not less than 90 per cent of Net Distributable Cash Flows (NDCF) be distributed at both the InvIT level and the holding company or SPV level, subject to the provisions of the Companies Act, 2013 or the Limited Liability Partnership Act, 2008 as applicable. Distributions are to be declared half-yearly for publicly offered InvITs and yearly for privately placed InvITs. Amendment and relaxations have been introduced wherein a holding company may now offset its negative net distributable cash flows against cash flows received from its SPVs where its own NDCF is negative, subject to adequate disclosure.

  • Leverage and its Monitoring

Aggregate consolidated borrowings and deferred payments, net of cash and cash equivalents, must not exceed 70 per cent of the value of InvIT assets. Borrowings above 25 per cent and up to 49 per cent require a credit rating and unitholder approval. Borrowings above 49 per cent only require credit rating of “AAA” or equivalent. The fund must be utilised only for the acquisition or development of an infrastructure project. In addition, the InvIT must have a track record of six consecutive distributions following listing and obtain unitholder approval. Investments in overnight mutual fund schemes are treated as cash and cash equivalents, and the aggregate of cash and cash equivalents is excluded when computing the value of assets for this purpose.

The Third Amendment introduced a risk-based overlap, wherein an InvIT whose borrowings exceed 49 per cent must undertake a valuation of its assets at the end of every quarter and submit both that valuation report and a quarterly report to the designated stock exchanges along with its quarterly financial results. If an InvIT exceeds this 49% limit, SEBI permits fresh borrowings, but restricts them strictly to capital expenditure for enhancement of assets, major maintenance for road projects, and refinancing of principal debt.

  • Valuation of Assets & Disclosure

Regulation 21 requires a full valuation at the end of each financial year, with the report submitted to the designated stock exchanges alongside the annual financial results. Half-yearly valuation reports accompany the quarterly financial results for the quarter ending 30th September, and valuation reports are to be submitted to the trustee simultaneously with their submission to the stock exchanges, within 15 days from receipt. Reporting timelines under Regulation 23 have been aligned with the financial results calendar. The quarterly report on the activities of the InvIT is now due within the period specified by SEBI for quarterly financial results.

  • Governance Norms & Control by Unitholders

The audit architecture has been aligned to the norms applicable to listed companies. Regulation 22 confers on unitholders a set of rights, including annual meetings, approval rights over specified matters, and the right to remove the investment manager, the trustee, the auditor or the valuer. This signifies a major shift of control from the sponsor to the unitholder.

  • Mandatory Disclosure in offer documents

Schedule III of Regulations mandates comprehensive disclosures in every offer document or placement memorandum of an InvIT. It requires disclosure of the InvIT’s constitution and registration details; particulars of the sponsor, investment manager, project manager, trustee and other key parties, details of the investment strategy and underlying infrastructure assets, financial information, valuation methodology, borrowing arrangements, distribution policy, risk factors, related party transactions, taxation; legal and regulatory matters; governance framework; litigation; and sector-specific information necessary for an informed investment decision.

In addition, the Schedule mandates that the offer document be supported by specified documents, including the full valuation report, auditors’ report, project implementation or project management agreement, due diligence certificate of the lead merchant banker, in-principle approval from the recognised stock exchange(s), and such other material reports. Collectively, these mandatory disclosures and supporting documents establish a robust disclosure framework designed to promote transparency, facilitate regulatory oversight and protect investor interests.

The reduction in the private placement ticket, the recalibration of the public float definition, the alignment of reporting calendars, and the shift to risk-based valuation for leveraged structures have been accompanied by tighter and more frequent disclosure requirements.

4. RISKS INVOLVED IN INVIT

Infrastructure Investment Trusts (InvITs) are often presented as stable, yield-generating investment vehicles backed by operational infrastructure assets. However, their apparent stability should not obscure the complex risk architecture embedded within the structure. While the underlying infrastructure assets may generate relatively predictable cash flows, the ability of those cash flows to reach investors depends upon a series of contractual, statutory and operational mechanisms, each of which introduces its own layer of uncertainty. Consequently, an assessment of InvITs requires a holistic examination of asset-level risks, cash flow risks and structural risks inherent in the trust framework.

Equally significant is the fact that many of the principal risks affecting InvITs are not readily diversifiable. Sector-specific risks—such as fluctuations in traffic volumes for toll roads, payment delays by power distribution companies, or tenant concentration in logistics parks—may vary across different asset classes. However, risks arising from leverage limits, evolving regulatory requirements, governance constraints, distribution mechanisms, and valuation practices are common across the InvIT ecosystem.

5. INVIT OUTLOOK – GLOBAL & INDIA

Globally, InvITs (commonly referred to as REITs in several jurisdictions) have evolved into a mature asset class, with over 1,000 listed REITs/InvITs spread across more than forty countries and an aggregate market capitalization of approximately USD 2 trillion2. Compared to mature markets such as the United States, Australia, Singapore and Japan, India’s InvIT market remains at a relatively early stage of development, despite recording strong growth since the framework was introduced in 2014 and the first listings in 2017.

India vs the World: The Gap3

Country REIT and InvIT Market as % of GDP
United States ~12%
Australia ~8–10%
Singapore ~7–9%
Japan ~5–7%
India ~1.5%

While the Indian market has expanded rapidly in terms of assets under management and the number of InvITs, it continues to face certain structural challenges, including

  •  relatively lower retail participation,
  •  limited secondary market liquidity,
  •  a narrower pool of infrastructure assets concentrated primarily in roads and power transmission; and
  • a comparatively smaller institutional investor base.

Continued regulatory reforms, broadening of eligible asset classes, enhanced market liquidity, and greater participation from domestic institutional and retail investors are expected to bridge these gaps and further strengthen India’s position in the global InvIT market.

A notable recent development addressing the liquidity constraints of InvITs is SEBI’s streamlined framework for the conversion of privately placed listed InvITs into publicly offered InvITs. The August 2025 amendments removed conversion-specific sponsor lock-in requirements and aligned the conversion process with the regulatory framework applicable to follow-on public offers, thereby reducing procedural barriers for mature private InvITs seeking access to public markets. Cube Highways Trust is the first InvIT to utilise this framework, having received unitholder approval, filed its offer documents with SEBI, and launched its public offer. This may provide a viable pathway for improving liquidity and expanding institutional participation in the InvIT market without requiring fresh capital to be raised by the trust.

Further, Mutual Funds have also recognised the importance of InvIT as a significant inclusion to their multiasset portfolio & hybrid schemes in order to diversify the investments while providing a relatively stable income stream, thereby also ensuring long term portfolio stability. This move will also contribute to broadening the institutional investor base.

India’s InvIT market is expected to witness a three-fold growth, supported by the Government’s infrastructure development agenda and asset monetisation initiatives. With assets under management of approximately INR 7.1 lakh crore as on 31 March 2026, the industry is projected to expand to nearly INR 21 lakh crore by 2030.

2 https://www.niftytrader.in/markets/reit-invit-aum-20-trillion-sebi-reforms/

3 https://www.niftytrader.in/markets/reit-invit-aum-20-trillion-sebi-reforms/

6. INVIT IN INTEREST OF STAKEHOLDERS

The InvIT market has witnessed increasing investor confidence, reflected in rising assets under management, cumulative distributions exceeding ₹91,000 crore, and a steadily expanding investor base. During FY26 alone, nearly 2 lakh new unitholders joined the InvIT ecosystem, taking the total investor base to approximately 5.58 lakh unitholders, indicating growing retail participation alongside continued institutional interest.4

Supported by stable cash flows from operational infrastructure assets, predictable distribution mechanisms, and a transparent regulatory framework, InvITs are increasingly being recognised by its stakeholders as an opportunity for:

  •  participation in long term financing for existing infrastructure projects;
  •  freeing-up developer capital for investing in new infrastructure projects;
  •  low- risk investments that attract long term investors such as endowment and pension funds’
  •  facilitation ownership of diversified infrastructure assets by retail investors; and
  •  implementation higher standards of governance in infrastructure development & management

InvIT, as a structure, have opened up an opportunity for individual participation in infrastructure investments as an asset class by establishing a regulated, professionally-managed structure while ensuring liquidity, stable income from investments, and diversification of overall investment risk.

4 https://www.business-standard.com/finance/investment/invits-cumulative-distribution-since-inception-reaches-91-000-cr-report-126061601308_1.html

Outsourcing Directives For SEBI Regulated Intermediaries – Delegation V/S Accountability

SEBI’s 2011 guidelines regulate outsourcing to ensure investor protection and regulatory accountability.

  • While intermediaries may outsource ancillary tasks like technology support, “core” functions—including investment decisions, compliance, and risk profiling—must remain under their direct control
  • SEBI adopts a “substance-over-form” approach, intervening when third parties effectively assume regulated roles regardless of their formal titles
  • Recent enforcement orders demonstrate that accountability cannot be delegated; intermediaries must maintain effective oversight and remain fully liable for the acts and omissions of all service providers.

INTRODUCTION

Over a period of time, advances in technology, increasing regulatory complexity and the need for operational efficiency have led many SEBI regulated intermediaries to engage third-party service providers for a variety of support functions. While outsourcing can improve efficiency, scalability and cost effectiveness, it also raises concerns regarding investor protection, accountability, confidentiality, operational resilience and regulatory oversight.

Recognizing these concerns, the Securities and Exchange Board of India (“SEBI”) issued Circular No. CIR/MIRSD/24/2011 dated 15th December 2011 titled Guidelines on Outsourcing of Activities by Intermediaries (“Outsourcing Guidelines”). The Circular applies to all SEBI-registered intermediaries, including stock brokers, merchant bankers, portfolio managers, investment advisers, research analysts, mutual funds, depository participants, registrars and transfer agents, debenture trustees, custodians and other regulated entities. The principles enshrined in these guidelines extend to person’s (within or outside the group) who perform activities on behalf of the regulated intermediaries.

WHY REGULATE OUTSOURCING?

The Outsourcing Guidelines are substantially based on principles developed by the International Organization of Securities Commissions (“IOSCO”) for mitigating various risks associated with outsourcing which may be operational risk, reputational risk, legal risk, country risk, strategic risk, exit strategy risk, counter party risk, concentration and systemic risk. It also reflects SEBI’s broader regulatory objective of ensuring that investors continue to deal with regulated entities that remain responsible for the services provided.

If regulated intermediaries are permitted to outsource core functions without adequate oversight, a situation may arise where the licensed entity merely acts as a conduit while actual regulated activities are carried out by outsourced third parties. Such arrangements may undermine investor protection, dilute accountability and impair regulatory supervision.

Accordingly, the Circular seeks to ensure that:

  • Regulatory accountability remains with the registered intermediary;
  • Investors continue to receive services from regulated entities;
  • “Core” business activities are not outsourced to third persons;
  • SEBI’s supervisory and inspection powers remain unaffected; and
  • Intermediaries retain effective control over outsourced functions.

The central principle emerging from the Circular/Guidelines is that outsourcing should facilitate business operations, not substitute the intermediary’s regulated role.

SEBI has provided illustrative examples of activities considered core in nature:

Intermediary “Core” Activities
Stock Broker Execution of orders and monitoring of client trading activities
Depository Participant Dematerialization of securities
Mutual Fund Investment related activities
Portfolio Manager Investment related activities
All Intermediaries Compliance functions

The list above is illustrative rather than exhaustive. Whether a function constitutes a core activity depends on the nature of the intermediary’s regulated business and the extent to which the intermediary continues to exercise independent judgment, supervision and control.

The Accountability Anchor

As a general principle, functions involving investment discretion, advisory judgment, regulatory compliance, investor protection obligations and fiduciary responsibilities shall not be outsourced.

While designing the outsourcing framework for any organization, it is pertinent to keep the following parameters in mind:

i. Activities which can be outsourced

ii. Activities which cannot be outsourced

iii. To Whom Activities can be outsourced

iv. Terms of Outsourcing

v. Responsibilities & Obligations of the intermediary and third party in respect of outsourced activity towards client, regulator & market

BUILDING AN EFFECTIVE OUTSOURCING FRAMEWORK

The Outsourcing Guidelines require intermediaries to establish a comprehensive framework for managing outsourcing arrangements. The responsibility for such framework rests with the Board of Directors, partners or equivalent governing body of the intermediary.

The Key Constituents that should be kept in mind at the time of designing an Outsourcing Framework are as under:

1. Outsourcing Policy- Determining the activities that can be outsourced and are prohibited and its Governance and Monitoring arrangements

2. Risk Assessment – Effective Risk Assessment procedures should be carried out to address outsourcing risks and relationships with third party.’

3. Appropriate Due Diligence of Service Providers including evaluation of it’s: –

  • Financial strength;
  • Technical competence;
  • Experience and expertise;
  • Compliance track record;
  • Infrastructure capabilities;
  • Data protection standards; and
  • Business continuity arrangements.

4. Tightening of Contractual Obligations in Outsourcing Agreements

5. Ongoing Monitoring of Outsourced Services and Providers

6. Confidentiality and Data Protection

7. Business Continuity Planning Measures in case of Default of Service providers

8. Outsourcing within the Group wherein Shared Resources cannot overtake the responsibility of core functions and Implementation of Chinese Wall measures to ensure transactions are undertaken at arm’s length without compromising accountability.

The Circular permits intermediaries to outsource support and ancillary functions — for example, technology infrastructure maintenance, legal support and similar services that do not constitute core business activities. The line is crossed when external parties begin to participate in, generate, or drive core business activities. Therefore, it’s quintessential to have an outsourcing framework which by design does not defeat its core purpose and is also implementable in its true spirit. The situation should not arise whereby the market has only third parties to provide intermediation services while the registered intermediaries confine themselves to earning income.

ENFORECEMENT ORDERS

Although there are relatively few reported cases involving standalone violations of the Outsourcing Guidelines, SEBI has repeatedly relied upon the principles underlying the Circular
while examining whether intermediaries have impermissibly delegated core regulated functions to third parties.

A recent SEBI Final Order QJA/MN/IMD/IMD-SEC-4/32418/2026-27, dated May 26, 2026, (the “Order”), in the case of First Global Finance illustrates how these principles apply in practice. A SEBI-registered portfolio manager (the “Portfolio Manager”) had engaged in a technology consulting agreement with a third-party vendor. SEBI conducted an on-site inspection and a forensic audit covering a period of approximately two and a half years.

  • The findings revealed that the arrangement was, in substance, an outsourcing of core investment-related activities, wherein specific buy/sell allocations were generated by algo systems and transmitted for execution and personnel of the outsourced entity were involved in execution related communications & instructions.
  • Further, the compensation structures to the outsourced entity related to investment function and overall operational arrangement demonstrated substantial involvement in investment related activitiesOther multiple activities which corroborated and substantiated the role of technology consultant, detailed as under, had very well exceeded and surpassed his core responsibilities and his compensation structures were not commensurate to the title of services carried.
  • Governance documents i.e. the Board Resolutions did not separately identify the role of a consultant and was included to form a part of Investment Committee to take all investment related decisions. Distinguishing between technical invitees and core decision making members shall be made at the time of composition of committee and while circulating a Board Resolution and imposing a contemporaneous limitation reflecting such restricted role.
  • Participating, rendering an opinion and concurrence of collective decision making in substance cannot be viewed as originating separately and exclusively from a technical consultation, wherein the technology consultant was given authority and power to participate in decision making function of Investments.
  • The expression “investment decision” is broader than model portfolio approval and extends to all multiple inter-related determinants which involve governing actual deployment of client fund.
  • Sharing of performance linked fees is a clear indication that the outsourcing entity was contributing, participating or influencing the investment process which generated performance and can in no way be classified as fees for maintaining technological infrastructure.

Outsourcing cannot be examined in compartmentalized or an isolated manner but is a collation of multiple activities put together and the underlying intention to perform the activity.

It was further observed, in the matter of M/s AFCO Capital India Private Limited (QJA/SS/CFD/CFD-SEC-5/32324/2025-26) vide order dated 30 March 2026, a person who was not an employee of the company was assigned the responsibility to authorize and operate activities for the purpose of open offer. A serious compliance breach was identified as the merchant bankers desirous of outsourcing their activities shall not, however, outsource their core business activities and compliance functions. In the said case, outsourcing of core activities have been compromised, thereby dampening the core principle of outsourcing.

SEBI’s order the matter of Bharosa Technoserve Ltd (Order/AN/SM/2024-25/30748-30751) dated 11 September 2024 was explicitly clear that the core function of Risk Profiling & Suitability Assessment of clients was not carried out by the Investment Advisor and was outsourced to a technology platform provider and the client had access to investment advice without their intervention, which was in all practical sense violating the intent of the law.

Taken together, these cases demonstrate that, SEBI does not object to outsourcing per se. Rather, SEBI intervenes where the outsourced arrangement effectively transfers investment discretion, advisory judgment, merchant banking functions, compliance responsibilities or investor-facing regulated activities to third parties.

The enforcement actions reviewed above demonstrate that SEBI adopts a substance-over-form approach and focuses on whether a third party has effectively assumed functions that are expected to be performed by the regulated intermediary itself.

KEY TAKEAWAYS – PHILOSOPHY OF OUTSOURCING

A review of the Outsourcing Guidelines and enforcement actions indicates the following principles:

(a) Substance Prevails Over Form

SEBI examines the actual role performed by a third party and not merely the terminology used in agreements. A service provider described as a consultant, advisor, technology provider or support vendor may nevertheless be regarded as performing a regulated activity if it effectively influences or undertakes the relevant function.
(b) Investment Decisions Must Remain with the Registered Entity
Investment discretion, portfolio construction, security selection and investment recommendations are regarded as core functions that must remain with the regulated intermediary.
(c) Compliance Functions Cannot Be Outsourced
Responsibility for regulatory compliance remains with the intermediary irrespective of any outsourcing arrangement.
(d) Accountability Cannot Be Delegated
While operational activities may be outsourced, accountability for those activities cannot be transferred to a service provider.
(e) Effective Control Must Be Retained
The intermediary must continue to exercise independent judgment, supervision and oversight over all outsourced activities.
The intention of the directive is to distinguish between operational support functions and core regulated activities. While administrative, technological and ancillary support services may be outsourced subject to adequate safeguards; investment discretion, compliance functions, investor-facing regulated activities and other core business functions must remain under the direct control of the registered intermediary. Further, for functions outsourced, the arrangement shall not affect the rights of investors against the entity and the entity remains fully liable for omissions and acts of the third party.
“It is not what we do, but also what we do not do, for which we are accountable” – Molière

Corporate Governance: Overview and Challenges

Corporate governance in India has evolved from promoter-driven roots to a robust framework under the Companies Act 2013 and SEBI LODR 2015. This system mandates diverse board committees to oversee financial integrity and risks. However, a core challenge remains achieving “governance in substance” over mere procedural compliance. Boards currently grapple with information asymmetry, complex related party transactions, and emerging technological risks like AI. Ultimately, effective governance transcends checklists; it requires a culture of integrity, ethical accountability, and a reflective mindset to protect all stakeholders.

Introduction

Way back in the 17th century, with the emergence of joint-stock companies such as the Dutch East India Company, the foundations of modern corporate governance began to take shape. The concept of separating ownership from management introduced a need for accountability in business operations. Corporations grew in size and influence over the centuries, particularly after the industrial and economic expansion of the 20th century. This raised concerns regarding misuse of managerial powers, shareholder protection and ethical conduct, which led to the evolution of structured governance mechanisms across jurisdictions. Corporate scandals involving Enron, Lehman Brothers and Satyam Computer Services further highlighted the importance of strong governance practices and became major triggers for regulatory reforms.

The concept of corporate governance covers a set of rules, procedures and operational structures that guide the short-term and long-term action of companies. While safeguarding the interests of shareholders as well as all other stakeholders connected with the organization. Effective corporate governance not only strengthens investor confidence but also promotes sustainable growth and responsible corporate conduct.

This article gives an insight into various dynamics and challenges faced during the process of effective integration and implementation of corporate governance in an organization

The-Spirit-of-the-law

Evolution of Corporate Governance in India

The evolution of corporate governance in India has been shaped by economic reforms, regulatory developments and corporate frauds. Traditionally, Indian businesses were promoter-driven and family-controlled, except few large group’s others were not fully equipped to focus on minority shareholder protection, transparency and accountability. However, economic liberalization in 1991 and integration with global markets increased the need for stronger standards of governance.

Corporate governance reforms in India began with the introduction of the Desirable Code of Corporate Governance by the Confederation of Indian Industry (CII) in 1998. Thereafter, corporate scandals highlighted serious governance failures and led to major regulatory reforms. The Kumar Mangalam Birla Committee (1999), The Naresh Chandra Committee (2002) and Narayana Murthy Committee (2003) strengthened governance standards relating to auditor independence, financial disclosures, audit committees and shareholder rights.

A significant shift took place with the enactment of the Companies Act, 2013 coupled with changes in listing requirements. The introduction of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“SEBI LODR Regulations”), further strengthened governance standards for listed entities.

Legal Framework of Corporate Governance in India

The SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 prescribe corporate governance requirements for listed entities relating to shareholder rights, protection of minority shareholders, timely disclosures, dissemination of material information and grievance redressal mechanisms. The Regulations further prescribe requirements relating to board composition, including appointment of independent directors and woman directors, maximum limits on number of directorship’s, board meetings and performance evaluation of directors.

The Regulations also mandate constitution of various board committees and prescribe their functions and responsibilities. The Audit Committee is required to oversee financial statements, internal financial controls, statutory and internal audits, related party transactions, vigil mechanism and utilization of funds. The Nomination and Remuneration Committee is responsible for appointment and evaluation of directors and senior management, remuneration policy and board diversity. The Stakeholders Relationship Committee is responsible for resolution of shareholder and investor grievances. The Risk Management Committee is required to establish the risk management framework, identify, monitor and mitigate various risks including operational, financial, cybersecurity, business, regulatory, compliance etc. The role of risk management committee is becoming more onerous in today’s times where business environment is becoming more dynamic and getting complex.

The SEBI LODR Regulations further prescribe approval and disclosure requirements relating to related party transactions, oversight obligations relating to material subsidiaries and duties and obligations of independent directors, including separate meetings and familiarization programmes. Listed entities are also required to submit periodic corporate governance compliance reports to stock exchanges and make disclosures relating to Business Responsibility and Sustainability Reporting (BRSR), ESG risks and sustainability-related matters in annual reports.

Related party transactions remain as one of the most closely scrutinized areas under the corporate governance framework. This framework prescribes approval, disclosure and oversight requirements for related party transactions and has significantly expanded the scope of “related party” and “related party transaction” to include direct and indirect benefit arrangements involving listed entities and their subsidiaries. The framework also requires approval mechanisms through the Audit Committee and shareholders, enhanced disclosure obligations and monitoring of material related party transactions.

The regulatory framework further requires Audit Committees and Boards to monitor conflicts of interest, misuse of corporate assets and approval of related party transaction. However, practical challenges continue to arise in identifying beneficial interests, tracing indirect relationships and determining whether transactions are undertaken for the benefit of related parties through layered structures, subsidiaries or connected entities. Operational challenges also arise in determining arm’s length pricing, assessing ordinary course of business criteria, maintaining adequate documentation and ensuring timely disclosures across large corporate groups with complex structures and multiple subsidiaries. The committee members and the Board of Directors have to play a very critical role in identifying related parties, justification of transactions, deciding arm’s length pricing, approval and review process and relevant disclosures.

Corporate Governance – Not mere Compliances

“Governance is an act, which should be voluntary adopted, once codified takes the character of Compliances”

A) Governance beyond checklist-based approach

Corporate governance has gradually evolved beyond a disclosure and compliance-driven framework towards a broader system focused on accountability, ethical conduct and stakeholder protection. Merely constituting committees or complying with procedural requirements does not necessarily ensure effective governance. Recent governance discourse has increasingly distinguished between “compliance in form” and “governance in substance”, emphasizing that governance must operate in spirit and not merely through technical adherence to regulations. Governance must actually be done in addition to merely appearing to have been done. Concerns have also been raised that excessive procedural compliance may at times lead to a tick box approach rather than meaningful oversight and responsible decision-making. The purpose of these regulations gets defeated when rules are followed and principles are compromised.

B) Effectiveness and Oversight Challenges

Board effectiveness and quality of oversight have emerged as central governance concerns in recent years. Governance studies and boardroom discussions have highlighted issues such as passive boards, information asymmetry between management and directors and overdependence on promoter-driven decision-making. The role of the board is moving from the oversight function to the executory functions and line of demarcation is getting blurred. The increasing expansion of board responsibilities relating to ESG, cybersecurity, risk management, related party transactions and technology oversight has significantly increased governance and oversight expectations from directors.

C) Independent Directors and Board Challenges

Recent institutional governance surveys and boardroom discussions have reflected increasing challenges relating to the role of Directors in India. The “Survey on Corporate Governance – 6th Edition” (by excellence enablers) observed concerns relating to concentration of committee memberships, long tenures of directors and increasing governance responsibilities placed upon boards and audit committees. The Survey further noted that the average age of independent directors in India remained above 63 years during FY 2025, while boards are increasingly expected to oversee evolving areas such as artificial intelligence, cybersecurity, ESG, data governance and technology-driven risks. Recent reports have also indicated that resignations of independent directors from listed companies rose significantly during FY 2026, reflecting increasing governance pressures and board-level accountability concerns.

The effectiveness of independent directors is often impacted by limited access to complete information, insufficient time for detailed review of board agendas and increasing complexity of business operations. The key is whether the right question was being asked in the meeting, whether everyone participated in the discussion or not, whether accurate and complete data were available for taking decision and whether they were recorded properly.

Governance discussions have also highlighted concerns regarding concentration of board positions within limited professional and promoter networks and limited availability of directors possessing specialized expertise in areas such as finance, technology, law, sustainability and risk management. These challenges have increasingly raised concerns regarding board diversity, technological understanding and timely identification of governance red flags in complex and technology-driven corporate environments.

Emerging Governance Risks – Technology

Companies are increasingly dependent on technology-driven operations, data analytics and AI-based systems for business decisions, customer interaction, financial processes and compliance functions. Governance discussions have also highlighted concerns regarding inadequate board-level oversight of technology risks. In several instances globally, governance failures have arisen due to weak cybersecurity controls, inaccurate technology disclosures, overreliance on automated systems and lack of understanding of digital and AI-related risks at the board level. The increasing use of fintech platforms, digital payment systems, cross-border data transfers and third-party technology vendors has further expanded operational and regulatory risks for companies. These risks are further aggravated where members of the board lack adequate technological understanding and are unable to effectively keep pace with rapidly evolving digital and AI-driven business environments.

Conclusion

The true foundation of corporate governance lies in the integrity, ethical conduct and accountability on the part of management. Integrity, though a personal attribute, is a foremost quality that one has to possess, qualification, commitment, skill and capabilities come later. Honest disclosures, transparent decision-making, protection of shareholder interests and compliance with legal and regulatory obligations require a governance culture that operates not merely in form, but in spirit. Corporate governance also carries a broader responsibility towards investors, regulators, employees and society, as a whole, as companies operate not only for profitability but also as responsible contributors to economic growth and public trust. Corporate governance, therefore, cannot be measured merely through compliance frameworks and disclosures, but through the value systems and culture that drives each individual working for the organization. Good Governance comes from reflective mindset rather than reactive skill set.

Decoding Conflict Of Interest Situations In Securities Market – Regulated Intermediaries

Conflicts of interest in securities markets arise when professional positions are exploited for gain, manifesting as actual, potential, or perceived situations. SEBI regulations require intermediaries to establish systematic frameworks for identification, avoidance, and prevention. Identification involves recognizing misaligned incentives, while avoidance relies on Board oversight and disclosure. Prevention depends on structural safeguards such as “Chinese Walls,” role segregation, and ethical codes. Ultimately, maintaining market integrity requires a shift towards a principle-driven governance culture, where client interests are consistently prioritized over revenue-driven considerations to ensure long-term investor confidence.

DEFINING CONFLICT OF INTEREST

Conflicts of Interest may be defined in several ways, including any situation in which an individual or entity is in a position to exploit a professional or official role for personal or corporate benefit. This is a manifestation of the moral hazard problem, particularly in institutions operating in the financial sector (or related areas), that provide multiple services, where potentially competing interests may lead to concealment of information or dissemination of misleading information. A conflict of interest exists when a party to a transaction could potentially makes gain by taking actions that are detrimental to another party in the transaction.

It is important to recognise that any situation inherently presenting the possibility of a conflict can become problematic, if not effectively addressed. Conflicts may be classified as actual, potential, or perceived. An actual conflict exists when there is a direct and present clash of interest. A potential conflict may arise in the future based on existing circumstances. A perceived conflict exists when a situation appears to compromise fairness or independence, even if no actual conflict exists. In financial markets, perception materially impact trust and market integrity.

Managing Market integrity

REGULATORY CONTEXT

From a regulatory perspective, the relevance of a conflict lies not merely its existence, but whether it creates a material risk of adverse impact on client interests. Further, conflicts may arise both at an organizational level due to the design of business structures and at an individual level, owing to the nature of revenue models. These conflicts are often driven by personal incentives, relationships or access to information. This dual dimension makes conflict identification and management inherently complex.

The SEBI (Intermediaries) Regulations, 2008 lay down the overarching obligation on intermediaries to avoid conflicts of interest, make appropriate disclosures, and establish mechanisms to address such situations. These principles are further supplemented by specific regulations applicable to various intermediaries, which provide more detailed procedural guidelines.

Further, SEBI Circular CIR/MIRSD/5/2013 mandates intermediaries to formulate and implement a Conflict of Interest policy, requiring a structured approach to identification, management and disclosure of conflicts. In effect, this shifts the focus from ad-hoc disclosures to a more system driven framework embedded within organizational processes.

As noted above, based on the nature of activities, specific regulatory frameworks for each category of entity prescribe mechanisms to identify potential conflict of interest. These frameworks require entities to identify, avoid and mitigate such l conflicts, and to establish a code of conduct for both the regulated intermediary and its personnel.

FOR EXAMPLE,

  • SEBI (Prohibition of Insider Trading) Regulations, 2015 mandate the formulation of a Code of Conduct and a Code of Fair Disclosure, governing information handling and trading restrictions to prevent conflicts arising from Unpublished Price Sensitive Information (UPSI).
  • SEBI (LODR) Regulations, 2015 address conflicts of interest through governance frameworks and disclosure mechanisms applicable to listed entities.
  • SEBI (Merchant Bankers) Regulations, 1992 manage conflicts through requirements relating to independence in issue management and rigorous due diligence obligations.
  • SEBI (AIF) Regulations, 2012 require disclosure of conflicts in the placement memorandum and mandate fair treatment of all investors.
  • SEBI (Investment Advisers) Regulations, 2013 require advisers to identify and disclose conflicts while acting in a fiduciary capacity.
  • SEBI (Portfolio Managers) Regulations, 2020 mandate fair and equitable treatment across clients in investment decisions and trade allocation.
  • SEBI (Mutual Funds) Regulations, 2026 impose a fiduciary duty on asset management companies and trustees to act in the best interests of unitholders.
  • SEBI (Research Analysts) Regulations, 2014 address conflicts of interest through detailed disclosure requirements and restrictions on analyst conduct.
  • SEBI (Stock Brokers) Regulations, 2026 require segregation between proprietary and client trades to prevent misuse of client orders.

Collectively, this regulatory framework emphasises the need for intermediaries to adopt robust internal policies and systems for the identification, management and disclosure of conflicts of interest.

IDENTIFICATION, AVOIDANCE & PREVENTION

Conflicts can arise due to organizational structures as well as individual conduct. A conflict-of-interest policy provides a framework for managing such situations, with the objective of ensuring fair outcomes for clients and maintaining market integrity.

In practice, conflict management operates across three pillars—

(i) Identification of conflicts,

(ii)  Avoidance of conflicts, and

(iii) Prevention of conflicts.

IDENTIFICATION OF CONFLICTS

Effective conflict management begins with systematic identification. Intermediaries must recognize situations where their interests, or those of their employees, diverge from client interests, or where incentives may influence objectivity.

During the process of identifying conflict of interest situation, an entity should take into account the following indicative scenarios where the entity, an employee, or a relevant person:

  • Is likely to make financial gain, or avoid a financial loss, at the expense of the client
  • Has an interest in the outcome of a service provided to the client, or of a transaction carried out on behalf of the client, which is distinct from the client’s interest in that outcome;
  • Has a financial or other incentive to favour the interest of one client over another
  • Receives from a person other than the client an inducement in relation to a service provided to client, in the form of money, gifts, goods or services, other than the standard commission or fee for that service;
  • Has Access to confidential information and/or derives third-party benefits;
  • Has professional or personal associations or relationships with other organizations;

Adequate records should be maintained of services and activities where a conflict of interest has been identified.

AVOIDANCE OF CONFLICTS

Avoidance represents the first line of defence in conflict management. It involves structuring activities and decision-making processes in a manner that prevents conflicts from arising or reduces their likelihood.

In operational terms, this requires a clearly defined governance and escalation framework. Identified conflicts must be promptly reported to the compliance function and, depending on their materiality, escalated to senior management or the Board of Directors for review. This ensures that conflict resolution is not left to individual discretion but is subject to institutional oversight.

However, avoiding a conflict of interest may not always be possible or practical. In such cases, the following measures may be adopted:

  • The conflict of interest should be disclosed to the Board of Directors;
  • All Conflicted Transaction must be reviewed and approved by Board of Directors;
  • The Interested Party should not participate in any decision relating to such Conflicted Transaction;
  •  The Interested Party should not participate in any decision relating to such Conflicted Transaction;
  • Disclosure should be made to clients regarding possible source or areas of conflict of interest (e.g., disclosures in the Private Placement Memorandum for AIFs or Disclosure Document for Portfolio Manager Services);
  • Appropriate measures should be taken to avoid or mitigate the conflicts;
  • Any actual or potential conflict should be reported to a responsible authority, such as the relevant management team, department head, or key managerial personnel;
  • Where conflicts cannot be adequately managed, or where existing measures do not sufficiently protect Client interests, the conflict should be disclosed to enable the client to make a informed decision on whether to continue the relationship.

PREVENTION OF CONFLICTS

Prevention focuses on reducing the structural likelihood of conflicts. Unlike avoidance, which deals with identified situations, prevention is forward looking and embedded within organizational design.

A principles based approach is central to effective prevention. This includes maintaining high standards of integrity, ensuring fair treatment to clients, and aligning business practices with client suitability. Equally important are structural safeguards such as information barriers between functions, neutrality in incentive structures, and clear segregation of roles.’

The objective is not to eliminate conflicts which is neither practical nor necessary but to minimize situations where conflicting incentives arise in the first place.

INTERNAL CONTROLS FOR MANAGING AND MITIGATING CONFLICTS

Once identified, conflicts should be managed through appropriate controls, with transparency and timely disclosure forming the foundation. Clients must be adequately informed to enable informed decision making. Structural safeguards such as Chinese Walls and segregation of roles should be implemented to restrict the flow of sensitive information across functions. These information barriers may extend to separation of personnel, reporting lines, systems and documentation to ensure that confidential information is accessed only on a need to know basis.

A robust compliance framework plays a central role in monitoring and managing conflicts. This includes periodic review of conflict situations, enforcement of confidentiality obligations, and maintenance of secure records for effective oversight. Employees should be governed by a strong code of conduct covering personal trading, handling of inside information and disclosure requirements, supported by regular training and surveillance systems to detect unusual activities. Incentive structures should also be aligned to ensure that client interests are not compromised by revenue driven considerations.

In practice, conflicts manifest in various forms such as biased research, front running, mis-selling or preferential allocation. These risks can be mitigated through targeted controls including functional independence, pre-approval mechanisms, suitability assessments and transparent allocation policies. Ultimately, continuous review of systems and controls is essential to ensure that conflict management frameworks remain effective and responsive to evolving risks.

A FUTURE INSIGHT IN ADDRESSING CONFLICT OF INTEREST

As discussed above, management of conflict of interest also requires strong governance and clear accountability. Senior management must take responsibility for establishing a culture of transparency and ethical conduct. They must ensure that policies are not merely documented but are effectively implemented.

With increasing digitalization, one can expect the development of centralised oversight systems that go beyond traditional monitoring and actively manage conflicts of interest. Such frameworks could create a structured environment where roles, responsibilities and transactions across intermediaries are mapped and aligned within a unified system.

This would assist in identifying overlaps in duties—for instance, where the same entity or individual is involved in multiple functions like advisory, execution, or research, which may give rise to conflicts. The system could automatically flag such overlaps and enforce controls, such as restricting certain actions, requiring approvals or triggering disclosures. Instead of merely flagging suspicious transactions, such systems would focus on preventing conflicts at a structural level by ensuring that incompatible roles are identified and managed in advance.

In conclusion, conflicts of interest are an inherent part of business activities; however, the manner in which they are managed is critical. Poor handling of conflicts can undermine market fairness, distort price discovery, and erode investor confidence. Intermediaries must consistently priorities clients and investors interests and uphold trust.

This approach not only ensures compliance with SEBI regulations but also supports long term stability and confidence in the securities market. The time has come for organizations to transition from a rule-based compliance mindset to a principle-driven governance culture. Companies must ensure, both in letter and spirit, that conflicts of interest are addressed not merely through policies, but through ethical conduct embedded across all levels of the organization.

Structural Shift In Merchant Banking Regulations – Aligning With Maturing Capital Markets

The SEBI (Merchant Bankers) (Amendment) Regulations, 2025, modernize India’s capital markets by replacing the 1992 framework. Key reforms include a tiered categorization (Category I and II) with significantly higher net worth requirements, reaching ₹50 crore for Category I by 2028. A new liquid net worth mandate and a cap on underwriting commitments (20x liquid net worth) mitigate systemic risk. To ensure active participation, minimum revenue thresholds are introduced. Furthermore, non-core activities must be managed through Separate Business Units (SBUs), shifting oversight toward substance-based supervision.

I. INTRODUCTION

Merchant bankers occupy a pivotal and institutionally sensitive position within the architecture of the modern capital market and function as the principal intermediaries and gatekeepers between issuers seeking access to capital and investors deploying risk capital.

In the Indian context, merchant bankers have historically played a foundational role in the development and expansion of the country’s primary securities market. The Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992 (“erstwhile Regulations”), were formulated at a time when India’s equity markets were still in their formative phase. Issue sizes were relatively small, institutional participation was limited, and regulatory priorities were centred on market creation rather than systemic risk containment.

As we deep dive into the Indian Market Scenario in the last few decades, the scale, pace, and complexity of India’s capital markets today bear little resemblance to the conditions that prevailed when the 1992 regulatory framework was introduced.

There are more than 230 registered merchant bankers; however, only a smaller set of Book Running Lead Managers are actively managing Initial Public Offerings (IPOs). The companies planning IPOs in the upcoming Year 2026 number more than 190, of which 84 have received SEBI approval and 108 are awaiting approval. This shall set a new fundraising potential to more than ₹2.5 Lakh Crore from more than 190 issuers1.

Further, there has been a steep rise in the Draft Red Herring Prospectus (DRHP) Filings, with 19 startups and more than 24 companies preparing IPO documentation. In the month of February 2026 alone;

DRHP’s filed on SME Exchanges – 6 companies

DRHP filed on Mainboard – 2 Companies

SME IPO Listings – 14 Companies

Mainboard IPO Listings -3 Companies2.

The sharp increase in public issue sizes, the rapid expansion of the SME IPO segment and heightened retail investor participation have explicitly highlighted the limitations of the erstwhile Regulations. Acknowledging this structural disconnect, the Securities and Exchange Board of India, through the Securities and Exchange Board of India (Merchant Bankers) (Amendment) Regulations, 2025 (‘’Amended Regulations’’), has undertaken the first comprehensive amendment of the merchant banking framework in over three decades.

1 https://timesofindia.indiatimes.com/business/india-business/ipo-market-2026-

over-190-companies-line-up-for-debut-over-rs-2-5-lakh-crore-fundraisingtargetted/

articleshow/126172612.cms

2 https://www.ipoplatform.com

II. REGULATORY RATIONALE FOR REFORM:

The capital adequacy framework under the Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992, anchored to a uniform net worth requirement for merchant bankers of ₹five crore, had ceased to be proportionate to the scale and complexity of contemporary capital market transactions, thereby requiring increasing minimum net worth requirements in a phased manner from ₹25 Crores in 2027 to ₹50 Crores in 2028 for existing Category I regulated intermediaries, i.e. merchant bankers.

Effective from January 1, 2026, these amendments reflect a clear shift towards a prudential, risk-focused, and activity-based regulatory approach, aimed at strengthening market integrity while aligning Indian standards with evolving international regulatory benchmarks.

This regulatory transition was preceded by a structured consultative process initiated through SEBI’s consultation paper issued in August 2024, which systematically identified key gaps in the existing regime, including inadequate capital thresholds, an open-ended scope of activities, underwriting risk concentration, and the persistence of dormant registrations. This process underscores SEBI’s move towards evidence-based and participatory rulemaking in the regulation of market intermediaries.

III. KEY AMENDMENTS:

a) Capital Re Architecture: Tiered Categorisation and the advent of Liquid Net Worth

The Securities and Exchange Board of India (Merchant Bankers) (Amendment) Regulations, 2025, introduce a tiered classification of merchant bankers, creating Category I and Category II intermediaries. Category I merchant bankers are authorised to undertake all permitted activities under Regulation 13A of the Amended Regulations, including lead management of main board public issues, whereas Category II merchant bankers may undertake all other permitted activities except main board public issues. This bifurcation aligns regulatory obligations with market scale, ensuring that high-risk main board mandates are undertaken by well-capitalised entities. The revised norms shall apply to existing MBs in a phased manner as under:

Category Current Requirement (As per 1992 Regulations) Phase 1 (on or before January 2, 2027) Phase 2 (on or before January 2, 2028)
Category I ₹5 crore ₹25 crore & Liquid Net worth – 6.25 Cr. ₹50 crore & Liquid Net worth – 12.5 Cr.
Category II ₹5 crore ₹7.5 crore & Liquid Net worth – 1.875 Cr. ₹10 crore & Liquid Net worth – 2.5 Cr.

*Please note all new applicants shall adhere to the revised Net worth Requirements.

b) Compliances of minimum revenue from permitted activities

It has been observed that several Merchant Bankers are engaged only in activities other than core issue management and its related activities, utilising SEBI registration primarily as a reputational asset rather than as an operational mandate. Accordingly, Merchant Bankers shall now be required to generate minimum revenue on a cumulative basis over the three immediately preceding financial years as ₹Twenty-Five Crores for Category I & ₹Five Crore for Category II. The first assessment with respect to minimum revenue from permitted activities will be carried out w.e.f. 1st April 2029. This will allow only serious and credible market players to sustain in the merchant banking business. However, professionals auditing merchant banking companies, as a matter of practice, reconcile revenue reported in Half-yearly reports to SEBI with minimum revenue from permitted activities reflected in the statement of Profit & Loss to ensure ongoing compliances.

c) Compliances in respect of underwriting obligations

The rapid growth of the SME IPO segment further exposed deficiencies in due diligence standards, underwriting discipline, and conflict management, especially among smaller and thinly capitalised intermediaries. Regulation 22B(2) of the amended regulations caps total underwriting commitments at twenty times a merchant banker’s liquid net worth, replacing the earlier regime that permitted disproportionate exposure based on notional net worth. This reform materially mitigates systemic risk and ensures that underwriting obligations are backed by financial strengths.

d) Threshold for Determining Merchant Banker Association with Issue of Securities

A merchant banker, being a promoter or an associate of either the issuer of the securities or of a person making an offer to sell or purchase securities in terms of any of the regulations made by the Board, shall not lead manage any issue or be associated with any activity undertaken under any of the regulations made by the Board by such issuer or person. The threshold for determining the association of a merchant banker, either by control directly or indirectly through its subsidiary or holding company, has been reduced from fifteen percent to ten percent.

Merchant bankers are prohibited from lead-managing public issues where their key managerial personnel or relatives hold, in aggregate, more than 0.1% of the paid-up share capital or shares whose nominal value is more than Ten Lakh rupees, whichever is lower. These measures reinforce independence, objectivity, and fiduciary accountability across merchant banking operations.

e) Professional Accountability and Institutional Governance

The amended framework also elevates professional standards within merchant banking entities. Principal officers must possess a minimum of five years’ experience in financial markets. Compliance oversight has been strengthened under Regulation 28A through mandatory NISM Series-IX and Series-IIIA certifications, reinforcing regulatory adherence and investor protection. Transitional provisions allow existing compliance officers to continue subject to experience thresholds and timely certification, balancing continuity with enhanced competence.

The Great Upgrade India New Merchant Banking ERA

f) Redefining the Scope of Merchant Banking and the Separate Business Unit (SBU) Framework

The Amendment Regulations explicitly recognise that SBUs are not separate legal entities; the focus is on in substance segregation, operational independence, independent reporting lines, and the maintenance of robust Chinese walls to prevent risk contagion. Under the amended Regulation 13, merchant bankers are expressly permitted to undertake activities directly connected to the securities market lifecycle, including;

(i) managing of public issues, qualified institutions placements, rights issues of securities and advisory or consulting services incidental to such issues;

(ii) managing of:

a. acquisitions and takeovers under the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011;

b. buy-back under the Securities and Exchange Board of India (Buy Back of Securities) Regulations, 2018;

c. delisting under the Securities and Exchange Board of India (Delisting of Equity Shares) Regulations, 2021;

d. compliances as may be required under the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 in respect of any scheme of arrangement;

e. implementation of a scheme under the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021; and

f. advisory or consulting services incidental to the activities specified in clauses (a) to (e);

(iii) underwriting activities as specified by the Board from time to time; private placement of listed or proposed to be listed securities on a stock exchange recognised by the Board and activities incidental thereto.

(iv) advisory or consulting services incidental to the activities specified in clauses (a) to (e);

For the purpose of this clause, ‘securities’ shall be treated as ‘proposed to be listed’ from the date of approval of the board resolution of the issuer, for the issuance of such securities to be listed on a stock exchange recognised by the Board;

(v) managing the international offering of securities and advisory or consulting services incidental to such offering;

(vi) filing of placement memorandum of an alternative investment fund;

(vii) issuance of a fairness opinion;

(viii) managing of secondary market transactions of securities listed on a stock exchange recognized by the Board and activities incidental thereto;

(ix) market making in accordance with the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018;

(x) and any other activity as may be specified by the Board from time to time.

Activities outside the core list are no longer permissible as part of merchant banking and must, if undertaken, be conducted through Separate Business Units (SBUs), thereby ensuring a clear distinction between core merchant banking and other financial services activities. To ensure a smooth transition, existing merchant bankers are required to restructure non-core activities into SBUs within six months from the effective date of January 1, 2026.

Key Differences in Erstwhile Regulations and Amended Regulations

Feature 1992 Regulations (Erstwhile Regulations) 2025 Amendments (Amended Regulations) Strategic Shift
Categorization Unitary framework (Category I dominant) Two-tier framework (Category I and Category II) Recognition of market bifurcation between Main Board and SME platforms
Minimum Net Worth ₹5 Crores ₹50 Crores (Category I) / ₹10 Crores (Category II) Increase to ensure financial resilience and institutional strength
Liquidity Requirement No specific liquidity requirement Mandatory Liquid Net Worth (minimum 25%) Shift from book solvency to immediate solvency
Underwriting Exposure No explicit cap on underwriting Underwriting capped at 20× Liquid Net Worth Risk-taking capacity strictly linked to liquid capital
Valuation Activity In-house valuation permitted Valuation prohibited; mandatory use of Registered Valuer Removal of conflict of interest between deal execution and valuation
Data Localization No data localization requirement Mandatory data storage within India Data sovereignty and assured regulatory access
Record Retention Period 5 years 8 years Alignment with tax, enforcement, and other investigation statutes
Activity / Revenue Requirement No minimum revenue requirement Minimum revenue thresholds: ₹25 Cr (Category I) / ₹5 Cr (Category II) “Active player” doctrine to eliminate dormant registrations

VI. Way Forward: Towards a Resilient, Credible and Globally Aligned Merchant Banking Ecosystem

The regulatory overhaul of the merchant banking framework marks a transformative step in the evolution of India’s merchant banking landscape, establishing a regulatory directive that carefully balances prudential discipline with operational flexibility. The Amended Regulations enable market participants to adapt to heightened standards without disrupting market continuity or capital formation.

Some of the key takeaways are:

  •  Merchant banking regulation in India has decisively moved from form-based registration to substance-based supervision, commensurate with the evolving and growing capital market activities.
  • Capital adequacy is operationally enforced through tiered net worth thresholds, liquid asset requirements, and underwriting exposure limits.
  • The positive list framework defines the boundaries and permissible merchant banking activities.
  • Licence continuity is now tied to demonstrable market participation, reinforcing the principle that merchant banking is an active institutional responsibility rather than a passive regulatory entitlement.

Collectively, these measures position India’s merchant banking industry to operate with greater credibility, resilience, and strategic alignment with international standards, ensuring that the primary markets function efficiently and securely while supporting long-term capital formation objectives.

The Rise of Algorithmic Trading In Securities Market: Retail Participation and Regulatory Shifts

The Indian securities market is experiencing a structural shift as algorithmic trading expands from institutional dominance to robust retail participation via API-driven platforms. To mitigate risks and protect investors, SEBI has tightened regulations, positioning brokers as principal gatekeepers for third-party algorithms. Algos are now categorized into White Box and Black Box, with Black Box providers required to register as Research Analysts. Unlike the U.S., India enforces stricter rules, including prior exchange approval and mandatory order tagging. This rigorous framework generates significant opportunities for professionals in compliance, system audits, cybersecurity, and risk management.

The Indian securities market has witnessed a steady shift in the share of algorithmic and non-algorithmic trading across segments. While institutional participation continues to account for a significant proportion of algorithmic volumes, the gradual penetration of automation into retail trading marks a structural evolution in market conduct.

Algorithmic trading refers to the use of computer programs to automatically generate and/or execute trades based on pre-defined rules, parameters, or quantitative models, with limited or no real-time human intervention.

Long before the advent of algorithmic trading in India, dealers manually monitored market indicators, price movements, and technical parameters to execute trades in securities on stock exchanges on real time basis. As trading strategies became increasingly rule-based and repetitive—often driven by fixed indicators and predefined conditions—the limitations of manual execution became evident. This operational monotony, coupled with the growing need for speed, consistency, and discipline, catalyzed the adoption of algorithmic trading systems to automate decision-making and execution processes.

Cash Markets

Derivative Market

Equity Futures

Equity Options

Index Futures

Stock Futures

Traditionally, algorithmic trading in India was dominated by institutional players leveraging Direct Market Access (DMA) and co-location facilities to achieve ultra-low latency and efficient execution. Retail traders, in contrast, have largely accessed automation through broker-provided APIs and third-party platforms. Over time, all stakeholders in the algo trading ecosystem i.e. stock brokers, technology and API providers, strategy vendors, and trader have evolved as integrated functions, thereby leading to a more complex and interdependent market structure that raises new regulatory, compliance, and accountability considerations.

A key inflection point in this transition has been the rise of discount brokers and fintech platforms that lowered entry barriers for technologically inclined retail traders. The availability of APIs, developer-friendly documentation, and plug-and-play models have enabled a new layer of participants to either build or to deploy automated strategies without actually incurring any huge capital expenditure. This shift has created a parallel ecosystem of strategy developers, platform providers, and retail users, blurring the lines between trading, technology, and advisory services.

REGULATORY EVOLUTION OF ALGORITHMIC TRADING IN INDIA

With increased volume of algo trading including that of retail participation, SEBI’s regulatory focus expanded from institutional algos to the algos used by retail trades. While the core algo framework continued to apply formally at the broker level, SEBI incrementally tightened risk management norms such as order-to-trade ratio penalties, system audit requirements, and broker responsibility for surveillance of algorithmic activity routed through their infrastructure.

This period marked a regulatory transition from “who runs the algo” to “who enables the algo.” Brokers were positioned as the principal gatekeepers, even where trading logic originated from third-party platforms or client-side automation. With increase of retail algo trading, the occurrences of market mis- selling’s, bogus performance claims, could not be ruled out.

RECENT REGULATORY PUSH

SEBI’s recent regulatory push marks a structural shift from ensuring “Safer participation of retail investors in Algorithmic trading”, vide SEBI circular dared 4th February 2025. SEBI explicitly recognized retail algos as a distinct regulatory category and mandated exchanges to frame comprehensive operational standards governing APIs, algo registration, tagging, and risk controls. This reflects SEBI’s policy intent to balance technological adoption with systemic stability and investor protection, especially in light of the rapid growth of API-based retail trading.

Algos shall be categorized into two categories i.e. White Box Algos and Black Box Algos. White Box algos are algos where logic is disclosed and replicable and Black box algos are algos where logic is not known to user and is not replicable. For Black Box algos the algo provider shall register as a Research Analyst and maintain a detailed research report for each such algo and confirm to the exchanges that such report has been maintained. In case of any change in the logic governing the algo, register such algo as a fresh algo and maintain a detailed research report for the new algo, and confirm to the exchanges that such report has been maintained.

Pursuant to SEBI’s directions, National Stock Exchange (NSE) issued implementation standards and detailed operational modalities in May–July 2025. This framework also formalizes the role of third-party algo platforms as “Algo Providers” who must be empanelled with exchanges, with brokers acting as principals and bearing ultimate responsibility for orders routed through APIs. It also defines the standard operations related to API Access for Clients, APIs without registering algo, client generated algos, broker generated algos, threshold orders per second, Algo ID tagging and risk management.

International Financial Services Centre Authority (IFSCA) has recognized the growing importance of algorithmic trading for the growth and development of securities market in IFSC and therefore released consultation paper on Guidelines for Algorithmic Trading on the Stock Exchanges in IFSC. It provides for responsibilities of Stock Exchange which includes load management, performance study of its systems, Periodic Testing of Algorithms and audit trail.

WAY FORWARD

The expanding regulatory framework around algorithmic trading is materially increasing the compliance and operational functions across all market participants—including stock exchanges, brokers, algo and strategy providers, technology vendors etc.

The USA markets are generally considered to have the highest proportion of trades executed algorithmically, whereas in India the percentage of algo trading as a share of total trades is relatively lower; however, India’s regulatory framework is far more stringent, with active involvement of brokers and exchanges in compliance and risk supervision.

Key differentiators in India include the requirement of prior approval and mandatory order tagging of each algorithmic strategy, empanelment of brokers acting as regulatory gatekeepers and exchange-level approval required prior to deployment, algo registration and tagging, etc.

On the contrary, the U.S. algorithmic trading is primarily supervised through firm-level risk management systems, internal controls, and ongoing compliance and surveillance mechanisms which is adhered in India through API security, simulation testing, audit trails, surveillance, and incident reporting.

In view of the above, meaningful opportunities for professionals across legal, compliance, risk, audit, cyber security, and technology domains shall be available which include:

  • Designing governance frameworks,
  • implementing compliant trading architectures.
  • conduct system and model audits,
  • manage regulatory change, and
  • bridge the gap between complex trading technology and evolving SEBI/NSE requirements

These opportunities will position regulatory and tech-fluent professionals as key enablers of compliant innovation in the algorithmic trading ecosystem.

Intent vs. Action – When Does Investment Education End and Investment Advice Begin?

The distinction between Investment Education and regulated Investment Advice lies in the activity’s impact rather than its label: education imparts conceptual understanding, while advice influences specific execution. SEBI regulations mandate registration for anyone providing advice or research for consideration, whereas “pure education” must exclude specific recommendations, performance claims, and the use of live market data to predict prices. To remain compliant, educators generally must utilize data with a three-month lag, ensuring they do not analyze current market trends to prompt trades. Recent SEBI orders against entities like Avadhut Sathe Trading Academy highlight that substance prevails over form; using “educational purpose” disclaimers offers no protection if the content involves live chart analysis, specific stock discussions, or misleading profit testimonials. Ultimately, if communication uses live data to direct investment decisions on identifiable securities, it crosses into regulated territory.

INTRODUCTION

The Indian securities market has witnessed a rapid expansion of stock market educators, trading academies and financial influencers offering structured learning programmes to retail participants. With increased access to technology, live trading platforms and social media reach, market education has transformed into a full fledged commercial ecosystem. While such initiatives contribute positively to financial literacy, they also raise significant regulatory concerns when educational content begins influencing real time investment decisions.

Advisory begins when education is applied to identifiable securities in a manner capable of influencing investment behaviour. Explaining that a particular stock is showing “bullish technical indicators” or that a “breakout appears” moves beyond the educational intent. Even without the usage of explicit words such as “buy” or “sell”, such communication starts influencing investor decision making.

Education intends to disseminate conceptual knowledge, and investment advice cannot come under the garb of educational activities.

RELEVANT REGULATORY FRAMEWORK

The SEBI (Investment Advisers) Regulations, 2013 defines “Investment Advice” as an advice relating to investing in, purchasing, selling or otherwise dealing in securities and advice on investment portfolio containing securities whether written, oral or through any other means of communication for the benefit of the client and shall include financial planning however, investment advice given through newspaper, magazines, any electronic or broadcasting or telecommunications medium, which is widely available to the public shall not be considered as investment advice for the purpose of these regulations.

The regulation further defines “Investment Adviser” as any person who, for consideration, is engaged in the business of providing investment advice to clients or other persons or group of persons and includes a part-time investment adviser or any person who holds out himself as an investment adviser, by whatever name called;

Any person acting as an investment adviser or holding itself out as an investment adviser shall obtain a certificate of registration from the Board (SEBI) under these regulations.

Further, Regulation 2(1)(q) of SEBI (Research Analyst) Regulations, 2014 defines “Research Analyst” as a person who, for consideration, is engaged in the business of providing research services and includes a part-time research analyst.

Services such as preparation or publication of the research report or content of the research report, providing or issuing research report or research analysis, making ‘buy/sell/hold’ recommendation, giving price target or stop loss target; offering an opinion concerning public offer, recommending model portfolio; or providing trading calls; or any other service of similar nature or character are defined as research service in the regulations.

“No person shall act as a research analyst or research entity or hold itself out as a research analyst unless he has obtained a certificate of registration from the Board (SEBI) under these regulations.”

 

The Thin line Investment Education vs Investment Advice

A person engaged solely in education shall mean that such person is not engaged in any of the two prohibited activities, i.e.

(i) providing advice or any recommendation, directly or indirectly, in respect of or related to a security or securities, without being registered with or otherwise permitted by the Board to provide such advice or recommendation; and

(ii) making any claim, of returns or performance, expressly or impliedly, in respect of or related to a security or securities, without being permitted by the Board to make such a claim.

One of the essential elements distinguishing investor education from advice/recommendation is the market data based on which educational contents are being developed. Using live data for educational purposes is clearly outside the scope of pure educational activity as it involves analysing current data to predict future prices, which falls under the definition of Investment Advisory (IA)/ Research Analyst (RA) activity. Such a person should not be using the market price data of the preceding three months to speak/talk/display the name of any security, including using any code name of the security, in his/her talk/speech, video, ticker, screen share, etc., indicating the future price, advice or recommendation related to security or securities.

Under the extant regulatory framework, a pure educational institute can have data with a one-day lag so that it can use this for preparing educational content. However, it can only use three-month-old data for educational purposes in the class or through any media, without falling within the scope of IA/RA activities.

The one-day lag for providing price data for educational purposes is the minimum technical delay to be adhered to by MIIs and market intermediaries, while the three-month lag criteria is a content-based condition to be adhered to by educators for their content to be regarded as purely educational.

Further, it is proposed vide SEBI Consultation Paper dated 06th Jan 2026, that a uniform lag of 30 days for both sharing and usage of price data may be made applicable for educational and awareness activities.

UNDERSTANDING FROM THE REGULATOR’S LENS

Recently, the Securities and Exchange Board of India (SEBI), through its interim ex parte order issued in December 2025 in the matter of Avadhut Sathe Trading Academy Private Limited*, has delivered one of the most detailed regulatory examinations distinguishing Securities Market Education & Investment Advice. The order does not merely penalise a single entity; it clarifies fundamental principles governing the boundary between market education and regulated investment advisory and research activity.

SEBI initiated an examination into the activities of Avadhut Sathe Trading Academy Private Limited and its promoters following multiple complaints received from course participants and also on account of any serious action taken by the company based on the administrative warning given by SEBI in the Financial Year 2023-24. The academy offered various stock market training programmes, ranging from introductory webinars to advanced mentorship courses, for which substantial fees were charged. These programmes were marketed as educational in nature and were promoted across digital platforms.

At the outset, it was observed that neither the academy nor its promoters were registered with SEBI as investment advisers or research analysts. Despite operating within the securities market ecosystem and charging consideration for market related instruction, no regulatory registration had been obtained.

*Source: SEBI Interim Order cum Show Cause Notice in the matter of Avadhut Sathe Trading Academy Private Limited, Order No. QJA/KV/MIRSD/MIRSD-SEC-1/31823/2025–26

Key Findings of SEBI
Upon examination of the session recordings, SEBI noted repeated instances where identifiable securities were discussed using live market data. Trainers were found predicting future price movements, suggesting directional bias and explaining trading setups with precise stop loss and target levels.

In several sessions, participants confirmed during live interaction that trades were executed based on the guidance provided. These statements were treated as corroborative evidence of inducement for carrying out trading activities. The complaints indicated that live market sessions were conducted during paid courses, wherein specific stocks and derivative instruments were discussed. Participants alleged that trainers frequently referred to entry prices, target levels, and stop loss points while analysing live price charts. In several instances, the trainers displayed their own trading terminals, open positions and mark to market profits during sessions.

It was further alleged that trade related discussions were continued through closed WhatsApp groups accessible only to paid participants. Promotional videos and testimonials selectively showcased profitable trades, creating an impression of assured or consistent returns.

In view of the above, SEBI concluded on a prima facie basis that the activities went beyond academic insights and amounted to investment advisory services under the Investment Adviser Regulations, 2013. The regulator observed that disclaimers stating the sessions were “only for educational purposes” could not negate the actual substance of the conduct.

Accordingly, SEBI issued an interim ex parte order restraining the entities from providing investment advice, restricting access to the securities market and directing cessation of unregistered advisory activities pending final adjudication.

The interim order also invokes the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003 (PFUTP Regulations), which apply to all persons influencing the securities market.

Apart from carrying out unregistered Investment Advisory/Research Analyst activities, the entities have also disseminated false and misleading information through social media in a reckless or careless manner to influence the decision of investors dealing in securities. The entity circulated testimonials of participants through its social media channels; it falsely advertised that participants were able to generate supernormal profits. SEBI investigation found that the participants had actually suffered net losses and such testimonial videos have been recklessly circulated on social media to induce unsuspecting and gullible investors to enroll for the entity’s programs/advisory/analyst services, thus SEBI found such acts to be, prima facie, in violation of Regulation 4(2)(k) of the PFUTP Regulations.

Similar orders have also been passed by SEBI in December 2024 in the matter of “Baap of charts” for selling educational courses where direct buy/sell recommendation were provided in the disguise of investment advisory activities and in the matter of Asmita Patel Global School of Trading (APGSOT) in February 2025 wherein they offered unauthorised, high-fee investment advice disguised as education, leading to significant financial penalties and market restrictions.

THE THIN LINE BETWEEN INVESTMENT EDUCATION AND INVESTMENT ADVICE

The distinction between them is not based on terminology but on impact. Education imparts understanding, and investment advisory influences thinking that directs execution. The regulatory framework is not decided by the tools used—charts, indicators or data—but by the manner in which they are applied. Use of live market data, identifiable securities, predictive commentary, specific price levels, collective language and real-time demonstrations progressively converts education ultimately into investment advice.

Disclaimers cannot neutralise this transformation. As consistently observed by SEBI, substance prevails over caption, and labelling content as “educational” cannot override conduct that effectively instructs investors on what trades to execute. Live market sessions further intensify this risk due to immediacy and replicability, particularly when combined with paid mentorship or performance-oriented models, where investor expectation naturally shifts from learning outcomes to trading results.

This requires revisiting the role of many people involved in this ecosystem, one of them being professionals who have an edge over others in understanding the implications of the regulatory framework governing financial market activities.

ROLES OF PROFESSIONALS

The role of professionals guiding, advising and auditing the companies should act as the first line of proactive compliance for individuals/companies engaged in securities market education and digital content creation.

In advising such clients, the evaluation must focus on substance rather than labels and examine whether identifiable securities are discussed, consideration in any form is received, future price movement is predicted, live market data other than what is allowed is used, or promotional content creates inducement through selective profitability or testimonials.

Where these elements exist cumulatively, the activity may cross the fine line of difference from education into regulated advisory requiring registration under SEBI regulations, while misleading representations may independently attract scrutiny under the PFUTP framework.

By identifying these trigger points at an early stage, professionals can help prevent inadvertent regulatory violations that commonly arise from misunderstanding the narrow boundary between permissible education and the regulated advisory framework on the securities market.

In case of a professional, say a Chartered Accountant (CA) provides advice/recommendation on securities as an asset class for the purpose of tax planning/tax filing, he is not required to get registered as a part-time IA/RA. However, if a CA is providing security-specific advice/recommendation to its client, even though as part of tax planning/tax filing, he is required to seek registration as part-time IA/RA.

If a person is engaged in, an educational activity or is employed as a professor and as part of employment/business, is providing security-specific information/recommendation, he is required to seek registration as IA/RA.

CONCLUDING REMARKS

As market innovation continues to reshape how knowledge is delivered, regulatory interpretation cannot be misconstrued to operate in an unregulated manner. The challenge lies not in restricting educational activities, but in ensuring it operates within the true spirit of the law, with a transparent and accountable framework. In this evolving balance, clarity of intent, structure and compliance will decide whether it is investment education or investment advice.

Real Estate Investment Trusts (REITs): Decoding the Structure, Purpose, and Investment Merits

REITs, introduced to India via SEBI Regulations 2014, democratize access to high-quality commercial real estate by enabling fractional ownership. These trusts, overseen by a Sponsor, Trustee, and Manager, must distribute 90% of net cash flows to unit holders, offering stable yields and liquidity through stock exchange listings. Currently, seven Indian REITs manage assets worth approximately ₹2.3–2.5 lakh crore. While adoption is hindered by limited awareness and interest rate sensitivity, recent SEBI reforms—including SM REITs—aim to mainstream the asset class as it expands into data centers and logistics.

I. INTRODUCTION

Real Estate Investment Trusts (REITs) are among the most significant innovations in global real estate and financial markets, offering a transparent and accessible avenue for investors to participate in income generating commercial assets. Originating in the United States in the 1960s, to provide retail investors access to large scale real-estate which was previously available only to institutions, REITs have since evolved into a widely adopted global investment structure. Today, jurisdictions such as the US, Singapore, Japan and Australia operate mature REIT markets known for strong governance, liquidity and stable yields, effectively integrating real estate with capital markets.

In India, the REIT framework was formally introduced through the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations 2014, marking a major step toward transparency and institutionalisation in the real estate sector. These regulations established standardised valuation practices, stringent disclosure norms and investor protection mechanisms aligned with international standards. Structurally, a REIT is a securitised trust that owns, operates or finances income generating assets. Investors purchase units of the REIT, which are mandatorily listed on recognised stock exchanges, thereby obtaining equity like liquidity supported by stable real estate backed cash flows. REITs must invest a significant majority of their assets in completed revenue generating properties and are required to distribute at least 90 percent of Net Distributable Cash Flows to unit holders, ensuring steady income. Through professional management, portfolio diversification and mandatory disclosures, REITs provide an efficient and investor friendly mechanism for participating in long term real estate performance across global and Indian markets.

The Indian REIT market currently comprises of seven SEBI-registered REITs, as per SEBI website with data uploaded up to 18th December 2025. Collectively, these REITs manage aggregate assets under management (AUM) of approximately ₹2.3–2.5 lakh crore (As per IRA), representing a substantial institutional real estate footprint in India. The underlying asset base is predominantly Grade-A commercial office real estate, with a portfolio comprising large, consumption-oriented retail malls and urban shopping destinations. Together, these seven REITs reflect the growing depth, diversification, and institutionalization of India’s commercial and retail real estate ecosystem under the SEBI (REITs) Regulations, 2014.

II. THE REIT STRUCTURE

The operational structure of a REIT is carefully designed to achieve transparency, accountability, and operational efficiency. The framework rests on three primary pillars, the Sponsor, the Trustee, and the REIT Manager, each of whom plays a critical and independent role in ensuring the success of the REIT. Additionally, much of the asset ownership is maintained through Special Purpose Vehicles (SPVs), which hold the individual properties under the REIT umbrella.

The Sponsor is the promoter entity or group responsible for establishing the REIT and transferring eligible real estate assets or SPV shareholding to the trust. Sponsors typically consist of experienced real estate developers or investment entities with extensive track records.

The Trustee functions as an independent fiduciary responsible for safeguarding unit holders’ interests. The Trustee ensures regulatory compliance, monitors the performance and actions of the REIT Manager, and oversees the custody of the assets held by the trust.

The REIT Manager acts as the operational driver of the REIT. It is entrusted with property management, leasing strategies, financing decisions, investor communication, risk management, and overall commercial performance. The Manager’s responsibilities have a direct bearing on asset occupancy, yield generation, and long-term value creation.

The structural relationship between these entities, including the SPVs, enables REITs to maintain governance, operational flexibility, and scalability.

structural relationship between these entities, including the SPVs, enables REITs to maintain governance, operational flexibility, and scalability.

REITs

III. NEED FOR REITs AS AN INVESTMENT PRODUCT

Real Estate Investment Trusts emerged globally as a structural reform to address opacity, inconsistent valuations, and fragmented ownership that historically characterised real estate markets. By placing income generating assets within a regulated trust framework, REITs introduced standardised valuation practices, periodic disclosures, governance oversight, and compliance-based transparency. This transformed real estate into a securitised and publicly monitored investment class comparable to mainstream financial instruments. Mature markets such as the United States, Singapore, Japan and Australia illustrate how REITs enhance market integrity, attract long term institutional capital, and broaden investor participation. India adopted this global model through the Securities and Exchange Board of India Real Estate Investment Trusts Regulations 2014, aligning domestic real estate investing with international best practices and creating an institutional mechanism for transparency and financial discipline.

The central rationale behind REITs both globally and in India has been the democratization of real estate ownership and the mobilisation of patient capital into high quality commercial assets. Traditional real estate investment required significant capital, involved high transaction costs, and offered limited liquidity, restricting participation largely to wealthy individuals and institutions. REITs resolve these barriers by enabling fractional ownership through exchange listed units, combining the liquidity of public markets with the stability of asset backed cash flows from completed real estate. In the Indian context, this structure has enabled capital inflows into Grade A offices, retail centres, logistics parks and industrial facilities, allowing developers to deleverage and reinvest while converting illiquid property holdings into monetizable financial assets.

Finally, the introduction of REITs was intended to deepen and diversify the products & capital markets themselves. Prior to REITs, Indian capital markets were largely dominated by equity and debt instruments, offering limited avenues for investors seeking steady, asset-backed, yield-oriented products. REITs fill this structural gap by offering predictable income distributions, relatively lower volatility, and a strong linkage to economic productivity through commercial real estate performance. Their regulated nature, mandatory distribution of 90% of Net Distributable Cash Flows (NDCF), and governance standards elevate them far above conventional property transactions. In essence, REITs represent a hybrid investment class, combining the liquidity of public markets with the stability and cash-flow resilience of high-quality real estate, thereby strengthening financialization, market depth, and investor choice within the broader investment ecosystem.

IV. REITs AND KEY MERITS OF INVESTING IN REITs

1. Income Stability, Liquidity and Professional Management

REITs are preferred for their predictable income, supported by the mandatory distribution of at least ninety percent of net distributable cash flows. Their listing on recognised stock exchanges provides liquidity and enables convenient entry and exit, unlike traditional real estate which is costly and slow to transact. Professional management ensures efficient leasing, tenant retention and asset maintenance, leading to sustained occupancy and stable long term cash flows.

2. Dual Benefit of Yield and Capital Appreciation with Diversification Advantages

REITs deliver a combination of steady rental yields and potential capital appreciation as high quality commercial properties typically gain value over time. Their diversified portfolios across cities and tenant categories reduce concentration risk and protect against localized market disruptions. Periodic rent escalations in commercial leases also offer inflation aligned income growth, enhancing overall financial returns.

3.SEBI Regulatory Framework and Superior Investor Protection

a) Transparency and Standardised Valuation

SEBI’s regulatory framework ensures transparency through quarterly financials, annual audited accounts and compulsory independent valuations based on uniform methodologies. Public disclosure of valuation assumptions eliminates the opacity historically associated with real estate.

b) Prudent Asset Composition and Leverage Controls

Regulations require at least eighty percent of REIT assets to be completed and income generating, significantly reducing development risk. Borrowings cannot exceed forty nine percent of asset value without credit rating and approval from seventy five percent of unit holders, ensuring financial discipline.

c) Governance Safeguards

A clear separation between the sponsor, trustee and manager, along with mandatory arm’s length related party transactions and independent unit holder approval, reduces conflicts of interest and enhances institutional credibility.

V. REITs NOT AS FIRST CHOICE PRODUCTS, WHY?

Despite a supportive regulatory framework, REITs have not yet emerged as a first-choice investment product for Indian investors primarily due to a combination of limited awareness, yield sensitivity, and market perception issues. REITs compete directly with traditional fixed-income products and direct real estate, yet their distribution yields fluctuate with interest rate cycles, making them less attractive during high-rate environments. The relatively small size of the Indian REIT market, limited trading liquidity, and concentration in office and retail assets further restrict broad investor appeal. Also alternative products like Real Estate Mutual Funds, which offer a more efficient alternative to REITs for long-term investors, are better positioned to navigate the structural challenges of India’s predominantly unorganised real estate market by providing diversified, professionally managed exposure without the operational, legal, and liquidity risks associated with direct property ownership. As a result, while REITs are institutionally credible and regulated, they are still viewed as a niche, yield-oriented product rather than a core allocation, delaying their adoption as a mainstream first-choice investment.

To further increase participation, the REIT structure can be strengthened by rebalancing sponsor influence, internalising management functions, simplifying SPV layers, expanding asset eligibility, and enhancing investor control, thereby improving alignment, transparency, and long-term scalability in India’s unorganised real estate market.

VI. SEBI MEASURE TO GIVE EXPOSURE TO REITs

SEBI has recently undertaken a series of targeted regulatory initiatives to deepen investor participation in REITs and strengthen their role within India’s capital markets. Key measures include rationalisation of minimum investment and trading lot sizes, enhanced disclosure, valuation and governance standards, and greater capital-raising flexibility through follow-on offerings and debt issuances. A significant recent development is the reclassification of Real Estate Investment Trusts (REITs) as equity-related instruments, which facilitates enhanced participation by Mutual Funds and Specialized Investment Funds (SIFs) and supports greater institutional capital inflows (28 November 2025 Circular). In parallel, SEBI has introduced Small and Medium REITs (SM REITs) to enable fractional ownership of real estate assets under a regulated framework, thereby broadening access for retail and high-net-worth investors. Collectively, these measures reinforce SEBI’s intent to position REITs as a mainstream, liquid and yield-oriented asset class in the Indian investment ecosystem.

VII. FUTURE OUTLOOK

Real Estate Investment Trusts represent a structural transformation in how economies financialise and institutionalise real estate. Globally, REITs have bridged the gap between physical property ownership and modern capital markets by introducing transparency, standardised valuation, and regulatory discipline. India’s adoption of this framework places it within a mature international ecosystem where REITs already serve as essential vehicles for deepening markets, democratising ownership, and converting real estate activity into stable, tradable financial returns.

The strength of REITs lies in their ability to translate commercial real estate productivity into predictable income supported by institutional governance. In India, where real estate has long been marked by opacity and fragmentation, REITs have set new benchmarks of credibility and professionalism. They have opened access to high quality commercial assets for domestic investors while attracting global pension funds, sovereign wealth funds, and long horizon allocators seeking stability in a high growth market.

As India’s economic landscape expands, REITs are poised to diversify into next generation asset classes including data centres, digital infrastructure, industrial warehousing, last mile logistics, and technology enabled office ecosystems. This trajectory mirrors the evolution seen in mature global markets where REITs have successfully expanded into specialised segments such as healthcare, cold storage, hospitality and renewable infrastructure. With regulatory clarity improving and taxation frameworks stabilising, India is positioned to attract deeper pools of long-term international capital, strengthening its role as a compelling yield driven investment destination.

The future relevance of REITs in India therefore extends beyond real estate alone. They stand at the intersection of financial market development, urban growth, investment democratisation, and economic formalisation. If supported through progressive policies and continued institutional participation, REITs have the potential to become one of India’s most influential financial instruments over the coming decade, aligning the country more closely with global REIT markets while shaping a sophisticated, transparent and yield oriented investment environment.

Governance Framework Of Alternative Investment Funds (AIFs) In Gift City

1. INTRODUCTION

The establishment of the International Financial Services Centre (IFSC) at Gujarat International Finance Tec-City (GIFT City) is conceived as a globally benchmarked financial jurisdiction within India’s sovereign territory. The IFSC provides an operational, regulatory, and tax framework in line with other leading financial centres. It represents India’s effort to bring offshore financial activities onshore, thereby reversing decades of capital outflow through fund domiciliation in foreign jurisdictions.

Within this rapidly evolving ecosystem, the Alternative Investment Fund (AIF) segment has emerged as one of the most dynamic pillars of the IFSC’s growth trajectory. Globally, AIFs comprising private equity, venture capital, hedge, infrastructure, and debt funds have become key channels of long-term, risk-capital deployment across sectors and geographies. India’s onshore AIF industry, regulated by SEBI, has already demonstrated exponential growth, crossing significant milestones as a privately placed investment vehicle. The establishment of AIFs within GIFT City’s IFSC builds upon this domestic success, extending it into the international domain. These funds provide a platform for global investors, sovereign wealth funds, pension funds, family offices, and high-net-worth individuals to access India-focused and global investment opportunities through a jurisdiction that combines regulatory credibility with tax efficiency and cross-border flexibility.

The introduction of the IFSCA (Fund Management) Regulations, 2022 & amended as IFSCA (Fund Management) Regulations, 2025 (Referred as ‘the FME Regulations’) marked an evolution in India’s international fund management regime. Prior to their enactment, fund activities within the IFSC were governed by adapted versions of domestic SEBI regulations, which proved restrictive for global fund management objectives. The FME Regulations consolidated these fragmented norms into a single, comprehensive, and principle-based framework, providing clarity, uniformity, and global parity. The Regulations introduced the concept of a Fund Management Entity (FME), a registered and regulated manager responsible for establishing and operating AIFs, Mutual Funds, and Portfolio Management Services in the IFSC. This framework aligns India’s fund governance standards with international best practices while facilitating cross-border investments, foreign currency operations, and global investor participation.

2. DISTINCTIVENESS OF AIFs IN GIFT CITY VIS-À-VIS DOMESTIC AIFs

A. Regulatory Philosophy and Orientation

The domestic AIF framework under SEBI primarily caters to Indian markets, while it can accept investments from NRIs or foreign investors, its underlying assets are predominantly Indian securities. In contrast, the IFSC AIF regime under IFSCA follows a globally aligned, principle-based framework that allows both domestic and foreign investors to participate and facilitates investment in securities across multiple jurisdictions, promoting true cross-border fund management.

B. Unified Oversight and Entity Structure

SEBI primarily regulates the fund with an active oversight on sponsor and manager, creating distinct compliance norms. The IFSC framework simplifies this by introducing the Fund Management Entity (FME) as a single regulated entity performing all managerial and fiduciary roles.

C. Currency Flexibility and Investment Scope

While domestic AIFs operate in Indian rupees and invest primarily in Indian securities, IFSC regulated AIFs may raise capital in freely convertible foreign currencies and invest globally, facilitating diversified cross-border portfolio strategies.

D. Taxation and Fiscal Incentives

IFSC AIFs enjoy a favourable tax regime including a ten-year tax holiday for FMEs, capital gains exemptions, GST relief, and no withholding tax on certain foreign distributions, enhancing post-tax investor returns.

E. Regulatory Flexibility and Global Alignment

IFSCA’s principle-based approach allows flexible fund structuring, valuation, and leverage subject to disclosure and investor consent, promoting innovation and global competitiveness.

F. Institutional Infrastructure and Operational Ecosystem

GIFT City provides an integrated ecosystem with offshore banking units, foreign currency settlement, professional custodians, and specialized dispute resolution enabling seamless international fund operations within India.

G. Strategic Positioning of IFSC AIFs

The IFSC regime elevates India from being a capital destination to a global capital management hub, competing with international jurisdictions by offering globally compliant, tax-efficient, and operationally agile fund structures.

3. KEY AMENDMENTS INTRODUCED UNDER THE IFSCA (FUND MANAGEMENT) REGULATIONS, 2025

The IFSCA (Fund Management) Regulations, 2025 (“FME Regulations”) introduces a series of substantive and clarificatory reforms aimed at enhancing managerial flexibility, refining qualification norms, streamlining governance, and deepening the international competitiveness of GIFT City’s fund ecosystem. The following sections outline the principal changes introduced by the 2025 framework:

Category II AIFs maintained their dominance in the market, attracting the highest commitments and deploying the largest share of capital. Within Category I, Venture Capital Funds (VCFs) remained the most active, while Special Situation Funds and SME Funds recorded steady gains in both fundraising and capital deployment. The cumulative net investments made by AIFs, reflected in Assets Under Management (AUM), stood at ₹5,38,161 crore at the end of FY 2024–25.

Overall, gross cumulative funds raised by AIFs reached ₹7,95,143 crore as of March 31, 2025, while cumulative capital distributions to investors stood at ₹2,31,713 crore. These figures not only highlight the continued growth and resilience of the AIF ecosystem but also emphasize its increasing role in supporting India’s alternative financing landscape and driving capital towards emerging and other segments of the economy. (Source: SEBI Annual Report 2024-25)

I. Flexibility and Enhancement in Appointment of Principal Officer and Other Key Managerial Personnel

The 2025 framework revises qualification and experience norms for Principal Officers, Compliance Officers, and other KMPs by recognizing globally accepted certifications like CFA and FRM and relaxing the minimum education requirement to a graduate degree for professionals with over 15 years of experience. It broadens experience criteria to include up to two years of consultancy work, mandates at least three years of compliance or risk management experience for Compliance Officers, and requires FMEs with AUM above USD 1 billion to appoint an additional fund-management KMP within six months of the financial year-end. The prior approval requirement for KMP appointments is replaced with a simple intimation process, with vacancies to be filled within six months. Overall, these reforms enhance flexibility, strengthen governance, align with global standards, and promote standardized competence across FMEs.

II. Revised Eligibility Norms for Registered FME (Retail)

The eligibility framework for Registered FMEs (Retail) has been clarified and expanded. Applicants must demonstrate either:

(i) five years of collective experience in managing AUM of at least USD 200 million with over 25,000 investors, or

(ii) that their controlling shareholders (holding at least 25%) have operated in fund management-related businesses such as portfolio management, investment advisory, or distribution for a period of not less than five years, managing assets of at least USD 50 million for 1,000 or more investors.

A minimum net worth of USD 2 million continues to apply. Additionally, the third key managerial person may now be appointed prior to filing the first retail scheme’s offer document, providing operational flexibility during establishment.

III. Stringent assessment for Fit and Proper Person Credentials

The Amended Regulations have introduced stricter fitness and integrity checks for applicants and persons associated with FMEs. Disqualifications now include cases where charge sheets have been filed or charges framed in economic offences, or where a person has been restrained by any regulator or court in matters relating to financial misconduct.

A materiality threshold has been introduced for prior regulatory orders, allowing IFSCA to assess their impact on eligibility based on discretion and context. Moreover, any person declared as “not fit and proper” by any regulatory authority is ineligible to apply until the criteria are fully satisfied.

IV. Key Amendments to Schemes: Venture Capital, Restricted, and Retail

(a) Placement Memorandum and Minimum Corpus

For Venture Capital (VCF) and Restricted Schemes, investments may now commence only after IFSCA confirms that the Private Placement Memorandum (PPM) has been taken on record.

The validity of the PPM has been extended from six months to twelve months, with a one-time six-month extension available upon payment of 50% of the new scheme filing fee.

The minimum corpus requirement has been reduced from USD 5 million to USD 3 million, with open-ended schemes permitted to commence operations upon raising USD 1 million, achieving the minimum within twelve months.

(b) Joint Investor Provisions

The threshold for joint investors (spouse, parents, and children) has been relaxed to USD 250,000 for VCFs and USD 150,000 for Restricted Schemes, broadening accessibility for family-based participation.

(c) Investment and Diversification Norms

The 2025 regime introduces enhanced flexibility:

  •  Open-ended fund-of-funds and retail schemes may now invest in unlisted securities issued by appropriately regulated funds in their home jurisdiction.
  •  Concentration limits for sectoral, thematic, and index-linked funds are relaxed in line with benchmark weights, and listing of close-ended retail schemes is optional for investments above USD 10,000.

(d) Related Party Transactions and Contributions

Funds are prohibited from transacting with associates or investors contributing 50% or more of the corpus without 75% investor approval by value, though this does not apply to fund-of-funds with pre-disclosed investments. The restriction on FME and associate contribution exceeding 10% has been waived where such entities are non-residents with no Indian ultimate beneficial ownership (UBO) and where diversification criteria are met.

V. Reforms Relating to Family Investment Funds (FIFs)

The definition of Family Investment Fund (FIF) has been broadened to remove restrictive references to “self-managed funds,” allowing greater structural flexibility. The concept of a “single-family office” has been expanded to include various legal forms, companies, LLPs, trusts, partnerships, and other body corporates where individuals of a single family hold substantial economic interest. FIFs may be classified under Category I, II, or III AIFs, depending on their investment strategy.

4. STRATEGIC DIFFERENTIATORS OF THE IFSC FRAMEWORK FOR FMES

One of the most compelling yet less-discussed advantages for FMEs in the IFSC is the regulatory architecture deliberately designed to remove “jurisdictional friction” that typically constrains cross-border fund management. Unlike domestic regimes where taxation, currency rules, investment restrictions, and securities oversight stem from multiple independent regulators, the IFSC uniquely consolidates all financial lawmaking, across banking, securities, insurance, derivatives, investment funds, and fintech, under a single unified authority (IFSCA). This allows FMEs to structure products that combine elements of AIFs, PMS, ETFs, private credit, and digital asset strategies without navigating the fragmented approvals required onshore.

The IFSC also permits FMEs to design umbrella fund platforms, set up multi-strategy master–feeder structures, and operate multi-currency share classes with segregated books. This structural coherence where fund management, banking channels, settlement infrastructure, and capital flows are engineered to operate in a single harmonized loop gives FMEs in GIFT City a level of operational agility that meaningfully differentiates it from both domestic India and competing offshore domiciles.

5. WAY FORWARD- TOWARDS A GLOBALLY ALIGNED AND FUTURE-READY FUND ECOSYSTEM

With the introduction of the Fund Management Entity model, cross-border investment flexibility, and an internationally competitive tax and compliance environment, IFSCA has established a foundation that is distinct in its approach and purpose, one that harmonizes India’s regulatory prudence with global best practices. The underlying objective has been to create an enabling environment that attracts international fund sponsors, institutional investors, and professional intermediaries while maintaining strong governance standards and market discipline.

The 2025 amendments signal a transition from procedural oversight to outcome-based supervision, one that prioritizes competence, accountability, and investor protection without impeding operational innovation. The redefinition of the Family Investment Fund, relaxation of portfolio management thresholds in IFSC collectively enhance the jurisdiction’s credibility and alignment with global fund domiciles.

For fund managers, institutional investors, and allied professionals, the regulatory trajectory offers both opportunity and responsibility: opportunity in the form of greater operational latitude and market access, and responsibility through heightened standards of governance and transparency. As the IFSC framework continues to evolve, it is poised to serve as a bridge between India’s domestic financial depth and the international capital ecosystem, positioning GIFT City as a jurisdiction of choice in the global fund management landscape.

Alternative Investment Framework for Mobilising Private Capital

THE RISE OF ALTERNATIVE ASSET CLASS

The Alternative Investment Fund (AIF) industry in India has emerged as a dynamic and fast-evolving segment of the financial market, playing an increasingly critical role in channelling long-term capital into high-growth sectors and alternative asset classes. Over the past few years, this segment has gained prominence as a preferred investment vehicle for institutional and high-net-worth investors seeking diversification beyond traditional avenues. Backed by regulatory support, rising investor appetite, and growing sophistication in fund management practices, it has witnessed consistent growth in both participation and capital deployment.

In line with this trend, the AIF industry continued its strong upward trajectory with number of AIF’s sharply rising to 1,526 by March 31, 2025, from 1,283 in the previous year, reflecting a notable expansion in fund registration across all categories. Category III AIFs led this growth with a 33% rise, followed by Category II at 17% and Category I at 11%. On the capital front, the total commitments raised across all categories increased by 18.9% to r13,49,051 crore, up from r11,34,900 crore a year earlier. This was accompanied by a 24.7% increase in funds raised and a substantial 32.2% rise in investments made during the year, highlighting the growing deployment capacity of AIFs.

Category II AIFs maintained their dominance in the market, attracting the highest commitments and deploying the largest share of capital. Within Category I, Venture Capital Funds (VCFs) remained the most active, while Special Situation Funds and SME Funds recorded steady gains in both fundraising and capital deployment. The cumulative net investments made by AIFs, reflected in Assets Under Management (AUM), stood at ₹5,38,161 crore at the end of FY 2024–25.

Overall, gross cumulative funds raised by AIFs reached r7,95,143 crore as of March 31, 2025, while cumulative capital distributions to investors stood at r2,31,713 crore. These figures not only highlight the continued growth and resilience of the AIF ecosystem but also emphasize its increasing role in supporting India’s alternative financing landscape and driving capital towards emerging and other segments of the economy. (Source: SEBI Annual Report 2024-25)

UNDERSTANDING AIFs: THE REGULATORY FRAMEWORK

AIFs in India are governed by the SEBI (Alternative Investment Funds) Regulations, 2012. These funds are private pooled investment vehicles that collect money from investors to invest in line with defined strategies. SEBI classifies AIFs into three distinct categories:

  •  Category I AIFs – Promote early-stage ventures, social ventures, SMEs, infrastructure, and distressed asset strategies.
  • Category II AIFs – Invest in unlisted entities and private capital strategies without leveraging (except for operational needs).
  •  Category III AIFs – Employ complex or leveraged trading strategies to generate short-term, market-linked returns.

i. Category I AIFs: Capital for Innovation, Inclusion, and Impact

Category I AIFs are development-focused vehicles aimed at investing in sectors that are socially or economically beneficial. These include start-ups, SMEs, infrastructure, social ventures, and stressed assets. Due to their role in nation-building, these funds may receive government incentives or regulatory relaxations.

Venture Capital Funds (VCFs) are designed to invest in early-stage startups that exhibit high growth potential, particularly in innovative and disruptive sectors such as technology, healthcare, and consumer services. These funds typically take equity positions in emerging businesses, providing not just capital but also strategic guidance, mentorship, and access to networks. The aim is to nurture these startups through their formative stages and benefit from substantial value creation as they scale.

Angel Funds are a specific sub-class of VCFs that pool capital from accredited individual investors commonly known as angel investors to support seed-stage startups. These funds are geared towards very early-stage companies, often pre-revenue, and typically require a minimum investment commitment of r25 lakh per investor. Angel Funds allow for direct investment into specific portfolio companies, offering greater flexibility and alignment with investor preferences.

Special Situation Funds (SSFs) focus on distressed and non-performing assets, investing in opportunities such as security receipts issued by asset reconstruction companies, stressed loans, or companies undergoing insolvency proceedings under the Insolvency and Bankruptcy Code (IBC). These funds aim to unlock value through asset recovery, financial restructuring, and operational turnaround strategies, often operating in high-risk, high-reward scenarios.

SME and Social Venture Funds are structured to support small and medium enterprises (SMEs) as well as ventures that generate measurable social impact. These funds channel capital into underserved sectors and communities, facilitating inclusive growth through impact-oriented financing. Investments often target businesses involved in education, healthcare, financial inclusion, sustainable agriculture, or clean energy—where both financial returns and positive social outcomes are prioritised.

ii. Category II AIFs: Private Market Debt and Long-Term Capital

Category II AIFs represent the most active segment of the AIF space, comprising private equity funds, debt funds, and real estate or infrastructure-focused vehicles. These funds invest in unlisted companies and private instruments without employing leverage, except for operational requirements. Their close-ended structure and long holding periods make them suitable for medium to long-term growth strategies.

Private Equity Funds (PEFs) focus on investing in unlisted companies that are either in their growth phase or are mature businesses requiring capital for expansion, operational improvements, or restructuring. These funds often take significant or controlling stakes in the investee companies, enabling them to influence strategic decisions, drive value creation, and ultimately exit through IPOs, mergers, or secondary sales.

Debt Funds operate by extending structured debt or mezzanine financing to companies, particularly those seeking capital without diluting ownership. These funds play a crucial role in meeting the financing needs of businesses that may not have ready access to traditional bank loans or equity markets. By focusing on credit risk and collateral structures, debt funds generate returns primarily through interest income and fees, often with lower volatility compared to equity investments.

Fund of Funds (FoFs) take a multi-manager approach by investing in a portfolio of other Alternative Investment Funds (AIFs) rather than directly into individual companies or securities. This structure offers investors broad diversification across strategies, sectors, and asset managers through a single investment vehicle. FoFs are particularly attractive for those looking to access a wide range of AIF exposure while mitigating risk through professional manager selection and portfolio construction.

In FY 2024–25, Category II AIFs accounted for the largest capital base and continued to dominate overall industry deployment, particularly in sectors like real estate, NBFCs, and private credit.

iii. Category III AIFs: Complex Strategies and Long-Term Equity

Category III AIFs are designed for professional investors seeking short-term alpha through trading strategies, derivatives, leveraged positions at the same time favourable for long only equity strategies. These funds can be open-ended or close-ended, offering greater flexibility and liquidity, and are the only category permitted to use leverage extensively.

Within the Category III space, several distinct sub-categories of funds have emerged, each employing specialised strategies to generate returns irrespective of broader market conditions.

Hedge Funds are known for their pursuit of absolute returns using a variety of complex strategies. These may include long-short equity positions, arbitrage opportunities, global macroeconomic plays, and market-neutral techniques. By taking both bullish and bearish positions and actively managing risk, hedge funds aim to outperform traditional benchmarks, especially during periods of market volatility.

Quantitative or Algorithmic Funds (Quant/Algo Funds) rely on sophisticated, data-driven models to identify trading opportunities. These funds use algorithms, artificial intelligence, and statistical techniques to execute high-frequency trades or capitalize on market inefficiencies. Their decisions are often devoid of human emotion, focusing instead on real-time data patterns and predictive analytics.

Tactical Allocation Funds take a dynamic approach to portfolio management by actively shifting capital across different asset classes such as equities, bonds, commodities, or currencies based on evolving macroeconomic trends, geopolitical events, or market momentum. These funds aim to optimize returns by anticipating market cycles and adjusting exposure accordingly, rather than adhering to a fixed asset allocation strategy.

Category III funds saw a 33% increase in registrations in FY 2024–25, the highest among all categories, with the top 10 funds accounting for 61% of total investments—highlighting growing institutional interest in these high-risk, high-reward strategies.

SEBI’S 2025 REFORMS: A NEW ERA FOR ANGEL FUNDS IN INDIA

In a landmark move to bolster India’s early-stage investment landscape, the Securities and Exchange Board of India (SEBI) introduced a revised regulatory framework for Angel Funds in 2025 under the AIF Regulations, 2012. These reforms aim to enhance transparency, improve governance, and encourage broader investor participation, all while simplifying the operational structure of angel investing.

Under SEBI’s revised regulations effective September 10, 2025, Angel Funds can raise capital only from Accredited Investors, tightening eligibility norms. Existing funds may continue onboarding up to 200 non-accredited investors until September 8, 2026. A minimum of five Accredited Investors is required before the first close, to be achieved within 12 months of Private Placement Memorandum (PPM) acknowledgment. The framework allows direct investments into startups without launching separate schemes and removes the obligation to file term sheets with SEBI, though internal records must be maintained. Follow-on investments are permitted post-startup stage, capped at ₹25 crore, with no increase in original shareholding and only on a pro-rata basis by existing investors. The lock-in remains one year, reduced to six months for third-party exits. Angel Funds may also invest up to 25% of their corpus overseas, subject to SEBI’s NOC. Investment allocation must be transparently disclosed in the PPM, with rights and distributions aligned pro-rata. Sponsor and manager commitments have been reduced to 0.5% of each investment or ₹50,000, whichever is lower, replacing the earlier 2.5% of corpus or ₹50 lakh requirement.

By limiting participation to Accredited Investors, who meet SEBI’s defined financial thresholds, the framework ensures that Angel Funds engage with experienced and capable investors. This allows for greater operational flexibility and innovation while providing these investors exclusive access to early-stage, high-potential startup opportunities under a regulatory environment suited to their expertise.

SEBI’S 2025 OVERHAUL OF CO-INVESTMENT FRAMEWORK FOR AIFs

i. In a progressive move aimed at enhancing operational flexibility and broadening investor participation, the Securities and Exchange Board of India (SEBI) has introduced the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2025, along with a circular permitting co-investment through Co-Investment Vehicles (CIVs). This amendment significantly expands the co-investment framework for Category I and II Alternative Investment Funds (AIFs), enabling them to offer co-investment opportunities through dedicated CIV schemes established under the AIF Regulations. This is in addition to the existing Co-Investment Portfolio Manager (CPMS) route governed by the SEBI Portfolio Managers Regulations, 2020. The initiative aims to simplify fund structuring, reduce regulatory redundancies, and facilitate streamlined investor participation, particularly in transactions involving unlisted securities of investee companies already backed by the AIF.

ii. A CIV scheme refers to a new scheme launched under a Category I or II AIF, exclusively designed for accredited investors of a particular AIF scheme to co-invest in unlisted securities of the same investee company. Unlike the CPMS route, which involves separate registration and individual-level documentation, CIV schemes consolidate co-investments under a unified structure, reducing complexity for both investors and investee companies. Each CIV scheme must be separately filed with SEBI through a SEBI-registered merchant banker using a shelf placement memorandum and must remain ring-fenced from other AIF and CIV assets. Co-investments via the CIV route are restricted to accredited investors and are capped at three times the investor’s commitment to the main AIF scheme, subject to certain exemptions. Importantly, excused or defaulting investors from the main AIF are prohibited from participating in the related CIV scheme.

iii. To ensure regulatory consistency, SEBI has mandated that co-investments through CIVs must be made on terms no more favourable than those offered to the main AIF, with exits occurring simultaneously. Rights, obligations, and distributions are to be executed on a pro-rata basis, and CIV schemes are strictly prohibited from employing leverage. All co-investment-related expenses must be proportionately shared between the AIF and the CIV scheme. Despite the operational flexibility introduced, CIVs are accessible only to accredited investors, limiting broader
market participation. Fund managers are also subject to additional compliance requirements, including the need to file a separate placement memorandum and maintain distinct accounts for each CIV.

iv. To participate in a CIV scheme, an investor must qualify as an accredited investor, as defined under SEBI regulations. Accreditation is granted by a SEBI-recognised agency based on financial thresholds. For individuals, HUFs, family trusts, or sole proprietorships, eligibility is based on either a minimum annual income of r2 crore, a net worth of r7.5 crore (with at least r3.75 crore in financial assets), or a combination of r1 crore income and r5 crore net worth (with r2.5 crore in financial assets). For body corporates and non-family trusts, a net worth of at least r50 crore is required. In the
case of partnership firms, each partner must individually meet the accreditation criteria. These thresholds ensure that only financially sophisticated and capable investors gain access to the streamlined co-investment framework offered through CIVs.

v. In recent years, SEBI has adopted a more facilitative and differentiated regulatory approach towards accredited investors, acknowledging their financial sophistication, risk-bearing capacity, and ability to make informed investment decisions. This category of investors has been increasingly viewed as capable of participating in complex or higher-risk investment structures without requiring the same level of regulatory protection afforded to retail investors. Consequently, SEBI has introduced several relaxations and privileges specifically for accredited investors across various regulatory frameworks.

vi. For instance, accredited investors are permitted to invest in products that are otherwise restricted to retail participants, such as certain complex Alternative Investment Funds (AIFs), segregated portfolios under Portfolio Management Services (PMS), and now, the Co-Investment Vehicle (CIV) framework. They are exempted from minimum investment ticket sizes applicable to standard AIF and PMS investments, allowing greater flexibility in portfolio allocation. SEBI has also relaxed disclosure requirements and compliance timelines for investment vehicles dealing exclusively with accredited investors. For example, fund managers catering solely to accredited investors may be exempt from detailed client-level reporting or from maintaining standard fund tenure and corpus norms.

vii. Moreover, accredited investors can enter into customised investment agreements, benefit from reduced scrutiny in private placements, and gain access to faster onboarding processes under simplified KYC norms through accreditation. By offering these benefits, SEBI aims to promote new investor class without compromising on the core foundation of AIFs. The CIV regime is a further embodiment of this “lighter-touch” regulatory model, designed to facilitate efficient co-investment structures tailored to the needs and capabilities of accredited investors.

CONCLUSION AND WAY FORWARD

India’s AIF landscape has evolved into a pivotal pillar of the country’s capital markets, mobilising substantial private capital toward sectors that drive economic transformation, financial innovation, and inclusive growth. With continued investor interest, regulatory stewardship, and a deepening pool of fund management expertise, AIFs are increasingly positioned as strategic vehicles for channelling long-term, patient capital into critical and underserved segments of the economy.

The robust performance in FY 2024–25, marked by record growth in fund registrations, capital commitments, and deployment signals not only brings confidence in alternative investment strategies but also the maturing sophistication of the ecosystem. Category II AIFs continue to anchor the market with long-horizon investments in private equity, debt, and infrastructure, while Category I funds are reinforcing innovation, entrepreneurship, and impact-led development. The surge in Category III funds reflects growing institutional appetite for agile, market-linked strategies.

SEBI’s 2025 reforms underscore a decisive regulatory pivot enhancing transparency, aligning investor interests, and expanding participation pathways. The revised angel fund framework strikes a balance between governance and agility, while the introduction of Co-Investment Vehicles (CIVs) represents a calibrated response to the demand for greater structuring flexibility and investor alignment, particularly in high-conviction deals.

With the foundations now firmly in place, India’s AIF industry is well-equipped to serve both roles as a catalyst as well as a conduit for strategic, long-term capital supporting innovation, resilience, and inclusive prosperity in the evolving financial architecture.

Guarding Market Integrity: The Evolving Contours of SEBI’S PFUTP Framework

A. INTRODUCTION

The SEBI Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market Regulations 2003, commonly referred to as PFUTP Regulations, were introduced as a direct response to systemic weaknesses observed during the late 1990s and early 2000s pertaining to market manipulation, to meet its objective of preserving market integrity, ensuring investor protection, and promoting transparency in India’s securities markets.

These regulations are broad in scope having mix of principle and rule-based approach. It applies to all market participants whether individuals, entities, or intermediaries, and are designed to curb manipulative, deceptive, or unethical conduct in connection with securities trading, public offerings, and disclosures. It prohibits person from buying, selling or otherwise dealing in securities in fraudulent manner by using any manipulative or deceptive device.

The term “fraud” under PFUTP is defined expansively to “include any act, expression, omission or concealment committed whether in a deceitful manner or not by a person or by any other person with his connivance or by his agent while dealing in securities in order to induce another person or his agent to deal in securities, whether or not there is any wrongful gain or avoidance of any loss, and shall also include—

(1) a knowing misrepresentation of the truth or concealment of material fact in order that another person may act to his detriment;

(2)a suggestion as to a fact which is not true by one who does not believe it to be true;

(3)an active concealment of a fact by a person having knowledge or belief of the fact;

(4)a promise made without any intention of performing it;

(5)a representation made in a reckless and careless manner whether it be true or false;

(6)any such act or omission as any other law specifically declares to be fraudulent,

(7)deceptive behaviour by a person depriving another of informed consent or full participation,

(8)a false statement made without reasonable ground for believing it to be true.

(9) the act of an issuer of securities giving out misinformation that affects the market price of the security, resulting in investors being effectively misled even though they did not rely on the statement itself or anything derived from it other than the market price.

And “fraudulent” shall be construed accordingly.”

The PFUTP Regulations apply to all persons, regardless of whether they are registered intermediaries, institutional investors, listed companies, or individual market participants.

The wide scope is intentional, reflecting SEBI’s philosophy that market integrity depends not just on the conduct of regulated entities but also on all participants operating within the ecosystem. SEBI, through its investigative and adjudicatory mechanisms, is empowered to detect and act against such misconduct by leveraging surveillance data, trading patterns, and documentary evidence.

B. APPLICABILITY

These regulations apply to act occurring in connection with the buying, selling, or otherwise dealing in securities, whether on-exchange, off-market, or in public offerings. The regulations are also designed to capture both actual misconduct and attempted or intended wrongdoing, even if no loss or damage occurs. The expansive language ensures that enforcement is not limited to technical breaches but encompasses conduct that undermines fair play and transparency.

A landmark case that highlights the application of this definition is SEBI vs. Kanaiyalal Baldevbhai Patel (SAT Appeal No. 44 of 2006). In this case, the Hon. Securities Appellate Tribunal upheld SEBI’s action against a market participant involved in circular trading to create artificial volumes in the shares of a company. The Tribunal observed that the intent behind the transactions was not genuine investment or trading interest, but rather to give a misleading appearance of market activity. The ruling reinforced that intent to manipulate or mislead, even in the absence of direct monetary gain, falls squarely within the definition of fraud under PFUTP.

This interpretation underscores the principle that SEBI focuses not only on outcomes but also on intent and conduct. In an emphatic demonstration of regulatory resolve, SEBI, between April 2024 and June 2025, initiated proceedings against large number of entities wherein the alleged contraventions spanned a wide spectrum of malfeasance ranging from price and volume manipulation, to front-running, dissemination of deceptive information, and fraudulent misstatements in financial disclosures. This scale of enforcement is emblematic of the regulator’s sharpened surveillance system.

The PFUTP framework is thus preventive as well as disciplinary, aimed at deterring unethical behaviour, penalizing the contraventions and ensuring fair, transparent, and trustworthy market operations.

C. KEY AMENDMENTS INTRODUCED UNDER THE 2024 REGIME

The SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) (Amendment) Regulations, 2024 (‘2024 Amendments’) brought important changes aimed at making the existing framework more effective in preventing and penalizing market abuses. These amendments broaden the definition of fraudulent activities, clarify what counts as manipulative behaviour, and address new types of misconduct seen in today’s markets. The main changes include:

I. INCLUSION OF MULE ACCOUNTS FOR INDIVIDUAL TRADING

One of the major updates in the 2024 amendments is the clear recognition of “mule accounts.” These are trading or bank accounts that, while registered in one person’s name, are actually controlled or operated by someone else. Such accounts have been used to hide the original identity of person behind securities transactions, reducing transparency and enabling market manipulation. By explicitly including mule accounts in the regulations, SEBI can now hold the actual controllers/beneficiaries accountable. Any transactions done through these accounts are considered manipulative, fraudulent, and unfair, and are therefore prohibited under the law.

II. INCLUSION OF MULE ACCOUNTS IN MANIPULATION OF CORPORATE ASSETS AND FINANCIAL STATEMENTS

While SEBI has previously dealt with these issues on misuse of company assets and the manipulation of financial reports by listed companies, this amendment specifically includes bringing Mule Accounts directly under the PFUTP regulations, wherein the diversion of assets or manipulation of earnings impacts the market price of a company’s securities, such actions are now clearly classified as fraudulent and unfair trade practices.

This change emphasizes that misconduct is construed as a serious abuse of the securities market. The amendment clearly states that these acts will always be considered violations under the regulations, removing any doubt about their legal status. This move also supports SEBI’s long-held view that corporate wrongdoing affecting market prices must be treated as market fraud.

D. DEALING IN SECURITIES CONSIDERED DEEMED TO BE FRAUDULENT PRACTICE

Regulation 4(2) of SEBI (PFUTP) Regulations provides an illustrative list of activities that constitute fraudulent, manipulative, or unfair trade practices. These include:

  •  Creating False or Misleading Market Appearances: Deliberate actions that give the illusion of active or genuine trading, misleading market participants about demand or supply.
  •  Dealing in Securities Without Intent to Transfer Beneficial Ownership: Transactions conducted merely to inflate, depress, or cause fluctuations in security prices, without any intention of actual ownership transfer, aimed at wrongful gain or loss avoidance.
  •  Artificially Securing Minimum Subscription: Fraudulently inducing subscriptions in securities issues, including advancing money to others to meet minimum subscription requirements.
  •  Inducing Price Manipulation Through Payments: Offering or agreeing to pay money or other benefits to any person, directly or indirectly, to cause artificial price movements.
  •  Manipulating Security Prices or Reference Benchmarks: Any act or omission that influences or manipulates the price of a security or its benchmark price.
  •  Publishing Misleading or False Information: Knowingly disseminating false or misleading statements about securities or the market to influence prices or investor decisions.
  •  Market Participants Trading Without Client Knowledge or Misusing Client Funds: Executing transactions on behalf of clients without their knowledge or consent, or misappropriating client funds or securities held in fiduciary capacity.
  •  Circular Trading: Engaging in a series of transactions between parties, including intermediaries, to create a false impression of market activity or to manipulate prices.
  • Fraudulent Inducement for Enhanced Brokerage: Persuading others to trade securities with the primary intent of increasing brokerage or commission income fraudulently.
  •  Falsifying Records by Intermediaries: Altering or backdating contract notes, client instructions, or account statements to misrepresent transactions or holdings.
  •  Insider Trading with Unpublished Price-Sensitive Information: Placing orders while in possession of material non-public information affecting security prices.
  •  Planting False News: To induce Sale or Purchase of securities
  •  Mis-selling of Securities: Knowingly making false/misleading statements, concealing/omitting material facts, etc.
  • Illegal mobilization of Funds by sponsoring or causing to be sponsored or carrying on or causing to be carried on any collective investment scheme by any person.

E. FRONT-RUNNING AND ITS DISTINCTION FROM INSIDER TRADING WITHIN THE PFUTP FRAMEWORK

Front-running is a critical aspect of SEBI’s PFUTP Regulations, designed to uphold fairness and transparency in securities markets.

Front-running arises where an intermediary or market participant leverages advance knowledge of a substantial impending order. The compliance concern here is the breach of fiduciary responsibility, particularly were brokers or dealers trade in advance of client instructions.

It differs from Insider trading, which pertains to trading while in possession of unpublished price sensitive information (UPSI) relating to the company itself. The compliance obligation here centres on safeguarding confidential corporate information from misuse by insiders or connected persons.

Both practices are prohibited under SEBI regulations but rest on different sources of confidential information. The case pertaining to SEBI vs. Kanaiyalal Baldevbhai Patel, (2018) 207 Comp Cas 416 (SC), covers front-running as a fraudulent and unfair trade practice, allowing enforcement actions based on circumstantial evidence such as suspicious trading patterns and communication records.

In the above-mentioned order, the factors like market liquidity and order size relative to average volumes were considered to contextually assessed the case. Moreover, SEBI has expanded its vigilance to cover emerging market manipulation techniques, including coordinated digital campaigns designed to artificially influence security prices. While insider trading and front-running are distinct in theory, in practice, they often intertwine in market abuse investigations. For compliance professionals, this means implementing robust surveillance systems, strict internal controls, and information barriers to detect, prevent, and address both forms of misconduct effectively.

F. CONCLUDING REMARKS

The SEBI PFUTP Regulations serve as a cornerstone for maintaining the integrity, transparency, and fairness of India’s securities markets. Through continuous evolution, most notably the recent 2024 amendments, SEBI has strengthened its regulatory framework to effectively tackle a broad spectrum of manipulative and deceptive practices, including mule accounts, financial statement manipulations, front-running, and coordinated digital misinformation campaigns. These regulations not only emphasize the prevention of outright fraud but also target conduct that disrupts market functioning and investor perceptions.

Following measure may further strengthen the PFUTP Framework:

a) Regulatory Refinement: SEBI must continue to refine the PFUTP framework, particularly by codifying guidance on emerging trading practices, ensuring that the law remains both technologically neutral and forward-looking.

b) Surveillance and Forensics: Leveraging artificial intelligence, machine learning, and data analytics in trade surveillance will be indispensable to detect patterns of collusion, layering, spoofing, and other technologically sophisticated manipulations.

c) Institutional Safeguards: Strengthening the role of intermediary’s stockbrokers, asset managers, and depositories in embedding surveillance, information barriers, and fiduciary accountability will serve as the first line of defence against front-running, insider trading, and misuse of mule accounts.

d) Global Convergence: Given the transnational nature of financial flows and digital trading, enhanced cooperation with international regulators will be necessary to combat misconduct that transcends jurisdictions. This can further be combined with global measures undertaken for prevention of money laundering.

e) Investor Awareness and Deterrence: A culture of deterrence must be reinforced not merely through penalties but also through systemic awareness campaigns, enabling investors to identify and avoid manipulative schemes, particularly those propagated via digital platforms.

Ultimately, preserving market integrity demands collective vigilance, timely enforcement, and adaptive regulatory frameworks that respond swiftly to emerging threats. By aligning regulatory rigor with market realities, SEBI and stakeholders can ensure a fair and resilient securities ecosystem that safeguards investors and supports sustainable capital market growth.

Bond Market – Online Bond Platform Provider (OBPP)

1. STRATEGIC CONTEXT: BRIDGING THE GAPS

The Indian corporate debt market, though sizeable in terms of outstanding issuances, has for decades suffered from structural and behavioural constraints that have hindered its growth potential. Retail investor participation has remained persistently low, with the secondary market dominated by institutional investors such as banks, mutual funds, and insurance companies. Trading activity has largely been concentrated in a limited set of highly rated issuances, while vast sections of the bond universe have remained illiquid. Moreover, price discovery has historically been opaque, with real-time transactional information accessible primarily to wholesale participants. This combination of limited transparency, inadequate retail access, and liquidity fragmentation created a market that, while functionally viable for institutions, was effectively exclusionary for smaller investors and lacked depth in the broader sense.

Historically, the Indian bond market evolved in two distinct phases.

THE WHOLESALE DEBT MARKET

The Wholesale Debt Market (WDM) segment of the NSE and BSE is the institutional nucleus of India’s debt market, created in the mid-1990s to provide a transparent, regulated platform for large-value transactions in fixed-income securities such as government bonds, treasury bills, state loans, corporate bonds, and debentures, where participation was largely dominated by institutional investors with retail involvement remaining negligible. According to official data released by the Securities and Exchange Board of India (SEBI), during the period FY 2015 to FY 2019, the transaction count typically was in the range of 5 lacs to 7 lacs transactions per year1. This trend reflected a largely institutional market with limited depth and lower retail penetration.

1 https://www.sebi.gov.in/statistics/corporate-bonds/trades-corporate-bonds/Data-For-FY-2015-2022.html

SHIFT TOWARDS RETAIL PARTICIPATION

Post FY 2020, SEBI’s calibrated interventions, such as the introduction of the Electronic Bidding Platform, the Retail Direct Scheme for G-Secs, and enhanced disclosure norms significantly bolstered market activity.

The latest data indicates that for FY 2023–24, corporate bond trades settled at approximately ₹ 13.73 lakh crore across nearly 1.29 million transactions, and in FY 2024–25 (up to the latest reporting period), around ₹ 17.09 lakh crore across 1.2 million trades have already been executed. The trajectory underscores not only the scale of market formalisation but also signifies the pivotal role of regulatory oversight in shaping transparency and participation.

While these reforms strengthened institutional trading and improved compliance discipline among issuers, they did not directly address the retail investor’s ability to discover, assess, and participate in fixed-income opportunities in a safe and transparent environment.

THE BEGINNING OF ONLINE BOND PLATFORMS

During the intervening period between 2018 & 2022, India witnessed the mushrooming of online bond platforms distributing fixed income securities to the retail public at large albeit outside the regulatory framework.

An Online Bond Platform Provider in common parlance, operates like a digital e-commerce platform for fixed income securities accessible to the retail investors.

Recognising this gap and to prevent market abuse, SEBI introduced a formalised framework for Online Bond Platform Providers (OBPPs) through its circular dated 14 November 2022, to create a new category of regulated segments to be registered with the exchange. The framework was conceived with dual objectives: to widen investor access by leveraging technology-driven distribution and to embed robust investor protection.

As of early 2025, there are approximately 27 Active Online Bond Platforms which are registered with SEBI2, however, the retail participation through the online bond platforms saw a marked increase: volumes rose from approximately ₹ 1,644.16 crore on April 1, 2023, to about ₹ 2,459.45 crore by February 19, 2024 reflecting early fiscal-year growth dynamics.

2 BSE & NSE Website

With the operationalisation of Online Bond Platform Providers (OBPPs) and the launch of “Bond Central” in December 2023, the trading ecosystem is expected to move toward a more retail-inclusive and data-driven framework, which may progressively bridge the gap between historical institutional concentration and future broad-based participation.

2. REGULATORY FRAMEWORK FOR OBPPs

The regulatory architecture for OBPPs is the culmination of a decade-long reform trajectory in India’s debt market, shaped by SEBI’s sustained efforts to address structural inefficiencies and to democratise fixed-income investing. The underlying policy rationale was to bridge the asymmetry between wholesale and retail bond market participation, leveraging digital platforms to enable transparent price discovery, centralised settlement, and standardised disclosures—without diluting prudential safeguards.

2.1 Foundation

The 2022 framework mandates that OBPPs:

  •  Be incorporated in India and registered as stockbrokers in the debt segment;
  • Obtain explicit authorisation from a recognised stock exchange;
  •  Appoint a Compliance Officer (minimum qualification: Company Secretary) and at least two Key Managerial Personnel with a minimum of three years’ securities market experience.
  •  Obtain a SEBI Complaints Redress System (SCORES) authentication and put in place a well-defined mechanism to address grievances that may arise or likely arise while carrying out OBPP operations.

This authorisation is continuously contingent on adherence to SEBI’s conduct, disclosure, and operational norms. Breaches attract enforcement action under the SEBI Act, including suspension of platform activity and monetary penalties.

2.2 Product Eligibility and Expansion

Originally confined to listed corporate bonds, the permissible universe was expanded in June 2023 to include:

  •  Listed municipal debt securities,
  •  Securitised debt instruments,
  •  Government Securities (G-Secs), State Development Loans (SDLs),
  • Treasury Bills, and
  •  Sovereign Gold Bonds.

3. KEY OPERATIONAL GUIDELINES

3.1 Transaction Architecture

All OBPP transactions must be routed through the Request for Quote (RFQ) mechanism of a recognised stock exchange, enabling competitive price discovery within a regulated and auditable framework. Settlement is executed via a recognised clearing corporation acting as a central counterparty, eliminating bilateral settlement risk. This operational integration not only mitigates counterparty risk but also ensures that price discovery happens within a transparent, regulated environment.

3.2 Investor Disclosures

Mandatory measures include KYC verification via SEBI-recognised KRAs, risk profiling, and product suitability assessment before onboarding. Product displays must feature credit ratings, maturity, coupon structure, liquidity indicators, and issuer disclosures, accompanied by prescribed, non-waivable risk statements.

3.3 Technology and Governance Standards

OBPPs must:

  •  Maintain high-availability systems with disaster recovery capabilities;
  •  Ensure secure, real-time API connectivity with market infrastructure institutions;
  •  Preserve all investor interactions and trade data for at least eight years;
  •  Deploy real-time monitoring for trade reconciliation and system performance.

4. OTHER INVESTOR PROTECTION MEASURES

OBPPs are prohibited from marketing unregulated products alongside regulated offerings. All communications must conform to the SEBI Advertisement Code, ensuring fairness, accuracy, and prominent disclosure of risks and eligibility criteria. Written conflict-of-interest policies must explicitly address instances where the platform operator or affiliates act as issuers, arrangers, or significant holders in the securities on offer.

  •  Price Transparency and Discoverability

One of the most significant advantages for the public is the elimination of information asymmetry. OBPPs operate through the RFQ mechanism integrated with recognised stock exchanges, ensuring that all bids and offers are visible in real time. Investors can benchmark prices against market-wide quotes, reducing reliance on opaque dealer negotiations. This enhances trust and enables more informed decision-making, particularly for retail investors who lack institutional bargaining power.

  •  Settlement Security and Reduced Counterparty Risk

Trades routed through OBPPs are mandatorily cleared via recognised clearing corporations, providing central counterparty protection. For retail participants, centralised settlement ensures that funds and securities are exchanged on a guaranteed basis, bolstering confidence in the integrity of the transaction process.

  •  Portfolio Diversification and Yield Optimisation

Access to corporate bonds through OBPPs enables retail investors to diversify beyond equity-linked products and low-yield bank deposits. Over time, this can contribute to a more balanced household investment portfolio, with fixed-income allocations aligned to long-term financial objectives.

  •  Accessibility and Inclusion

OBPPs provide retail investors with a digital entry point into a market previously dominated by institutional desks. By lowering the minimum investment size, from ₹ 10 Lakhs to ₹ 1 Lakh and option to issue plain vanilla instruments at ₹ 10,000 through private placement mode, standardising digital interfaces, these platforms allow individuals including first-time savers, small investors, and high-net-worth individuals to diversify beyond traditional instruments such as fixed deposits and small savings schemes.

PAVING THE ROADMAP FOR UNTAPPED RETAIL SEGMENT

SEBI has ensured that OBPPs cannot operate as opaque distribution channels. As technological penetration expands and investor education improves, India’s corporate bond market stands at the cusp of a structural transformation, aligning more closely with global best practices while addressing its own historical constraints.

The OBPP landscape presents a great-opportunity of India’s fixed-income markets, combining the scale of digital distribution with the rigour of securities market regulation. Success in this space will depend on sustaining operational discipline through scalable compliance ecosystems, robust data governance, and proactive market conduct oversight. This has opened the investment avenues for retail investors, thereby promoting and aligning to the objectives of SEBI to deepen the corporate bond market and investor protection.

Concert Camera Cartoon

Mutual Fund “Lite” – Rewriting The Grammar Of Passive Investing

EVOLVING MARKET LANDSCAPE

The Indian mutual fund industry, governed by the SEBI (Mutual Funds) Regulations, 1996, has witnessed an unprecedented evolution over the last two decades driven by a sustained policy focus on financial inclusion, digital infrastructure expansion, and increased investor awareness. The growth trajectory has been further accelerated by the entry of retail investors from Tier 2 and Tier 3 cities, facilitated by low-cost digital platforms, simplified customer norms, and systematic investment planning becoming culturally entrenched.

However, this expansion has also revealed a structural rigidity in the regulatory ecosystem, wherein all mutual fund Sponsors and Asset Management Companies (AMCs), irrespective of investment strategy or complexity, are subject to a uniform and comprehensive set of compliance obligations. This includes stringent capitalisation norms, expansive governance frameworks, granular disclosure requirements, and exhaustive reporting and audit cycles, originally designed to mitigate risks associated with actively managed, high-discretion investment vehicles.

THE IMPERATIVE FOR REGULATORY DIFFERENTIATION

As per the AMFI Database1, the mutual fund industry’s Assets Under Management (AUM) reached ₹65.74 lakh crore in March 2025, which is a 23.11% increase year on year from ₹53.40 lakh crore as on March 2024. Out of which, the AUM of passive mutual funds in India reached ₹11.47 lakh crore in March 2025. This marks a notable increase of 22.7% compared to ₹9.34 lakh crore in March 2024. What is remarkable, is that the passive mutual fund industry at large has witnessed an exponential increase of 119.8% in a 3-year span.

1 https://www.amfiindia.com/Themes/Theme1/downloads/AMFIMonthlyNote_March2025.pdf

This number demonstrates the convergence of several critical factors such as rising investor demand for low-cost products, increased indexation of capital markets, global regulatory trends toward passive investing, and the operational simplicity of rule-based investment models. In particular, passive investment strategies such as Index funds and Exchange Traded Funds (ETFs), which are inherently transparent, rules-driven, and involve limited portfolio churn, have emerged as viable vehicles for delivering low-cost, scalable investment access to first-time investors. Notwithstanding their risk-mitigated structure, these schemes have, until now, been subject to the same compliance and capital thresholds as actively managed products.

Recognising the inefficiencies and entry barriers created by this undifferentiated framework, the Securities and Exchange Board of India (SEBI) undertook a significant policy recalibration. In furtherance of its mandate to promote capital formation, investor protection, and orderly market development, SEBI introduced a tailored regulatory carve-out under the Mutual Fund Regulations.

Vide circular dated 16 December 2024, SEBI formally launched the “Mutual Fund Lite” framework—a streamlined, compliance-light regime designed exclusively for mutual funds proposing to offer only passive investment schemes. A passive mutual fund scheme is a mutual fund that replicates or tracks a specified market index where the underlying securities shall be equity, plain vanilla debt securities, physical commodities and exchange trade derivatives. Investment in Equity Derivatives of underlying securities forming part of the Index shall be available as an investment option in case the underlying security is not available for purchase.

The Mutual Fund Lite regime is a distinct regulatory channel that allows new entrants to establish and operate passive-only mutual fund structures with an intent to promote ease of entry, encourage new players, reduce compliance requirements, increase penetration, facilitate investment diversification, increase market liquidity and foster innovation. It embodies the principle of proportionality in regulation—where the regulatory burden is commensurate with the risk posed by the investment strategy.

ESTABLISHMENT OF MUTUAL FUND LITE UNDER SEBI (MUTUAL FUNDS) REGULATIONS, 1996 LEGAL CODIFICATION AND STRUCTURAL CARVE-OUTS

The Mutual Fund Lite regime is now firmly embedded within the SEBI (Mutual Funds) Regulations, 1996, through the introduction of Chapter IX (Regulations 79–89). This provides a standalone legal structure tailored for entities intending to offer exclusively passive investment schemes, alongside a streamlined governance and compliance regimen.

The framework introduces several key pillars:

  •  Sponsors must demonstrate both financial capacity and commitment to operate solely within the passive-investment paradigm.
  •  Parameters for determining eligibility for application of sponsor of a mutual fund under the main route warrants the sponsor to have a sound track record, maintenance of net worth, profit track record in 3 years out of 5 years (including 5th year), average profitability, capital contribution, minimum deployment of net worth in AMC, etc.

In case of an alternate route, some of the key points include sponsor capitalisation is expected at a higher amount along with a combined management experience of 20 years.

STATUTORY BOUNDARIES UNDER THE MUTUAL FUND LITE REGIME

Permitted Passive Schemes

The permissibility of schemes is tightly circumscribed and deliberately restricted to eliminate portfolio discretion, lower operational risks, and ensure transparency.

A Mutual Fund Lite entity may only offer the following categories of passive investment schemes and any other schemes as SEBI may define from time to time:

1. Index Funds, which replicate a specific index whether equity or debt approved by SEBI or constructed in accordance with SEBI recognised methodology, and follow a non-discretionary, rules-based investment pattern;

2. Exchange Traded Funds (ETFs), which are required to passively track such recognised indices and be listed and traded on recognised stock exchanges, thereby offering liquidity and real-time price discovery.

3. Fund of Funds (FoFs), which are permitted solely where the underlying investments are limited to the aforementioned index funds and/or ETFs, whether domiciled domestically or in foreign jurisdictions, provided they adhere to the passive investment mandate.

4. Hybrid ETFs / Index Funds are a new class of passive funds where AMCs can launch a new class of Hybrid passive Funds which shall replicate a composite index comprising of equity and debt and enable investors to invest in a single product having exposure to equity & debt instruments.

Investment Restriction

Passive scheme shall not be allowed to invest in the following:

  •  Unlisted Debt Instrument
  •  Bespoke or Complex Debt Products
  •  Securities with special features
  •  Inter scheme transactions
  •  Short Selling
  •  Unrated Debt and Money Market Instruments (except G-secs, T-Bills and other money market instruments)

It is of critical legal significance that no active management, sectoral themes, or discretion-based portfolio construction is permitted under this regulatory carve-out. The Lite framework is, by express design and regulation, constructed to avoid fund manager discretion, reduce tracking errors, and ensure faithful replication of the prescribed index, that inherently limit systemic and investor level risks.

DISTINCTION BETWEEN MUTUAL FUND LITE AND CONVENTIONAL MUTUAL FUNDS: A REGULATORY AND OPERATIONAL DICHOTOMY

The Mutual Fund Lite regime institutionalises a deliberate divergence from the conventional mutual fund regulatory framework. It is not merely a variation in product type but a shift in regulatory theory—rooted in the doctrine of proportional regulation and calibrated supervision.

The following key distinctions underscore the bifurcated architecture between the two regulatory tracks:

1. Capital Adequacy Norms

Under the Mutual Fund Lite framework, Asset Management Companies (AMCs) are required to maintain a minimum net worth of ₹35 crore (₹50 Crore In case of entering through Alternate Route), a significant reduction from the ₹50 crore mandated (₹100 Crore In case of entering through Alternate Route), for conventional AMCs as per Regulation 21 of the SEBI (Mutual Funds) Regulations, 1996.

This reflects the reduced operational complexity and limited risk exposure associated with passive investment strategies, justifying a lower entry threshold for new or niche participants.

2. Scope of Permissible Schemes

Entities operating under the Mutual Fund Lite regime are restricted to passive investment schemes—including index funds, exchange-traded funds (ETFs), and funds of funds (FoFs) investing exclusively in such passive strategies.

Unlike full-scope AMCs that may launch a wide array of actively managed, thematic, or tactical schemes, the Lite framework enforces product discipline and predictability, aligning offerings with the regime’s simplified risk profile and investor expectations.

3. Governance and Organizational Requirements

The governance architecture for Mutual Fund Lite AMCs is streamlined. Key exemptions include:

  •  No mandatory constitution of Risk Management Committees (RMC) or Valuation Committees. Further the requirement of an RMC shall be optional and the audit committee of AMC may undertake the additional role of RMC.
  •  Relaxation in the appointment of certain Key Managerial Personnel (KMPs). However, core fiduciary obligations remain intact. Trustees continue to be bound by statutory duties, and SEBI retains its full supervisory and enforcement authority under the SEBI Act, 1992 and applicable mutual fund regulations. This ensures that while operational governance is simplified, regulatory accountability remains uncompromised.

4. Compliance and Disclosure Requirements

The compliance framework is recalibrated to reflect the inherently lower-risk profile of passive funds. Key relaxations include:

  •  Reduced frequency of audits
  •  Simplified disclosure formats in offering documents and periodic reports.

Nevertheless, transparency and disclosure obligations remain essential, preserving investor confidence and market discipline.

Entities are expected to maintain high standards of data integrity and reporting accuracy, in line with SEBI’s disclosure principles.

5. Hiving of Existing Active & Passive Funds

Existing MFs having both active and passive schemes may hive off respective passive schemes covered under MF Lite Framework, if they so desire, to a different group entity, thereby resulting in management of active and passive schemes by separate AMCs but under a common sponsor. However, each sponsor shall be permitted to obtain up to two registrations i.e. one each for MF- active and MF- Lite,

Further, they shall completely segregate and ring-fence its resources including infrastructure, technology and staff etc. for passive MF management from the active MF management.

However, MF Lite shall only offer schemes of passive investment and any other scheme as defined by SEBI from time to time.

Also, the existing AMCs shall now have the liberty at its disposal to operate two different set ups, each resonating to the investment strategy, thereby delivering better investor performance aligning to the risk appetite.

6. Fast Track Registration of MF Lite Schemes

Fast tracking of Scheme Information Document shall be mandatory for schemes under the framework; however, Key Information Memorandum shall not be required for a respective scheme in case of MF Lite, easing out additional operationalities at the time of launching a scheme.

IMPLICIT COMPLIANCE RECALIBRATIONS AND THE STRATEGIC WAY FORWARD

For institutions evaluating entry or expansion within the asset management space, the Mutual Fund Lite regime offers a platform of legal clarity and procedural economy—while simultaneously demanding strategic precision in scheme structuring and investor communication.

In its regulatory design, Mutual Fund Lite envisions an ecosystem where market entrants are not handicapped by existing capital thresholds or intricate organizational structures, but are instead empowered by clarity of scope and precision of responsibility. This opens avenues for bespoke, low-cost structures that can serve niche investor cohorts with differentiated financial access goals—without triggering compliance machinery disproportionate to underlying risks.

The strategic implications of this model are manifold: it incentivises lean governance without weakening oversight, facilitates product innovation within statutory bounds, and enables ecosystem participants to calibrate their operational and advisory models to a lighter, yet equally robust, regulatory regime.

For stakeholders involved in the architecture of collective investment—be it through structuring, operationalisation, audit, risk oversight, or regulatory interpretation—this regime rewrites what preparedness must look like. The way forward lies in:

  •  Streamlining audit and internal control frameworks around leaner fiduciary structures;
  •  Crafting legally rigorous scheme documents that conform to tight regulatory boundaries while enabling product flexibility;
  •  Building digital compliance infrastructure that supports direct-to-investor ecosystems and automated disclosures;
  •  And perhaps most crucially, adapting professional mindsets to a regime where governance is not defined by scale, but by discipline, clarity, and proportionality.

Professionals have a new opportunity at their doorstep to expand their horizons and assess how mutual funds are structured, advised and monitored.

The Mutual Fund Lite pathway aligns with SEBI’s long-standing vision of fostering growth in the passive fund management segment, expanding investor choice, and promoting digital innovation within the asset management industry.

Redefining IPO Frameworks: A Detailed Exploration of SEBI’S March 2025 ICDR Amendment

THE EVOLUTION OF THE ICDR FRAMEWORK

Over the past two decades, India’s equity capital markets have undergone a dramatic transformation, characterised by a progressive shift to a sophisticated, disclosure-based regulatory framework. At the core of this journey lies the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (‘Regulations’) first introduced in 2009 and later revamped in 2018 to consolidate and modernisze multiple prior issuances.

The ICDR framework has since served as the statutory compass for every issuer seeking to access public capital, dictating the eligibility, disclosure, and procedural architecture for initial public offerings (IPOs), follow-on public offerings (FPOs), rights issues, and preferential allotments. With the deepening of capital markets and diversification of issuer profiles spanning traditional industrial giants, digital-first startups, and MSMEs, SEBI has regularly amended these regulations to balance investor protection with ease of capital formation.

The latest amendment, notified in March 2025, builds on this philosophy, it opts for precision over a sweeping overhaul: nuanced modifications intended to simplify compliance, improve disclosure symmetry, enhance inclusivity for smaller issuers, and rationalize expectations around employee incentives and post-issue governance. Its significance lies not in revolutionising the IPO framework, but in refining it to reflect the practical realities of an evolved and maturing market. The key changes have been explained as under:

• Subtle Codification of Evolving Corporate Practices: SARs and Promoter Contributions

One of the most quietly consequential developments has been the formal incorporation of Stock Appreciation Rights (SARs) into the recognised universe of employee incentive instruments for unlisted companies approaching IPOs. While SARs have long been favoured by unlisted, innovation-driven enterprises for their performance-linked structure and non-dilutive character, their treatment under the Regulations, was hitherto undefined particularly in relation to promoter contribution and pre-issue lock-in.

The amendment resolves this uncertainty by expressly recognizing equity shares allotted pursuant to SARs under a scheme compliant with the SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021. A new proviso to Regulation 14(1) provides that such shares, if allotted prior to the filing of the draft offer document, shall be eligible to be included in the minimum promoter contribution. Simultaneously, the proviso to Regulation 16(1)(a) exempts these shares from the customary one-year lock-in applicable to other pre-issue capital, provided the allotment is made under a compliant SAR scheme.

These clarifications enhance regulatory predictability and align SEBI’s norms with global IPO practices involving employee incentives and promoter structuring.

  •  Expanding the Boundaries of Financial Transparency: Optional Disclosure of Sub-Material Transactions

The amended regulatory framework allows voluntary disclosure of financial information including audited or Chartered Accountant-certified pro forma financials pertaining to acquisitions, divestitures, or business combinations that do not meet the prescribed materiality thresholds under Regulation 2(1)(r) and associated guidance.

Additionally, disclosures related to working capital utilization must now give reference to the audited standalone financials, if restated consolidated figures significantly impact them. This move bridges disclosure asymmetry, ensuring investors access a coherent financial picture even when standalone restatements are not legally mandated.

This calibrated flexibility reflects an evolved understanding of contemporary business strategy, particularly within sectors such as technology, digital services, and life sciences, where smaller acquisitions though quantitatively immaterial may yield significant qualitative transformation in capabilities, market reach, or intellectual capital.

By enabling such disclosures at the issuer’s discretion, the amendment supports greater narrative continuity in the offer document, especially for entities pursuing inorganic expansion. It mitigates information asymmetries without imposing blanket disclosure burdens, thereby preserving proportionality in regulatory compliance.

The revised framework also inherently enhances the role of statutory auditors and professional certifiers, embedding their opinion into a broader context of strategic disclosures. It signifies a regulatory shift from minimum compliance toward facilitated transparency, empowering issuers to shape more nuanced and investor-informative public offer documents.

  •  Reintroducing Agility into Shareholder-Centric Capital Raising

Rights issues, historically a dominant mechanism for equity capital raising in India, had witnessed declining adoption in recent years due to procedural rigidity and cost-intensive regulatory intermediation. A significant shift in this landscape is witnessed by rationalising the compliance requirements and re-establishing rights issues as a viable, efficient, and shareholder-centric fundraising route.

Key regulatory relaxations are embedded in Regulation 3 and Regulation 60 of the Regulations. Under the amended Regulation 60(1)(c), issuers making a rights issue not exceeding ₹50 crore are no longer required to appoint a lead manager, thus reducing intermediary costs. Additionally, Regulation 3 proviso now exempts specified categories of rights issues from the requirement of submitting the draft letter of offer to SEBI for prior review, subject to compliance with prescribed eligibility conditions.
Meanwhile, Regulation 8A introduces caps on Offer-for-Sale (OFS) quantities based on pre-issue shareholding. Shareholders holding ≥20% can now only offer up to 50% of that holding in an IPO, while those below 20% are limited to 10%. These percentages are to be calculated as of the draft offer document filing date and include any pre-IPO secondary transfers, ensuring alignment with updated ownership structures and preventing excessive secondary dilution.

Complementing these changes is the introduction of a simplified disclosure framework under Schedule VI, which mandates a standardized, template-based disclosure regime. This significantly enhances clarity and reduces documentation complexity for mid-cap and promoter-driven companies, while ensuring consistency in investor communication.

Collectively, these reforms democratize access to the capital markets by lowering entry barriers and facilitating faster execution. The amendments are calibrated to maintain regulatory oversight without compromising procedural efficiency, thereby enabling a broader base of listed entities to pursue rights issues as a credible capital augmentation strategy.

  •  Institutionalising Governance in SME Listings: Raising the Bar Without Raising Barriers

These amendments, notified in March 2025, are aimed at strengthening investor protection and elevating the credibility of SME listings, while preserving access for genuine capital seekers.

Under the revised Regulation 229, issuers seeking to list on SME platforms must now satisfy specified quantitative eligibility criteria, including profitability thresholds and a defined operational track record post-conversion from partnership or proprietorship entities. This enhancement reflects a refined risk-based regulatory posture that seeks to elevate the qualitative profile of listed SMEs and attract long-term institutional participation.

Further, the threshold for mandatory monitoring of issue proceeds has been lowered from ₹100 crore to ₹50 crore. Issues above this threshold are now subject to monitoring by a credit rating agency, while issues below must comply with a statutory auditor certification requirement through quarterly financial disclosures. These provisions enhance transparency in fund deployment without disproportionately burdening smaller issuers.

Further, Regulation 281A introduces an exit mechanism for dissenting shareholders if post-IPO changes are made to the use of proceeds or core business terms. This provision elevates issuer accountability and reinforces investor protection without imposing disproportionate compliance costs on small-cap issuers.

Collectively, these reforms embed greater discipline, integrity, and investor confidence into the SME listing framework. The emphasis on governance-led eligibility, deployment oversight, and post-listing accountability strengthens the structural foundation of India’s SME capital market architecture, fostering a more predictable and responsible market environment.

  •  Convergence and Coherence: Harmonizing Disparate Regulatory Standards

Perhaps the most quietly impactful facet of the amendment lies in its harmonization of definitions, interpretations, and compliance expectations across SEBI’s broader regulatory universe. In recent years, inconsistencies between the ICDR Regulations, LODR norms, and other SEBI codes have bred interpretive uncertainty—especially in transitional situations like promoter reclassification, subsidiary disclosures, and related party governance.

By reconciling these definitions and aligning procedural interpretations across its regulatory framework, SEBI has reduced friction not just for issuers, but also for advisors, auditors, and regulators themselves. The legal and compliance machinery surrounding an IPO is now better equipped to deliver consistent, defensible interpretations—minimising last-minute escalations and interpretive disputes.

  •  Refining Post-Listing Governance: Calibrated Expectations from Anchor Investors and Monitoring Agencies

The IPO lifecycle does not conclude at listing. Increasingly, regulatory attention has turned toward the post-offer environment, particularly the stabilisation of shareholding structures and the integrity of fund utilisation. Within this context, two quiet but meaningful refinements have emerged.

First, the revised framework grants issuers greater discretion in capping the number of Anchor Investors, eliminating the erstwhile ceiling of 15 per category. This minor change, on the surface, unlocks deeper flexibility in constructing the pre-listing institutional book — especially in sectors where investor specialisation matters more than scale. For instance, new-age tech companies may prefer sector-focused funds with domain knowledge over larger, generalized institutional investors. The ability to curate a more tailored anchor cohort enhances both signaling and stability.

Second, with the reduction of the threshold for mandatory appointment of Monitoring Agencies (from ₹100 crore to ₹50 crore of fresh issue proceeds), SEBI signals a renewed commitment to post-issue fund discipline. While the mechanics of monitoring are not novel, the expansion of its application reflects regulatory concern over potential misalignments between disclosed intentions and actual deployment — a theme particularly relevant in IPOs driven by aggressive valuation narratives. From a compliance standpoint, it places renewed responsibility on merchant bankers and independent auditors to enforce a continuous feedback loop post-listing.

CONCLUDING INSIGHT: A REGULATORY ARCHITECTURE IN QUIET MATURITY

The 2025 amendments to the Regulations represent not disruption, but distillation. Rather than reinventing the playbook, they refine it harmonizing legacy provisions with contemporary issuer behavior, clarifying interpretive uncertainties, and enabling capital market access to evolve without compromising integrity. Navigating India’s capital markets in 2025 and beyond will demand not just knowledge of the law, but an ability to engage with its spirit. These reforms are a reminder that regulation, at its best, is not a constraint but a combination of trust and accountability.

Beyond the issuers and investors, this round of reforms recalibrates the professional ecosystem supporting IPOs and other public issues. The optional financial disclosures for non-material transactions place greater emphasis on judgment and credibility, especially where Chartered Accountants are called upon to certify supplemental data. Similarly, relaxed rights issue requirements reduce the procedural load on lead managers, instead reorienting their role towards strategic guidance and investor alignment.

In its true sense, professionals are no longer just process facilitators; they are becoming capital market interpreters, navigating clients through a disclosure and eligibility regime increasingly focused on maturity over mere legality.

Specialised Investment Funds (SIFs) – Way To New Investment Opportunities

1 . THE EVOLVING INVESTMENT LANDSCAPE

India’s capital markets have long been characterized by a dichotomy in investor behaviour: retail investors gravitate towards mutual funds for their risk-diversified portfolios and ease of access, while High Net-Worth Individuals (HNIs) and institutional investors often prefer PMS for its personalized portfolio construction and active management. However, the absence of an intermediary vehicle that caters to investors seeking more flexibility than mutual funds, but without the significant capital commitment demanded by PMS, has left a regulatory void. This gap had led to the emergence of unregulated schemes that, while attractive to investors, carry substantial operational and financial risks due to their lack of oversight.

The introduction of Specialized Investment Funds (SIFs) under the SEBI (Mutual Funds) Regulations, 1996 vide circular dated 16th December, 2024, directly addresses this regulatory vacuum. This initiative also reinforces the stability of the broader asset management ecosystem by channelling investor interest into a regulated space, thereby reducing systemic risk.

2. RATIONALE BEHIND THE INTRODUCTION OF SIFs

The decision to introduce SIFs is driven by several strategic considerations that reflect both current market needs and long-term objectives for the development of India’s capital markets.

  •  Bridging the Investment Gap: SIFs are designed for investors who require a degree of customization beyond what traditional mutual funds provide but do not wish to engage in the bespoke, high-commitment strategies associated with PMS. By incorporating elements of both approaches, SIFs provide a unique solution that blends the accessibility and diversification of mutual funds with a level of portfolio flexibility and customisation that traditionally resided within the realm of PMS.
  •  Mitigating Regulatory Arbitrage: Historically, the lack of a formal product designed for these sophisticated investors led to regulatory arbitrage, where investors sought alternative, often unregulated, investment avenues. By establishing SIFs within the existing mutual fund regulatory framework, SEBI curtails the proliferation of such unregulated schemes and ensures that the capital raised through SIFs is subject to the same transparency, governance, and oversight as traditional mutual funds.
  •  Enhancing Investor Protection: The regulatory framework governing SIFs includes stringent disclosure requirements and risk management protocols, which help safeguard investor interests. These regulations reduce the risk of operational and counterparty risks, ensuring that investors are more likely to receive fair treatment and that their investments are protected by the same regulatory safeguards afforded to other mutual fund products.
  •  Market Deepening and Liquidity Enhancement: By introducing a new investment product category, SEBI aims to deepen India’s capital markets, fostering greater liquidity. With a larger, more diverse range of investment products, the Indian market is better positioned to attract both domestic and foreign capital, thus improving overall market efficiency.
  •  Global Alignment: SEBI’s introduction of SIFs also aligns with international best practices. Similar structures, such as the European Union’s Alternative Investment Fund Managers Directive (AIFMD), have successfully implemented regulatory frameworks for specialized investment vehicles. The adoption of a similar model in India enhances its attractiveness as a destination for foreign investors, while also ensuring that the domestic products are consistent with global standards.

3. KEY FEATURES OF SIFs

The introduction of SIFs is characterised by several distinct features designed to cater to sophisticated investors, while maintaining robust regulatory oversight.

  •  Sound Track Record, Registration and Approval Process: SEBI has allowed existing mutual funds to launch SIFs with prior approval from SEBI under their current trust structures without the need for creating a new trust, provided they comply with no disciplinary action criteria along with sound track record under Route 1 and in case of MF registered under alternate route, appointment of separate CIO and Fund Manager of SIF with defined experience requirement.

This streamlined process enhances operational continuity and minimises regulatory overhead for fund houses, thus simplifying market entry for investors.

  •  Minimum Investment Threshold: To ensure that SIFs are accessible only to qualified investors, SEBI mandates a minimum investment of ₹10 lakh at the PAN level for all investors exclusively for participating in SIFs. This threshold acts as a filter to ensure that only those with sufficient financial capacity and risk tolerance are eligible to invest. However, accredited investors, as defined by SEBI’s criteria, are exempt from this threshold, which ensures that high-net-worth individuals and institutional investors can access these products without being constrained by the minimum investment requirement. The AMCs shall be required to monitor Investment threshold and ensure that there are no active breaches.
  •  Investment Strategy and Launch Framework: The framework for launching SIF strategies follows the established process for mutual fund schemes. AMCs must submit an offer document to SEBI, along with the requisite fees and approvals from their trustees. A standardized application format ensures consistency across SIF strategies, contributing to operational transparency and efficiency. Additionally, AMCs are required to submit an Investment Strategy Information Document (ISID) that outlines the fund’s specific investment objectives, strategy, and risk management practices, rationale for compliance ensuring that investors are well-informed before making their investment decisions.
  •  Investment Permissibility and Restrictions: SIFs are permitted to invest across a wide array of asset classes authorised under the Mutual Fund Regulations, with specific investment caps and restrictions designed to manage risk effectively. For instance, exposure to debt instruments from a single issuer is limited to 20% of the fund’s NAV, SIFs can also invest in derivatives, with a cap of 25% of the fund’s NAV, thus offering enhanced flexibility in terms of market positioning. These caps reflect SEBI’s balanced approach to enabling flexibility while safeguarding against undue concentration risk.
  •  Expense Ratio and Fee Structure: The expense ratios for SIFs are governed by the same regulations as other mutual fund schemes, ensuring uniformity in cost structures across the industry.
  •  Distribution of SIF
    Distribution of SIF products shall be subject to such entity having passed National Institute of Securities Markets (‘NISM’) Series-XIII: Common Derivatives Certification Examination
  •  Branding
    To maintain clear differentiation between SIFs and traditional mutual funds, SEBI mandates that AMCs employ distinct branding and marketing strategies for their SIF products as per SEBI guidelines, including separate branding, advertising, standard disclaimers, guidelines on usage of sponsor or asset management company or mutual fund’s brand name, and maintenance of a separate website/webpage to differentiate SIF offerings, etc.

This ensures that investors are aware of the differences in risk profile, investment strategy, and expected returns between SIFs and conventional mutual funds.

  •  Benchmarking
    Investment Strategies of SIF shall follow a single-tier benchmark structure. The AMC at its discretion may also provide second tier benchmark for investment strategies as applicable for specific schemes. The AMC shall appropriately select any broad market indices available, as a benchmark index depending on the investment objective and portfolio of investment strategy.
  •  Governance, and Risk Management
    In terms of governance, AMCs and trustees must ensure robust risk management frameworks, including comprehensive stress-testing and scenario analysis, to ensure the protection of investor interests. These governance measures are designed to prevent any reputational risk spillover from the SIF to the broader mutual fund industry, preserving the integrity and trust of the Indian asset management ecosystem.

4. RECENT CLARIFICATIONS AND DEVELOPMENTS

In line with SEBI’s commitment to refining its regulatory framework, recent clarifications have been issued to further streamline the operation of SIFs:

  •  Clarification on Investment Threshold: SEBI clarified that the ₹10 lakh minimum investment requirement applies at the PAN level, covering all SIF strategies under a single AMC. This removes potential confusion for investors allocating capital across multiple SIF offerings from the same fund house.
  • Flexibility for Interval Strategies: SIFs adopting interval strategies have been granted greater flexibility in the selection of instruments with longer tenures or lower liquidity, providing fund managers with more freedom to optimise returns over extended periods.
  •  Standardised Application Format: SEBI introduced a standardised format for mutual funds intending to establish SIFs, ensuring greater operational efficiency and consistency in the application process.

FUTURE OUTLOOK FOR SIF

SIFs thus represent more than just a new category of investment vehicles—they signal SEBI’s commitment to fostering a robust, transparent, and inclusive asset management ecosystem. As these funds mature, they are poised to attract capital from domestic and global investors alike, serving as a critical bridge to deeper market penetration and sophistication.

With their introduction, the focus shifts to the meticulous crafting of asset allocation strategies, portfolio innovation, and investor engagement, all under the vigilant oversight of SEBI’s regulatory framework. The long-term trajectory of SIFs will ultimately depend on how well they balance these dual imperatives—flexibility and control—ensuring that the evolution of India’s capital markets is both dynamic and resilient.

The strategic deployment of SIFs will invariably drive market efficiency and liquidity, supporting India’s ambition to become a competitive global investment hub.

High Value Debt Listed Entities – Corporate Governance Reforms

BACKGROUND

The Securities and Exchange Board of India (“SEBI”), in exercise of its powers under the SEBI Act, 1992 has introduced the SEBI (Listing Obligations and Disclosure Requirements) (Amendment) Regulations, 2025 (“LODR Amendments, 2025”) which has made a pivotal reform in corporate governance norms applicable to High Value Debt Listed Entities (“HVDLEs”)

SEBI has introduced a new governance regime under Chapter VA of the SEBI (LODR) Regulations, effective from 1st April, 2025, exclusively applicable to High Value Debt Listed Entities (HVDLEs)—defined as listed entities having outstanding listed non-convertible debt securities of ₹1,000 crore or more and does not have any listed specified securities. Notably, this chapter ceases to apply automatically if the outstanding listed debt falls below the ₹1,000 crore threshold for three consecutive financial years. In case outstanding debt equals or exceeds ₹1,000 crore during the financial year, the company shall ensure compliance with such provisions within six months from the date of such trigger.

This sunset clause introduces a dynamic compliance parameter, requiring ongoing monitoring of eligibility thresholds and continuity of governance obligations based on capital structure and market presence. This implies that secretarial, legal, and compliance teams must periodically reassess regulatory status and plan transition frameworks accordingly.

These reforms institutionalise greater transparency, board and committee efficacy, and stakeholder accountability, while introducing uniform compliance timelines and enhanced audit oversight. SEBI has reaffirmed its commitment to a resilient and investor-centric capital market framework that upholds market integrity and governance discipline.

BOARD COMPOSITION REQUIREMENTS

Chapter V-A mandates that the board of HVDLEs comprise of at least 50% non-executive directors and include at least one-woman director. Furthermore, directorship ceilings have been formalised—capping overall listed entity directorships at seven, and for whole-time directors acting as independent directors, the limit is set at three.

Where the Chairperson of Board of Directors is Non-Executive Director, at least one third of Board of Directors shall comprise of Independent Directors and where the listed entity does not have regular non-executive chairperson, at least half of Board of Directors shall comprise of Independent Directors. This structural alignment with entities having listed equity, promotes governance diversity, and encourages focused board participation.

For professionals advising on board constitution or holding multiple governance roles, this entails an essential review of existing mandates and directorship portfolios to ensure continued eligibility. Company Secretaries and Nomination and Remuneration Committees (‘NRC’) will be expected to institutionalise these checks through robust board database management and real-time compliance tracking tools.

MANDATORY CONSTITUTION OF BOARD COMMITTEES

The amended framework further strengthens mechanism by oversight by mandating the constitution of four key committees—Audit Committee, NRC, Stakeholders Relationship Committee, and Risk Management Committee.

The Audit committee shall have minimum of three directors as members out of which at least two-thirds of the members shall be independent directors. This brings HVDLEs in closer alignment with governance practices as applicable to entities having listed equity, but more importantly, it necessitates substantive engagement at the committee level.

Committee charters must be carefully formulated to reflect both statutory responsibilities and entity-specific risk environments. Professionals involved in board advisory, internal audit, and governance roles must support the formalisation of these committees through functional delineation, performance evaluation mechanisms, and governance reporting metrics.

RELATED PARTY TRANSACTION (RPT) POLICY AND APPROVALS

In a significant enhancement, the amendment mandates that HVDLEs formulate a policy on materiality of RPTs, to be reviewed at least once every three years. Notably, royalty or brand usage payments exceeding 5% of annual turnover are deemed material. All material RPTs as defined by the audit committee under sub-regulation (3) of regulation 62K, shall require prior approval from the audit committee and a No Objection Certificate from the debenture trustee.

Transactions entered with a related party individually or together with previous transactions during a financial year exceeding Rupees one thousand crore or ten percent of the annual consolidated turnover shall be considered material. While omnibus approvals are permitted, they are capped at a validity of one year.

This layered approval structure significantly strengthens the governance lens applied to inter-group or related party dealings. Professionals engaged in transaction advisory or guiding on setting up group governance frameworks must be mindful of procedural rigour, especially where prior approvals are required across stakeholders with differing interests. The compliance function must also be equipped to track omnibus approvals with adequate audit trails and expiry thresholds.

PERIODIC RPT DISCLOSURES

Entities are now required to submit half-yearly disclosures of all RPTs in a prescribed format alongside standalone financial statements to the stock exchanges. This increased disclosure frequency enhances transparency and reinforces market discipline around related party dealings.
It necessitates the integration of finance and secretarial functions to align reporting cycles, automate data extraction from accounting systems and ensure that all disclosures are reconciled with board approvals and audit committee records.

GOVERNANCE OF MATERIAL UNLISTED SUBSIDIARIES

To prevent governance arbitrage via unlisted arms, the amendment prescribes that material unlisted subsidiaries incorporated in India must have at least one independent director from the HVDLE on their board. Additionally, financials of such subsidiaries must be reviewed by the audit committee, and significant transactions must be disclosed by the holding company at the board level.

The Minutes of the meeting of the Board of Directors of the unlisted material subsidiary shall be placed at the meeting of Board of Directors of the HVDLE. Any disposal of shares or relinquishment of control in these subsidiaries requires a special resolution from shareholders.

This aligns group-wide governance structures and ensures that key strategic actions in subsidiaries receive full parent board visibility and shareholder scrutiny. From a legal perspective, this underscores the need for pre-transaction governance checks and documentation alignment between subsidiary and parent company.

OBLIGATIONS WITH RESPECT TO EMPLOYEES INCLUDING SENIOR MANAGEMENT, KEY MANAGERIAL PERSONNEL, DIRECTORS AND PROMOTER

A director cannot serve on board of more than ten committees or act as a chairperson on more than five committees across all listed entities which shall be determined as follows: –

a) For calculating the limit of the committees on which a director may serve, all public limited companies, whether listed or not, including HVDLEs and all other companies including private limited companies, foreign companies and companies under Section 8 of the Companies Act, 2013 shall be excluded

b) For the purpose of determination of limit, chairpersonship and membership of the audit committee and the stakeholders’ relationship committee alone shall be considered.

Directors must inform HVDLEs about their committee roles and updates. All board members and senior management must annually affirm adherence to the code of conduct. Senior management must disclose any financial or commercial transactions with potential conflicts of interest. Additionally, no employee, director, or promoter can enter into compensation or profit-sharing agreements related to securities dealings without prior board and shareholder approval. Such agreements, including those from the past three years, must be disclosed to stock exchanges and approved in upcoming board and general meetings, with all interested parties abstaining from voting.

SECRETARIAL AUDIT AND COMPLIANCE REPORTING

This regulatory amendment mandates secretarial audit not only for the HVDLEs but also for their Indian-incorporated material unlisted subsidiaries. Additionally, a secretarial compliance report must be submitted to the stock exchanges within 60 days from the end of each financial year. For practicing professionals in this space, this introduces an expanded scope of responsibility across the group and demands elevated diligence in maintaining verifiable documentation and audit evidence. Advisory teams must ensure that the governance processes implemented at the subsidiary level are harmonised with the parent’s frameworks and withstand regulatory scrutiny.

OTHER CORPORATE GOVERNANCE REQUIREMENTS

HVDLE must submit a periodic corporate governance compliance report, in a format prescribed by the SEBI, to recognized stock exchanges within 21 days of the end of the reporting period. This report should include disclosures of material related party transactions, any cyber security incidents or data breaches, and must be signed by either the compliance officer or the CEO.

Additionally, HVDLEs may include a Business Responsibility and Sustainability Report in their annual report, covering environmental, social, and governance (ESG) disclosures, as specified.

WAY FORWARD

These amendments, demand deeper engagement in board and committee processes, necessitate refined documentation and disclosure systems, and requires cross-functional alignment amongst legal, secretarial, finance, and strategy teams.

Implicitly, it raises the expectation of professionals, to act not just as compliance certifiers, but as enablers of robust governance architecture, particularly in a high-value debt context where stakeholder expectation and responsibilities are distinct from equity markets.

The following changes may be required way forward for effective implementation of the amendments:

  •  Shift From Reactive to Proactive Compliance

Listed entities must transition from reactive compliance to a proactive, technology-enabled governance framework, incorporating real-time dashboards and cross-functional coordination to ensure continuous regulatory alignment.

  •  Empowered and Data-Driven Board Committees

Board committees must be empowered with data-driven insights, independent expert access, and enhanced oversight capabilities to fulfil their fiduciary and statutory responsibilities with greater diligence and accountability.

  •  Elevating the Compliance Function

The compliance function must be redefined as a strategic pillar, with compliance officers, legal counsels, and corporate secretaries acting as proactive advisors on governance, ethics, and reputational risk.

  •  Reinforcing Transparency in KPIs and RPTs

Entities must implement robust protocols for KPI disclosures and related party transactions,  ensuring materiality, auditability, and arm’s-length standards in line with both domestic and global benchmarks.

Rights Issue Simplified (SEBI ICDR Amendments, 2025)

CONCEPTUAL FRAMEWORK FOR RIGHTS ISSUE

A Rights Issue is a well-established capital-raising mechanism that enables companies to generate additional funds while preserving the pre-emptive rights of existing shareholders. The legal foundation for Rights Issue in India is enshrined in section 62(1)(a) of the Companies Act, 2013 (“Companies Act”), which mandates that any further issuance of capital must initially be offered to existing shareholders.

Unlike preferential allotments or public offerings, Rights Issue confer a distinct advantage by allowing companies to raise capital swiftly without requiring shareholder approval in a general meeting. Instead, the Board of directors is vested with the authority to approve and execute the Rights Issue under Section 179(3) of the Companies Act, subject to compliance with the statutory offer period, which must range between 15 to 30 days as stated in Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014.

For listed companies, the regulatory landscape extends beyond the Companies Act, with additional oversight by the Securities and Exchange Board of India (SEBI) under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”). In view of cumbersome procedure, companies usually do not consider Rights Issue as preferred mode. Following chart below depicts that in past Issuers have preferred QIP and Preferential Allotment over Rights Issue.

The other major factor was that of involvement of the timelines to complete the process of Rights Issue. The chart below shows the time taken for Rights Issue process for listed companies:

As shown above, issuers have preferred fund raising mode like preferential issues or QIP which usually takes lesser time vis-à-vis Rights Issue. It was also observed that even though the existing shareholders have the first right to participate in fund raising activity of the issuer, the listed entities have preferred to raise fund though preferential issue by offering it to select few investors including promoters’ reason being swift fundraising, attracting strategic investors and increase in promoter’s stake.

SEBI CONSULTATION PAPER DATED 20th AUGUST 2024

To enable faster Rights Issue and to simplify procedures, SEBI initiated a comprehensive review of the Rights Issue framework and released the consultation paper on 20th August, 2024. This consultation paper aimed to address key inefficiencies, including extended timelines, disproportionate compliance costs, and structural constraints, which made Rights issues less attractive compared to alternative fundraising methods.

Some of the key Issues which were needed attention were-

  •  Rights Issue below ₹50 crore were exempt from the ICDR Regulations, creating an uneven compliance burden across different categories of issuers.
  •  high cost associated with mandatory merchant banker engagement, which was often disproportionate to the size of the issue.
  •  inefficiencies stemmed from challenges in handling unsubscribed shares, which restricted issuers from effectively managing excess demand or reallocating unclaimed shares.

In addition to above, the proposed Rights Issue guidelines also addressed the other shortcoming associated with the prevalent Rights Issue process such as lengthy time-period, requirements of filing detailed Draft offer letter, appointment of intermediaries, etc.

Following extensive industry feedback on this consultation paper, SEBI made significant amendments to ICDR Regulations on 3rd March, 2025, effective from 4th April, 2025 designed to streamline processes, enhance transparency, and improve overall market efficiency. These changes aim to ensure that Rights Issue remain a viable and competitive method of capital raising while fostering greater investor participation.

KEY AMENDMENTS RESHAPING THE RIGHTS ISSUE FRAMEWORK & THEIR LIKELY IMPACT

  •  Application of ICDR Regulations to Rights Issue Below ₹50 Crore

Prior to the amendments, Rights Issue below R50 crore were exempt from ICDR Regulations, creating regulatory disparities between small and large issuers. SEBI has now mandated uniform compliance with ICDR Regulations for all Rights Issue, irrespective of size, ensuring transparency, investor protection, and a level playing field across the market.

This amendment brings additional compliance requirements, particularly in terms of enhanced disclosures, financial reporting, and regulatory approvals. While this may increase regulatory costs for smaller issues, it also enhances investor confidence and credibility, potentially improving subscription rates.

  •  Reduction of Rights Issue Timeline from 317 Days to 23 Working Days

Prior to the Recent ICDR Amendments, while a fast-track Rights Issue typically took 12-14 weeks, a non-fast-track Rights Issue used to take approximately 6-7 months from the date of the board meeting approving the Rights Issue until the date of closure of the Rights Issue leading to valuation mismatches, investor resistance, and a lack of responsiveness to market conditions. The Recent ICDR Amendments provide that the Rights Issue may be completed within 23 working days from the date of the board of directors of the issuer approving the Rights Issue (except in case of Rights Issue of convertible debt instruments which require prior shareholders’ approval).

Reduction in timeline for completing a Right Issue from 317 days to just 23 working days will enhance efficiency, predictability, and responsiveness to market conditions, allowing companies to raise capital in a shorter timeframe and minimizing exposure to price fluctuations and the Investor will also get benefit that it will counter the volatility and enhance liquidity in the secondary market.

  •  Elimination of Mandatory Merchant Banker Requirement

SEBI has done away with the requirement of compulsory merchant banker involvement in Rights Issue, allowing issuers to self-manage the process or engage advisors selectively.

This will result in reduction in compliance costs and timelines, particularly for mid-sized and smaller companies, which previously incurred substantial fees for engaging merchant bankers and taking time for completing the process. This amendment will grant companies with greater control over the Rights Issue process, enabling them to structure offerings in a cost-effective and efficient manner.

  •  Improved Treatment of Unsubscribed Shares

Historically, the inability to effectively manage unsubscribed shares has been a significant challenge for issuers. SEBI’s amendment now permits issuers to reallocate unsubscribed portions to specified investors, thereby increasing the likelihood of full subscription and reducing the risk of undercapitalization. This change introduces greater flexibility for companies, allowing them to strategically distribute shares based on market demand. This amendment enhances the overall attractiveness of Rights Issue, as companies are now better equipped to manage excess demand and prevent subscription shortfalls. The companies need to ensure efficient allocation of unsubscribed shares while complying with SEBI’s revised guidelines, its legal enforceability. Also, companies must exercise due diligence to ensure compliance with the evolving framework, failing which it can lead to regulatory scrutiny and potential legal ramifications.

For professionals, this regulatory shift present both Challenges and Opportunities. The opportunity for compliance and advisory services shall witness a rise, as the role of Merchant Banker has substantially reduced at one hand and on the other hand regulatory environment has become more complex. This change opens opportunities for legal, accounting, and regulatory advisory services which includes preparation of comprehensive offer documents, ensure regulatory compliance, and reviewing disclosures. The compressed timeline necessitates faster regulatory filings, due diligence, disclosures, etc. which will open new opportunities for Chartered accountants (CAs) and Auditors.

FUTURE OF RIGHTS ISSUE IN THE CONTEXT OF INDIA’S CAPITAL MARKET

SEBI has effectively streamlined the Rights Issue process, contributing to a more predictable and efficient capital-raising environment, making Rights Issue a more attractive option for corporate Issuers.

To further strengthen the Rights Issue framework, adopting of digital platforms to streamline the application process, reducing the paperwork, and integrating blockchain technology for real-time subscription tracking, can improve transparency and allow for more effective monitoring of fund utilization.

For companies which are fully compliant having strong financials and credibility, expedited regulatory approvals may be granted under the concept of Green Route Channel, which could further enhance market efficiency. This would encourage greater participation from a diverse range of companies, making the Rights Issue process more accessible and attractive. Further relaxation of disclosure requirements for smaller issues may be provided in case companies adhere to stringent investor protection policies.

As capital markets evolve, various developments will also unfold but continued vigilance and proactive adaptation will be crucial for maintaining a competitive and investor-friendly capital-raising mechanism and retaining the trust in the integrity of the capital market ecosystem. These amendments reinforce SEBI’s emphasis on transparency, particularly through stricter fund utilisation monitoring mechanisms and enhanced investor protection measures.

Research Analyst Regulations – Re-Birth

INTRODUCTION

Research Analysts play a very important role as they analyse information on securities and provide recommendations, and investors normally rely on their advice. However, such advice is many times prone to conflicts of interest arising from preparation and dissemination of research reports with vested interest. Such research analysts include independent research analyst, an intermediary that employs any research analyst or research entity that issues any research report.

This led to the need for Research Analyst Regulations way back in 2013 to establish a regulatory framework to ensure impartial reporting, address conflict of interest, improve governance standards, minimise market malpractices, etc. In order to regulate and streamline the activities of individuals and entities offering research analyst (RA) services, The Securities and Exchange Board of India (Research Analysts) Regulations, 2014, were notified on 1st September, 2014. However, every regulation stands the test of time and must be revisited from time to time.

One such instance that required to re-consider the relevance of existing regulatory framework, has been the mismatch in the large investor base vis-à-vis the number of investment advisors (IA) which led to the proliferation of unregistered entities acting as IA’s & RA’s.

It was extremely crucial to place a conducive regulatory framework by simplifying, easing and reducing the registration requirements and cost of compliance for RA’s and bringing in regulatory changes commensurate with the continually evolving nature of their business and the large investor base.

With this backdrop, The Securities and Exchange Board of India (SEBI) has issued amendments to Research Analyst Regulations on 16th December, 2024 and issued operating guidelines vide circular dated January 8, 2025. The recent changes include:

i. registration of part-time research analyst,

ii. appointment of independent compliance officer,

iii. compliance audit requirements,

iv. segregation of research & distribution activities,

v. capping on fees,

vi. qualifications & certification requirements,

vii. deposit requirements,

viii. dual registration requirements, etc.

One of the eye openers has been, who shall be a classified as Research Analyst? Persons providing ‘research services’ for consideration shall only fall within the definition of research analyst.

This implies that research services rendered without any consideration shall be outside the ambit of these regulations.

The key changes outlining the changes in the RA industry are discussed below, most of which are to be implemented by 30th June, 2025, unless specified otherwise:

PART-TIME RESEARCH ANALYSTS

There are many persons who provides research services however their main activity is not that of providing research services. SEBI has now introduced specific provisions for part-time research analysts, acknowledging the diverse professional backgrounds of individuals and not engaged in business / employment related to securities market and does not involve handling/ managing of money / funds of client / person or providing advice / recommendation to any client /person in respect of any products / assets for investment purposes. Further, applicant engaged in in any activity or business or employment permitted by any financial sector regulator or an activity under the purview of statutory self- regulatory organisations such as Institute of Chartered Accountants of India (‘ICAI’), Institute of Company Secretaries of India (ICSI), Institute of Cost Accountants of India (ICMAI) etc. shall be considered eligible for registration as part-time RA.

This shall create more avenues for CA’s providing their statutory services. For example, a CA who shall be engaged in providing security specific recommendations to the client, which is not investor specific, even though as a part of tax planning/tax filing is required to seek registration as a Part time RA. This provision allows for flexibility in the industry, opening opportunities for professionals in other domains to engage in research analysis while adhering to regulatory frameworks. However, one must keep in mind the provisions of Code of Ethics of ICAI before engaging in such assignment.

Part-time RA shall be required to have similar qualification and certification requirements prescribed under RA regulations for full-time RAs. They shall provide an undertaking stating that it shall maintain arms-length relationship between its activity as RA and other activities and shall ensure that its services are clearly segregated from all its other activities at all stages of client engagement and a specific disclaimer may be given to that extent.

The investor should at all times keep in mind that no complaints can be raised to SEBI for the other services provided by a part-time RA.

APPOINTMENT OF COMPLIANCE OFFICER

With the objective of reducing the cost of compliance by having a fulltime compliance officer, Regulation 26 of the RA Regulations allows non-individual research analysts to appoint an independent professional who is a member of professional bodies like ICAI, ICSI, ICMAI, or other bodies specified by SEBI, provided the professional holds the relevant certification from NISM as required by SEBI. However, the principal officer of the firm must submit an undertaking to the SEBI’s Research Analyst Administration and Supervisory Body (RAASB)/SEBI affirming that they will be responsible for ensuring compliance with the Act, regulations, notifications, guidelines, and instructions issued by SEBI or RAASB.

In this case, Practising Chartered Accountants will have better opportunities to be appointed as independent professionals in regulated entities, however, there lacks clarity whether one independent professional CA can be appointed as compliance officer in various RA entities or whether any statutory restrictions as applicable to number of audits permissible by a practising CA shall apply.

COMPLIANCE AUDIT REQUIREMENTS

Regulation 25(3) of the RA Regulations requires RAs or research entities to conduct an annual audit to ensure compliance with the RA Regulations. Practising CAs shall ensure that the audit is completed within six months from the end of financial year and the compliance audit report. Such compliance report along with adverse findings, if any and action taken thereof, duly approved by RA shall be submitted within 1 month from the date of audit report but not later than 31st October.

SEGREGATION OF RESEARCH AND DISTRIBUTION ACTIVITIES

Regulation 26C (5) of the RA Regulations mandates client-level segregation between research and distribution services within the same group or family of a RA or research entity. Furthermore, new clients must choose between receiving research services or distribution services at the time of onboarding. One of the key changes is that Stock broking activities shall not be considered as distribution services for the purposes of this regulation.

Clients are allowed to retain their existing assets under their current research or distribution arrangements without being forced to liquidate or switch them. However, they must comply with the new segregation requirements for any future services provided. The PAN of the client serves as the key control record for identifying and segregating clients at the individual or family level.

A member of ICAI/ICSI/ICMAI or auditor have to confirm compliance with client level segregation requirements within six months from the end of financial year.

While giving such certification, the practising CA shall ensure that for individual clients, the “family” is considered a single entity, and the PANs of all family members are grouped together for segregation purposes. Further verification should be done, whether the client has provided an annual declaration or periodic updation in respect of dependent family members. Further, RAs providing research services exclusively to institutional clients and accredited investors may be exempt from these segregation rules, provided the client signs a waiver acknowledging this.

FEE STRUCTURE AND CLIENT CHARGES

The new regulations outline the maximum fees that research analysts can charge their clients, ensuring transparency in the fee structure and a level playing field for both IA’s & RA’s.

RAs can charge maximum fee of ₹1,51,000 annually per individual or Hindu Undivided Family (HUF) client and exclude non-individual clients, accredited investors, and institutional clients seeking proxy advisory services. For these clients, fees will be negotiated bilaterally and are not subject to the specified caps. RAs may charge fees in advance with the client’s consent, but the advance should not exceed one-quarter of the annual fee. However, statutory charges are not included in this fee cap. The statutory auditor and the compliance auditor shall ensure adherence to these limits during the course of the audits of such research analysts.

i. Changes in Qualification and Certification Requirements

No person can act as an RA without possessing a requisite qualification. SEBI has prescribed minimum qualifications for Research Analysts as under: –

A professional qualification or graduate degree or post-graduate degree or post graduate diploma in finance, accountancy, business management, commerce, economics, capital market, banking, insurance, actuarial science or other financial services from a university or institution recognized by the Central Government or any State Government or a recognised foreign university or institution or association.

Or

A professional qualification by completing a Post Graduate Program in the Securities Market (Research Analysis) from NISM of a duration not less than one year or a professional qualification by obtaining a CFA Charter from the CFA Institute.

One of the major changes as compared to the erstwhile regulations is eliminating the need of having in place a graduate in any discipline with an experience of atleast 5 years in activities relating to financial products or markets or securities or fund or asset or portfolio management.

This change has led to a level playing field for new entrants as well as veterans in this field.

ii. Persons associated with research services shall, at all times, have minimum qualification of a graduate degree in any discipline from a university or institution recognized by the Central Government or any State Government or a recognized foreign university or institution.

iii. An individual registered as research analyst under these regulations, a principal officer of a non-individual research analyst, individuals employed as research analyst, person associated with research services and in case of the research analyst being a partnership firm, the partners thereof if any, who are engaged in providing research services, shall have, at all times, a NISM certification.

This has expanded its scope of bringing within its ambit “Persons Associated with Research Services” to have at all times minimum qualification as well as certification requirements, which shall also include all sales staff, service relationship & client relationship managers, who may not be involved in any research function but by virtue of being associated have to be qualified and certified.

DEPOSIT REQUIREMENTS FOR RESEARCH ANALYSTS

The new regulation has done away with the requirement of having a minimum net worth as it was identified that the RA’s provide research services broadly owing to their understanding and knowledge of the subject and their skills to arrive at a suitable advice/recommendation under a particular circumstance.

Further, the services provided are fee based and not related to management of client fund and securities and no significant infrastructure requirements, hence the concept of maintaining networth may not be aligned with the activities of RA.

To safeguard the interests of investors and enhance the financial credibility of research analysts, SEBI has introduced mandatory deposit requirements with immediate effect and for existing clients by 30 April 2025, based on the number of clients which is detailed as under:

  •  Deposit Structure Based on Numbers of Clients:
  •  0 to 150 clients: ₹1 lakh
  •  151 to 300 clients: ₹2 lakh
  •  301 to 1,000 clients: ₹5 lakh
  •  Over 1,000 clients: ₹10 lakh

This deposit must be maintained in a scheduled bank with a lien in favour of SEBI’s Research Analyst Administration and Supervisory Body (RAASB). This deposit shall be utilized for dues emanating out of arbitration and reconciliation proceedings, if RA fails to pay such dues.

DUAL REGISTRATION: INVESTMENT ADVISER AND RESEARCH ANALYST

SEBI has introduced provisions allowing individuals or firms already registered as Investment Advisers (IAs) to apply for dual registration as RAs subject to maintaining arms-length relationship between its activity as IA and RA and shall ensure that its investment advisory services and research services are clearly segregated from each other.

This provision was introduced considering the overlapping nature of activities under IA & RA services.

PRINCIPAL OFFICER DESIGNATION

The erstwhile Regulations did not mandate the requirement of designation of Principal Officer; however, the need was felt that the overall function of business and operations of non-individual RAs should be looked into by a responsible person.

Also, Regulation 2(1)(oa) of the RA Regulations mandates that if a partnership firm is registered as a research analyst, one of its partners must be designated as the principal officer and where no partner meets the necessary qualification and certification criteria, it must apply for registration as a research analyst in the form of an LLP or a body corporate.

This change must be made by 30th September, 2025, as per the SEBI directive.

USE OF ARTIFICIAL INTELLIGENCE (AI) IN RESEARCH

Any research analyst or research entity using artificial intelligence (AI) tools to provide services to clients is solely responsible for ensuring the security, confidentiality, and integrity of client data and also responsible to disclose the extent of AI tool
usage in their research services to clients and additional disclosures as may be necessary to enable informed decision of continuance or otherwise with the RA.

For existing clients, compliance with this requirement must be met by 30th April, 2025.

Research services provided by research analyst or research entity

Regulation 20(4) of the RA Regulations requires that research services provided by a RA or research entity must be supported by a research report that includes the relevant data and analysis forming the basis of the research. The RA or research entity must maintain a record of such research reports to ensure transparency and accountability.

Research services being provided by research analyst or research entity to any of its clients availing its other services as registered intermediary in another
capacity shall be considered as research services provided ‘for consideration’ even though no fee is charged by such research analyst or research entity directly from the client.

This implies that Research services provided by the research entity, who is also registered with SEBI as stock broker, to the clients availing its stock broking services are considered as research services ‘for consideration.

MODEL PORTFOLIO GUIDELINES

Regulation 2(1)(u) and 2(1)(wa) of the RA Regulations now define research services provided by research analysts to include the recommendation of model portfolios. In order to provide clarity on recommendation in respect of model portfolio by RA’s and to provide for safeguard of model portfolio, the guidelines issued shall ensure recommendations of model portfolio such as minimum disclosures, rationale for recommendations, nomenclature and performance of such recommendations.

The compliance auditor shall ensure as a part of its audit procedures check compliance with obligations set out under the model portfolio guidelines.

DISCLOSURE OF TERMS AND CONDITIONS TO THE CLIENT

Regulation 24(6) of the RA Regulations mandates that RAs or research entities must disclose the terms and conditions of their research services to clients and obtain their consent before providing any services or charging any fees. They should also include the Most Important Terms and Conditions (MITC), notified vide SEBI circular dated 17th February, 2025.

KYC REQUIREMENTS AND RECORD MAINTENANCE

Under Regulation 25(1) of the RA Regulations, RAs or research entities are required to follow Know Your Client (KYC) procedures for fee-paying clients and maintain KYC records as specified by SEBI.

WEBSITE REQUIREMENTS

RA Regulations mandates that RAs or research entities must maintain a functional website that includes specific details as outlined by SEBI.

CONCLUDING REMARKS

The new SEBI guidelines represent a significant step towards improving the transparency and accountability of the research analyst industry in India and also easing regulations to bridge the gap between number of investors vis-à-vis the number Registered RAs.

The change in the business model of research as a function also requires corresponding changes to the regulations to be at pace with the RAs, which include recognition of model portfolios within the definition of research services, introducing the concept of Part-time RAs, eliminating the need for experience, to allow ease of entry and participation of exuberant young minds in the securities market, etc.

Such changes demonstrate that the regulator has been watchful, supportive and in sync with the industry that it regulates while ensuring the investor trust and confidence is retained in the securities market.

Reshaping Of the Prohibition of Insider Trading (PIT) Regulations, 2015

REGULATOR ADDRESSING CHANGING REALITY

PIT as a concept finds its origination way back in 1992 around the same time when SEBI Act, 1992 was enacted. The objective of the “The Securities Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015 is to prevent Insider Trading by prohibiting trading, communicating, counselling, or procuring ‘unpublished price sensitive information’ relating to a company to profit at the expense of the general investors who do not have access to such information”

SEBI (PIT) regulations have undergone various amendments from time to time based on changing market conditions and experience gathered through regulatory enforcement actions. The focus has always been on making the regulation more predictable, precise and clear by suggesting a combination of principle-based regulation and rules that are backed by principles.

Some of the key changes which have been implemented in the last one year include;

i. re-visiting the key elements of trading plan,

ii. amending the definition of connected person and relatives,

iii. bringing Mutual Funds Units under the ambit of PIT Regulations.

BROADENING THE REACH

In order to understand some of the key changes which include rationalizing the scope of expression of connected person and introducing the definition of ‘relative’, it is important to understand how these terms were defined prior to the amendment:
1. An ‘insider’, as defined in regulation 2(1)(g) of PIT Regulations, means any person who is i) a connected person; or ii) in possession of or having access to Unpublished Price Sensitive Information (UPSI).

2. A ‘connected person’ in terms of regulation 2(1)(d)(i) of the PIT Regulations is any person who is or has during the six months prior to the concerned act been associated with a company, directly or indirectly, in any capacity including by reason of frequent communication with its officers or by being in any contractual, fiduciary or employment relationship or by being a director, officer or an employee of the company or holds any position including a professional or business relationship between himself and the company whether temporary or permanent, that allows such person, directly or indirectly, access to unpublished price sensitive information or is reasonably expected to allow such access.

3. ‘Unpublished price sensitive information’ as provided under Regulation 2(1)(n) of the PIT Regulations means any information, relating to a company or its securities, directly or indirectly, that is not generally available which upon becoming generally available, is likely to materially affect the price of the securities and shall, ordinarily including but not restricted to, information relating to the following: (i) financial results; (ii) dividends; (iii) change in capital structure; (iv) mergers, de-mergers, acquisitions, de-listings, disposals and expansion of business and such other transactions; (v) changes in key managerial personnel.”

4. The following categories shall be ‘deemed to be connected person’ unless the contrary is established: –

(a)an immediate relative of connected persons specified above; or

(b) a holding company or associate company or subsidiary company; or

(c)an intermediary as specified in section 12 of the Act or an employee or director thereof; or

(d)an investment company, trustee company, asset management company or an employee or director thereof; or

(e)an official of a stock exchange or of clearing house or corporation; or

(f)a member of board of trustees of a mutual fund or a member of the board of directors of the asset management company of a mutual fund or is an employee thereof; or

(g) a member of the board of directors or an employee, of a public financial institution as defined in section 2 (72) of the Companies Act, 2013; or

(h) an official or an employee of a self-regulatory organization recognised or authorized by the Board; or

(i) a banker of the company

Such categories of persons that are “deemed to be connected” persons are the ones who may not seemingly occupy any position in a company but are in regular touch with the company and its officers and are in know of the company operations. However, it is observed by the regulator that certain other persons who are not deemed to be connected person as per the extant regulation may also be in a position to have access to UPSI by virtue of their proximity and close relationship with the “connected person” and hence can indulge in Insider Trading and present enforcement challenges.

To rationalise these challenges, the following additions are made to the categories of “deemed to be connected person”: –

(i) a concern, firm, trust, Hindu undivided family, company, or association of persons wherein a director of a company or his relative or banker of the company, has more than ten percent of the holding or interest

(ii) a firm or its partner or its employee in which a ‘connected person’ is also a partner; and

(iii) a person sharing household or residence with a ‘connected person’.

Though this amendment appears as simple, it poses a challenge on implementation and execution. For example, in case of a person, in a professional engagement with the company that allows him the access of UPSI, his firm, other partners, all employees of the firm are considered deemed to be connected persons. As all employees are covered there seems to be no distinction between Key Managerial Personnel and support staff. In a scenario, where a person has only 1 % share in the firm, it shall lead to all other partners and employees of that firm to be classified as deemed to be connected person.

The question further arises on the point (iii) above that, how one defines sharing household or residence with connected person, whether the stay is permanent or temporary, the nature of relationship, nature of sharing arrangement, etc. SEBI’s view in this is that the primary objective of this inclusion of household or residence sharing individual is to cover those who, by virtue of their close relation or co-habitation with the connected person, could come in possession of price-sensitive information and indulge in insider trading. Regarding concerns about the meaning of residence, duration of residence or the inclusion of individuals sharing a residence on a rental basis, it is important to emphasize that investigations are event-driven based on attendant facts and circumstances. The intent is to cover relevant individuals during the process of investigation based on their accessibility to UPSI, rather than limiting it by the time frames or residential arrangements.

Under the current framework, connected persons are presumed to possess UPSI unless they can prove otherwise. This creates a rebuttable presumption, placing the onus on the accused to demonstrate his innocence. This may be logical for an individual reasonably assumed to have access to UPSI, expanding the number of people falling under the definition of connected person significantly increases the number of people unjustly burdened by this presumption.

DEFINITION OF RELATIVE

The change in the definition from “Immediate Relative” to “Relative” further adds to the number of people falling under the definition of connected person.

The definition prior to amendment of “Immediate Relative” of a person means spouse / parent / sibling / child of such person or of the spouse, who is dependent financially on such person, or consults such person in taking decision relating to trading in securities. Regulator has been of the view that the communication of UPSI to a related person does not necessarily depend on whether the relative is financially dependent or consults in trading decisions.

Price-sensitive information can also be transferred to such relatives for reasons such as natural love and affection without being them financially dependent and they can potentially indulge in Insider Trading.

Therefore, in order to bring such persons within the regulatory ambit, “Relative” shall mean the following:

(i) spouse of the person;

(ii) parent of the person and parent of its spouse;

(iii) sibling of the person and sibling of its spouse;

(iv) child of the person and child of its spouse;

(v) spouse of the person listed at (iii); and

(vi) spouse of the person listed at (iv)

It is intended that the relatives of a connected person also become connected person for the purpose of these regulations with a rebuttable presumption that the connected person had UPSI. However, this amendment does not require any additional disclosures and shall be limited for the purpose of establishing insider trading during investigation.

As per Regulation 4 (1) of SEBI (PIT) Regulations, 2015, no insider shall trade in securities that are  listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information.

There have been judicial contours in the past wherein Securities Appellate Tribunal (SAT) had fully or partially set aside SEBI orders like in the matter of NDTV Ltd (2023 SCC Online SAT 855) on the grounds that SEBI had not deep dived into the issue of whether alleged trades were undertaken to take advantage of any UPSI that may have been in possession of the parties.

In one of the earlier judgements in the matter of SEBI v/s Abhijit Rajan (SEBI v/s Abhijit Rajan 2022 SCC Online SC 1241), which was also upheld by the Supreme Court, SAT held that in order to penalize an entity for insider trading, it is imperative to establish that entity’s trades were motivated by UPSI.

The onus of showing that a certain person was in possession of or had access to UPSI at the time of trading would therefore, be on the person levelling the charge after which the person who has traded when in possession of or having access to UPSI may demonstrate that he was not in such possession or that he has not traded or he could not access or that his trading when in possession of such information was squarely covered by the exonerating circumstances.

Therefore, it is important that various other additional parameters such as financial dependency, factors of commonalities between both relatives not being in the immediate relationship, Person Acting in Concert, alleged insider trading pattern vis-à-vis the UPSI, motives of making unlawful gains owing to the relationship status, etc, may also be considered for levelling the charge.

MOVE TO RE-DEFINE UPSI

In addition to the above, SEBI has released a consultation paper to include certain events in the definition of UPSI with the objective to bring greater clarity and uniformity of compliances by aligning the definition of UPSI with events from Para A and Para B of part A of Schedule III as enumerated under Regulations 30 of SEBI (LODR) Regulations, 2015.

Prior to April 2019, “material event in accordance with listing agreement” was part of UPSI.SEBI had conducted a study on a subject matter on material events disclosed to the stock exchanges and events classified as UPSI by listed entities wherein companies were limiting the classification of UPSI to items explicitly mentioned in Regulation 2(1)(n) of the PIT Regulations, often failing to align with the broader intent and spirit of the law.

This led to the need for reviewing the definition of UPSI which has been proposed vide consultation paper dated 09 November 2024 with the objective of bringing regulatory clarity, certainty and uniformity in compliance for the listed entities.

The recommendations aim to align the illustrative list of UPSI events with the material events enumerated in Para A and Para B of Part A of Schedule III of the LODR Regulations. This alignment would ensure that the revised definition does not adversely impact the ease of doing business or lead to undue compliance challenges for listed entities.

The proposal after considering the feedback from the market participants was discussed in the SEBI Board Meeting to include the following within the definition of UPSI(which are pending to be notified);

a. Change in rating/s other than ESG rating/s,

b. Fund Raising proposed to be undertaken,

c. Agreements by whatever name called which may impact the management or control of the company,

d. Fraud or defaults by the company, its promoter, director, key managerial personnel, senior management, or subsidiary or arrest of key managerial personnel, senior management, promoter or director of the company, whether occurred within India or abroad. Definition of fraud or default for the purpose of this clause was included,

e. Change in key managerial personnel, other than due to superannuation or end of term, and resignation of a Statutory Auditor or Secretarial Auditor,

f. Resolution plan/ Restructuring/one-time settlement in relation to loans/borrowings from banks/financial institutions,

g. Admission of winding-up petition filed by any party / creditors, admission of application by the corporate applicant or financial creditors for initiation of corporate insolvency resolution process (CIRP) against the company as a corporate debtor, approval of resolution plan or rejection thereof under the Insolvency and Bankruptcy Code, 2016,

h. Initiation of forensic audit, by whatever name called, by the company or any other entity for detecting misstatement in financials, misappropriation/ siphoning or diversion of funds and receipt of final forensic audit report,

i. Action(s) initiated or orders passed by any regulatory, statutory, enforcement authority or judicial body against the company or its directors, key managerial personnel, senior management, promoter or subsidiary, in relation to the company,

j. award or termination of order/contracts not in the normal course of business,

k. outcome of any litigation(s) or dispute(s) which may have an impact on the company,

l. Giving of guarantees or indemnity or becoming a surety, by whatever named called, for any third party, by the company not in the normal course of business,

m. granting, withdrawal, surrender, cancellation or suspension of key licenses or regulatory approvals,

n. For identification of events, enumerated in this clause as UPSI, the guidelines for materiality referred at para B of Part A of Schedule III of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015, as amended from time to time, shall be applicable.

As the intent of law was not perceived by the market participants which were drafted on the back of a combination of “principles” and “rules backed by principles” are now shifting base to a rule-based approach. This shift seems to be the result of aggressive  ideas and white-collar crimes intended to circumvent the laws and take an undue advantage of the financial ecosystem.

Regulators are trying their best to curb such malpractices and give directives and principles on dealing in Securities Market, but cannot drive the intent of the person. In order to achieve minimum regulation and maximum governance, the onus lies on the market participants to abide by the laws in the right spirit.

SME IPOS: Regulatory Challenges and Proposed Reforms

BACKGROUND

Small and Medium Enterprises (SMEs) have long been considered the backbone of the global economy, driving innovation, creating jobs, and contributing significantly to economic growth. In India, SMEs are a critical segment of the business ecosystem, and over the past few years, many SMEs have turned to public markets to raise capital and expand their operations. The advent of the Small and Medium Enterprises (SME) Platform on stock exchanges, particularly the BSE SME Platform and the NSE SME Emerging Platform, has provided these companies with an opportunity to access a broader pool of investors, enhancing their growth prospects. However, as these companies increasingly tap into public investments, the risk of fraudulent activities and mismanagement has also grown, raising concerns over the integrity of the process. Additionally, that SME’s are promoter driven or family-run business with minimal private equity, which limits checks on promoter influence.

A striking example of this trend is the case of Trafiksol ITS Technologies Ltd., a company that specializes in providing intelligent transportation systems and automation solutions. Trafiksol filed its Draft Red Herring Prospectus (DRHP) for an Initial Public Offering (IPO) in May 2024, offering 64.10 lakh equity shares with the aim of raising funds for various purposes, including the purchase of software for its operations. However, soon after the subscription period, a complaint raised serious doubts about the company’s financial practices and the legitimacy of its business dealings, particularly its procurement of software from a vendor with questionable credentials. This led to a series of regulatory investigations and the subsequent halting of the company’s IPO listing.

The allegations against Trafiksol revealed the other side of the SME IPO market, where issues such as misleading prospectus disclosures, fraudulent vendor relationships, and concealment of material facts can lead to severe investor losses and erode trust in the market. As the investigation into Trafiksol unfolded, it became clear that the company had relied on a third-party vendor (TPV) with dubious financials, raising alarms about potential misuse of IPO proceeds and the company’s failure to conduct adequate due diligence.

This case serves as a stark reminder of the need for robust and urgent regulatory oversight in SME IPOs, as well as for greater transparency from companies seeking to raise public capital.

REGULATORY CONCERNS AND PROPOSED CHANGES TO THE SME IPO FRAMEWORK

The increasing participation of investors in Small and  Medium Enterprises (SMEs) listed on stock exchanges, coupled with growing regulatory concerns, has prompted the Securities and Exchange Board of India (SEBI) to  review and propose changes to the SME IPO framework. Investor participation in SME offerings has surged significantly, with the applicant-to-investor ratio rising from 4X in FY 2022 to 46X in FY 2023 and 245X in FY 2024. However, concerns have arisen about the governance practices of SME listed companies, many of which are promoter-driven and exhibit a high concentration of shareholding. There have been instances of fund diversion, revenue inflation, and circular transactions involving related parties, shell companies, and connected parties. SEBI has taken action against such companies in the past, but the issue of related party transactions (RPTs) remains a point of concern. SEBI has found that one in two SME listed entities have undertaken RPTs of over ₹10 crores, with one in seven involving more than 50 per cent of the company’s consolidated turnover. These risks underline the need for more stringent scrutiny of SMEs, with the ultimate goal of protecting investors’ interests.

To address these issues, SEBI has worked with stock exchanges, merchant bankers, and its Primary Market Advisory Committee (PMAC) to propose reforms aimed at strengthening both the regulatory framework for SME IPOs and the governance norms for these companies. These proposals focuses on the IPO process and migration from the SME platform to the Main Board, along with corporate governance norms and post-listing disclosures for SME-listed companies.

KEY PROPOSALS AND RATIONALES

  1. Increase in Minimum Application Size: SEBI has proposed raising the minimum application size for SME IPOs from ₹1 lakh to ₹2 lakh, or even ₹4 lakh, to reduce the risk of investor losses in high-risk SME stocks. This change would attract more informed, risk-taking investors rather than smaller retail investors who may be less prepared to deal with the risks inherent in SME investments. This proposal also aims to enhance the credibility of the SME segment by limiting participation to those with more risk tolerance.
  2. NII (Non-Institutional Investor) Allocation: To align SME IPOs with main-board IPOs, SEBI recommends that the NII category be split into two sub-categories: one for investments up to ₹10 lakh and another for amounts above ₹10 lakh. Additionally, it suggests moving from proportional allotment to a “draw of lots” method for the NII category, similar to the retail category. This aims to provide a more equitable distribution of shares in the case of oversubscription.
  3. Increase in Minimum Allottees: Currently, SME IPOs require a minimum of 50 allottees to be considered successful. SEBI proposes increasing this threshold to 200 to ensure broader investor participation and enhance the stability of the listing, which would help build investor confidence.
  4. Phased Lock-In for Promoters: The lock-in period for promoters’ holdings in excess of the minimum promoter contribution (MPC) is proposed to be phased, with 50 per cent remaining locked in for two years after the IPO and the remaining 50 per cent for one year. This gradual release is intended to prevent rapid exit by promoters after listing, ensuring they have a long-term interest in the company’s performance. SEBI also suggests extending the lock-in period to 5 years for the minimum promoter contribution for SME IPOs.
  5. Restriction on Offer for Sale: It is suggested to put restriction on OFS part of SME IPO to 20 per cent of issue size as OFS proceeds are not forming capital of issuer and they may limit for OFS in issue size as well as threshold may be prescribed for selling shareholders also which shall not exceed more than 20 per cent of their pre-issue shareholding on fully-diluted basis.
  6. Monitoring of Issue Proceeds: Mandatory Appointment of monitoring agency shall be applicable for issuer company if fresh issue size is higher than 20 Crore or for specified objects. They will certify on utilisation of proceeds and will ensure funds are used for the purposes disclosed in the offer document, thus reducing the risk of misuse or diversion. This will also bring more transparency for investors and accountability for issuer.
  7. Increased Tenure of Promoter Lock-In: Since, SME companies are mostly promoter driven, it is necessary to ensure that promoter continues to have certain skin in the game until the company is on the SME Exchange. It is proposed that lock-in on minimum promoter contribution (MPC) in SME IPO shall be increased to 5 years. Additionally, lock-in on promoters’ holding held in excess of MPC shall be released in phased manner i.e. lock-in for 50 per cent holding in excess of MPC shall be released after 1 year and lock-in for remaining 50 per cent promoters’ holding in excess of MPC shall be released after 2 year.
  8. Eligibility for SME IPO: To improve the quality of companies listed on SME exchanges, SEBI proposes stricter eligibility criteria. For instance, companies should only be allowed to list if they have an operating profit of ₹3 crore in at least two of the last three financial years. Additionally, the promoter group of the issuing company should not have been involved in any fraudulent activities, like being debarred from the capital markets or being labelled as wilful defaulters or fugitive economic offenders.
  9. Disclosure of Firm Arrangement for Financing: In cases where a project is partially funded by a bank or financial institution, SEBI suggests requiring issuers to disclose the details of the sanction letters and appraisals in the offer document. This will provide additional transparency and safeguard investor interests by ensuring the financial feasibility of projects.
  10. Public Availability of Offer Documents for Comment: Unlike main-board IPOs, which require a 21-day public comment period for the Draft Red Herring Prospectus (DRHP), SME IPOs currently lack such a provision. SEBI now proposes to extend this requirement to SME IPOs, ensuring that investors have ample opportunity to review and comment on the offer documents before they are filed with stock exchanges. This increase in transparency would allow for a more informed investor base and help identify potential issues early on.
  11. Convertible Securities: Similar to main-board IPOs, SEBI recommends that SME companies convert all outstanding convertible securities into equity before filing for an IPO. This would offer investors a clearer picture of the company’s capital structure.
  12. Applicability of RPT norms to SME: Applying RPT norms under LODR Regulations to SME listed entities would contain the risks of siphoning of funds through related parties. In view of the above, it is proposed that the applicability of RPT norms under LODR Regulations should be extended to SME listed entities other than those which have paid up capital not exceeding ₹10 crores and net worth not exceeding ₹25 crores. This will harmonize the applicability of RPT norms between SME listed entities and Main Board listed entities. However, materiality threshold under Regulation 23(1) of LODR Regulations for approval by shareholders for RPT shall be only for transactions exceeding 10 per cent of annual consolidated turnover, and not lower of ₹1,000 crore or 10 per cent annual consolidated turnover since SMEs may not enter into high value transactions exceeding ₹1,000 crores.
  13. Merchant Banker Due-Diligence Certification: SEBI proposes that Merchant Bankers must submit a due-diligence certificate to stock exchanges at the time of filing the draft offer document, aligning this requirement with the practices for main-board IPOs. This will help ensure that proper due diligence is conducted before the offering, providing more protection for investors.
  14. Post-Listing Exit Opportunity for Dissenting Shareholders: SEBI suggests introducing provisions for post-listing exit opportunities for dissenting shareholders in case there are changes in the objects or terms outlined in the offer document. This will ensure that investors are not unfairly impacted by such changes after the IPO.
  15. Clarification on Price Adjustments for Corporate Actions: SEBI has noted cases where issuers conduct corporate actions like bonuses or stock splits shortly before an IPO, resulting in a mismatch between the actual value of shares and the issue price. To address this, SEBI proposes that the price per share for determining eligibility for minimum promoters’ contribution should be adjusted for such corporate actions, ensuring consistency and fairness in the IPO process.

Out of the proposed changes, SEBI in its 208th board meeting conducted on 18th December, 2024 reviewed SME framework under SEBI (ICDR) Regulations, 2018, and applicability of corporate governance provisions under SEBI (LODR) Regulations, 2015 on SME companies approved the following amendments to SEBI (ICDR) Regulations, 2018 and SEBI (LODR) Regulations, 2015:-

  • An issuer shall make an IPO, only if the issuer has an operating profit (earnings before interest, depreciation and tax) of ₹1 crore from operations for any 2 out of 3 previous financial years at the time of filing of its draft red herring prospectus (DRHP).
  • Offer for sale (OFS) by selling shareholders in SME IPO shall not exceed 20 per cent of the total issue size and selling shareholders cannot sell more than 50 per cent of their holding.
  • Lock-in on promoters’ holding held in excess of minimum promoter contribution (MPC) to be released in phased manner i.e. lock-in for 50 per cent promoters’ holding in excess of MPC shall be released after 1 year and lock-in for remaining 50 per cent promoters’ holding in excess of MPC shall be released after 2 years.
  • Allocation methodology for non-institutional investors (“NIIs”) in SME IPOs to be aligned with methodology used for NIIs in main board IPOs.
  • Amount for General Corporate Purpose (GCP) in SME IPO shall be capped to 15 per cent of amount being raised by the issuer or ₹10 crores, whichever is lower.
  • SME issues shall not be permitted, where objects of the issue consist of Repayment of Loan from Promoter, Promoter Group or any related party, from the issue proceeds, whether directly or indirectly.
  • DRHP of SME IPO filed with the Stock Exchanges to be made available for 21 days for public to provide comments on DRHP, by making public announcement in newspaper with QR code.
  • Further issue by SME Companies to be permitted without migration to Main Board subject to the issuer undertaking compliance of the provisions of SEBI (LODR) Regulations, 2015 as applicable to the companies listed on the Main Board.
  • Related party transaction (RPT) norms, as applicable to listed entities on Main Board, to be extended to SME listed entities, provided that the threshold for considering RPTs as material shall be 10 per cent of annual consolidated turnover or ₹50 crore, whichever is lower.

While the SME IPO market plays a crucial role in enabling small and medium enterprises to access capital and expand their operations, recent incidents have exposed the vulnerabilities within this space. The concerns regarding transparency, corporate governance, and the potential misuse of IPO proceeds highlight the need for stronger oversight and regulatory reforms. The proposed regulatory changes by SEBI aim to enhance investor protection, bolster corporate governance practices, and improve market transparency. By focusing on tightening eligibility criteria, implementing phased lock-in regulations, and conducting more stringent scrutiny of promoters, SEBI seeks to create a more secure and reliable environment for SMEs to raise funds, while protecting retail investors from unnecessary risks.

For SMEs to truly reach their full potential, it is essential that companies maintain the highest standards of accountability and governance. By fostering a transparent, investor-friendly ecosystem, we can ensure that legitimate, growth-driven businesses thrive without the threat of exploitation or fraud. This will not only safeguard investor interests but also cultivate a sustainable, long-term investment landscape that supports the ongoing growth and success of SMEs in India.

From Speculation to Stability: SEBI’s Comprehensive Regulatory Measures in Derivatives Markets

BACKGROUND

Derivatives are a cornerstone of modern financial markets, providing a vast array of tools for speculation, risk management, and portfolio diversification. However, despite their usefulness, derivative instruments come with a set of inherent risks, especially when traded by retail investors who may not have the necessary expertise or tools.

Given the changing market dynamics in the equity derivatives segment in recent years with increased retail participation, offering of short-tenure index options contracts, and heightened speculative trading volumes in index derivatives on the expiry date, the regulator seeks to enhance investor protection and promote market stability in derivative markets, while ensuring sustained capital formation.

Dynamics of Derivatives with the Retail Segment

The retail segment in India has seen substantial growth in derivatives trading, particularly in the equity F&O (Futures and Options) market. However, recent studies conducted by the Securities and Exchange Board of India (SEBI) have raised concerns about the financial health of retail traders in the equity F&O segment. Significant trading activity happens during the day of expiry and significant speculative activity happens during the contract expiry period.

A recently updated study issued by Department of Economic and Policy Analysis, SEBI on individual traders in the equity F&O segment reveals alarming statistics about the financial outcomes for retail participants. The derivatives market turnover in India has significantly surpassed the cash market turnover. Reports suggest that Indian markets account for 30 per cent to 50 per cent of global exchange-traded derivative trades, aided by technology, increasing digital access and varied product offerings. The total number of Demat accounts in India rose to 15.8 crore as at the end of May 24, of which 12.2 crore accounts were opened since April 2020. Between FY22 and FY24, a staggering 93 per cent of over one crore individual F&O traders incurred average losses of ₹2 lakh each, factoring in transaction costs. A small fraction, around 3.5 per cent (about 4 lakh traders), faced even more significant losses, averaging ₹28 lakh per person. Only 1 per cent of traders were able to generate profits exceeding ₹1 lakh after accounting for transaction costs. These findings highlight the persistent struggle of retail investors in the high-risk world of equity derivatives.

The distribution of profits paints a stark contrast between individual traders and institutional players. While proprietary traders and Foreign Portfolio Investors (FPIs) generated substantial profits of ₹33,000 crore and ₹28,000 crore respectively in FY24, individual traders as a group faced collective losses of ₹61,000 crore. The lion’s share of these profits by larger entities came from algorithmic trading, with 97 per cent of FPI profits and 96 per cent of proprietary trader profits attributed to automated systems. This suggests that individual traders, without access to such sophisticated tools, are at a significant disadvantage in the market. This poses a question whether derivatives are a product for the retailers.

Transaction costs also play a critical role in exacerbating the losses faced by individual traders. On average, retail participants spent ₹26,000 per person on F&O transaction costs in FY24. Over the three-year period from FY22 to FY24, these traders collectively spent about ₹50,000 crore on transaction costs, with brokerage fees accounting for 51 per cent and exchange fees contributing to 20 per cent. Transaction costs add a substantial burden to traders already struggling with poor market performance, further eroding their capital.

The study also notes an increase in participation from younger traders and those from smaller cities. The proportion of traders under 30 years of age in the F&O segment rose sharply from 31 per cent in FY23 to 43 per cent in FY24. Furthermore, 72 per cent of individual traders came from Beyond Top 30 (B30) cities, surpassing the proportion of mutual fund investors (62 per cent from B30 cities). This shift suggests a growing trend of younger and less affluent traders demonstrating penetration from emerging cities of India entering the F&O market, often without sufficient experience or understanding of the risks involved.

Despite the overwhelming evidence of losses, many individual traders continue to participate in the F&O market. Over 75 per cent of loss-making traders persisted with their trading activity, indicating a strong sense of urge or a reluctance to exit the market. This persistence, coupled with the increasing participation of younger and less experienced traders, calls for greater regulatory attention and more robust investor education programs to prevent further financial distress in the retail trader community.

The SEBI study clearly illustrates the challenges faced by individual traders in the equity F&O segment, particularly the high rates of loss, significant transaction costs, and the disparity in profits between retail traders and institutional investors. Additionally, the popularity of shorter-duration options in indices with few stocks and high volatility could amplify leverage.

According to the RBI’s bi-annual Financial Stability Report (FSR), trading volumes in the derivatives segment have grown exponentially in notional terms. However, when measured by premium turnover, the growth has been more linear. The ratio of premium turnover to the cash market has remained stable over the past three years. Additionally, the popularity of shorter-duration options in indices with few stocks and high volatility could amplify leverage. Retail investors might be impacted by sudden market movements without proper risk management, which could have knock-on effects on the cash market. However, it is crucial for retail traders to understand the risks involved in derivatives trading — especially in illiquid markets — and adopt prudent risk management strategies, including diversification, position sizing, and leveraging hedging tools effectively.

One such scenario includes trading in Illiquid options. Trading involves buying and selling options contracts that have low trading volumes and limited market participation. These options tend to be associated with less popular underlying assets, distant expiration dates, or strike prices that are far from the current market price of the underlying asset. Because of the reduced trading activity, illiquid options typically have wider bid-ask spreads, meaning the difference between the price a buyer is willing to pay and the price a seller is asking for is larger.

The primary risk of trading illiquid options is the difficulty in executing trades at favourable prices. With fewer market participants, large orders can significantly impact the price of the option, resulting in slippage — where the execution price is worse than anticipated. Additionally, illiquid markets can make it harder to close a position, as there may not be enough buyers or sellers at the desired price.

Recently SEBI has passed various adjudication orders on entities involved in trading in Illiquid stock options on Derivative Trading platform of BSE. SEBI observed large-scale reversal of trades in stock options leading to creation of artificial volume at BSE.

Pursuant to SEBI Investigation, it was observed that a total of 2,91,744 trades comprising 81.40 per cent of all the trades executed in stock options segment of BSE during the period were allegedly to be non-genuine in nature and created false or misleading appearance of trading in terms of artificial volumes in stock options and therefore to be manipulative or deceptive in nature.

The entities on which adjudication is passed by SEBI were involved in Reversal Trade. Reversal trades are considered to be those trades in which an entity reverses its buy or sell positions in a contract with subsequent sell or buy positions with the same counterparty during the same day. The said reversal trades are alleged to be non-genuine trades as they are not executed in the normal course of trading, lack basic trading rationale, lead to false or misleading appearance of trading in terms of generation of artificial volumes and hence are deceptive and manipulative.

The entities were adjudicated under provision of PFUTP Regulations, 2003.

This led to an urgent need for regulatory reforms to address these issues, including measures to reduce transaction costs, enhance transparency, and promote better risk management practices among individual traders. Additionally, increased investor education and support, particularly for young and inexperienced traders, could help mitigate the risks associated with derivatives trading. Without such interventions, the current trends of rising participation and continued losses could further harm the financial well-being of retail investors. SEBI has also been considering a review of the eligibility criteria for determining entry/exit of stocks in derivatives segment.

Identifying the Risk

Risk management is not possible without identifying the risks and understanding the consequence of not managing the risk effectively. This can be particularly problematic for retail traders who may lack sufficient expertise to manage these risks effectively. The key risks involved in derivative trading include:

Market risk refers to the risk of a decline in the value of the underlying asset. This can happen if there is a sudden change in market conditions, such as a global financial crisis or a natural disaster. If the value of the underlying asset falls significantly, the value of the derivative can also decline, potentially leading to significant losses for investors.

Leverage can enhance the impact of market risk. Since an investor is required to pay only the margin or premium, as the case may be, the actual exposure to the underlying would be a multiple of the amount paid. If the investor has not properly understood and put a significant amount of capital towards the margin or premium, the losses could be huge, potentially wiping the investor out financially.

Liquidity risk is another significant one. It refers to the risk that an investor may not be able to exit a position in the derivative market quickly or at a fair price. In the Indian securities markets, most actively traded derivatives contracts are short-term, so liquidity risk may not be much as the contract will expire soon.

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people, or systems, or from external events. While such instances could be rare, these incidents can lead to significant losses for investors who are unable to exit their positions in time.

Regulatory Measures to Strengthen Derivatives Framework for Increased Investor Protection and Market Stability

Recognising the growing risks and challenges faced by retail investors, SEBI has introduced several regulatory measures to strengthen the derivatives market and safeguard investor interests. Key regulatory reforms include the following:

  1. Upfront collection of premiums: Options being timed contracts with the possibility of fast-paced price appreciation or depreciation. Starting February 2025, the regulator requires that options buyers pay the full premium upfront. The upfront margin collection shall also include net options premium payable at the client level. This rule aims to reduce excessive intraday leverage and ensure that traders’ exposure to risk is in line with their collateral.
  2. Removal of calendar spreads: Effective from February 2025, calendar spreads (trading of offsetting positions across different expiry dates) will no longer be permitted on expiry days. Calendar spreads are seen as increasing market volatility and basis risk on expiry days, which can exacerbate price fluctuations and lead to higher market manipulation risks. Accordingly, on the day of expiry, the worst-case scenario loss shall be calculated separately for the contracts expiring on the given day and for the rest of the contracts.
  3. Intraday monitoring of position limits: Intraday monitoring of position limits from April 2025. Given the large volumes of trading on expiry day, there is a possibility of undetected intraday positions beyond permissible limits during the course of the day. Stock exchanges will be required to take a minimum 4 snapshots of traders’ positions during the trading day to ensure compliance with permissible limits, particularly during volatile expiry periods.
  4. Increase in minimum contract size: Starting November 2024, the minimum contract size for index derivatives shall not be less than ₹15 lakh at the time of its introduction in the market. Given the
    inherent leverage and higher risk in derivatives, this recalibration in minimum contract size, in tune with the growth of the market, would ensure that an inbuilt suitability and appropriateness criteria for participants is maintained as intended
  5. Rationalisation of weekly contracts: Expiry day trading in index options is largely speculative. Different Stock Exchanges offer short tenure options contracts on indices which expire on every day of the week. In order to specifically address this issue of excessive trading in index derivatives on expiry day, it has been decided to rationalize index derivatives products offered by exchanges that expire on a weekly basis. This measure seeks to curb excessive trading on expiry days and encourage more stable capital formation.
  6. Extreme loss margin (ELM): SEBI will impose an additional 2 per cent Extreme Loss Margin for all short options contracts expiring on a given day, effective from November 2024. This will help mitigate the risk of tail events and limit extreme price movements on expiry days.

The measures introduced by SEBI, including increased margin requirements, position limits, and stricter monitoring of speculative trading, are a step in the right direction to protect individual investors and ensure a more stable and transparent market environment.

Conclusion

The financial sector regulators, SEBI and RBI have always raised a concern on derivatives trading over increasing volumes in the F&O Market, highlighting its potential macro-economic impact. Recent measures introduced by SEBI are primarily aimed at reducing excessive speculative trading and ensuring better risk management practices. As market participants adapt to the new regulations in a phased manner, the potential for a more mature and stable derivatives market could emerge, benefiting both investors and the overall financial ecosystem in India.

“The aim is to enhance capital formation while ensuring capital protection”

X-X-X-X

Source: Analysis of Profit and Loss of Individual Traders dealing in Equity F&O Segment, issued by SEBI.

SEBI Consultation Paper and Circular on Measures to Strengthen Equity Index Derivatives Framework for Increased Investor Protection and Market Stability.

Prevention Of Market Abuse In The Securities Market

BACKGROUND

“Prevention of market abuse and preservation of market integrity is the hallmark of securities law” which was noted by the Honourable Supreme Court of India in its judgment N Narayanan v/s Adjudicating Officer way back in 2013.

SEBI has noted that while the Indian capital market has witnessed tremendous growth and by increased participation of the public, ‘market abuse’ is a common practice in the securities market. In the aforesaid judgement, the court has defined ‘Market abuse’as the use of manipulative and deceptive devices, giving out incorrect or misleading information, so as to encourage investors to jump conclusions, on wrong premises, which is known to be wrong to the abusers. In general parlance, Market abuse is generally understood to include market manipulation and insider trading and such activity erodes investor confidence and impairs economic growth. The SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations 2003 (PFUTP Regulations) deals with market abuse such as manipulative, fraudulent, and unfair trade practices.

The Court also went on to succinctly outline the duties and responsibilities of SEBI in regulating and ensuring market security and protecting investors from fraud and market abuse.

DEALING WITH MARKET ABUSE

The regulator’s journey for dealing with market abuse in the securities market has been an ongoing process with the emergence of markets, development of technology, information flow, and access to markets, which led to the need to review the securities law dealing with market abuse and the methods used for detecting, investigating and carrying out enforcement against such market abuse.
One such initial initiative was constituting a “Fair Market Conduct Committee” in 2017 to review the existing legal framework to deal with market abuse to ensure fair market conduct in the securities market especially the surveillance, investigation, and enforcement mechanisms being undertaken by SEBI to make them more effective in protecting market integrity and interest of investors from market abuse.

Their recommendations were in four separate parts dealing with:

i. market manipulation and fraud,

ii. insider trading,

iii. code of conduct relating to insider trading regulations and

iv. recommendations relating to surveillance, investigation, and enforcement process.

Such recommendations led to review and changes to relevant regulations including PFUTP and SEBI (Prohibition of Insider Trading) Regulations, 2015 framed by SEBI to deal with market abuse and to review the surveillance, investigation, and enforcement mechanisms being undertaken by SEBI to make them more effective in protecting market integrity and the interest of investors from market abuse.

Pursuant to this, moving forward in 2021, SEBI issued a Code of Conduct & Institutional mechanism for the prevention of Fraud or market abuse for Market Infrastructure Institutions (MII) such as Stock Exchanges, Clearing Corporations & Depositories obligating the MIIs for Issuing a Code of Conduct including;

i. To formulate a Code of Conduct to achieve Compliance with SEBI (Prohibition of Insider Trading) Regulations, 2015

ii. MD/CEO to frame the referred Code of Conduct.

iii. Identify & designate a Compliance Officer to administer the aforesaid Code of Conduct.

iv. Specify designated persons to be covered under the Code of Conduct.

MIIs shall put in place an institutional mechanism  for the prevention of fraud or market abuse including the following:

i. Adequate & effective implementation of internal control and administration of the same by Compliance officer.

ii. Annual Review by Regulatory Oversight Committee.

iii. Written Policies & Procedures for Inquiry including adequate protection to any employee reporting instances of fraud/suspicion of fraud or market abuse.

Thereafter, various measures have been introduced by SEBI from time to time to instill confidence among investors and retain trust in the securities market.

One of the many recent changes in July 2024, requires stock brokers to put in place an institutional mechanism for the prevention and detection of fraud or market abuse which has been introduced through the Stock Broker (Amendment) Regulations, 2024 giving the power to Brokers Industry Forum to frame the implementation standards including operational modalities. The effective date of implementation is different for various stock brokers, however, for Qualified Stock brokers it has been put into effect from 1st Aug, 2024.

RECENT ISSUES ON FRONT RUNNING

For ease of understanding, Front running is defined as an unethical and illegal practice where a broker, trader, or fund manager uses advanced knowledge of pending large transactions to gain a profit. For instance, if a mutual fund intends to purchase a significant number of shares in a company, a broker privy to this information might buy shares beforehand, selling them at a profit once the fund’s transaction influences the stock price.

There have been many instances of front-running in the past that have come to the notice of the regulators wherein broker-dealers, certain employees, and connected entities were found to have front-run the trades of the AMCs, Listed Companies, and FPIs. In one such case, SEBI has observed during its investigation that various entities connected to the Dealer have traded in different securities ahead of the impending orders placed on behalf of the Mutual Fund. Subsequently, soon after the Mutual Fund’s order was placed, these connected Noticees squared off their positions taken on the Exchange platform. In the process, substantial proceeds of profit were generated in the trading accounts of these connected entities, by placing orders ahead of and in anticipation of the price movement of scrips in a certain direction on account of the impending large buy / sell orders of the Mutual Fund. Such trades were executed from the trading accounts of the connected entities in a similar manner on numerous occasions during the Investigation Period.

Further, a recent case of front running of shares of an entity where the Employee (working in the Investment Department) was involved. The trading pattern of the alleged front runners during the investigation Period shows that orders for the first leg of their intraday trades were placed and executed just prior to the impending order(s) of entity and the orders for squaring off their trades i.e., second leg sell/ buy order(s) were placed at a limit price which is less/ more than the buy/ sell order limit price of the entity, ensuring that such sell/ buy order(s) would get matched with the buy/ sell order(s) of the company. It has also been prima facie observed that such trades were executed in a Buy-Buy-Sell (“BBS”) and/ or Sell-Sell-Buy (“SSB”) pattern.

In order to address such instances of market abuse including front-running and fraudulent transactions in securities, the consultation paper proposed to put in place a structured institutional mechanism at the end of AMCs, which can proactively identify and deter instances of such market abuse. It was noted that that there are no specific regulatory provisions that cast responsibility on the AMCs or their senior management personnel to put in place systems for deterrence, detection, or reporting of market abuse or fraudulent transactions. The possible instances / indicators of market abuse or fraudulent transactions in securities related to AMC’s transactions for Mutual Fund schemes are front-running, Insider Trading, Misuse of information by the AMC, its employees, distributors, broker-dealers, etc.

The regulatory framework for the institutional mechanism by AMCs for identification and deterrence of potential market abuse including front-running and fraudulent transactions in securities was issued vide Circular dated 05 August, 2024 for AMCs.

This mechanism shall consist of enhanced surveillance systems, internal control procedures, and escalation processes such that the overall mechanism is able to identify, monitor, and address specific types of misconduct, including front running, insider trading, misuse of sensitive information, etc. Accountability for implementing this framework is assigned to the Chief Executive Officer (CEO) or Managing Director (MD) of MFs, or the Chief Compliance Officer (CCO) of AMCs.

Broad Requirements for AMCs to Implement Institutional Mechanisms

To effectively implement the required mechanisms, AMCs must ensure the following:

a) Develop and implement systems to generate and process alerts in a timely manner.

To develop robust surveillance systems, AMCs should begin by defining specific alert types that indicate potential misconduct, such as unusual trading patterns or communication anomalies. Back-testing these systems with historical data will help refine the parameters and minimize false positives.

b) Review all recorded communications, including chats, emails, access logs, and CCTV footage during alert processing, while maintaining entry logs for their premises.

Implementing a review of recorded communications requires the establishment of a secured, centralized repository for storing all relevant materials, including emails, chats, access logs, and CCTV footage. Automated monitoring tools can flag communications that trigger alerts for further investigation while maintaining detailed entry logs for accountability. Despite these measures, challenges arise in balancing employee privacy rights with the need for surveillance. Managing and analyzing large volumes of communication data can become resource-intensive, and compliance with data protection regulations is essential to avoid potential legal pitfalls.

c) Formulate SOP’s

To address potential market abuse, mutual funds should create comprehensive written policies that clearly define what constitutes market abuse and outline investigation procedures. Gaining board approval for these policies ensures alignment with organizational goals and regulatory requirements.

d) Action on Suspicious Alerts

Establishing clear protocols for investigating alerts and potential market abuse is essential for effective response. This includes developing investigation timelines, responsible parties, and guidelines for disciplinary actions such as suspensions or terminations based on findings. Thorough documentation of investigations and outcomes is critical for transparency.

e) Escalation Process

Establish an escalation process to inform the Board of Directors and Trustees about potential market abuse instances and the results of subsequent examinations.

A structured reporting framework for escalating potential market abuse cases to the Board of Directors and Trustees is crucial for oversight. This includes establishing regular updates on the status of investigations to keep the Board informed and engaged. Training Board members to effectively understand and respond to potential market abuse instances is also important.

f) Whistleblower Policy

Maintain a documented whistleblower policy in line with sub-regulation (29) of regulation 25 of the SEBI (Mutual Fund) Regulations, 1996.

Developing a clear and accessible whistleblower policy is essential for encouraging employees to report misconduct without fear of retaliation. This policy should outline reporting mechanisms and protections for whistleblowers, along with conducting awareness campaigns to educate staff about its importance. Establishing secure channels for anonymous reporting can further enhance participation.

g) Periodic Review

To ensure ongoing effectiveness, mutual funds should schedule regular reviews of their policies and systems, incorporating feedback from staff and audit results. Benchmarking against industry best practices and adapting to regulatory updates is also necessary for maintaining compliance. Fostering a culture of continuous improvement helps organizations adapt to new challenges.

h) Reporting to SEBI

AMCs shall report all examined alerts to SEBI along with the action taken, in the Compliance Test Report (‘CTR’) and the Half-yearly Trustee Report (‘HYTR’) submitted to SEBI.

WAY FORWARD

Regulations can set forth rules and impose penalties, yet they may not deter individuals whose intent is to engage in fraudulent activities. To truly mitigate the risk of unethical conduct, it is essential to address the motivations and attitudes that drive potential fraudsters. A regulatory framework alone cannot suffice; it must be accompanied by a profound cultural transformation that prioritizes honesty, integrity, and ethical decision-making.

This shift involves fostering an environment where ethical behavior is not merely a compliance obligation but a core value embraced in its systems and processes by all stakeholders. By cultivating such a culture, the financial sector can ensure that its actions resonate with the principles of trust and responsibility. Fair market conduct can be ensured by prohibiting, preventing, detecting, and punishing such market conduct that leads to ‘market abuse’. With the changing dynamic of the securities market, this will be an ongoing and evolving responsibility of the regulator to be vigilant and address the issues on an immediate basis by adopting the best of both worlds’ i.e., Rule-based and Principle-based regulations. The Regulator’s hands-on and vigilant approach has helped in immediately fixing the problem while also understanding the larger concerns. Several Reg Tech measures have been introduced to address these concerns as regulators have proactively increased their enforcement action. Early adoption of Artificial Intelligence can help in the early detection of such instances of market abuse, and prevention mechanisms can be built into the surveillance systems which shall identify and prohibit probable fraud and introduce early corrective actions. In India, SEBI being the key financial sector regulator, is duty-bound to protect the interest of the investors in securities and to promote the development of and regulate the securities market.

“Authority can be delegated but responsibilities cannot be diluted.”

Reimagining Investment Advisory & Research Services

Editor’s Note: Late CA Jayant Thakur contributed to the Securities Law feature since 2006-07, since its inception, for nearly eighteen years on a month-on-month basis. After his passing the feature took a brief interval. We are delighted to restart this feature with new contributors CA Bhavesh Vora and CA Khushbu.

(Consultation Paper on Review of Regulatory Framework for Investment Advisers & Research Analysts)

BACKGROUND

SEBI (Investment Advisers) Regulations, 2013, and the SEBI (Research Analysts) Regulations, 2014, were established to regulate and streamline the activities of individuals and entities offering investment advisory and research analyst services. However, every regulation stands the test of time and must be revisited and redefined to commensurate with the evolving nature of business and adapt to the changing business trends.

In light of the growth in the securities market and a notable increase in investors, it is startling to see the current number of registered Investment Adviser (IAs) and Research Analysts (RAs) as compared to the large investor base. This discrepancy has resulted in a significantly low ratio of investment advisers per million individuals, leading to an increase in unregistered entities / individuals operating as IAs and RAs. It must be appreciated that SEBI has taken strict and timely action against such unregulated activities to protect the interests of investors.

At the same time, the Regulator has been a proponent for encouraging technological innovations in the best interest of the investors, to keep up with the changing trends in the industry. The regulators’ mindset to come one step closer to bringing parity to the role of investment advisers worldwide is demonstrated through its recent consultation paper.

“Investment Adviser” means any person, who for consideration, is engaged in the business of providing investment advice to clients or other persons or groups of persons and includes any person who holds out himself as an investment adviser, by whatever name called.

“Research Analyst” means a person who is primarily responsible for:

a) preparation or publication of the content of the research report; or

b) providing research reports; or

c) making “buy / sell / hold” recommendations; or

d) giving price target; or

e) offering an opinion concerning the public offer

With respect to securities that are listed or to be listed in a stock exchange, whether or not any such person has the job title of ‘research analyst’ and includes any other entities engaged in the issuance of research reports or research analysis

The Consultation Paper issued by SEBI regarding the Review of the Regulatory Framework for Investment Advisers and Research Analysts proposes several amendments aimed at establishing a regulatory landscape that is

a. Conducive to the evolving nature of IA and RA businesses

b. Adopting a principle-based approach

c. Simplifying compliance and reducing associated costs.

KEY HIGHLIGHTS OF THE PROPOSED CHANGES

1. Relaxation in Eligibility Criteria for IAs and RAs

The proposed regulatory changes by SEBI aim to attract young professionals and ease of entry to Investment Advisory (IA) and Research Analyst (RA) roles by lowering the minimum qualification requirements from a postgraduate degree to a graduate degree. Additionally, IAs and RAs would be required to obtain only their foundational certifications instead of taking the same before expiry from the National Institute of Securities Markets (NISM) upon registration, with periodic updates focused on regulatory developments.

The proposal also recommends the elimination of prior experience and minimum net worth requirements, acknowledging that these roles are fee-based and do not entail managing client funds. Instead, IAs and RAs would be required to maintain a specified deposit, lien-marked to the stock exchange, to cover potential dues arising from arbitration or conciliation proceedings.

2. Allowing Registration as Both Investment Adviser and Research Analyst

The proposal to allow individuals or partnership firms to register for both IA and RA services stems from the overlapping nature of activities in these roles. This proposal aims to enhance service offerings while preserving regulatory integrity and maintaining an arm’s length relationship between IA & RA Activities.

3. Registration as a Part-Time Investment Adviser / Research Analyst

The proposed amendments to the registration criteria for IAs and RAs will allow individuals or partnership firms engaged in non-securities-related businesses to register as part-time IAs or RAs. This change addresses previous concerns regarding the required separation between advisory activities and other business pursuits.

Under the new rules, part-time IAs and RAs cannot manage client funds or provide advice on non-regulated investment products. They must obtain a no-objection certificate (NOC) from their employer if employed, limit their client base to a maximum of seventy-five clients at any given time, maintain a separation of advisory services from other business activities, and include a disclaimer in communications about non-IA / RA services, clarifying that they are not under SEBI’s jurisdiction.

Eligible professionals include educators, architects, lawyers, and doctors who may register as part-time IA / RA. Ineligible candidates are those advising on assets such as gold, real estate, or cryptocurrencies. For instance, a Chartered Accountant is providing security – specific / recommendations to its client even though as Part of tax planning / tax filing, he is required to seek registration as a part-time IA / RA. However, in the existing regulatory guidelines, a member of ICAI who provides investment advice to clients incidental to the professional services are exempt from seeking registration under IA regulations.

A Chartered Accountant providing investment advice must ensure that their conduct aligns with these ethical principles. The ICAI’s Code of Ethics and Professional Conduct outlines the fundamental principles and rules that members must adhere to in their professional activities. These principles include integrity, objectivity, professional competence and due care, confidentiality, and professional behaviour.

4. Relaxations in the Designation of ‘Principal Officer’

Currently, non-individual IAs are required to appoint a managing director or an equivalent as the Principal Officer. However, industry feedback indicates that in organizations with multiple lines of business, these individuals may not be directly involved in the day-to-day operations of the investment advisory division.

To address this, the proposal allows such organizations to designate the business head or unit head of the investment advisory services as the Principal Officer, ensuring that they are responsible for overseeing these activities. In contrast, entities engaged solely as IAs must still appoint a managing director or designated director as the Principal Officer. Additionally, partnership firms are required to designate one partner as the Principal Officer, and those without eligible partners will be granted a timeline to restructure as Limited Liability Partnerships (LLPs).

Furthermore, the proposal introduces a requirement for non-individual RAs and research entities to designate a Principal Officer, aligning the RA regulations with those of IAs. This move aims to ensure responsible oversight of business operations across both investment advisory and research functions.

5. Allowing Appointment of Independent Professionals as Compliance Officers

Currently, both IAs and RAs are required to appoint a compliance officer responsible for ensuring adherence to the SEBI Act and associated regulations. However, there have been industry requests to allow the appointment of independent professionals—such as Chartered Accountants (CAs), Company Secretaries (CSs), or Cost and Management Accountants (CMAs)—as compliance officers, rather than requiring a full-time officer.

Under the proposal, IAs and RAs can appoint independent professionals as compliance officers, provided that the Principal Officer submits an undertaking affirming their responsibility for compliance oversight. Additionally, independent professionals must hold relevant certifications from the National Institute of Securities Markets (NISM) to be eligible for this role. This approach seeks to enhance flexibility while ensuring robust compliance monitoring and reducing compliance costs within the IA and RA sectors.

6. Clarity in Activities that Can Be Undertaken by IAs — Scope of Investment Advice

IAs can offer financial planning that includes a mix of regulated securities and legally permitted unregulated assets. However, they may only provide investment advice on securities regulated by SEBI or products overseen by other financial regulators. Non-individual IAs wishing to advise on non-specified products must do so through a separate legal entity to maintain an arm’s-length relationship. Additionally, individual IAs are prohibited from advising on instruments outside those regulated by SEBI or other financial regulators. These changes aim to enhance client protection and ensure IAs operate within a clear regulatory framework, thereby reducing risks associated with unregulated advice and services.

7. Use of Artificial Intelligence (‘AI’) Tools in IA and RA Services

While AI tools can assist IAs and RAs in delivering personalized services tailored to client-specific needs, they may not always provide accurate or comprehensive outputs, especially in complex financial situations, and also raise concerns about data security, particularly regarding the sensitive information shared during interactions. Additionally, AI tools might lack transparency regarding the methodologies employed in generating recommendations, which is critical for ensuring compliance with risk profiling and suitability assessments.

To address these concerns, any IA or RA utilizing AI tools must fully disclose the extent of their use to clients, enabling informed decision-making regarding their services. Ultimately, the responsibility for data security and regulatory compliance remains solely with the IA or RA, regardless of how AI tools are employed in their advisory or research activities.

8. Flexibility for IAs to Change the Modes of Charging Fees to Clients

The proposed fee structure for IAs provides the liberty to switch between fixed fees mode (limited to R1,25,000 p.a.) and Asset under Advice (AUA) Mode at 2.5 per cent p.a. on AUA without any waiting time period, which under the existing regulations is a 12-month period. The maximum fee charged will be the higher of the two limits. For accredited investors, fee structures will be determined through bilaterally negotiated contractual terms, providing greater flexibility in fee arrangements while maintaining regulatory boundaries.

9. Relaxation in Requirement for Corporatisation by Individual IAs

The proposed changes to Regulation 13(e) of the IA Regulations would allow individuals to operate their advisory businesses without being compelled to transition into a corporate structure by broadening the requirement for compulsory corporatization of an individual IA i.e. 300 clients or fee collection of ₹3 Crore during the financial year, whichever is earlier.

10. Definitions of ‘research analyst’ and ‘research services

The IA Regulations require payment consideration for services rendered by investment advisors (IAs), but the current definition of “research analyst” under the RA Regulations does not explicitly mention any payment consideration, leaving room for arbitrary interpretation of the scope of services. To address this, a proposal suggests modifying the definition to state that only those providing research services “for consideration” should be classified as research analysts. “Consideration” would encompass any economic benefit, including non-cash benefits, received for such services.

Additionally, the proposal recognizes that some research analysts are currently offering services like model portfolios and stop loss target recommendations, which aren’t explicitly defined in the existing regulations. To adapt to industry practices, it is proposed that these services be included under the definition of research services provided by research analysts.

11. KYC Requirements and maintenance of record

Currently, investment advisors (IAs) must follow KYC procedures as specified by SEBI and maintain relevant records. However, research analysts (RAs) lack specific provisions for disclosing terms and maintaining client identification records. It is proposed that RAs also adhere to KYC procedures for fee-paying clients and maintain KYC records as mandated by SEBI. Both IAs and RAs are required to upload these records to the KRA system. Additionally, they must keep detailed client records, including personal information, service details, and fees charged. RAs must document disclosures of service terms and maintain records of client communications, while IAs providing execution services need to record client consent calls.

12. Clarity in the identification of ‘persons associated with research services’

The proposed changes to the RA Regulations aim to define “persons associated with research services” to align with existing definitions in the IA Regulations. This new definition will include any member, partner, officer, director, employee, or similar staff of a research analyst or research entity involved in providing research services to clients or the public. It specifically encompasses client-facing roles such as analysts, sales staff, and client relationship managers, regardless of their titles. However, it will exclude individuals performing purely clerical or administrative functions without any connection to research services or client interaction. This clarification seeks to enhance consistency and clarity in identifying personnel associated with research activities.

13. Exemption to Proxy Advisers from the RAASB framework

SEBI has established a framework for the administration and supervision of research analysts (RAs) through the RAASB, which also applies to proxy advisers (PAs) under the RA Regulations. This framework aims to effectively manage the anticipated growth in the number of RAs. However, SEBI has received requests from proxy advisers to be exempted from the RAASB framework, citing the distinct nature of their services and potential conflicts of interest when overseen by exchanges. In response, it is proposed that proxy advisers be exempt from the RAASB framework, with their administration and supervision falling solely under SEBI’s jurisdiction.

14. Eligibility of ‘partnership firm’ for registration as RA and certification requirement for its partners

Regulation 6(i) of the RA Regulations currently considers individuals, bodies corporate, and LLPs for registration as research analysts (RAs) and is proposed to be amended to explicitly include “partnership firm.” Additionally, Regulation 7(2) states that partners of a research analyst must hold a NISM certification. It is proposed to clarify that this requirement applies only to partners who are actively engaged in providing research services, aligning their qualification requirements with those outlined in Regulation 7(1).

15. Fees chargeable to clients by RAs

To establish a level playing field between Investment Advisors (IAs) and Research Analysts (RAs) regarding fee structures, it is proposed that RAs be subject to similar maximum fee limits as IAs. The proposed fee structure for RAs includes the following key points:

1. RAs may charge fees within limits set by SEBI, ensuring that fees are fair and reasonable.

2. RAs can charge a maximum of ₹1,25,000 per annum per family for individual clients, while this limit does not apply to non-individual clients, such as Qualified Institutional Buyers (QIBs), accredited investors, and institutional clients seeking proxy adviser recommendations.

3. RAs may charge fees in advance, but such advance payments cannot exceed one month’s fees.

4. If RA services are terminated prematurely, clients are entitled to a refund of proportionate fees for the remaining service period.

5. Unlike IAs, RAs cannot charge breakage, separation, or alienation fees upon early termination, as they do not incur the same fixed costs associated with client onboarding and assessments.

This framework aims to create consistency and fairness in fee structures across both roles.

16. Client-level segregation of research and distribution services by RAs

Currently, individual Investment Advisors (IAs) are prohibited from providing distribution services, and their family members cannot offer such services to clients advised by the IA. Additionally, if a client is receiving distribution services from other family members, the IA cannot provide advice to that client. Non-individual IAs must maintain client-level segregation between investment advisory and distribution services, ensuring an arm’s length relationship by operating through distinct departments.

This restriction is based on the principle that IAs should deliver unbiased advice, which could be compromised if they receive payments from product issuers under a distribution model. Similarly, Research Analysts (RAs) are expected to provide independent research, necessitating a clear separation between their research activities and any distribution services to avoid conflicts of interest.

To align RAs with the existing provisions for IAs, it is proposed that RAs also implement client-level segregation between research and distribution services. However, IAs and RAs providing advisory or research services exclusively to institutional clients and accredited investors may be exempt from these segregation requirements, provided that the investors sign a standard waiver acknowledging this arrangement.

17. Guidelines for recommendation of ‘model portfolio’ by RAs

According to Regulation 2(1)(u) of the RA Regulations, Research Analysts (RAs) are authorized to provide “buy / sell / hold” recommendations and price targets for securities listed or to be listed on a stock exchange. However, RAs have begun issuing “model portfolios,” which offer recommendations for multiple securities based on specific parameters, for which there are no existing guidelines for model portfolio recommendations regarding minimum disclosures, rationale, nomenclature, and performance.

To address this gap, it is proposed that SEBI shall issue guidelines for model portfolios created by RAs. This framework will include a clear definition of model portfolios and establish standardized reporting and disclosure requirements, which will be developed by the Industry Standards Forum (ISF) in collaboration with the RAASB and SEBI.

18. Disclosure of terms and conditions of services to the client

Currently, the RA Regulations do not mandate the disclosure of terms and conditions or clients’ rights, which may leave clients unaware of their entitlements in the event of grievances. To enhance transparency, it is proposed that Research Analysts (RAs) be required to provide explicit client consent and documentation outlining service conditions. Similar to Investment Advisors (IAs), RAs will also need to adhere to Know Your Customer (KYC) procedures for their fee-paying clients and maintain KYC records, as specified by SEBI.

These records should be uploaded to the KRA system according to SEBI guidelines. RAs and IAs will be required to keep comprehensive records of clients, including client lists, PANs, details of the services provided, and fees charged. Additionally, RAs must document disclosures regarding the terms and conditions of their services. Both RAs and IAs should maintain records of all communications with clients related to their services, including physical documents, emails, and messages. For IAs offering implementation or execution services, it is essential to record calls where client consent for such services is obtained.

19. Other regulatory changes concerning both IAs and RAs:

It is proposed to clarify the registration requirements for individuals providing investment advisory (IA) and research analyst (RA) services under Indian regulations based on the client’s domicile and the type of securities involved according to the provided matrix under:

Sr No. Domicile of Client / Investor Securities / asset class (Indian / Global) on which IA / RA services are provided

 

 Whether a person providing

IA / RA services for

consideration (irrespective of

whether he is located in or

outside India) is required to

obtain registration as IA / RA

from SEBI
1

 

 Person resident in India / NRI / PIO

 

 Indian

 

 Yes

 
2

 

 Person resident in India / NRI/ PIO

 

 Global (indices containing Indian securities as underlying) / Global (exclusively foreign securities)

 

 No

 
3

 

 Other than a Person resident in India / NRI PIO

 

 Indian / Global (indices containing Indian securities as underlying) / Global (exclusively foreign securities) No

 

Additionally, persons located outside India can issue research reports on Indian securities without registration, provided they have an agreement with a registered RA or research entity. However, this arrangement does not impose regulatory responsibilities on the external party.

To ensure accountability, it is proposed that individuals outside India intending to provide research services to clients located in India related to securities listed or proposed to be listed on a stock exchange in India must obtain registration as RAs under the RA Regulations, by establishing a subsidiary or office in India for this purpose. This change aims to create clarity and regulatory oversight in cross-border advisory and research services.

20. Compliance Audit Requirements

Under the proposed regulations, IAs and RAs are required to undergo compliance audits. Currently, the regulations mandate audits conducted by members of ICAI / ICSI. However, the amendments allow firms to select auditors from various professional bodies such as ICMAI, enhancing flexibility in compliance audits. The proposal seeks to streamline the auditing process while ensuring adherence to regulatory standards.

21. Clarity in the applicability of IA Regulations / RA Regulations to trading call providers

If a trading call is given after assessing the client’s risk profile and product suitability, it is considered a “one-to-one” service and falls under IA Regulations. Conversely, if the trading call is made without such assessments, it is classified as a “one to many” service and falls under RA Regulations.

NAVIGATING THE ROAD AHEAD

As the Indian financial landscape evolves, the above changes seek to enhance accessibility and adaptability within the research and advisory sector, encouraging a greater pool of professionals to enter the market. However, while the intentions behind these proposals may be commendable, they raise critical questions that merit careful consideration within the context of these proposed changes, summarized as under:

  • The Balancing Act

Balancing compliance with operational efficiency is crucial to ensure that advisory firms can thrive without being overwhelmed by regulatory demands.

  • Segregation of Services

Maintaining a clear separation between research and distribution services is vital to upholding unbiased advisory practices.

  • Interplay of Technology & Data Privacy

While the use of AI tools can enhance service efficiency, the Indian financial advisory sector faces unique challenges in terms of data privacy and security and their co-existence can shape the future of the advisory industry.

  • Client Protection & Grievance Redressal

The expansion of IAs’ scope to include advice on unregulated assets can lead to significant risks, especially in a market where awareness of such products is limited. The potential for conflicts of interest in ancillary services, such as tax planning or real estate investment, can compromise the fiduciary duty owed to clients. A Separate Identifiable Grievance redressal channel will have to be developed for regulated and unregulated assets by the IA’s.

  • Bridging the Gap Between Experience & Young Minds

Given the complex nature of financial products, the lack of prior experience requirements for new entrants may create a gap in sound practical knowledge and understanding of market dynamics.

In summary, while the proposed changes aim to make investment advisory and research services more accessible and adaptable to evolving market dynamics, addressing these concerns comprehensively is essential to ensure that the regulatory framework not only promotes growth with the changing dynamics but also protects the interests of investors and maintains high standards of professional conduct.

Note from Authors:

The “Securities Law” feature of the BCAJ was contributed by the Late CA Jayant M. Thakur for many years with his insightful, exceptional, and thoughtful analysis. Those contributions have significantly benefitted many readers. We are deeply humbled to take his dedication forward and continue his commitment to excellence for the benefit of members.

Companies Act — Some Changes Upcoming Soon

The Securities and Exchange Board (SEBI) of India has always been, updating its regulations. It sets up Committees on specific areas to suggest changes, issues such reports, takes feedback, and then appropriately modifies the Regulations. Now, even the Ministry of Corporate Affairs (MCA) is initiating major changes to the Companies Act, 2013 (the Act). Major and frequent changes may be tough for practitioners and companies to keep up with, but at least some of their grievances are addressed and market evils are tackled. The MCA has often been seen to be sleepy in updating the laws, while SEBI has always taken a lead as far as listed companies are concerned. Part of the reason is that the SEBI Act contains just a few substantive provisions like powers to take action by SEBI including levy of penalties, procedure for appeals, etc. But largely it is a very brief enactment since most of the powers for laying down the details are delegated to SEBI. Hence, subject to the procedure for placing the amendments before Parliament, SEBI has been able to act swiftly in changing the law. On the other hand, the Companies Act, 2013, involves hundreds of provisions requiring hardwiring of many details including even the amounts. Many rules have been made to lay down details in several areas. However, there are several provisions in the Act which make substantive requirements. This requires amendments to be approved by Parliament which can be long and tortuous. But now, MCA seems to be becoming active. A good example is the fairly detailed report of the Company Law Committee released in March, 2022. It is also reported in the media to be implemented soon. Further, the term of the Committee is further extended and more aspects are to be covered. We can cover some of the amendments proposed as per the report released as also discuss some proposals said to be in the works as reported by the media with fair, though broad, details even if official confirmation is yet to be released on these. Undoubtedly, the proposals are at the initial stage and may be modified as the discussions progress. But that said, let us consider some important proposals with some angles I could think of.

ISSUE OF FRACTIONAL SHARES

Fractional shares often arise particularly out of corporate actions like mergers, bonus issues, etc. The law presently does not permit companies to make a fresh issue of fractional shares and, in any case, there is not a proper market for that. So companies typically opt for a workaround. All the fractional shares are accumulated and then a trustee sells them in the market and the proceeds are distributed proportionately to the respective shareholders.

However, there is a radical new proposal of permitting issue of fractional shares on an independent basis. The arguments given are primarily two. Some shares are so expensive that buying even one share may require spending more than ₹1,000 and, in one case, even more than ₹1 lakh. Thus, the Committee report says, the purchase of such shares is inaccessible to small investors. The proposal then is that the issue of fractional shares may be permitted, for listed and unlisted companies, with consultation with SEBI for the listed companies. The report cites that 1.42 crore new retail investors have entered into the market just in F.Y. 2021.

However, the Report lacks further details of the proposal on issuing fractional shares and hence several questions arise.

What will be the face value of such shares? Would multiple face-value shares be permitted? Say, if the original face value is ₹10, would fractional shares having face value of ₹1, ₹2, ₹5, etc. be permitted? Or even ₹0.50 or ₹0.10? Assuming there will be flexibility, will not there be a separate quoted price for each of such groups of shares? It would be perhaps naïve, considering history, to assume that the price quoted for a ₹1 share would be one-tenth of the price quoted in the market for the ₹10 face value shares, which may be the predominant category of the share capital.

We have seen (history now) the “odd lot” share market. Since there was a fixed minimum market lot, there was a problem with selling them. If the market lot size was, say, 50, one could not sell on the stock exchange their shareholding of, say, 27 shares. So a parallel market developed where agents would buy such shares at a discount, often heavy, and then accumulate them and sell almost all of them at the market lot. Of course, this issue has been largely resolved because the market now permits the sale/purchase of even 1 share. But the experience should teach us to be wary.

Another example is the issue of Differential Voting Right (DVRs) shares. The only difference between them and the ‘ordinary’ shares was that DVRs had fewer voting rights, depending on the terms of the issue. This concept has flopped miserably with some 3 odd companies only having issued them. The price of such DVRs is quoted at a discount, often as much as 50 per cent of the ‘ordinary’ shares.

So would this also happen to fractional shares? And would history repeat itself at the expense of small investors?

Curiously, the only example really given for this proposal is just one scrip, that is MRF, which is quoted at more than ₹1 lakh per share. But should the rule be made of such an exception?

Also, nothing prevents companies from issuing bonus shares, for example, to make shares available at a lower price.

Perhaps this proposal requires detailed reconsideration or at least clarity of the fine print of the proposals.

SOME OTHER IMPORTANT PROPOSALS

Space would not permit going into even major substantive proposals in detail of this lengthy report. So reference may be quickly made to some important of such proposals. One is for increasing communication through electronic mode.

Then there is a proposal to permit the issue of Restricted Stock Units and also Stock Appreciation Rights. These, though separate topics by themselves, require detailed consideration.

Then there is a move to eliminate the need to file affidavits. It is proposed to replace them with a simple self-declaration. The advantages are at least two. One is that it eliminates the need to buy stamp paper and get them notarised. The other is an approach of placing some element of trust in the concerned persons. Of course, the liability for violation/false declarations would remain the same.

A DIFFERENT REGIME FOR UNLISTED COMPANIES

While presently, we have a separate regime for listed companies regulated by SEBI, there are also some requirements in the Act for listed companies. Typically, the stricter of the two laws apply. But SEBI as an independent body has expertise and wide powers. A parallel regime seems to be the intention to be set up. This is what a detailed report in Business Standard of 25th September, 2023 states. The details of the proposal, which still can be stated to be general and also subject to official announcement, make for an interesting read. Notably, it is reported, that this would be a part of the Company Law Committee report in the upcoming second part.

Firstly, it would be applicable only to “large” companies. Nothing is stated specifically on what would constitute large companies. However, it is a fact that many unlisted companies are larger, at least in terms of valuation than some listed companies.

Here too, a few recent examples, one of which is specifically cited by name in the media report, is stated to be the motivation driving this proposal. The question again then is whether we are making a rule from an exception. Be as it may be, larger companies may require special focus. The other side is that smaller companies, which are in lakhs, may hopefully face a more relaxed regime.

It is stated that the new regime would not be a “light touch” one. Presumably, there will be detailed provisions. In particular, the punitive consequences of violations may be high. One will have to see how the proposal actually turns out to be. It would be of concern if the provisions are as harsh as, say, Section 447 of the Act which provides for very strict punishment under a very widely worded definition of “fraud”. This Section itself requires a close relook. But that does not seem to be the agenda. One hopes that since the intent of the Committee is to make India an easier place to conduct business. While consequences of serious violations ought to be harsh, a too widely drafted definition of what is such a serious violation may end up being intimidating or discouraging companies.

A welcome proposal is about auditors who resign. They would be asked to specifically state whether their resignation is due to fraud or similar serious wrongs observed in the company. The present Act already has certain provisions. But such a specific declaration would be helpful since later, if wrongs are soon found, they also can be confronted. On the other hand, the question would be whether an auditor would be required to ascertain whether there was fraud? The present requirement gives some leeway of judgment to the auditor. But generally, the powers of auditors as well as their legal expertise may not be wide enough for them to collect conclusive evidence and decide whether or not there was fraud. They may then face the Shakespearean dilemma of declaring there was fraud or there is not. Particularly, if they declare there is fraud, they could be subject to a lawsuit from the company/officials. They may end up taking a legal opinion that the information with them may be insufficient to declare that there is a confirmed fraud. And that would defeat the provisions. But in any event, this seems to be in the right direction. Indeed, such a requirement should also be made for independent directors and Key Managerial Personnel.

Finally, the question would be on who would administer this new regime. Presently, we have an independent body like SEBI that is not only well-empowered under the law, but has specialized knowledge of the field. If the new regime would still be under MCA, one wonders how effectively it would be implemented. Perhaps, an independent body for such unlisted companies, with wide powers, could be created.

Interestingly, we already have the Serious Frauds Investigation Office (SFIO) created under the Act itself which has wide powers to collect information, summon persons and investigate and give reports to various regulators under different laws. What more or better would the new regime and its administering body do, would have to be seen.

CONCLUSION

Several other amendments, largely technical or those relating to procedural aspects, are also proposed. For example, enabling more and more use of electronic technology, removing minor ambiguities, etc. These may be particularly important for those involved in day-to-day compliance like the Company Secretaries. Generally, they all seem to be in the right direction.

At the end, while the amendments proposed are several, they do not tackle the larger issue of keeping the principal provisions in the Act itself and do not move towards setting up a specialized independent body for unlisted companies to which extensive powers are delegated. Hopefully, as the media report says, the Committee report, the second part, would be released soon followed by a draft Bill which will give more details and the fine print.

SEBI Acts Tough against Market Manipulators

The Securities and Exchange Board of India (SEBI) on 16th September, 2022, passed a stiff order of penalty, on a case involving, among others, allegedly synchronised trades. By the other order, it also debarred some of the parties from the securities markets. Soon thereafter, in June 2023, the Securities Appellate Tribunal (“SAT”) rejected the appeals against the order in an almost dismissive way to the appeal. What is noteworthy is that SEBI has shown that it means serious business in such cases. The penalty levied is fairly large, considering the facts and figures involved, apart from the order to restrain persons from the markets. This should hopefully show that SEBI now means business in tackling this almost uniform feature in cases of market manipulation. If this approach continues, this should mean that the manipulators see a strong deterrent to engaging in such activities.

SYNCHRONISED MANIPULATIVE TRADING

Price manipulation is rarely carried out without involving synchronised trading. But, such cases have seemingly gotten away without strong deterrent penal measures. The use of synchronised trades has been a regular feature for decades.

The pattern is almost consistent in such cases. The manipulators, using blatant or camouflaged techniques, use this modus operandi with successful results. Small investors rarely carry out the most basic efforts and work to check up on the history of price and volume, or the fundamentals of the company. So while investors pile on by being attracted to the prospect of quick and handsome, the manipulators sell and exit.

COMMON PATTERNS OF SYNCHRONISED MANIPULATIVE TRADING

The method may vary in small details, but some features are common. There is a circular on trading amongst a group of persons who also steadily increase the quoted price. This artificial spurt in price and volume is meant to create an image that something good is about to happen which selected people know and anticipate.

Another common pattern has been to project that the company is engaged in a business that is the latest fad. At one time, for example, we had the dotcom boom, then internet-based services and apps, infrastructure, etc. The advantage of using such methods from the point of view of the manipulators was that past fundamentals become totally irrelevant. There may be occasional star performers and some genuine but failed attempts. But smart manipulators recognised that this front would attract investors. This included changing the name of the company, passing resolutions to start such a business, etc.

What allegedly happened in this particular case? (Till there is a finality in the form of a Supreme Court, one cannot consider the matter as closed for this particular case.) The price of the shares was hiked up by a slow increase with small synchronised trades at successively higher prices. SEBI has also stated that thereafter, even SMSes were circulated about the potential of the company. And hence, yet again, as public interest grew, those who held shares in the company sold them at a high price. And, yet again, the price slowly crashed to as low as almost 2 per cent of the highest price.

WHETHER THE LAW IS LACKING?

It is not as if the law is lacking in this regard. Multiple provisions in the SEBI PFUTP regulations deal with such manipulative practices. The transactions have been dissected into individual steps and portions and make each of them specifically an offence. This includes circular trading, artificially jacking up the price, the price, spreading false news, etc.

IMPLEMENTATION OF THE LAW

That is the law. Next comes the investigation which plays an important role. These days, SEBI carries out very meticulous analysis of the parties, the trades, the bank accounts, etc., of the parties. These days much of the data is available almost instantaneously thanks to electronic trading. SEBI then takes it to the next level by meticulously investigating the background of the parties, including their relations, personal or commercial, and study of their bank statement and internal transactions. The parties may not even realise that they are being investigated since such information is available from stock exchanges or other authorities directly. Of course, at a later stage, SEBI may summon some or all of the parties to question them independently. Often, the weakest persons in the group, including those who are mules, may break down and confess. But even otherwise, too, many of the facts, available from credible independent third parties like banks, brokers, etc., cannot be so easily countered or explained away.

LOW DETERRENT ACTION IN THE PAST

What was perhaps lacking was the final step of a strong deterrent step which would make the wrongdoers feel the loss and even realise that such acts are simply not profitable enough. Unfortunately, in too many cases, while the penalty has been levied, it has rarely been proportionate to the severity of the crime.

A recent example that can be taken is of the brazenness of false trading in illiquid options. It was found that thousands of persons engaged in circular trades in illiquid options. The objective did not seem to be enticing and cheating investors. Rather, it was very likely to pass on profits or loss for tax evasion. A person who had profits and did not want to pay tax traded in the options by buying high and then selling very low and that too with the same counterparty and also, often, within a gap of barely minutes. Though this may not harm investors directly, it violates multiple SEBI regulations and, worse, creates an impression of stock markets as being a lawless jungle. When SEBI initiated proceedings, it was prolonged by the need to serve notice, give hearings to each party, etc. Quite a few parties went in to appeal the clogging of the dockets of SAT, which requested SEBI to come with a scheme of settlement. SEBI did so but for various reasons including Covid, it did not get the required response. So the dockets of SAT clogged again, which yet again requested SEBI to make another attempt. The second scheme of 2022 got a better turnout. However, the moral here was that since the parties got away effectively with barely a rap on the knuckles, it did not have any real deterrent effect.

Hopefully, orders like this one, assuming they attain finality, will make parties think really hard before contemplating such acts. And even if there is some change in appeal, it will be a lesson in principle generally.

A SIMILAR FIRM APPROACH IS NEEDED IN OTHER OFFENCES

Going a step further, I think a similar firm hand is needed in other categories of market evils, including insider trading, front running, etc., where often there is no real deterrent action. Fortunately, here too, the data generated is quick and SEBI’s investigation is often thorough. Law is also helpful and empowers SEBI to disgorge the illicit profits, debar parties, etc. SEBI has powers to levy very stiff penalties. Here, too, if some examples are set, there can be a fear and also a sense of inevitability of getting caught. Granted that parties can be more sophisticated here using mules, underhand passing of profits, use of sophisticated technology, etc. So establishing guilt may not always be easy. But here again, SEBI often interviews the weakest links in the chain who may spill the beans. That said, perhaps some changes could help.

CLOSING NOTE: PROPOSAL OF SEBI TO DEEM CERTAIN SUSPICIOUS TRANSACTIONS AS VIOLATIONS UNLESS REBUTTED

Although discussed in great detail earlier in this column, it is worth mentioning that a group of radical proposals to deal comprehensively with the menace of insider trading, front running, etc., have been made by SEBI in a consultation paper issued in March 2023.

This aspect is worth mentioning since SEBI has proposed to deal particularly with those sophisticated manipulators where there is multiple evidence of crime committed all over but it is difficult to pinpoint the parties and find them guilty. Very specific examples of what had transpired in certain actual cases (names withheld in paper but not difficult to guess).

SEBI noted that while several Supreme Court rulings have generally supported the stand of SEBI in using circumstantial evidence of a clear pattern of suspicious transactions, it was also noted that this was not sufficient enough, and a generic set of enabling provisions was needed. The Supreme Court ruling allowed SEBI to use the lower benchmark of circumstantial evidence to indicate guilt. But that too required crossing certain hurdles which sophisticated market manipulators and legal technicalities could make the process difficult and delayed.

Hence, SEBI has proposed a set of provisions which would deem the parties involved as guilty if a certain pattern of suspicious trading is observed. This does not mean that this one-sided judgement of SEBI would close the matter. The parties would still get a chance to present their case and rebut the finding and allegation. In short, the onus shifts to the parties to rebut the allegations or be deemed guilty.

These provisions, if implemented, could certainly make the task of SEBI easier. But there is also a flip side to this. Presently, SEBI carries out extensive investigations to establish guilt. It is possible that these efforts may be diluted if such deeming provisions are available.

Also, such provisions are like putting a genie out of the bottle, which cannot be put back in. SEBI may be perceived to be exercising arbitrariness. While good benchmarks are provided before the provisions are applied, one would not know how they are applied in actual cases. Here again, considering the rewards, large sophisticated abusers of the law may continue to escape. Smaller parties on the other hand may find it difficult to hire expensive legal advice to present a credible and effective defence to shift the onus back.

It is also doubtful how courts would view such provisions, which almost give a one-sided power to SEBI to a large extent. Whether such provisions are held arbitrary and unconstitutional? This aspect becomes even more important when we consider that it is SEBI, who would make Regulations to implement this proposal and not Parliament made law or amendments. In the nearly six months after its introduction, there does not seem to be any indication from SEBI of whether and how it is going to implement these proposals. But, to conclude, a fair re-haul of the law is certainly needed to counter the brazen cases of market abuse.

Updated FAQS on Insider Trading Throw Light on Many Complex Issues

BACKGROUND

The Securities and Exchange Board of India (SEBI) has recently issued (on 31st March, 2023) comprehensive Frequently Asked Questions (FAQs) on its regulations relating to insider trading – the SEBI (Prohibition of Insider Trading) Regulations, 2015 (the Regulations). It is good to see this practice continuing whereby, not just clarifications, even if not binding, are given on important and repetitive issues, but they are all updated and provided at one place. The Regulations are fairly complex with a series of deeming provisions. Insider trading violations are regularly caught through a fairly sophisticated data surveillance, coupled with good investigation and quick orders. Of course, some orders are found wanting on evidence or principles of law applied and do not stand up on appeal, but the fact that such Regulations exist and there is a close watch acts as a deterrent. Insider trading reduces the credibility of markets since investors would feel demoralised if, whether in purchase or in sale, the insiders are able to illegally profit from information they are entrusted with as fiduciaries.

The Regulations are also distinct, in the sense that many of the provisions have a note attached to them which explain the intention of the particular provision. The FAQs add further to this by explaining and clarifying many provisions.

BINDING NATURE OF FAQS

It would be axiomatic to say that the Act and the Regulations and even certain notifications/circulars have a binding effect but not the FAQs. Indeed, they bind not even the regulator, i.e., SEBI, as the FAQs themselves take pains to emphasise. Paragraph 4 of the FAQs, says that the FAQs “…are in the nature of providing guidance on the SEBI (PIT) Regulations, 2015 and any explanation/clarification provided herein should neither be regarded as an interpretation of law nor be treated as a binding opinion/decision of the Securities and Exchange Board of India”.

That said, the FAQs do reveal the mind of the regulator on certain provisions. They explain many concepts useful to the student, the compliance officer and practitioner. Often, the question may not be of technical interpretation but of understanding what a particular provision means to say. Importantly, the cautious compliance officer and companies may prefer to toe the line by following the interpretation given in the FAQs, since it is likely that SEBI may initiate proceedings. The appellate authorities, however, may not give more than a passing view to the FAQs, if at all.

There are 59 frequently raised questions that are answered in the FAQs. While it would not be possible to cover all of them, some of the important ones can be highlighted.

PLEDGE OF SHARES – THEIR CREATION, INVOCATION AND RELEASE

The concept of pledge of shares has to be seen, in context of the Regulations, from at least three perspectives. Firstly, what is pledge of shares and how it is created, invoked and released? Secondly, why is it relevant for these Regulations? Thirdly, who are the persons who have obligations when they pledge their shares or get the pledge released, etc?

Pledge of shares, as a concept is well understood. Shareholders may want to raise finance against the security of shares held by them. Such security may be in the form of hypothecation or pledge, with the latter being more preferred by lenders. Pledge is generally governed by the Indian Contract Act, 1872 but a detailed discussion on this would be beyond the scope of this article. Unlike earlier times when physical shares with duly executed transfer deeds were deposited with the lenders, the depository system requires a different method. The pledge has to be registered with the depository. Invocation of such pledge is easier. Some lenders may still want to go all the way and ask the borrower to actually transfer the shares to the lender’s DEMAT account. The implications of such a ‘pledge’ is a complex issue by itself and deserves a separate detailed discussion.

The Regulations deal with insider trading and the first reaction would be that pledge is not trading as commonly understood. However, the Regulations have learnt from history. A shareholder may pledge while being in possession of unpublished price sensitive information (UPSI) and realise a higher value of shares. Thus, the scope of the terms has been widened to include pledge, and therefore also their invocation and release. Note though that the Regulations provide for this widened meaning by way of a note to the definition of ‘trading’.

Thus, the Regulations require specified insiders not to carry out a pledge while being in possession of UPSI. In other words, the restrictions on trading also apply to the creation of a pledge.

DEALING IN SECURITIES OTHER THAN SHARES/CONTRA TRADES

Do the Regulations apply only to dealings in shares or do they apply to dealings in futures and options too? Do they apply to exercise of ESOPs and also to sale of shares arising on exercise of ESOPs?

To begin with, the Regulations make it clear that they apply to ‘securities’, the definition of which is wide enough to include futures and options. Since ESOPs are a form of options, it is clear that the Regulations apply to ESOPs too. The FAQs specifically deal with this issue to put this issue beyond any doubt.

The question then comes of contra trades. As a matter of principle, the Regulations prohibit trading while in possession of UPSI. However, in case of close insiders (i.e., ‘Designated Persons’ as identified by the company), a stricter rule is adopted. Trading by them at a short intervals, called contra trades, is banned altogether since such trading would typically be done only on basis of UPSI. But several questions arise.

Firstly, futures and options get reversed within a short period. The Regulations do not provide how to deal with this. The FAQs have provided a view as follows. If a person buys futures/options and then sells them (or vice versa) within the maturity period of less than six months, then it would be deemed to be a contra trade and hence prohibited. However, if such trades mature by physical settlement, then they will not be deemed to be contra trades and hence not banned.

Even entitlements to rights shares are treated as securities and hence trading in them would attract the contra trade ban.

As far as ESOPs are concerned, the view expressed is as follows. The first part relates to grant of ESOPs. These are not treated as ‘trading’ and hence grants can be made even when the trading window is closed. Similarly, exercise of ESOPs is also not treated, the FAQs say, as trading. Hence, the acquisition of shares on exercise of ESOPs can be done even while in possession of UPSI. There is yet another concession regarding ESOPs. If shares are acquired on exercise of ESOPs, they do not invite the six-month ban of contra trades and hence such shares can be sold within six months of acquiring the shares.

CHARTERED ACCOUNTANTS AND OTHER FIDUCIARIES AND THE REGULATIONS

Firms of Chartered Accountants render services to listed companies in many ways. They may act as auditors (statutory or internal or tax), they may act as advisors for many services. This is so also for other professionals such as company secretaries, lawyers, etc. They are very likely to have access to UPSI and hence would generally be deemed to be insiders.

However, they have a further and more elaborate role. They are required to frame a code of conduct which should contain at least the minimum requirements specified in the Model Code. This includes pre-clearance of trading in specified securities, ban on contra trades therein, etc.

Moreover, they are also required to maintain a structured database. Essentially, this is maintenance of prescribed details of persons to whom UPSI is shared with. And maintain such records for at least the minimum specified period. Such database “shall not be outsourced” and “shall be maintained internally”. On the question of keeping such a database on third party servers such as Amazon, Google, etc. which are also maintained outside India, the FAQs give a cryptic answer, instead of a clear ‘yes’ or ‘no’. The answer given merely reiterates the responsibilities of the Board and the Compliance Officer to ensure that all Regulations, laws, etc. are complied with. However, on the question whether the company can use the software provided by third party vendors, the FAQs state that such software and services are provided on a login basis. The vendor may have access to the data and this would be contrary to the requirements of the Regulations.

Professionals rendering services to listed companies and having access to UPSI may range from small proprietorship to a large multi-partner firm, but the requirements are the same.

The FAQs confirm that these requirements are to be complied with by all professionals who have an access to the UPSI.

RELATIVES OF INSIDERS

There is often a confusion on the extent to which persons connected with the insider are also covered by the Regulations. The FAQs speak about this on some aspects.

The term ‘insider’ is broadly defined to cover several groups of persons who may have access to the UPSI. However, apart from persons directly connected to the company, there may be persons who have connection with them. For example, there may be a CFO of a company. The question is whether the family members of such a CFO would also be deemed to be insiders. The Regulations have sought to strike a fair balance but in the process has created confusion. Apart from relatives, several entities connected with such persons are also covered as insiders unless proven otherwise. But we could focus on one term that creates some confusion and practical difficulties too.

‘Immediate relatives’ of specified insiders are also deemed to be insiders, unless proven otherwise. The term ‘immediate relatives’ is defined in a curious manner. It includes not only the spouse, but also parents, siblings and children of such a person or their spouse, but they should be either financially dependent on such a person or should consult such persons in taking decisions relating to trading in securities. On first part, identifying such relatives should be easy enough. The question is applying the two alternate conditions.

Firstly, the question is whether the relative is financially dependent on such a person. This should be generally easy in many circumstances such as a minor child or a non-working spouse, etc. However, there may be grey areas such as a relative who earns and contributes to the household. Whether such persons can be said to be financially dependent?

The other condition is easier to explain but difficult to prove. Does such a relative consult the insider for their decisions on trading in securities? Financial discussions in families are very likely to happen and it would be difficult to prove otherwise. This makes things particularly difficult when the relatives actually take an independent decision. Let us say one person is a partner in a firm of Chartered Accountants acting as statutory auditor and also an advisor to several listed companies. The spouse works in another company and manages their own investments without consulting or even informing the other spouse. If by chance, trading is done by such a spouse in securities of a company where the spouse has access to UPSI, it will be difficult to prove that there was no violation of the Regulations. Now take the matter further where the spouse is a lawyer rendering services to various listed companies. Now the difficulty becomes compounded.

CONCLUSION

The FAQs are welcome generally as they not only clarify several concepts but give a good starting point for taking a view. Many of the difficulties expressed above arise in spite of these FAQs and not because of them. And the Regulations are also complicated because insider trading is not only common, but is often done by while collar educated persons who can use many sophisticated methods including technology to evade the law. Caution then becomes the rule and applying the interpretation given by the FAQs can give a higher level of assurance that one is within the law, even if the clear fact is that they are not binding, not even on SEBI itself.

SAT Dumps SEBI’S Pump-and-Dump Order in Bollywood Celebrity’s Case

BACKGROUND

A Bollywood celebrity and his family/associate were widely in the news recently because of a judgment SEBI made against them. SEBI held, in an interim and ex parte order, that they were allegedly involved in a pump-and-dump stock scam and made illicit profits. While this celebrity, Arshad Warsi (AW) and family/associate (together ‘AWS’), were alleged to have made Rs. 76 lakhs, the total profits made by the whole ‘group’ were about Rs. 41 crores. The 21 parties including AWS were debarred from stock markets, directed to impound these allegedly illicit profits in an escrow account and their bank accounts, and assets frozen in the interim.

This case is an example of how good intentions, and quick and extraordinary efforts can still result in serious injustice. While SEBI’s order shows quick action on all fronts including pursuing internet giants like YouTube for information and meticulously collating all information, it also shows how conclusions in law and facts ended up being flawed. The Securities Appellate Tribunal (‘SAT’) came down harshly on the order and even laid down several prerequisites for future orders. The parties, at least some of them, clearly suffered due to this order, for which SAT repeatedly said, it had no evidence whatsoever. However, hopefully, since SEBI will be required to follow the pre-requisites and prove the basic assertions, other parties may not suffer in the future and if they do, they have this precedent to cite and get quick justice (the order of SEBI is dated 2nd March, 2023 and the order of SAT is 27th March, 2023).

QUICK SUMMARY

At the outset, it may be stated that the whole matter is still under investigation. The SEBI order is interim in nature. Such interim and ex parte orders are passed to ensure that a wrong is not being continued and also parties are not able to take actions in the meantime to frustrate justice. Being ex parte, it also obviously means that the parties have not been given any prior opportunity to present their case. Thus, all the assertions and ‘facts’ and statements made here are provisional and need to be taken as allegations.

That said, this was one of the countless cases that, if the findings are true, are serious and daring, almost brash, scams. It is not as if they have started with the invention of the internet. But the internet has given more opportunities to reach a wider audience, to audio-visual techniques of psychological manipulation, and also use anonymity. On the other hand, using digital methods also means leaving digital footprints which can be speedily tracked, collected and collated. Instead of using laboured methods of investigation, making calls, going door to door, etc., SEBI too can use digital means to fight digital-based scams.

The findings/allegations of SEBI as per the order are as follows. There were two companies whose share prices were ‘pumped’ up by a barrage of false information and reports mainly through YouTube. Though the modus operandi and even some parties were common in both the cases, here, we are concerned with one of these companies – Sadhna Broadcast Ltd (SBL). The perpetrators uploaded several videos on YouTube in channels having a following of lakhs of people. Their reach was further widened by paying crores of rupees to Google Ad sense, which helped in reaching people interested in investing. This was also supplemented by creating artificial trading, leading to an impression that there are numerous people eagerly interested in buying the shares. Thus, the combination of targeted messaging of good prospects of the company accompanied by such false trades and rising prices created a rush amongst gullible investors looking for quick and easy profits, and who feared missing the proverbial bus.

The scam ended like all other scams. The perpetrators started selling their holding at the artificially raised prices, pocketed the profits of tens of crores of rupees, leaving investors holding the shares at the price which then crashed back.

ALLEGED INVOLVEMENT OF ARSHAD WARSI, FAMILY, ASSOCIATE (AWS)

SEBI found that, amongst others, AWS had also purchased shares at relatively low prices and sold them at higher prices, thus making, in all, net profits of about Rs. 76 lakhs (this was very likely an erroneous calculation by SEBI, as discussed later). SEBI held that AWS, like some others, was a party to the scam and thus the strictures were passed against them too. SEBI also pointed out that call data records showed that AW had telephonic contact with the person accused to be the primary perpetrator of the scam.

Accordingly, AWS were required to impound the profits so made in an escrow account with a lien in favor of SEBI. Till they did that, their bank accounts were frozen and they were barred from alienating any of their assets. Further, they were barred from dealing in securities markets and their demat accounts were also frozen.

SEBI NEGLECTING A FUNDAMENTAL ACCOUNTING CALCULATION OF PROFITS/LOSSES?

SEBI did show that AWS had purchased and sold shares of SBL. This made their profits, as alleged by SEBI, illegal. However, the SEBI order itself showed certain significant other information. While AWS did buy and sell these shares, they again purchased more shares. These purchases were made not only at a higher price but also of a larger quantity. These shares remained, it appears from SEBI’s order, with AWS. SEBI consciously ignored these shares in stock since it stated that it was concerned with the profits made.

To some extent, this approach by SEBI may be justified if other facts also pointed to intimate involvement in the scam. It is common for parties engaged in volume creation to buy and sell shares in a circular manner. Thereafter the group can sell most of the shares but some shares need to remain in their hands. For the purposes of the scam committed by the group as a whole, the fact that there were shares in hand in one or more of the parties, even out of their purchases, may not be material.

However, in case of AWS, no other factor was present showing intimate involvement. These shares that remained in hand were purchased at a high price, and if one considered the value of the shares at the post scam rates, AWS actually suffered a significant loss. The net loss even after adjusting the earlier profits was very likely at least Rs. 1 crore.

However, as stated earlier, SEBI ignored this aspect.

APPEAL TO SECURITIES APPELLATE TRIBUNAL (SAT) AND REVERSAL OF ORDER BY SAT

AWS filed an appeal with SAT. SAT went through the order and also heard both the sides. It noted several intriguing aspects. AWS was not involved at all in creation of the YouTube videos. Also, they did not feature in them. Neither did they recommend the shares to anyone. They had no connection (except one, discussed later) with either the main perpetrators or the other parties in terms of such scam. SAT repeatedly pointed out that there was not even an iota of evidence of guilt against AWS.

It was noted though that AW had a professional connection with the main alleged perpetrator. Such person, MS, had retained AW for a professional assignment in a film.

SAT noted yet another interesting aspect. AWS had purchased shares not from the public but from parties named in the order as being allegedly involved in the scam. Further, their sales too had counter parties named in the SEBI order. In other words, their profits were not made at all from any of the public investors.

Taking all the above into account, SAT ordered that the directions against AW and family to be reversed substantially. SAT repeatedly pointed out said that there was no evidence whatsoever against AWS of any involvement. However, it noted that considering the professional relation, even if this did not amount to any guilt, the fact remained that it did not totally rule out the guilty. SEBI had yet to complete the investigation and therefore it could not be ruled out that SEBI may find and present some evidence that would stand up, unlike the present situation where there was none. Accordingly, SAT ordered that AW and family should deposit 50 per cent of the profits in escrow and provide an undertaking to deposit the remaining 50 per cent in case of finding of confirmed guilt. As far as the associate of AW was concerned, there was no order of impounding of any profits. In view of this, all directions against her were reversed by SAT.

LESSONS AND CONCLUSIONS

In its order, SAT repeatedly pointed out the dangers of hastily placing restrictions such as freezing of bank accounts, demat accounts, debarring persons from trading, etc. in ad interim, ex parte orders. Even if such restrictions are provisional, there have to be a certain level of evidence which point out to guilt. In the present case, there was none against AWS. SAT cited copiously from the order of Supreme Court (in Radha Krishan Industries vs. State of Himachal Pradesh (2021) 6 SCC 771) which had made detailed observations on the preconditions of making provisional attachment of bank accounts. These were applied in this case too. These should help not only guide SEBI in making orders in the future but also would help parties who have faced such directions from SEBI.

Having said that, it is also notable that this case received wide publicity because of the celebrity name and hence this order received detailed attention and analysis which otherwise possibly may not have received. Also, the celebrities, possibly unlike ordinary persons, could afford competent legal advice and also file an urgent appeal. This obviously helped them get relief in barely a month. The fact is that SEBI often passes such orders and the parties find that much of the restrictions continue for a long time till SEBI finally completes the investigation, issues show cause notices, and final orders. Till that time, parties continue to suffer.

Further, freezing of bank accounts and directions to deposit in the escrow account, the alleged profits are often made on a group basis, imposing joint and several liability. Thus, each person suffers such restrictions unless the whole profit is deposited, even if the profit may not be with him.

All in all, the order of SAT is welcome and an important precedent for future application.

Major Changes in the Functioning of Listed Companies Imminent

BACKGROUND

SEBI has recently, on 21st February, 2023, circulated a consultation paper (“the Paper”) proposing amendments relating to topics that fall under what is commonly understood as corporate governance. These have also been approved by SEBI at its Board meeting on 29th March, 2023. The actual amendments have not yet been notified, and hence the text of the new provisions is awaited.

The amendments are proposed to the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“the LODR Regulations”). These can be categorised into four broad areas:

a.    Agreements binding the listed entity, directly or indirectly.

b.    Special rights to certain shareholders.

c.    Sale, disposal or lease of assets outside the “scheme of arrangement route.”

d.    Certain directors having a tenure which does not require them to put themselves up for reappointment from time to time, which the Paper calls Board Permanency.

Other than (c), the remaining three effectively give some shareholders special rights, thus creating a category of shareholders that has more rights than others. This is against the principles of shareholder’s democracy where all the shareholders are equal in the sense of one share-one vote. The proposed amendments seek to correct this to some extent. The category in (c) is meant to place some checks on the transfer or lease of assets otherwise through the approval of NCLT under a scheme of arrangement.

It needs to be recollected and emphasised that these requirements will be over and above those contained in the Companies Act, 2013, for listed entities. Hence, the stricter of the two would apply in case of overlapping requirements.

As is generally the case, when SEBI decides to make amendments, it circulates a consultation paper for public comments, takes feedback, and then finalizes the amendment which SEBI has done this time too.

Some of the amendments proposed are far-reaching and have retrospective effect in the sense that they apply even to existing arrangements. These arrangements may end up being reversed if certain requirements are not complied with. Much also depends on the exact final wording of the new requirements in the law. In some cases, the wording proposed or otherwise used to describe changes, are capable of multiple interpretations. This could lead to confusion and possibly litigation.

Let us discuss each of the proposed amendments in detail as to their implications, if given effect to.

AGREEMENTS BINDING THE LISTED ENTITY, DIRECTLY OR INDIRECTLY

Agreements that bind the company and are not in the ordinary course of business, if they have material implications, are something shareholders and the general investor public would want to know about. Under certain circumstances, where required in law, these may even require approval of the shareholders. The LODR Regulations do contain certain disclosure requirements relating to shareholder agreements and similar or other agreements.

However, SEBI has realized that there may be many more categories of such agreements where the company is not even a party but yet there may be material implications on the company. The promoters, management, etc., for example, may enter into such agreements. SEBI has now desired that certain agreements where, even if the company is not a party but if there are certain specified implications on it, there should be disclosure, approvals, etc. This is required where such an agreement, for example, “impacts management or control, whether or not entered into in the normal course of business” or if they “intend to restrict or create any liability” on the listed entity.

SEBI is of the view that such agreements require screening as to whether they are in the interests of the company. For this purpose, three requirements are now being proposed to be made.

Firstly, it is required that there should be disclosure to the company and the stock exchanges of such agreements.

Secondly, the Board of the company should examine such agreements and give its opinion “along with detailed rationale’ whether the agreement is “in the economic interest of the company.”

Thirdly, the agreement would be subject to the approval of the shareholders, by a “majority of the minority”, and that too by a special resolution. It is not specifically made clear what is ‘minority’ here but, taking a cue from other SEBI Regulations, it may mean shareholders other than the promoters.

Importantly, these requirements will also have an effect on existing agreements. Thus, even agreements that continue to be in force will have to undergo such disclosure and screening requirements.

The proposed new provisions would obviously have far-reaching effects. The fact that they apply to subsisting agreements made in the past can create difficulties for the company, for the parties, particularly for the counterparties. The company may have benefitted from such agreements which in many cases would have brought in issue proceeds to the company. This may enable the company/promoters/management to back out of commitments after having enjoyed the gains. But this could lead to litigation since the affected parties may seek recourse in law.

The terms used in the Paper such as “intend to create”, “economic interest”, “impact management or control”, etc. are not defined and in any case, are not precise. The term “control” has already been the subject of past controversy and grey areas still remain. These uncertainties may further compound the difficulties.

It remains to be seen whether the actual text of the amendments resolve these issues, or adds to them!

SPECIAL RIGHTS TO CERTAIN SHAREHOLDERS

Very often, agreements are entered into with investors whereby certain rights are given to them. This may include a right to nominate one or more directors on the Board, consent/veto rights on important matters, etc. To give fuller binding effect to such clauses, they are usually incorporated in the Articles of Association of the company.

SEBI has pointed out, and to this extent rightly so, that such rights put certain shareholders on a pedestal. Though all the shareholders of the same class are meant to be equal, particularly in the sense of one share-one vote, these shareholders are more equal than the others and get special treatment. They get a right, for example, to nominate a director on the Board which otherwise only shareholders having a majority of the voting shareholders would have. They can block certain decisions proposed by the company that ordinary shareholders, even those holding relatively substantial holdings, may not have.

SEBI has now proposed that such special rights shall be subject to review by way of approval of shareholders once every five years. This proposal applies even to existing agreements, and companies would be bound to take such approval within five years of the notification of the amendments.

This requirement too is well intended. But it suffers from the same issues as the preceding proposal. It enables the company to take benefits from an investor but the rights may lapse after five years if the shareholders do not approve at the time of such renewal. Considering that the proposals apply even to existing arrangements, the impact is wider and again, like the preceding proposal, may create difficulties for the investors as also the company, promoters, etc.

SALE, DISPOSAL OR LEASE OF ASSETS OUTSIDE THE “SCHEME OF ARRANGEMENT” ROUTE

Disposal of substantial assets can be carried out either through the scheme of arrangement route through approval by the National Company Law Tribunal or by the shareholders, depending on the nature of the transaction. Certain disposal of assets may not attract either approval though, but in the present case, we are concerned with those that require such approval.

Where approval of the NCLT is required, SEBI has no further suggestions. However, in case of “slump sale” outside this NCLT route, SEBI has recommended that there should be a disclosure of “the objects and commercial rationale” for such transactions.

Moreover, it is required that there should be approval of the shareholders in the form of the majority of the minority. This is in addition to the requirement of special resolution under the Companies Act, 2013. SEBI believes that this would give a say to the minority shareholders and thus they would be able to reject a proposal that would affect their interests adversely.

END TO ‘PERMANENCY’ OF CERTAIN DIRECTORS

SEBI has noted that certain directors are not required by law, contractual arrangements, etc. to retire and hence, for all practical purposes, are ‘permanent’. What is effectively meant is that shareholders do not have an opportunity to consider from time to time whether they are giving worthwhile services on the Board and whether they should be continued. Other directors ‘retire by rotation’ and hence shareholders have a chance to deny them reappointment. The law itself permits part of the Board to be non-retiring. The articles may even provide that some directors are for ‘lifetime’. SEBI considers this position as not a desirable one. Hence, it has proposed that all directors should be required to present themselves for reappointment at least once in five years. This applies even to existing directors and those directors who would have completed tenure of five years as on 31st March, 2024 without having been subject to reappointment by shareholders, may be required to present themselves for reappointment at the first general meeting of the company after 1st April, 2024. However, since the amendments, as this article is being written, are still not notified, it is possible that this date may be extended.

Technically speaking and in law, no director is really ‘permanent’ and ordinarily any director can be removed by a simple/special majority. Hence, in this sense, the position may appear the same that if a majority of shareholders are required to approve the reappointment, the same majority can remove him or her.

However, this does not always solve the problem. Firstly, removal of the directors is not always easy since an attempt by shareholders to remove a director may be met with resistance and litigation and thus, at the very least, delays. Secondly, the articles may provide for a complex procedure including a supermajority to remove a particular director or directors. Whether such a provision is valid in law and also in due compliance with requirements, may become another point of litigation and hence yet another hurdle in the removal of a director. The new requirements of SEBI, if implemented, may effectively overcome such difficulties and thus every director may end up having to regularly present himself before shareholders for reappointment.

CONCLUSION

The recommendations are noteworthy, to say the least and could create difficulties for many listed companies, and may even be partly counterproductive. One also hopes that SEBI has received extensive feedback on this and that in the actual final amendments, there will be some relief.

SEBI Acts against Pump-N-Dump Operations through Telegram Channels

BACKGROUND

SEBI, on 25th January, 2023, passed a detailed interim order (in the matter of Superior Finlease Ltd) against persons allegedly involved in market manipulation through the popular messaging app, Telegram. This followed several search and seizure operations conducted about a year ago at multiple locations where SEBI seized, amongst other things, mobiles, hard disks, etc. SEBI found that a well-organized scam using the age-old “pump and dump” method was being carried out with illicit gains of Rs. 3.89 crores generated. SEBI carried out an elaborate and methodical investigation to join the various dots together. This revealed several interesting facts and issues, legal and otherwise. While such scams are regularly seen and even predictable now in their pattern, this was perhaps one unique case where the bare bones of the modus operandi were exposed in detail. SEBI carried out searches that enabled it to get its hands on mobile devices which contained lurid and explicit details of the scam.

At the outset, though, it must be emphasised that this was an interim order. Interim orders are usually passed in cases where the regulator cannot wait for the investigation and further proceedings to be wholly completed and only final orders are passed. Waiting a long time may not only mean that the scam could go on, but the illicit profits may also be diverted and the evidence destroyed, etc. However, this also means that the order lays down findings of SEBI to which the parties may have had no opportunity of presenting their side. Thus, it would be a one-sided case at that stage. Often, such orders are appealed against particularly if it is found that they contain grave errors and charges, and would result in injustice and even besmirching of the names of innocent parties. Appellate authorities do give relief in case of obvious errors or if it is found that the losses caused to parties may be irreversible and more than the benefit obtained by such order. Hence, the findings and conclusions in this order (and the discussion here) should be treated as mere allegations at this point.

Nonetheless, SEBI deserves due credit not just for the elaborate investigation and detective work including of technical aspects, but also for expressing its findings well in the order with graphs, transcripts of conversations and even sharing their recordings.

WHAT IS PUMP-AND-DUMP?

Pump and dump operations are age-old. And, sadly, they work again and again. Even SEBI has recognized the human psychology involved, where, the public and particularly lay investors, get a Fear of Missing Out (FOMO, as how this has become part of today’s popular slang) and act. This is partly because of greed which blinds them to rational and skeptical analysis and partly because of the sense of urgency created by the operators.

Pump and dump involve, as is obvious from the term, two parts. One is the initial part of pumping up the price. This involves two aspects. One is, of course, the steady raising of the price of the shares of the concerned company. This is done by a group of operators trading amongst themselves at a successively higher price. The second is creating volumes, though this may not always be the case. Nevertheless, high volumes create an appearance of credibility that there are many buyers even at higher prices.

Usually, most of the shares of the company are in the hands of this group of persons since otherwise, the public shareholders who see the price rising may sell their holding which could not only result in a fall in prices but also increase the cost of the operations. Thus, such operations are often carried out in companies that have little operations. Having said that, such operations are also seen in fully functioning companies where the idea is to pump up the price to enable a further issue of shares/securities at a higher price or simply to offload holdings to raise funds.

The second part involves dumping the shares at the higher price to the unsuspecting and expectant public who are eager to acquire these shares since they are promised a much higher price later. At this stage, the operators are selling and the public is buying. Of course, as was actually seen in this case too, the operators may have to step in if the price falls due to reasons such as some sellers coming in. Shares are thus offloaded within a price range and then the operators pack their bags and leave the investors high and dry.

SUMMARY OF THE INVESTIGATION AND FINDING IN THIS CASE INCLUDING INTERESTING ASPECTS

SEBI received complaints that certain telegram channels were giving out tips for dealings in shares through telegram channels. Telegram, as is well known, is a popular messaging application with others including WhatsApp, Signal, etc., and of course, the regular SMS services. Interestingly, action has already been taken in respect of stock manipulation scams through SMS messages by restricting messages with the use ‘buy’, ‘sell’, etc. However, acting against apps is more difficult as they are privately owned and also have secrecy features built in. Telegram has become more popular since it has many more features including anonymity, larger size of groups, etc.

SEBI followed such channels and noted that they did engage in giving out tips. Importantly, it was found that just the two channels put together had a subscriber base of more than 23 lakh persons. This was the ready audience the operators had and, as SEBI notes, even if a minuscule number of these people fell to the scam, it was enough for it to succeed and illicit gains of crores be made.

What is more, the channels also had paid subscribers. For getting periodic tips in various ranges, the subscribers paid periodic (weekly/fortnightly/monthly) subscriptions of Rs. 5000-10000. This by itself was a money-making operation. It may be noted that several SEBI regulations deal with such giving of tips, whether for money or otherwise, and if these are given by unregistered persons or against regulations, they are illegal. SEBI has, in recent times, passed numerous orders against such unregistered persons making recommendations.

SEBI found that there was an alleged mastermind who controlled a listed company and a broking firm. He approached certain intermediaries who in turn involved other persons including those who operated such telegram channels. SEBI found that the mobiles they seized had actual recordings of telephonic conversations between the parties where they summarized how broadly the scam would be managed and how they would share the profits. SEBI found that the parties had agreed that the portion of the price above Rs. 100 would be paid as a commission by the sellers to the other persons involved. There was discussion of even how a certain percentage of this commission would be retained for contingencies. The alleged mastermind was said to have even stated in this regard, justifying the retention, that “Mein beimaan aadmi nahi hu lekin…” (“I am not a cheat but…”). Considering that the whole operation was allegedly for making fraudulent profits from unsuspecting lay public investors, the irony cannot be missed.

Then there were messages of the actual working of the profits made and the amounts to be shared along with how they were paid or to be paid.

SEBI investigated methodically several things in this regard. It tracked the movement of the prices of the shares, their volumes and the persons who engaged in the trading leading to D-day when the offloading was to happen. It gave findings of a connection between these parties including how the trading was financed by the alleged mastermind. Thereafter, screenshots of the recommendations through messages in the telegram channel to buy such shares with the high target prices (and also the stop loss price) were found and given in the order. SEBI also not only tracked the number of calls between the parties including the total time of such calls, but it also traced the mobile locations to further support its case of connections between the parties. The bank account statements of some of the parties were analysed to show the flow of funds which were then linked with the agreed plan of financing and also sharing of the illicit profits.

Statements of parties were taken, and certain parties were said to have confessed and also explained the modus operandi and the role of various parties.

At the end, in this 93-page long order, SEBI concluded that multiple violations of law appeared to have taken place and also there was a need for immediate interim order giving directions. Accordingly, SEBI gave certain directions against 19 parties. It required that the total illicit profits of about Rs. 3.89 crores be impounded and incidental directions to banks, etc. not to permit debits to accounts till the money was paid, were given. It directed the parties not to buy or sell, such securities till further orders. Finally, the interim order was also to be treated as a show cause notice to parties asking them to give their responses as to why final adverse directions such as that of disgorgement, debarment, penalty, etc. not be passed.

SOME LEGAL ISSUES

As stated, the order is interim and comprises a set of allegations that do not give parties an opportunity to present their case. SEBI may also carry out further investigations and place them before the parties. It is thus possible that as the case progresses, perhaps also in appeals, there may be changes in the stated findings, conclusions, allegations, etc. Nonetheless, several legal questions can be considered at this stage itself that may be raised and ultimately resolved either by SEBI or by appellate authorities. Hence, the progress of this order would be worth tracking to see how such a case, perhaps the first of its kind in many aspects such as use of messaging apps, search and seizure, telephone recording, etc., progresses.

One issue is that the order is a combined one against 19 parties, who may be placed in unequal positions. Though SEBI has divided the roles of certain groups of parties, the law would require that each person’s guilt be individually established. An important aspect here is placing joint and several liabilities on a group of persons who are alleged to have jointly acted – and profited – from a part of the alleged scam. This has been questioned in the past and rightly so.

Then there are alleged confessions and statements. These may be retracted, possibly on grounds that they were made under duress, and the question of their validity would thus arise. In any case, other parties may seek cross-examination particularly if these statements are implicating them.

There are voice recordings taken from the mobile. There may be questions raised whether they are indeed of the persons that SEBI claims they were. And whether there would be a need under the law of expert voice analysis.

The transactions in the bank have been alleged to be for financing the trades, sharing illicit gains, etc. While there may be other corroborating evidences, the question in law would be whether other explanations may be plausible.

Also open to challenge are the reasons for mobile calls between the parties. Since, except for the recording found on the mobile itself, there are no details of what was discussed in the call, whether allegations that these show connections between parties would stand in law.

There are many other issues. Having said that, the Supreme Court (in Rakhi Trading ((2018) 143 CLA 15)) and Kishore R. Ajmera ((2016) 131 CLA 187) has created strong precedents to enable SEBI to apply lower benchmarks of proof in civil proceedings. However, if SEBI also initiates prosecution against these parties, the higher benchmark of proof may be applied, and hence the aforesaid issues may need stronger countering.

Finally, there is the issue of disgorgement of the illicit profits. These profits clearly correspond to the losses incurred by investors who fell prey to the scam. However, there are no explicit provisions in law to enable return of these profits to these investors.

CONCLUSION

While there is no solution to the greed amongst the public, which will regularly result in cases of cheating, it is also true that new technologies have made it even easier to reach a larger populace, anonymously and cheaply. Even right now, a simple search on telegram or even google, shows up multiple telegram channels, Twitter handles, etc. which claim to give ‘hot tips’ for stocks, futures and options. Close down one, and many more may crop up. However, SEBI’s making an example of a few may lead not only to a strong disincentive to others, but also awareness amongst the public. However, in practice, pursuing such cases could take longer and require evidence that stands up in law.

Of Mules and Securities Laws

BACKGROUND

Mules, in common parlance, are understood as beasts of burden. They mindlessly carry out severe labor work often for relatively small rewards. In the narcotic drug business, mules are those who carry/smuggle drugs from one place to another. In securities laws too, now, the term ‘mules’ has acquired a similar meaning. They refer to persons who do illegal work under the instructions of another mastermind. Theyget small rewards for doing such work or allowing their names to be used. The question is how they are treated in securities laws since the violations are carried out in their names?

USE OF MULES TO CARRY OUT NUMEROUS TYPES OF SECURITIES LAWS VIOLATIONS

The typical use of mules is to use their names to carry out certain acts, which if carried out in one’s own name, would be illegal or otherwise help links to be established whereby the acts would be held to be illegal. A corrupt person, for example, would take bribes and build wealth in the name of another person, and thus himself being free of scrutiny. Having wealth in one’s own name could be a presumption of having acquired it through corrupt means. In securities laws, there are similar reasons. An insider having Unpublished Price Sensitive Information (UPSI), for example, may use mules to carry out trades with benefit of such information and make illicit profits. Similarly, a front runner, who has information of impending large orders of clients/employers, may use these mules to carry out transactions in such scrips. Since it is expected that on account of the large orders of his client/employer, there would be significant movement in price, he would use these mules to enter into transactions first and then reverse these transactions when the orders of his employer/client are put through.

Then, there are those who engage in price manipulation. Often a group of persons are needed to carry out such acts. Such group of persons may engage in trades and counter trades, often in a circular manner whereby, at least initially, there may be no movement of shares outside such the group. If the intent is ‘pump and dump’, then, after the price is pumped up to higher levels, there would be off loading of the shares by the master mind to unsuspecting investors. At a later date, when there are complaints and investigations, the master mind may claim to have had no knowledge or connection with the various mules. The mules, assuming they are traceable or appear before SEBI against summons, too may claim having no connection.

Then there were the classic cases of share subscriptions in public issues to take the benefit of reservations for retail investors. It was alleged that share applications in large numbers were made in the names of thousands of such mules, and these were financed by a small group of people. These cases, which came to be popularly referred by one of the alleged persons, Roopalben Panchal, led to investigations and multiple proceedings that lasted for a long time. It was alleged that share applications were made in the name of such mules and shares allotted to such persons were sold and the profits/sale proceeds transferred back to the alleged financiers.

DETECTION/DEMONSTRATING VIOLATIONS OF SECURITIES LAWS USING MULES

The use of mules present a challenge to the regulator in proving and punishing violations of securities laws. The mules and their mastermind may claim no connection with each other and thus argue that there were no violations.

In case of insider trading, the work of SEBI is thus relatively easier as there are deeming provisions that hold several connected persons as insiders. Further, well settled principles of law (as laid down by the Supreme Court and as discussed later herein) help SEBI in using circumstantial evidence. Thus, several such orders are seen to be regularly passed from time to time.

That said, sophisticated capital market operators may use means that make detection and punishment difficult. Digital tools, messengers, etc. may also be used. In some cases, SEBI has meticulously traced mobile calls and established links between persons based on such connections. However, there are just too many ways to pass messages/make calls unless such messages remain on record. Here too, there are sporadic cases where SEBI has even used web archives to excavate deleted websites. But the technical challenges remain formidable.

SEBI does come to know of suspicious transactions through market surveillance. Financial transactions between the parties, introducing such mules in bank or broker accounts, etc. also help establish guilt. SEBI had, in one case, shown extraordinary initiative to track the movement of an alleged front runner through his mobile phone and found that the person used to withdraw cash through ATM from the account of such a mule. However, such cases are one off and do not help wider prevention, detection and punishment of securities laws violations.

SEBI’S ENFORCEMENT ACTION AGAINST SUCH MULES – DIFFICULTIES AND INJUSTICE

Even if detected, the unresolved issue is what action should be treated against mules? The dilemma particularly here is this. The ‘mastermind’ may claim that he has done no wrong, the transactions are not done by him and the rewards of the misdeeds are also not with him. It is the other person, the alleged mule, who has done everything. The mule may claim a similar story of innocence, the counter part. He may say he is just an uneducated person, maybe in the employment of the mastermind at a lower hierarchy earning a small salary or otherwise in a similar job elsewhere and who is recruited. He may claim that the rewards of the misdeeds have been transmitted to the real culprit, either by the way of ‘loans’ or through cash. In some cases, he may admit to have signed various documents on the basis of some small remuneration. It may be difficult for SEBI to ascribe/allocate blame to the “real culprit”. This is more so if it is admitted, or otherwise easily demonstrated, that the mule was aware that wrongful transactions were being done in his name.

Typically, SEBI has been punishing all the persons equally. They may all be debarred from capital markets. A common penalty be levied on them, payable jointly and severally and this stance is particularly justified if the money may be lying with the mule or if SEBI is unable to find out where it has landed.

The difficulties in taking such a uniform stand are several. Firstly, the mule gets punished as an equal to the main person, despite his role being less, maybe a name-lender. Secondly, levying the penalty as fully recoverable from the mule (even if on a joint and several basis) creates far more difficulties on the mule. His bank account and his meagre savings and properties may get attached/recovered. Even if he bears guilt in this regard, such a punishment is clearly disproportionate and unjust. The mastermind may also have bigger resources to fight the matter.

Recently, however, SEBI has been changing its stand for the better. For one, if it is possible to trace how much of the ill-gotten gains went to whom, the recovery is made accordingly from such persons, instead of recovering on a joint basis. Further, in several cases, even if not on a consistent basis with general principles laid down, SEBI has levied penalty/punishment on the basis of demonstrated involvement in the violation. The backgrounds of the parties too have been considered for this purpose. Hence, while some punishment may still be meted out, it may be proportionate to the guilt and involvement.

Admittedly, if it is not easy to find the culprits, then, demonstrate the violations and then go even further and allocate blame. However, SEBI has the benefit of at least two Supreme Court decisions (SEBI vs. Kishore R. Ajmera (2016) 3 Comp. LJ 198 (SC) & SEBI vs. Rakhi Trading (P.) Ltd. ((2018) 207 Comp Cas 443 (SC)) which have made deciding of the guilty easier on the principles of “preponderance of probability.” This principle does not require a proof of beyond reasonable doubt but a lower one based on what is more probable than not. SEBI could see the facts of the case, see the level of sophistication and resources of the persons involved, the cooperation given, etc. and ascribe blame and punishment accordingly.

VISHWANATHAN COMMITTEE REPORT

The SEBI Committee chaired by T. K. Vishwanathan had in August 2018 made certain recommendations on this topic. A method of detecting mule accounts was suggested. For this purpose, a formula was provided that lays down the volumes of trades based on income/net worth of the investor. If the broker finds that the volumes are beyond an “affordability index”, then the broker should exercise special diligence for such client. If the volumes are beyond this and even beyond prescribed levels, the account could be suspected as a mule account. However, though amendments to the Regulations were suggested, they have not yet been made.

SOME CASES

An interesting investigation was carried out by SEBI which culminated in an interim order dated 1st October, 2020. While a detailed analysis of this order could be a separate subject, it is seen that SEBI traced the mobile records and even the location of parties as available from such records. Based on these investigations, it alleged that mule accounts were created for carrying out front running and the primary person withdrew the cash from the bank accounts of such mules. However, SEBI ordered that the profits made be deposited by all the parties including the alleged mules and this liability for deposit was made joint and several. Till this was done, the assets, bank accounts, etc. were required not to be disposed off. Effectively, this meant that the alleged mules too suffered such embargo.

In an order dated 24th December, 2020, in the matter of Viji Finance Ltd, SEBI alleged that 78 parties were ‘mules’ or ‘name lenders’. They were low income/unskilled/uneducated people whose occupations included being a vegetable vendor, house painter, auto drivers, etc. For alleged violation of the Prohibition of Fraudulent and Unfair Trade Practices (PFUTP) Regulations, a penalty of Rs. 15 lakhs was levied jointly and severally on them. The result is that the full amount could be recovered from even any one of them and there would be no mechanism for them to share it between them. It is possible that they may not even know each other.

In an order dated 13th January, 2021, SEBI elaborated the concept of “Family and Friends” mule accounts. It was stated, “Before proceeding to deal with the circumstances, it will be appropriate to elaborate on the concept of “Family and Friends” mule accounts. These are trading accounts which are “lent” by persons known to the person who is effectively controlling / placing the orders in the trading account. For example, family members, extended family members, friends, acquaintances, etc. The person who is controlling the account / placing the orders gets access to the trading accounts based on trust or on the strength of relationship between him and the registered owner of the trading account.” Using this principle, the family members were held equally responsible for the alleged violations. They all were required to deposit the impounded amount their banks.

CONCLUSION

While legal issues of proving and apportioning guilt are difficult enough, the unorganized economy in India where transactions in cash may be made, adds to the difficulties. It is quite possible that the SEBI’s attempt may be barely scratching the surface.

Proposed Changes to Reporting Material Developments

INTRODUCTION AND BACKGROUND

SEBI has proposed changes to the provisions related to reporting of material events/developments by listed entities. These provisions are contained in the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“the Regulations” or “the LODR Regulations”).

Timely reporting of material events and developments with regards to listed entities is important for several reasons. It puts an end to speculation and gossip due to leaks, guesswork (informed or otherwise) or even media reports. It informs the investors and public of important developments in a timely way to enable them to take their decisions factoring these into account. Hence, they do not have to wait for the financial statements released within about one and half months at the end of every quarter, which, while have much improved over previous annual reporting, are still considered late if major developments take place between two such reporting dates.

Further, reporting right from the proverbial horse’s mouth, is more reliable than market gossip. Indeed, as we will see, while there are already some provisions related to reporting by listed entities to reports/rumors in the market, the proposed provisions now require mandatory reporting by certain listed entities.

Reporting of material events also helps curb insider trading since  more delayed the reporting, more are the chances of insiders abusing knowledge of price sensitive information. However, what is considered ‘material’ for the purposes of LODR Regulations is different from the corresponding term – price-sensitive information – under the Regulations relating to insider trading, even if one may see overlap. Further, while there is a fairly elaborate definition of what is considered price-sensitive, there is no specific definition of ‘material’ under the LODR Regulations.

Instead, it is seen that the term material is defined as a mix of specific cases that are deemed to be material and for other cases, there is a blend of policy and discretion. The listed entity is required to lay down a policy related to not only determining the materiality of events, but also one that gives an element of discretion to the specified key managerial personnel in this regard.

Further, while the Regulations related to insider trading focus more on proper preservation of price sensitive information and prevention/prohibition of its abuse, the LODR Regulations are more concerned with prompt reporting.

The LODR Regulations have broadly divided material events into two categories. There are a set of items deemed to be material leaving no discretion to the company in this regard. Thus, these have to be reported, irrespective of the amounts involved or their nature. Then, there is a list of items in respect of which the top specified executives have to exercise discretion and report if found material.

To these provisions, SEBI has now proposed several changes vide its consultation paper on 12th November 2022. After taking feedback, SEBI will notify the final amendments. However, as has been often the practice, and a good one at that, the consultation paper gives the actual wording of the proposed amendments to the regulations. Hence, even the fine print as proposed is available making it easier to visualize the implications in more detail than otherwise when only the description of the proposed amendments is given.

Let us consider some of the important amendments as proposed.

QUANTIFIED PARAMETERS TO GIVE MINIMUM LIMITS TO DETERMINE MATERIALITY

At present, as discussed, there are two categories of criteria to determine whether a particular event or development is material or not. In the first category, are clearly specified events deemed to be material and where, thus, no discretion is available to management but to report. There is criticism, and in some cases rightly so there are areas in which these deemed material events are not really material at all in substance. Hence, there is a needless deluge of information which the public may actually misconceive as material on one hand and, on the other hand, substantially material events get lost in these.

The second category relates to matters where a principle-based guidance is given by SEBI to determine materiality but the company has the discretion to decide whether or not an event is material in context of this guidance. It is now proposed that one more principle, a quantified one, be laid down to provide a minimum lower limit which, if crossed, would make the event material. Three alternative parameters are provided and if the impact of the information in financial terms exceeds any of these three parameters, then the same would be deemed material. These three parameters, simplified for present purposes are 2 per cent of turnover, 2 per cent of net worth or 5 per cent of average net profits of last 3 years, whichever is lower.

Quantified limits are always welcome as they reduce ambiguity, and thus also avoid second guessing by the regulator, often based on hindsight wisdom. However, they may often be far from the substance, and may at times make non-material events material, material events non-material or, worse, may miss items not easy to quantify.

Secondly, the quantified limits are applied irrespective of whether the event may impact the turnover, net worth or profits. Thus, an event may have a significant impact on the turnover but not on profits (or vice versa). If, even one of the limits is crossed, the event is deemed to be material. Thus, not only more events would be reported because quantified parameters are provided but the number would also be more since the parameters provided are three, and not necessarily connected to the nature of the event and the impact it may have on a particular parameter.

It is also provided that while the company may continue to determine the policy of how it determines material events, this policy will not dilute the specified quantified parameters. Thus, these parameters would represent absolute lower limits which even the policy or discretion cannot exclude.

ESCALATION OF INFORMATION OF MATERIAL EVENTS UP THE LADDER OF MANAGEMENT

Typically, it is the man or woman in the field or on the ground level who becomes aware of a development that could have such material implications requiring reporting under the Regulations. For example, there may be a fire at a plant whose implications would have to be determined as material or not. It may take some time for the information to reach, with relevant data, to the KMPs. However, these requirements specify a short time limit (which is proposed to be shortened even further, as we will see herein) within which the information should be reported.

SEBI now proposes that a system be laid down in the policy whereby the information of material events would be escalated up to the KMPs for them to determine whether such an event is material or not. The details of how this would work would be up to the company to frame.

SHORTER TIMELINES FOR REPORTING OF MATERIAL EVENTS

The present provisions have a generic requirement of reporting of material developments within a maximum of 24 hours. It is now proposed to divide these requirements into three categories. In case of developments that emanate from outside the organization, the time limit would be maximum 24 hours. In case the information emanates from within the organization, a shorter period of 12 hours would be available. In case of events arising out of Board meetings, within 30 minutes of closure of such meeting.

Companies particularly have to plan well for this since this is the maximum time available for many things. Firstly, for the information to reach the management. Secondly, for deciding whether the event is material, whether deemed to be so under the Regulations or otherwise determined to be so taking into account the principles as well as the quantified parameters laid down. Thirdly, to compile the information in the format, if so prescribed. Finally, reporting the same. Too often, the compliance officer and even external legal advisors have to provide inputs in the process. The already short time limits are being proposed to be cut further. This may end up affecting the quality of information including its clarity and specificity.

REACTING TO MEDIA REPORTS

Under existing provisions, it is discretionary for management to react to media reports or rumors regarding developments related to the company. Exchanges, however, may ask in some cases a company to react to specific news.

It is now proposed to make companies proactively react to news in mainstream media. To begin with, top 250 companies (based on market capitalization) would be required to react to news reported in mainstream media that could, if true, have material implications. What is considered mainstream media (which may be print or digital), however, is not defined or described.

Companies thus will now have to keep track of reports in mainstream media and react to them. No time limit has been prescribed but, at least in spirit of the provisions, the 24 hour limit may be considered.

RATINGS, REVISIONS, RATING SHOPPING

Presently, companies need to report on ratings and revisions thereon. Now it is proposed that such reporting should be carried out even if the rating (or revision thereto) was not requested by the listed entity or, if requested, such request has been withdrawn by it. This may counter rating shopping that some entities may engage in.

WIDER COVERAGE OF DEVELOPMENTS RELATING TO PERSONNEL

At present, resignations by independent director or auditor, frauds or defaults by promoter/key management personnel, etc, are required to be reported. Now, it is proposed that certain developments by other specified persons should also be reported on by the listed entity.

Such information, in situations like fraud, defaults, etc, would have to be informed first by the person concerned to the entity, for the latter to report. However, curiously, such persons themselves are not required to report to the company. SEBI may, however, take a view that the requirements implicitly require them to do such reporting and if they do not report, SEBI could take action against them. However, it would have been better if the provisions had contained a specific obligation on such persons to report to the listed entity and a time limit therefor. Even better, the person could report simultaneously also to the exchanges.

CONCLUSION

There are several other changes proposed. Curiously, there seems to be a distinct change in approach from a principle-based reporting to rule-based reporting. In other words, instead of laying down broad principles that would have wider effect but at the same time give discretion to the entity to decide for each event based on its substance, increasingly the discretion is being taken away. Instead, detailed rules are being specified for reporting giving quantified parameters, specific categories of events/persons, etc. Partly this may arguably be considered as a failure of the principle-based approach. However, rule based reporting may also end up being tick-the-box attitude where form has precedence over substance. Worse, particularly considering the wider coverage and also lower quantified limits, there may be a deluge of reporting in which the real material developments may be missed by most except the discerning few who have time and experience to monitor and screen the reports.

SEBI’s Consultation Papers On Suspicious Trading

BACKGROUND
To make it easier to catch persons engaged in wrongdoings in securities markets such as front running, insider trading, etc., SEBI has circulated a consultation paper on 18th May, 2023. The paper proposes a special set of regulations (a draft of which is also provided) that would, under certain circumstances, presume a person or group of persons guilty of certain wrongdoing. This would be a rebuttable presumption, and the proposed law also gives a set of defenses that the accused can demonstrate. The proposed law is perhaps an expression of frustration by SEBI that persons have been able to use the latest technology and the unorganised sector to carry out wrongs but without leaving any trace or track whereby SEBI could prove the wrongdoing.

The net cast is wide, and persons engaged in regular trading in securities could face proceedings under this law if their trading has features listed in the proposed regulations, if they become law.

THE TRADITIONAL WAY OF CATCHING WRONGDOERS
Essentially, the proposed law says that transactions with a particular pattern shall be deemed to be suspicious, and if they remain unexplained, they will be deemed to be in violation of law and will attract various penal consequences.

The paper expresses concern at the growing use of digital tools and certain other practices and that many transactions which clearly seem to be that of front running, insider trading, etc., go unpunished. SEBI highlights the use of messaging apps that have in-built encryption for messages and calls. Further, some have the feature of disappearing messages, whereby the messages do not remain on record, whether on the mobile or on the cloud. The calls made using such apps too do not have any record of who called whom, when, how long the conversation lasted, etc.

It has been seen in numerous earlier SEBI investigations, which resulted in successful prosecution of the wrongdoers, that SEBI could collect call data records between the mobiles of the parties. Thus, evidence of contact and communication between them, particularly at a time when sensitive information was available, could be easily established. However, such tools ensure that there is no track or trail which SEBI could lay hands on.

Typically, in cases of front running, insider trading, etc., the violation is rarely done singularly. It is usually done in concert between at least two persons, but often in a group. Thus, in the case of insider trading, the insider, i.e., a person who has access to inside information in a company due to being in a position of trust, such as a director, CFO, auditor, etc., communicates unpublished price-sensitive information (UPSI) to another person. The other person, either singularly or with friends / relatives / associates, engages in trading in securities and makes profits (or avoids losses) in violation of the law. In case of front running, the person having knowledge of large orders, say a Chief Dealer of a mutual fund, communicates such information to his friend, relative, etc. Such person then carries out planned trading before and after such large orders and makes risk free and easy profits.

Then comes the matter of sharing of ill-gotten gains. The parties may have financial transactions between them in various forms, though often weakly disguised as of being of some other nature. Such transactions help SEBI further to establish a connection between the parties. Also, they may show how the profits have been shared.

In each of such cases, SEBI meticulously collects information about the communication between them. The relations / connections between the parties are also compiled. This may include being relatives, being a common director in some companies, etc. Even relations on social media have been used to help create the base for there being a connection.

The background of connected persons, also being in communication with each other, existence of price-sensitive information, and finally trading while such sensitive information is not public, helps SEBI create a sufficient case that would stand up in law. Rulings of the Supreme Court that require a lower benchmark of proof in case of civil proceedings have helped SEBI further in this regard.

Only when the parties are able to show that one or more of such grounds are not correct, then the case could fail.

RECENT DIFFICULTIES IN PROVING GUILT
However, recent times have shown that SEBI, on its own admission, is finding itself much behind the wrongdoers. Perhaps learning from SEBI’s past methods of investigations, the wrongdoers have used techniques that make it very difficult for SEBI to gather evidence and establish guilt. The messaging applications, as discussed earlier, have been used to create trail-free communication by way of calls and messages. Financial transactions are carried out in cash and even offshore through hawala, as SEBI pointed out, actually happened in a recent case. Persons who are unconnected on record and are just name-lenders (also called “mules”) are taken help of. Even apps such as AnyDesk, which helps one person control another person’s computer through the internet, have also been alleged to have been used.

The result is that there is ample evidence of wrongdoing and handsome profits of crores of rupees. There is evidence that certain price-sensitive information existed which was not public. There is evidence that trading was done during such time which stands out from other trading of those very parties. Further, abnormal profits are made through such transactions in such securities, which again stand out from other trading which carry normal risk. What is absent is communication between the party having the information and the party carrying out trading. What is also absent is the financial connection and transactions between these parties which show sharing of such profits. Both of these are done, as explained earlier, through digital and other means beyond the reach of SEBI.

SEBI has given several examples of such cases which have occurred and though names and dates are not given (or changed), anyone following media reports can easily identify the cases. This is particularly because the amounts involved are so large that most have received extensive media coverage.

SEBI noted that in numerous such cases, parties carried out transactions that were too coincidental to be accidental. SEBI pointed out that parties bought securities just before some good news was released (or sold before bad news). Transactions with the clear fingerprints of front running were carried out before and after large, market moving orders. SEBI frankly admitted that though it dug for connections between the parties, it failed to find any. Considering the recent experience of finding the use of such easily available apps that facilitate untraceable and untrackable communication, SEBI judged that these cases may also have seen similar modus operandi. Worse, even in the cases where it could have or did take action, the evidence could not hold up again due to lack of clearly incriminating evidence and also vagaries of law. While the test of ‘preponderance of probability’ does help SEBI, the differing test methods by different appellate rulings meant that many further cases went out of regulatory reach.

This has culminated in SEBI deciding to give the law a wholly different approach. That is provide for a presumption of guilt when basic facts are evident and in such cases, shift the onus on the party to prove their innocence.

THE NEW APPROACH OF PRESUMED GUILTY, WHICH ASSUMPTION IS REBUTTABLE BUT WITH ONUS ON PARTY ACCUSED
SEBI has proposed a new regulation — the SEBI (Prohibition of Unexplained Suspicious Trading Activities in the Securities Markets) Regulations, 2023. The draft regulations have been attached to the consultation paper. Let us analyse its components.

Regulation 3(1) of the proposed regulations prohibits the carrying on of any Unexplained Suspicious Trading Activity (USTA). So there has to be a trading activity that should be suspicious and which the accused has been unable to ‘explain’. Regulation 2(1)(k) defines USTA in a wide manner. It includes suspicious trading activity in securities executed in such a manner for which there is no reasonable explanation.

The definition of the term “trading” would be the same as under the regulations relating to insider trading. Thus, buying, selling, subscribing, etc., are all covered. Further, the term securities, being widely defined, includes shares, futures, options, etc.

The term “suspicious trading activity” has been defined with yet more component terms — Unusual Trading Pattern and Material Non-Public Information. Unusual Trading Pattern will be such trading which parts from the normal trading activity undertaken by a person or persons in the sense that it involves a substantial change in risks over a short period of time. Furthermore, it should result in abnormal profits or averted abnormal losses. The term “Material Non-Public Information (MNPI)” reminds one of the term “Unpublished Price Sensitive Information” used in the regulations relating to insider trading. However, MNPI has been defined differently, even if the essence intended may be similar. It can be information about a company / security which is not generally available but when so made available had a ‘reasonable’ impact on the price of the concerned security. It may also be an impending order on an exchange which when executed, also ‘reasonably’ impacted the price of the concerned security. Finally, it also covers recommendations by ‘influencers’. If the advice / recommendation of the influencer — for securities and related markets, they are also called fin-influencers — reasonably impacts the price of a security, that information too is MNPI.

The term “influencer” in turn is defined as a person who is reasonably in a position to influence the investment decision in securities of a reasonably large number of persons.

The term “reasonably” has been used repeatedly but not yet defined. An explanation says that the meaning shall be such as notified from time to time.

Piecing all the components together, the term “USTA” can be understood. Essentially, it is that trading that stands out from normal trading and is in the presence of MNPI and results in abnormal results (profits made / losses avoided).

Critical then is the term “unexplained”. While this term is not defined, the meaning can be gathered from two places. The first is in the definition of USTA, where it has been stated that the trading should have been executed in circumstances ‘for which no reasonable rebuttal or explanation is provided’. Regulation 5(2) thereafter guides as to how such reasonable rebuttal can be provided. Effectively, it is showing that the components of suspicious trading activity such as MNPI, or trading beyond the normal pattern or being non-repetitive, etc., can be countered as untrue by facts. The accused has to provide documentary evidence in rebuttal.

If the accused is not able to give a reasonable rebuttal, he would be held guilty. Action can then be taken by SEBI as provided under law.

CRITIQUE
SEBI has given several examples and even demonstrated by some actual cases for which even orders are passed that parties have engaged in trading resulting in abnormal profits which could not be explained otherwise than by the conclusion of wrongdoing. Since the digital world and unorganised sector have helped suppression / elimination of evidence, SEBI is unable to take action. Hence, the proposal of regulations that shift the onus to the accused.

However, it is seen that several terms are used that are wide, vague and subjective. The rebuttal of the presumption of guilt is, in comparison, possible in a narrow way and also has to be supported by documentation.

Trading in securities markets in large quantities is normal in these times of easy availability of trading apps and tools, and the cost of trading has also become significantly low or even near-free. Tools to help analyse markets, including technical analysis, and help analyse several parameters updated constantly are also readily available at low cost. It is possible that for various reasons, persons may end up engaging in trading that viewed with hindsight rationale, along with trades of other persons, may be perceived to be suspicious enough to fit the definition under the regulations. Recently, it was even seen that a Bollywood celebrity was alleged to have engaged in activity that might fit the definition of these regulations. In that case, discussed earlier in this column, SEBI passed an adverse order, which was substantially reversed in appeal. However, one wonders whether the case if proceeded against under the proposed regulations would have been more difficult to rebut. Traders in securities markets, who also perform the valuable function of providing market liquidity, may end up constantly looking behind their shoulders and worrying whether their trading could in hindsight be deemed to be suspicious.

It will have to be seen whether more safeguards are provided in the final regulations giving reasonable protection to bonafide traders, and in such cases, the onus to establish guilt remains on SEBI.

SEBI Makes Significant Amendments to Corporate Governance Rules

BACKGROUND
SEBI has notified the amendments to the SEBI (Listing and Disclosure Requirements) Regulations, 2015 (LODR Regulations) vide notification dated 14th June, 2023. Except where specified, they will come into effect from the 30th day from the date of their publication in the Official Gazette. Thus, a short period has been given so that the amendments are understood and digested and systems laid down for their implementation.

The amendments relate generally to what one would call corporate governance requirements. Some of the amendments made are substantial in nature with far reaching effects. Importantly, an effectively retrospective application has been given to some amendments since they will apply also to subsisting arrangements and situations. Listed companies, their key management personnel, directors and others concerned will need to study and examine which of them apply to their companies and lay down processes to implement them.

These amendments follow the Consultation Paper issued on 21st February, 2023 and considering the feedback received to this paper, SEBI has implemented the proposals in a manner that is different in some aspects of what the original proposals laid down.

The LODR Regulations apply to listed entities but, for simplification and using a familiar term, the words “listed companies” are used here.

EXTENDING AND MODIFYING THE REQUIREMENTS RELATING TO REPORTING OF ‘MATERIAL’ DEVELOPMENTS

SEBI requires ‘material’ information to be dealt in a way that it is not misused while also shared with the public at the earliest possible stage so that investors and others concerned can keep track and take their decisions accordingly. The Regulations relating to insider trading provide for control of and prevention of misuse of price sensitive information by insiders. The LODR Regulations provide for disclosure of material information at an early stage.

Regulation 30 primarily deals with timely disclosure of material developments. SEBI has divided, broadly speaking, what constitutes material developments into two categories. In the first category are those developments that are deemed to be material and require reporting in the prescribed manner. There is no discretion to the management to decide whether or not a development is material, if it falls in this category. In the second category are listed certain events which and any other developments would be material if the management, following through a prescribed process and after considering a materiality policy laid down in advance by the Board, so decides. However, there are no objective/quantitative factors laid down to determine whether a development would be material.

Now, SEBI has prescribed three quantitative factors which would be also considered, in addition to the discretion of the management, as to what constitutes a material development. These are the following (simplified):

a. 2 per cent of the consolidated net worth of the company, if positive.
b. 2 per cent of its consolidated turnover.
c. 5 per cent of the average of absolute value of the consolidated net profits/loss.

If the value of impact of the development/event is more than the least of the above values, the development would be treated as a material one requiring reporting in the prescribed manner.

REACTING TO REPORTS IN ‘MAINSTREAM MEDIA’ ON ‘MATERIAL’ DEVELOPMENTS BY TOP 100/250 COMPANIES

Ordinarily, material developments in relation to a listed company emanate from within. Obviously, the company would be the first to know whether it has landed a major contract, whether a major disaster has occurred, whether a major acquisition has been agreed on, etc. The company would ordinarily share the information at a stage when only it could be called a ‘development’ and earlier than that. However, it is also common that the media, print and electronic, may come to know of it through leaks or otherwise and report on them. Usually, reputed media would give some time to the company to respond to such information but this is not always so and even otherwise, the company may not respond or not confirm. Such news then results in uncertainty.

SEBI has now amended the requirements of how companies should deal with such reports in ‘mainstream media’. For this purpose, it has defined what is ‘mainstream media’. The definition is exceedingly broad. It includes every newspaper registered with Registrar of Newspaper for India and news channel permitted by Ministry of Information and Broadcasting. Even newspapers, channels, etc. similarly registered, permitted or regulated outside India are covered.

If there is a report in any of such ‘mainstream media’, the company should respond to it within 24 hours by confirming, denying or clarify on it.

This requirement applies to top 100 companies in terms of market capitalization from 1st October, 2023 and to top 250 such companies from 1st April, 2024.

While there are some more detailed provisions, the sheer difficulty, perhaps impossibility, of complying with this requirement is apparent. There are numerous such ‘mainstream media’ and possibly beyond the physical capacity of a single company to keep track and respond as prescribed. Such media may be from any corner of India, indeed the world, and may be in English or a local language. It is submitted that SEBI should have a cut-off point in terms of size/reach of such media such as number of subscribers, etc., though it must be admitted that even making a definition of reach of such media also can be difficult.

Perhaps the status quo could be retained, for want of a better alternative. Since quite a few detailed criteria, including now quantitative ones, have been laid down, the company could be left to take a decision and SEBI could, in glaring cases where the company did not reveal the development in time, take action.

PROVISIONS GIVING SOME SHAREHOLDERS SPECIAL RIGHTS

There are two amendments that deal with agreements or provisions that put some shareholders on a higher or special position as compared to others. The first amendment deals with a situation where special rights are given to some shareholders. Broadly stated, SEBI has required that such special rights should be approved by a special resolution at a general meeting at least once in five years.

The new provision does not define what a ‘special right’ is and how it is given. It is possible that it may refer to a situation where some shareholders have exclusive or extra right as compared to other shareholders. Ordinarily, matters before a shareholders meeting are decided by “one equity share one vote”. It is another thing that the law itself may provide for a different manner and hence here, the intention may be to refer to a situation where the company itself has given special rights. Thus, a particular shareholder may have a right to veto some decision, even if agreed by the majority, or they may have a right to appoint a director, and so on.

It is now provided that such rights should be subject to approval of the shareholders by way of a special resolution once in every five years from the date of grant of such right. This provision applies to rights already granted before the date when this amendment comes into force. In such a case, such right should be approved by a special resolution within five years when this amendment comes into force.

There are certain exceptions provided to this general rule. They do not apply to rights given to:

a. A financial institution registered with or regulated by the Reserve Bank of India under a lending agreement in ordinary course of business.

b. A debenture trustee registered with SEBI under a subscription agreement for debentures issued by the listed entity.

These exceptions apply if such entities become shareholders as a consequence of such lending or subscription agreement.

SALE/LEASE/DISPOSAL OF UNDERTAKING OUTSIDE SCHEME OF ARRANGEMENT

Section 180(1)(a) requires the approval of shareholders by way of a special resolution in case the company proposes to sell, lease or otherwise dispose the whole or substantially the whole of an undertaking of the company. The section defines undertaking and makes other provisions in this regard.

SEBI has amended the LODR Regulations to provide a higher and different level of approval of the shareholders.

Let us consider some important amendments made. SEBI requires a prior special resolution where the notice of the meeting would need to disclose the object and commercial rationale for the proposed transaction.

The approval would not only have to be by a special resolution of the shareholders, but can be acted on only if the votes cast by the public shareholders in favor are more than the votes cast against by such shareholders. In other words, a “majority of the minority” also have to approve the transaction. Further, of the shareholders, the public shareholders who are a party to such transaction are debarred from voting.

Transaction with a wholly owned subsidiary does not require such approval, but provision is made the intent of which appears to provide against avoidance of this requirement by a transaction using this route.

It is not clear why such a higher level of approval is required and, particularly, why the approval of a majority of the public shareholders is required. Perhaps the intention may be that when a business unit itself is being disposed off, the public shareholders should have a greater say.

ALL DIRECTORS (WITH SOME SPECIAL EXCEPTIONS) NOW NEED TO TAKE APPROVAL OF SHAREHOLDERS FOR THEIR APPOINTMENT/REAPPOINTMENT

The Act permits some directors to be non-retiring, that is to say, they will continue as directors unless they are removed, they resign, etc. Often, the articles have provisions for indefinite continuation of some directors or even provide for permanency of sorts of their term. While the validity of such term in law is a separate topic for discussion, the result also is that some directors thus continue indefinitely. The law does provide for removal of a director by shareholders. But perhaps realising that this may be an uphill task for shareholders if the promoters/management may be against it, and also to ensure as a sound principle of corporate governance, a new provision now requires that every director should require appointment by shareholders once at least five years. This provision applies also to existing directors. Exceptions are provided for Managing Directors, Whole-time Directors, Independent directors and directors retiring by rotation, the obvious reasons seem to be that they in any case periodically require approval of shareholders. Exceptions are also for certain categories of nominee directors.

OTHER AMENDMENTS

There are several other amendments made.

Agreements by shareholders, promoters, directors, key managerial personnel, etc. which could have impact on the management of the company in the specified manner require to be disclosed to the company, which in turn will disclose this to the stock exchanges. This applies also to past agreements which are subsisting.

An amended provision now requires even more detailed requirements relating to Business Responsibility and Sustainability Report. Many aspects relating to this are yet to be specified by SEBI but when fully notified, it would need to be gone into in detail and require services of Chartered Accountants for ‘assurance’ and related matters.

Timelines for filling of vacancies in key managerial personnel and even independent directors have been tightened.

To conclude, SEBI continues to take a lead in updating and improving on corporate governance standards in listed entities as compared to the provisions under the Companies Act, 2013. The cost of compliance does rise but the expectations are that the payoff would be in terms of better image and lower costs of raising capital for listed entities.

SEBI Lays down Clearer Guidelines on What Constitutes ‘Misleading Information’

BACKGROUND

A recent SEBI Order on alleged misleading price-sensitive news by a journalist of a leading TV channel has wider ramifications. Not just news media but also companies, their senior executives, advisors of various forms and, more particularly in recent times, social media ‘influencers’ may need to consider the reasoning offered here. There is now even a word coined for this fast-growing group of social media influencers in investing – finfluencers (i.e. finance + influencers). While SEBI let off the journalist, and rightly so on the facts, the reasons provided for differentiating this case are noteworthy. Effectively, SEBI has laid down certain general principles on how communications to the public by various parties may be viewed. When would a person communicating to the public, in general, be said to have been misleading, acting fraudulently, acting recklessly, etc., to the point of becoming a violation of the law? The decision could help in answering these questions. And this would be relevant for persons including, say, the Chairman/CEO of a company (there is a case earlier where SEBI held him liable, only to find its Order reversed on appeal), the company secretary who communicates to the exchanges, various forms of advisors and ‘experts’ (registered with SEBI or not), etc.

The Order is also interesting since a core question raised was the constitutional guarantee of free speech, and it was claimed that the media had immunity from action. The Order considered several Court rulings in this regard.

Let us review this Order of SEBI and know what factors were deemed relevant to determine that the journalist concerned was not guilty. These factors should help determine how, another person could be found guilty on a different set of facts.

SEBI’S ORDER

SEBIs Order dated 31st October, 2022, bearing reference No. Order/NH/VS/2022-23/20979, is briefly summarized. A leading business TV channel’s journalist reported to it on a price sensitive matter. She reported that the merger of a leading listed company was approved by the National Company Law Tribunal (NCLT). She was personally present at the hearing of the NCLT. On receiving the report, the channel immediately interviewed the company’s Chairman on the implications of the ‘merger order’. The Chairman gave replies though he first qualified that he had not seen the merger order.

Now, mergers, takeovers, etc., are generally treated as material and price-sensitive information. This is particularly so because, depending on various factors such as the condition of the company being merged, the exchange ratio, etc., there could be significant demand – or offloading – of the company’s shares, thus impacting the market price. Thus, various SEBI Regulations provide for special treatment of such material/price-sensitive information. The SEBI Insider Trading Regulations, for example, require that it should not be leaked selectively or that insiders should not trade based on such information. The SEBI LODR Regulations require that material information should be disclosed forthwith in the specified manner. However, in this case, the question was the applicability of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003 (the PFUTP Regulations). The Regulations have multiple provisions prohibiting sharing of misleading information or other similar manipulative/fraudulent practices.

SEBI was of the view that the journalist misreported the development when, according to it, the merger was not approved, and the matter was still at an early stage. Hence, the reporting was premature and thus misleading and violated the PFUTP Regulations. SEBI initiated proceedings against the journalist (whilst also seeking inputs from the TV channel, the company, its Chairman, etc.).

There were several defences proffered by the journalist. Two were fundamental in law and special for journalists. First, she refused to share the source of her information, claiming this as a privilege of journalists. Secondly, she stated that any action against her for her report would amount to a violation of the fundamental right of freedom of expression under Article 19 of the Constitution of India.

Then, there were some more specific defences in light of the PFUTP Regulations. There was a question on whether the order of the NCLT on that day really amounted to a final verdict on the merger. The order was said to be ‘reserved’ by NCLT. Whether, particularly in light of the other factors in the proceedings before NCLT, issuance of a final order was a matter of formality or whether there was anything substantial still pending. This was more so in light of the fact that the NCLT did issue a formal order approving the merger, albeit several weeks later.

The journalist also pointed out that in her email to the TV channel, she mentioned that the written order was yet to be issued.

SEBI’S REASONING IN DISPOSING OFF THE PROCEEDINGS

SEBI made several points while finding the journalist not guilty.

It noted that the journalist and her family members did not trade in the securities of the listed company in question. Hence, no benefit was obtained from the report, even if one were to assume that the report was substantially incorrect.

SEBI also drew on several Court rulings which had opined that while, as an advisory, Courts would want journalists and media to avoid sensationalizing, they would be “loathe to restrain media”. It cited the decision of the Supreme Court in Rajendran Chingaraveluv. R. K. Mishra, ((2010) 1 SCC 457), where the Hon’ble Court held, “Every journalist/reporter has an overriding duty to the society of educating the masses with fair, accurate, trustworthy and responsible reports relating to reportable events/incidents and above all to the standards of his/her profession. Thus, the temptation to sensationalize should be resisted.”

It was also considered that in the news flashed immediately later by the TV channel, it stated that NCLT was yet to publish the written order.

However, particularly for the purposes of this article, what was most significant was the point made by SEBI on whether there was any intentional misleading by the journalist concerned. Was there any intention to influence investors to trade in a direction that they would not have done but for such news?

SEBI relied on the oft-quoted decision of the Supreme Court in N. Narayanan vs. SEBI [(2013) 12 SCC 152] to reiterate the law on the duty of the print and electronic media in relation to the securities market. The apex Court has stated that – “Print and Electronic Media have also a solemn duty not to mislead the public, who are present and prospective investors, in their forecast on the securities market. Of course, a genuine and honest opinion on market position of a company has to be welcomed. But a media projection on company’s position in the security market with a view to derive a benefit from a position in the securities would amount to market abuse, creating artificiality.” [emphasis supplied].

An earlier case of SAT was also cited where a company’s Chairman was alleged to have made a misleading statement, also on a price-sensitive matter of a possible takeover of another listed company. SEBI levied a significant penalty on the Chairman. SAT overturned the order on facts and reiterated the principle that “…in the absence of any motive or a scheme or any evidence a reported news item alone is not sufficient to prove a serious charge like fraud.

Thus, the litmus test appears to be the intention of the person making the communication. Emphasizing the wording of the Regulations, SEBI concluded in the present case that, to be held guilty of violating the provisions, it would need to be shown that “…that the (journalist) filed the impugned news report with (the channel) with a pre-determined intent to manipulate scrip prices or induce investors”. Thus, an intention had to be shown and that too of manipulating the scrip prices or inducing investors to act. Absent these, the charge of violating the relevant Regulations fails. The journalist was thus held not guilty of violating the provisions.

WIDE SCOPE OF THESE PROVISIONS, PARTICULARLY IN THESE DAYS OF SOCIAL MEDIA

The convenience of social media/internet has made it easy for individuals to present their views, informed or otherwise. For example, Youtube and Twitter have made it easy to share views economically and widely. A flourishing industry of social influencers has formed, including food reviewers, tech reviewers, plain entertainers and, for the purposes of this topic, influencers in the field of investing (finfluencers). Recently, Business Standard reported that SEBI is keeping a watchful eye on this group, and that they may end up being regulated. The concerns with this group are, however, different. Their intention primarily is not to maliciously induce investors to deal in some scrips. They intend to have a large following and ‘views’ (or eyeballs). The more the views, the more their earnings. And to increase the views, many use hyperbole and click-bait and the like or shallow tips for financial analysis that promise high and easy rewards but which often border on recklessness. The scheme of securities laws particularly expects professionally qualified people to be more responsible, and recklessness on their part may be viewed more strictly. SEBI closely regulates registered intermediaries, such as investment advisers, research analysts, etc., and requires them to follow a strict Code of Conduct. However, these groups appear to fall into a grey area in most cases.

There have also been cases where SEBI has found such persons allegedly engaging in acts that could fulfil all the prerequisites laid down earlier. SEBI has, for example, made findings that certain Telegram Channels are engaged in giving ‘tips’ of scrips to induce investors to buy the shares at inflated prices while they offloaded.

In another case, it was alleged that the anchor of a leading financial channel gave recommendations on television but illicitly made personal profits. Given the large viewership and following, his recommendations led to an immediate rise in purchases of such recommended scrips. SEBI alleged that the anchor/his family members had purchased these scrips just before such recommendations and sold them immediately after making the recommendations.

CONCLUSION

SEBI has laid down fairly clear criteria for determining whether or not communications to the public relating to securities violate the PFUTP Regulations, and then it would be a question of applying them in the facts of each case. Having said that, even this may not be the last word. In recent times, the settled rule is that even in cases of alleged fraud or manipulative practices, if the proceedings are civil (and not criminal), the proof required is not strict. The test is of ‘preponderance of probabilities’ and not ‘proof beyond reasonable doubt’ (Supreme Court in SEBI vs. Kishore Ajmera (2016) 196 Comp Cas 181 and SEBI vs. Rakhi Trading (P.) Ltd. (2018) 207 Comp Cas 443). Thus, while the media may still get some extra leeway, the rest may be judged with a more relaxed benchmark.

Supreme Court Holds that Profit Motive Necessary for Charge of Insider Trading – But with Several Nuances and Riders

BACKGROUND
The Supreme Court has recently held that for an insider trading charge to sustain, a profit motive should be established (SEBI vs. Abhijit Rajan, Order dated 19th September, 2022, ((2022) 142 taxmann.com 373)). If it was clear that the trades by an insider, even if in possession of inside information, were clearly to result in losses, at least considering the nature of the information, then the insider trading charge cannot sustain. This makes a material change in the approach to proceedings relating to insider trading. Till now, generally in the framing of the law as well as the approach of SEBI, it was taken for granted that trading by an insider in possession of (or access to) unpublished price sensitive information (UPSI) was ipso facto insider trading, which should result in adverse action such as disgorgement of profits made (or losses avoided), debarment, penalty, etc.

However, as we will see, there are several nuances and riders to this decision as well as further questions that arise in the application of this decision in diverse situations. However, before we go into that, let us consider the broad framework of the regulations relating to insider trading, namely, the SEBI (Prohibition of Insider Trading), Regulations, 2015 (“the Regulations”).

SEBI REGULATIONS RELATING TO INSIDER TRADING
There is a unique feature of these Regulations which makes them stand out as compared to other Regulations. And, that is the endless deeming provisions whereby certain situations are deemed to be true, if certain conditions are satisfied, irrespective of the actual ground reality. In some cases, the deeming fictions merely shifts the onus to the parties, and they can rebut the fiction by presenting the actual facts with evidence. But in other cases, the deeming fictions are carved in law, with no rebuttal possible.

For example, some persons are deemed to be insiders and generally cannot rebut that they are not. However, for example, in the case of relatives of an insider who also are deemed to be insiders, there is a rebuttal possible under certain circumstances. Certain categories of information are deemed to be price sensitive, irrespective of whether they are actually or not (though the decision of the Supreme Court makes certain interesting comments on this, as we will see later herein). Trading by an insider is deemed to be insider trading (again, Supreme Court makes some qualifications to this). Reverse trades by certain insiders are effectively deemed to be insider trading, so much so that they are wholly banned with very few exceptions possible. UPSI can be said to be published only if the dispersal of this information is in the prescribed mode – the fact that, say, it was already widely reported in media will be no defense. Moreover, there is a cooling or assimilation period from the time when the information is published to the time when trading is allowed. In other words, despite modern day instant notifications, etc., the information is deemed to be unpublished till this time passes. And so on.

This puts a person charged with insider trading trapped in a fortress out of which there are few escapes. An insider has to be very careful while trading so that he does not fall into any of these deeming traps of which he cannot come out, despite his best intentions.

Such a fortress of deeming fiction is said to be necessary mainly because insider trading is said to be difficult to detect and prove. The persons who are insiders may generally be at a senior level and often sophisticated white-collar educated persons. They may use many subterfuges, ‘mules’, advanced technologies to communicate the UPSI, etc. This may make the task of SEBI tougher, more so since SEBI has often argued of the inadequate powers it has for investigation. If such mechanisms are not available, every case of insider trading would be mired in litigation since every aspect would become subjective and prone to differing interpretations.

Certain of these deeming fictions came to be questioned in this decision and the Supreme Court appears to have parted ways from giving literal effect to them and has introduced that factors such as the intent of the parties should be considered.

SUMMARISED FACTS OF THE CASE
The person charged of insider trading (“the Insider”) was the Chairman and Managing Director of a listed company, that was engaged in the business of carrying out large construction/turnkey projects. It received a contract for a total cost of Rs. 1,648 crores. Another company received a similar contract but of a lesser size. The two companies formed SPVs and had holdings in each other’s SPVs. For some reason, the companies decided to terminate the SPVs and buy each other out. While this information was not published to the stock exchanges, the Insider sold a significant quantity of shares. The Insider was charged with violation of the Regulations. SEBI held that the information of termination of the agreements and the SPVs were price sensitive information, and thus the trading by the Insider while this information was not published amounted to insider trading. SEBI calculated the loss allegedly avoided due to such a sale and sought to forfeit (disgorge) such amount. There were disputes as to whether the date in respect of which the price was calculated for the determination of such loss was correctly ascertained. The Insider appealed to the Securities Appellate Tribunal (“SAT”), which set aside the order of SEBI. SEBI appealed to the Supreme Court, which upheld the decision of the SAT.

IMPORTANT ISSUES BEFORE THE SUPREME COURT
The Insider made several arguments before the Court, some of which helped in the decision going in his favour.

The Insider pointed out that he was in dire need of funds and that too for saving the company itself from insolvency. There were certain restructuring of the company’s debts going on with its lenders, one of the conditions of which was the infusion of funds by the Promoters. The Insider pointed out that he infused the sale proceeds of the sale of shares in the company to fulfil such obligations. Then he contended that the information was not price sensitive at all since the value of the contracts were miniscule with respect to the turnover of the company, particularly when taken on a net basis. He also questioned the basis of calculation of the losses avoided. SEBI contended that the closing price on the day after the information was released should be taken into account, and since it was lower, there were losses avoided. The Insider, however, stated that since the information was released well before closing on the first day, the closing price on that day should be taken into account, and since that was higher, there were no losses avoided.

Moreover, he pointed out that even if the information was deemed to be price sensitive, it was of a positive nature. Thus, it goes against the logic that he would sell shares on the basis of such information and be charged with insider trading. A person seeking to profit from such positive price sensitive information would buy shares since the price is likely to go up. SEBI contended that the intent of trades cannot matter, it is sufficient if an insider trades while in possession of UPSI.

The Supreme Court accepted that there are certain deeming provisions in the Regulations. However, it noted that while seven categories of information were deemed to be price sensitive, the particular information in question fell in the seventh category. This category specifically stated that the information should relate to “significant changes in policies, plans or operations of the company” (emphasis supplied). The Court noted that while the earlier categories of information (such as those relating to financial results, dividends, etc.) were ordinarily material, in this case, the information has to be significant enough. Hence, any changes are by themselves not necessarily price sensitive. The Supreme Court then analysed the transaction and noted that, on a net basis, the information was actually positive in nature. While other points were also analysed and discussed, the ruling turned on this point.

The Court held that it goes against human nature and logic that a person would sell shares to profit from insider trading when the information was positive in nature which would have resulted in price rise. The Court placed emphasis on the profit motive. A person cannot be charged with insider trading when the transaction was such that there was full absence of the profit motive. The Court factored into account, though clearly mentioning that this was not the deciding factor, that the Insider had carried out such trades to meet his obligations to the lenders to save the company. Thus, the Court ruled that the charge of insider trading failed and the amount disgorged by SEBI should be returned to the Insider.

NUANCES, RIDERS AND CONCERNS
There are several aspects of this case that need examination before a conclusion is drawn about the case. And these do not merely relate to the generic point that the decision should be seen on the facts of the case.

The Court held that this information related to the seventh category of information deemed to be price sensitive. Since this seventh category, as discussed earlier, specifically used the word “significant”, the information would be price sensitive only if significant. However, does it not mean that the earlier six categories of information are always deemed to be price sensitive? The Court made two observations. Firstly, it stated “nothing is required to show that the information listed in Items (i) to (vi)…is likely to materially affect the price of securities of a company”. However, it then said that “the likelihood of the price of securities getting materially affected, is inherent in Items (i) to (vi)..”. Can it be argued that, by the second set of words imply that even in respect of these first six items, the condition of their being price sensitive would have to be independently established? For example, if the financial results show no significant change or if the dividends have not changed materially from earlier periods, etc., can the information relating to such items be still held to be price sensitive?

The next question was when should the information be held to have been published? This is important because as in the present case, the amount of profits made/losses avoided are also determined on the basis of when the information can be held to be known. In the present case, the information was released at 1.05 pm and 2.40 pm respectively on the two exchanges. On that day, the price actually rose by 10 paise, while on the next day the price fell by 30 paise. The importance was obvious that in the first case, the argument was that the information was positive. The Court stated that it did not have to answer the question since it had already held that in the absence of profit motive, the charge of insider trading failed. Interestingly, at another place, the Regulations provide for a cooling period of 48 hours from the time when information was disseminated. Hence, arguably, both stands were incorrect. However, this question is sure to come in some later cases. Then, the fact that information, once released, spreads like wildfire in these days of social media, instant notifications, etc., may be considered by Courts, and perhaps such deemed cooling period of 48 hours may be questioned.

Then there is the question of determination of profits made or losses avoided. SEBI calculates, and this calculation is generally upheld, by taking into account the closing prices after disclosure of the UPSI. However, at the same time, the law provides and SEBI/Appellate Authorities contend that what matters is whether the information was price sensitive. The actual movement in price should not be relevant since the market may be subject to several influences. In view of this, is the calculation of profits with reference to the actual closing price correct? Take the present example. On the first day of disclosure, the price went up by 10 paise. This was found to be consistent with the stand of the Insider, endorsed also by the Court, that the information was positive in nature. However, on the second day, the price fell by 30 paise. This was consistent with SEBI’s stand that the information was negative in nature. In either case, this demonstrates that the use of the closing price is arbitrary and contradictory with the two stands taken. Again, in a future case, this question may be determined and the contradiction resolved.

CONCLUSION
While there are several other issues in this decision, it is fair to state that the Court has found several chinks in the fortress of deeming fiction in the Regulations. On one hand, this will help give justice, as in the present case, where the Insider was sought to be penalized despite his not attempting to profit from the UPSI. On the other hand, this will significantly reduce the relative certainty of such cases. SEBI will have more hoops to cross, and there will be more areas of litigation possible. Now it will be up to SEBI to pursue cases judiciously and not seek to enforce every deeming fiction and put the party – and SEBI itself – in much trouble and costs.

Social Stock Exchange – A Marketplace for Philanthropy finally in place with a few final touches remaining

BACKGROUND
Through a set of amendments to various SEBI Regulations made on 25th July, 2022 followed by a detailed circular dated 19th September, 2022 of SEBI laying down further details, the basic framework of the Social Stock Exchange (“SSE”) is finally in place. This will enable a whole ecosystem/marketplace where the donors and investors having an objective of social benefit will be able to find suitable organizations engaged in the type of social work they are interested in. On the other side, such social organizations (or ‘Social Enterprises’ or SEs, as the SEBI regulations term them) will also be able to find donors and investors.

There are several final touches still remaining, though. The stock exchanges hosting the SSE will need to lay down several requirements, such as information required in offer documents, etc. The framework for Social Auditors and accounting by SEs almost wholly remains to be set up. Then, there are other things, such as tax rebates, CSR-related amendments, etc., that are desirable and would give a boost to this exchange and will need to be considered by lawmakers and other regulators.

Let us, however, first review the concept of SSE, earlier discussed in this feature (July, 2020 BCAJ) when the initial developments took place. Now, that the formal amendments have taken place and the basic legal framework established, the subject is worth reviewing in more detail.


WHAT IS A SOCIAL STOCK EXCHANGE (SSE)?
To simplify a little, SSE is a marketplace for philanthropy regulated by SEBI and exchanges expected to keep a watchful eye on their functioning. It is a matchmaking place of investors/donors and organizations carrying on recognized socially beneficial activities. A framework for sharing information – one-time and regular – by SEs is laid down. A system to raise funds, particularly by innovative investment methods and even simple grants, has been set up.

Let us consider a basic example to understand this. There may be, say, a social organization, such as a school for mentally challenged students. In present times, such a school would have to struggle to seek donors through contacts of its trustees, past students, etc. The scope of raising funds, particularly for expansion, would thus be limited. However, it could register at the SSE and follow its guidelines and requirements. Then, the background, objects and achievements of the school can be shared with a wider audience through the exchange. Funds can be raised not only through social venture funds but also from the general public through an offer document, unlike a public issue of shares. Funds can also be raised through various instruments and modes suiting the differing requirements of SEs and donors/investors. There would be transparency and disclosure, ensuring regular information sharing. Such an information would be audited by the regular financial auditors as well as a new group of auditors called Social Auditors who would mainly check and confirm the correctness of information about social impact parameters disclosed.

Only SEs fulfilling certain qualifying requirements would be permitted to register themselves on SSEs and raise funds.

SSE is proposed to be a segment of stock exchanges with nationwide terminals. These stock exchanges need to lay down several supplementary and general requirements for the SEs, apart from requirements laid down by SEBI.

WORKING GROUP REPORTS OF SEBI
To study and recommend the formation of SSEs, SEBI set up expert working groups who, from time to time, have provided their reports. The Working Group, chaired by Ishaat Hussain, presented its report in June 2020 and made detailed recommendations on the structure and policies relating to SSEs. It also made recommendations on the legal changes required to enable the success of SSEs, which included changes to tax and company law (particularly those relating to corporate social responsibility).

The Technical Group then took the matter further and gave even more detailed recommendations on disclosure norms, setting up the other ecosystem components including Social Auditors, etc. Their report was submitted in May 2021.

These were considered and adopted by SEBI, and it was decided to go forward with amendments to the law under the purview of SEBI.


AMENDMENTS TO SEBI REGULATIONS
To set up the framework of SSEs, enable the SEs to register on the SSEs, and/or issue securities/raise funds, lay down various disclosure and other requirements, etc., SEBI made changes in relevant regulations on 25th July, 2022. The following regulations were amended:

a.    SEBI (Alternative Investment Funds) Regulations, 2012.

b.    SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.

c.    SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.

The principal amendments made relate to the following areas in the respective regulations.

SEBI (AIF) REGULATIONS
These Regulations govern the registration of various investment funds other than mutual funds. The existing ‘social venture funds’ have been renamed ‘social impact funds’ (SIFs) to represent the revised objective of such funds having a social impact. Such SIFs can issue Social Units which shall carry only ‘social returns or benefits’ and no financial returns for their investments. The minimum amount of corpus of schemes of such SIFs has been kept at Rs. 5 crores. Further, if the SIF invests only in securities of not-for-profit organizations registered or listed on SSEs, the minimum amount of investment by an individual investor in such a SIF is kept at Rs. 2 lakhs.


SEBI (ICDR) REGULATIONS
Definitions of, and requirements for ‘For Profit’ and ‘Not-for-Profit Organizations’ have been laid down. These have to be Social Enterprises (SEs). Also, specific requirements have been laid down for the SEs to qualify as such. These SEs should establish the primacy of their intent that has to be one or more of various social activities as specified. The SEs should also target those underserved or less privileged popular segments or regions that record lower performance in the development priorities of central or state governments. Even more specifically, the importance of such social intent would be demonstrated when the SEs meet one or more of the minimum quantified levels in terms of revenues, expenditure and target population. The minimum percentage specified for this purpose is 67 per cent.

Corporate foundations, political or religious organizations or activities, professional or trade associations, and infrastructure and housing companies (except affordable housing) are disqualified explicitly from being identified as SEs.

NPOs that are SEs need to be registered with an SSE. For this, they need to comply with various disclosure and other requirements. Such a registered SSE may then raise funds by multiple means including Zero Coupon Zero Principal Instruments (ZCZP), donations, etc. For Profit SEs may issue equity, debt, etc. in a regular manner.

SEs whose promoters, trustees, etc. face certain disqualifications such as being debarred by SEBI from accessing the capital markets, are willful defaulters, etc. and ineligible to register on SSE.

The amendments also provide for the manner and details of offer documents for raising funds.

Importantly, Social Auditors have been defined as individuals registered with a self-regulatory organization under the Institute of Chartered Accountants of India or other agency as specified by SEBI, and those qualified under a certification program conducted by the National Institute of Securities Markets. Social Audit Firms are entities that employ duly qualified Social Auditors and have a track record of conducting social impact assessment for at least three years.


WHAT ARE ZCZPs?
Not-for-profit organizations that are SEs are permitted to raise funds through Zero Coupon Zero Principal Instruments (ZCZP). The primary feature of this instrument is that there will be zero returns and even the principal will not be repaid. Effectively, thus, this is akin to a donation. However, the additional feature of ZCZPs is that they can be potentially traded. ‘Investors’ can thus transfer the instrument to someone interested in taking over at some stage. There may be interest in the ZCZP if the SE has performed its obligations well, and hence there is assurance that the donation may be well utilized.

SEBI CIRCULAR LAYING DOWN FURTHER DETAILS OF THE FRAMEWORK OF SSEs

SEBI vide Circular dated 19th September, 2022 has laid down several requirements and details related to the working of the SSE and related matters.

It has laid down the conditions under which a Non-Profit Organization (NPOs) can qualify for registration with an SSE. The requirements include having registration under the Income-tax Act, 1961, a minimum annual spending and funding, minimum age of the NPO, etc.

Disclosure requirements in the offer document by NPOs for issuing ZCZPs have been laid down. SEBI has laid down the minimum requirements, while the SSEs can require additional information to be given in such a document.

Annual reporting by NPOs registered with SSEs, who may also have raised funds through the SSE, has been prescribed. Such NPOs are also required to provide duly audited Annual Impact Reports.

The Circular notes that the Institute of Chartered Accountants of India is publishing a uniform accounting and reporting framework for NGOs. Till this is done, certain minimum disclosures have been prescribed.

CONCLUSION AND WAY FORWARD

While SEBI has largely completed its preliminary role in this regard, much of the remaining work is in progress. Stock Exchanges have much work to do, which SEBI has laid down for them in the Regulations/Circular. The profession of Social Auditors, too, will take time building up. ICAI has also its role cut out in terms of accounting and auditing requirements for SEs, particularly for Social Auditors. There are several more recommendations in the working group reports that have to be gradually implemented.

Apart from this, the government will also have to play a role in boosting this sector. Amendments to tax law would have to be made to provide tax rebates to investors and SEs in respect of several matters. Considering that corporates can play a significant role through the funds allocated for CSR purposes, amendments and clarifications would be needed, particularly with regards to investments/donations made to SEs.

While, as the reports of the working group note, other countries have also taken actions on these lines. However, the recommendations of the working group are far more holistic and ambitious. It is quite possible that in the near future, SSEs may become a vibrant and thriving marketplace for philanthropy. The result would only be more funds for socially valuable activities, better managed SEs and greater faith by donors in SEs, all of which can only spiral upwards in a virtuous cycle.

Insider Trading Regulations for Mutual Funds – SEBI Issues Draft Consultation Paper

BACKGROUND
SEBI released, on 8th July 2022, a consultation paper (“the Paper”) for provision for prohibition of Insider Trading in mutual funds. It may be recollected that the current regulations related to Insider Trading, (the SEBI (Prohibition of Insider Trading) Regulations, 2015, or “Insider Trading Regulations”) specifically state that they do not apply to mutual fund units. SEBI pointed out in the paper recently, two serious cases of alleged abuse by insiders of unpublished price sensitive information. Both included cases of redemption of units by insiders while having access to unpublished material information which allegedly helped them gain while the general public investors suffered. While the said persons acted against the SEBI rules under other generic provisions, there was clearly a void in terms of having specific provisions for insider trading in mutual funds.

Mutual funds have, as per Association of Mutual Funds of India, assets under management of – over Rs. 35 trillion. The stakes are clearly high and abuse of price sensitive information by trusted insiders could be of large amounts, as shown by the orders referred to (though not named) in the paper. Having a comprehensive set of regulations on insider trading for mutual funds thus was clearly overdue. SEBI thus took a quick step by issuing this Paper, that suggests detailed provisions for insider trading in mutual fund units, besides giving the draft wording of the new provisions as proposed.

A review of the proposed provisions can be made at this stage. A more detailed analysis of the notified regulations can be carried out once they are released.

BROAD FRAMEWORK OF THE PROPOSED REGULATIONS

SEBI does not propose to introduce separate insider trading regulations for mutual funds. Instead, it proposes to incorporate separate chapters in the existing Insider Trading Regulations for mutual fund units. Certain existing provisions have also been modified for this purpose.

The scheme of the proposed regulations, however, is broadly the same. There are similar definitions of an insider, connected persons, unpublished price sensitive information (UPSI), Code of Conduct, etc. These have been adapted to a significant extent to the unique features of mutual fund units. The offence of insider trading is on similar lines. The Code of Conduct for dealing in securities would also be laid down for mutual fund units. Even the concept of Trading Plan would be adopted and applied to mutual fund units.

Thus, the time tested, repeatedly amended current regulations and their framework is sought to be applied for mutual fund units. That can be good but also, in some ways, a bad thing, as later discussed herein.

It may be added here that, insider trading regulations for mutual fund units are not entirely new. There have been circulars/guidelines covering the subject in different ways that have been frequently amended over the years. But, clearly, these circulars/guidelines have relatively lesser legal standing as compared to the Regulations. Further, they are not as comprehensive. Now, as a part of the Regulations, they are intended to be comprehensive and carry the full force of the Regulations, thus inviting punitive/adverse actions as the consequences of their violations.

IMPORTANT FEATURES OF THE PROPOSED REGULATIONS FOR MUTUAL FUND UNITS

To begin with, the definition of ‘securities’ would be amended. Earlier, it specifically excluded mutual fund units. Now this exclusion would be omitted.

The definition of trading in securities would be amended to also include redeeming, switching, etc of securities. This would be in addition to the already existing activities of subscribing, buying, selling, etc. of securities. The new definition may sound like a hotch-potch since different concepts are mixed. Redemption and switching are unique features of mutual fund units, and hence sound out of place with other terms such as buying, etc. which are general for all types of securities.

The concept of ‘insider’, however, is defined separately for mutual fund units. It includes a connected person, and a person in possession of UPSI.

Similarly, the definition of ‘connected person’ is separately made for mutual fund units and rightly so. Apart from those who generally are accepted to have access to UPSI, a list of persons deemed to be connected has been provided that includes persons whose connection is unique to this industry.

The term UPSI is also separately defined to include several items of information. These items are considered unique to this industry. For example, it was found recently, that restrictions on redemption of securities created serious inconvenience and uncertainty amongst unit holders of a fund. It was also alleged and found that certain insiders had redeemed before such restrictions were announced. Information regarding restrictions on redemption or winding up of schemes is thus deemed to be UPSI.

Trading in securities (which now include mutual fund units) would be a contravention. So would be sharing or procuring of UPSI, except for specified ‘legitimate’ purposes.

Then, a unique feature related to sharing of UPSI is sought to be created for mutual fund units. A critical aspect of insider trading regulations is, when can unpublished price-sensitive information said to have become published? What are the acceptable modes of publishing UPSI to make this information available to the public. One acceptable means is to share information through the stock exchanges. However, this makes sense for listed entities. It is seen that almost 98% of the mutual fund units, as this Paper too emphasises, are unlisted. Hence, sharing of UPSI on exchanges would not help in achieving the objective of reaching the intended public. SEBI therefore proposes that a separate and independent platform be created under the aegis of AMFI or collectively owned by asset management companies, etc. The UPSI could be shared here, and since such an independent platform would be able to reach the mutual fund unit holders and prospective holders/public generally, it could prove to be a better mode and alternative.

The ‘Code of Conduct’ for trading in securities by designated persons is broadly in line with the existing Code for other securities. Similarly, the coverage of ‘fiduciaries’ for making a Code is also similar with audit firms, accountancy firms, valuers, law firms, etc. being specifically included under this category.

CONCERNS

The primary concern is that, using a time-tested existing framework for insider trading can also, unfortunately, be a disadvantage since the existing framework was tailored for a different form of security. Undoubtedly, SEBI also may have wanted to move speedily since not only have skeletons been tumbling out of the closet, but the further litigation against the orders have also showed, the existing framework was neither specific nor comprehensive. Also, abuse of price sensitive information as a concept has not changed, and continues to apply as much to mutual fund units. However, there are several reasons to argue that SEBI could have taken a wholly fresh look from the ground up. Mutual fund units have several fundamental differences. These units are held in investment vehicles, and not in businesses as generally known. The primary information of schemes such as NAVs, portfolios, etc. is already fairly transparent in view of existing requirements to share such information regularly. In comparison, traditional businesses that regularly generate material/price sensitive information, offer a different scope for abuse despite listed entities being bound to disclose several categories of material information promptly.

The existing insider trading regulations have been drafted and repeatedly amended on recommendations by Expert Committees. In comparison, the present draft regulations appear to have been prepared internally, thus missing out on the benefits of deliberations and close study carried out by an Expert Committee.

It is submitted that even otherwise, mutual fund units have a different structure and are subject to abuse in a different manner. As earlier SEBI circulars themselves state, investments that a fund makes for itself can be subject to abuse of at least two kinds. First includes, using such information for making one’s own investments. The second and far more serious is front running, which too has been repeatedly caught though a valid fear may be that it may be far more rampant than even the large number of cases caught. Sadly, the serious offence of front running is covered in a small sub-clause of a different regulation that aims to cover all forms of front running. Thus, a separate set of Regulations specifically for malpractices in mutual funds covering insider trading, front running, etc. could have been the better alternative.

One hopes then, that, while SEBI notifies, after taking due feedback, the amendments, it also sets up an Expert Committee to holistically look at this field and puts into place a comprehensive set of regulations separately for mutual funds which factor in the unique circumstances of this industry.

WHETHER INSIDER TRADING WOULD BE SUBJECT TO SIGNIFICANT PENALTY? – A MAJOR LACUNA?

This apparent lacuna deserves a separate part to highlight it in more detail. Presently, SEBI notifies Regulations (subject to, of course, review by Parliament), and hence can draft and cover the subject comprehensively as an expert and specialised body. However, a penalty is levied under the Act made by the Parliament. The SEBI Act was drafted 30 years back, albeit frequently amended. Notably, Section 15G which governs penalty for insider trading, has remained unchanged since its inception, as far as the present issue is concerned. It primarily governs insider trading only in “securities of body corporate listed on any stock exchange’’. This squarely excludes most, if not all, mutual fund units.

This special section levies a stiff penalty of a minimum of Rs. 10 lakhs and a maximum of Rs. 25 crores or three times the gains made, whichever is higher.

Prima facie, this section may not apply to unlisted mutual fund units. Would this mean that the penalty then would be leviable only under the residuary clause which is limited in nature?

Granted, it is the Parliament that has power to amend the Act. But without a parallel amendment, would the new regulations be largely toothless?

CONCLUSION

Better late than never and better something than nothing can be the two adages that one could apply to the proposed regulations. It is high time this mammoth industry is subjected to strict regulations. But at the same time, Mutual funds represent a different framework that deserve a tailor made approach. As readers know, they are used more by persons seeking relatively secure returns, and having a different frame of mind than investors in equity shares. Further, even the existing insider trading regulations have seen that adverse orders for violations have often been set aside in appeal. Hence, all the more, the regulations for mutual funds need to be framed with a fresh outlook and by an expert committee consisting of members knowing the industry well. One hopes, that these regulations will see this very soon. Nonetheless, it is good news that the evil of insider trading will soon be subject to regulation and punishment.

Controversy on What is ‘Control’ Set at Rest

BACKGROUND
An oft-litigated issue has been – when can a person be said to be in ‘control’ of a company? This is relevant not just in securities laws but to several other laws including the Insolvency and Bankruptcy Code, the Companies Act, 2013, Insurance law, Competition law, etc. The definition of ‘control’ under the SEBI Takeover Regulations, the Companies Act, 2013 and the IBC is on the same lines. Acquiring control of a company or even being in control has significant consequences. However, the definition of ‘control’ is very widely worded and has left doubts on how it would apply to facts. Thus, there has been uncertainty and hence litigation. As we will see later, SEBI did propose to make the definition more specific but later backtracked. Indeed, though a 12-year-old decision of SAT (Subhkam Ventures (I) P. Ltd. vs. (2010) 99 SCL 159 (SAT) – ‘Subhkam’) gave fairly clear guidelines and principles on how this definition of ‘control’ should apply. The matter was appealed before the Supreme Court. But since the matter got resolved on other grounds, the Supreme Court consciously refrained from commenting on the merits and stated that its decision should not be taken as a precedent over the issue. This was interpreted particularly by SEBI as leaving the matter open putting even the SAT decision as without having any finality. The uncertainty then continued.

A recent decision of the Securities Appellate Tribunal (SAT) (Vishvapradhan Commercial (P.) Ltd. vs. SEBI (2022) 140 taxmann.com 498 (SAT) – ‘Vishvapradhan’) has finally given some semblance of finality. This has happened because the Supreme Court in 2018 approved the Subhkam decision which elaborated the matter even further. However, this ruling was under the IBC and thus a level of uncertainty continued. Now, the latest Vishvapradhan SAT ruling has affirmed that the Supreme Court decision indeed applies even to securities laws. This gives one strong reason to hope that this matter is finally settled for good. Let us go into more details about the issues involved.

DEFINITION OF ‘CONTROL’ UNDER THE SEBI TAKEOVER REGULATIONS

The controversy rages around the definition of ‘control’ under these Regulations, which, incidentally, is more or less identical to that under the Companies Act, 2013, and which definition also applies to IBC. It reads as under (Regulation 2(1)(e) excluding the proviso, which is not of concern here):

(e)  “control” includes the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner:

The definition is an inclusive one and widely framed. Control may arise through a majority holding of equity, where the holding of the whole group is counted. Or it may be through agreements or in any other manner. The parts which have faced difficulty in interpretation relate to what amounts to control of management or policy decisions. Particularly here, the question is what the border lines are, if at all such lines could be defined, which would separate a situation where there exists control from one where it does not. This is particularly so when certain rights are given to certain investors holding a significant quantity of shares. These rights so granted may include the right to appoint a director or two, the right to veto certain significant decisions proposed to be taken by the company, etc. The question is whether such rights to participate in the management amounts to ‘control’?

IMPLICATIONS OF ACQUIRING/HOLDING ‘CONTROL’

If a person acquires control, he would be required to make an open offer under the Takeover Regulations which would have significant financial implications for the acquirer and possibly the benefit of a higher offer price to the selling shareholders. Such a person may also be classified as a promoter with various resultant implications. If one has control over certain specified companies that have defaulted on their debts, eligibility to participate in resolutions of companies under insolvency would be lost.

It is not surprising then that SEBI and other regulators are also vigilant on whether control is acquired. Investors who desire to obtain participation rights are also wary of whether having such rights would result in their being held to have acquired control.

THE SUBHKAM DECISION

In this decision, the SAT examined the issue in detail. The issue in question was, as described earlier, about an investor in a listed company which acquired certain participation rights in it. The question was whether this amounted to an acquisition of control. SEBI held that it did so amount to acquisition of control and required the investor to make an open offer. SAT reversed the order and used the analogy and metaphor of driving a car. It said that the crucial question was who was in the driving seat? Taking the metaphor further, it asked whether this would mean determining whether such a person had control not just of the steering wheel, but also the accelerator, the gears and the brakes. Or to put it more succinctly, the test was whether the person had proactive rights or reactive rights.

Acquiring of participation at best amounted to the occasional use of the brakes and occasionally (to extend the metaphor even further) giving driving instructions. It found that, on the facts of that case, the investor was not at all in the driver’s seat. Importantly, he could not initiate and implement any of the major decisions where it had veto rights. The definition of ‘control’ itself refers to having a right to appoint the majority of the directors and, by implications, it is submitted, having a right to appoint one or two directors who would be in the minority would not by itself amount to having control.

APPEAL TO SUPREME COURT AGAINST THE SUBHKAM DECISION

SEBI appealed to the Supreme Court but in the intervening period, certain events took place whereby the issue was rendered more or less infructuous. Thus, the Supreme Court did not have to decide on the issue and hence the matter was disposed of with a clarification that its decision did not amount to a precedent on the matter. While it did not set aside the SAT order either, undue emphasis or perhaps even an incorrect interpretation was being taken that the order of SAT too should not have any standing.

SEBI’S PROPOSAL TO LAY DOWN CERTAIN BRIGHT-LINE TESTS OF CONTROL

On 14th March, 2016, SEBI released a ‘consultation paper’ on the issue and particularly referring to the Subhkam decision, which considered whether certain specific bright-line tests could be laid down to help decide whether a person can be said to have or not have ‘control’. This, SEBI felt, would result in the definition being more specific. However, on receiving responses, SEBI decided that the definition did not need any change and dropped the proposal. It is submitted that this should have closed the matter, at least as far as SEBI is concerned. It, as we will see below, did not.

SUPREME COURT DECISION IN ARCELORMITTAL’S CASE

This decision (ArcelorMittal India (P.) Ltd. vs. Satish Kumar Gupta ((2018) 150 SCL 354 (SC)) was under the Insolvency and Bankruptcy Code, 2016 (IBC). The matter and issues thereunder were several and complex. But essentially, the question was the same – under what circumstances would a person (or group of persons) can be said to have control over a company? The implications, as mentioned earlier, of being held to have control were significant and serious – a person would be disqualified from offering a resolution plan.

The Supreme Court cited the Subhkam decision and held that the observations made therein on what amounts to having ‘control’ were apposite. The Court even went further and elaborated on the question but essentially, the principles laid down in Subhkam were approved.

THE SAT DECISION IN VISHVAPRADHAN

Most recently, in Vishvapradhan, SAT had the occasion to examine a similar question on whether such participative rights amount to control. Again, in this case, there were others too but the question that is relevant for this article was whether, on account of having certain participative rights, an investor can be said to have acquired control. SAT examined in great detail the exact rights that the investor had. It also considered the Subhkam decision and the Supreme Court decision in ArcelorMittal. SEBI clutched at several straws of arguments. It argued that the Subhkam decision did not, particularly in light of the Supreme Court observations on appeal, have any standing. It also argued that the ArcelorMittal case was under the IBC. It even argued that the Supreme Court decision in Subhkam was given by three judges while the ArcelorMittal ruling was by two judges.

The SAT rejected all these arguments. It affirmed that ArcelorMittal endorsed the Subhkam ruling, and the principles would need to be applied to the present case too. Accordingly, it held that acquisition of such participating rights did not amount to acquisition of control.

CONCLUSION AND THE WAY FORWARD

Arguably, then, it can be said that a level of certainty has finally prevailed on the control issue. And this extends to several laws where the definition is on similar lines. However, importantly, there is clarity on principles which then would have to be applied to the facts of an individual case. It is possible that in a given case, the rights may be such that the acquirer may be held to proactively have control. Thus, care would need to be taken in structuring such arrangements and it is likely that some cases may still see litigation. However, the clarity of the guidelines and the principles laid down to determine the issue should help SEBI and even the Appellate Authorities arrive at a conclusion.

It may not be out of place to mention that there are likely to be further developments on the matter. SEBI is actively exploring reforming the concept of ‘promoters’ and prefers to define and apply the term ‘person-in-control’. This is particularly in light of changing shareholding patterns. SEBI had issued a consultation paper on 11th May, 2021 on the subject and it is possible that it may implement the proposal at least in parts, though to implement the whole of it would require amendment of other statutes too falling under the purview of other regulators/Parliament. But it is submitted that the legal developments discussed here would actually help in the changed scenario too, perhaps even more so.

THE WIDE NET CAST BY THE STRINGENT ANTI-MONEY LAUNDERING LAW – COVERS CORPORATE FRAUDS AND SECURITIES LAWS VIOLATIONS

BACKGROUND
Hardly a week (or less) goes by when we read/hear news about cases being launched under the Prevention of Money-Laundering Act, 2002 (“the Act”) on company promoters/executives, politicians, celebrities, apart from various other groups. Arrests often accompany these. The dreaded Enforcement Directorate (ED) is seen as the lead organisation carrying out such action. This may rightly be seen as strange. It may appear that serious crimes that were seen to be covered by this Act may have been happening regularly, and this does not match with one’s understanding of events generally or even in the specific case if one reads the news report in detail.

More particularly, in the context of the topic of this feature, the situation sounds very surprising since action under this Act is taken for insider trading, stock market price manipulation, corporate frauds, etc. This is in parallel and in addition to the action that SEBI may have initiated.

As one would remember, and this is written right in the preamble of this Act, this law has been enacted pursuant to the fact that our country is part of the UN Political Declaration on this matter. Furthermore, the core focus of this declaration is use of anti-money laundering laws to tackle drug trafficking. This has been extended to money laundering relating to terrorism, armed action against the state and similar very serious and heinous acts. Considering the seriousness of the crime, the powers given to the authorities, as we will see in more detail later herein, are also wide and even peremptory. The punishment is also very severe. The question is whether such powers and punishment should be applied even to relatively far less severe crimes. And more so when there are already provisions in law to punish such crimes. More focus has been made herein on violations of securities laws and corporate laws.

SCHEME OF THE ACT
While a detailed analysis of this law and its background is beyond the scope of this feature, an overview of some relevant provisions is given herein to see the implications to violations of securities laws and corporate laws.

The preamble, as stated earlier, states that the law has been enacted pursuant to the Political Declarations of UN of 1990 and 1998 to the member states. There are several definitions, but the most relevant for this discussion are two. The definition of “scheduled offences” refers to the various offences listed in the Schedule to the Act. The Schedule consists of 3 Parts (A-C), and it is specified that in respect of offences listed in Part B, which consists only of certain offences under the Customs Act, the Act would apply only if the total value involved in such offence is Rs. 1 crore or more. By implication, all the remaining offences do not have any minimum amount for the law to apply.

Then comes the more substantial definition which is “proceeds of crime”. The definition is fairly elaborate but in substance, it covers those properties derived from the scheduled offences or the value of such property. Properties derived even from criminal activities relatable to the scheduled offences are also covered.
 
Section 3 defines what constitutes the offence of money laundering. The section is very widely worded. It covers any activity related to the proceeds of crime and includes its “concealment, possession, acquisition or use and projecting or claiming it as untainted property”. Every person involved in any such activity relating to the proceeds of crime is deemed to have committed the offence of money laundering. While we will not go into more details, suffice here to emphasise that it is very widely worded. To repeat, mere possession of proceeds of crime, is deemed to be money laundering.

Section 4 delves on punishment for money laundering, which is minimum of three years of rigorous imprisonment and can extend to seven/ten years. A fine is also leviable. Note that there are no provisions for the compounding of the offence. No minimum amount needs to be involved (except for the lone exception of specified offences under the Customs Act) for the punishment to be attracted.

There are detailed provisions for attachment, retention and confiscation of the property involved in money laundering.

Then there are provisions on how the guilt of money laundering is determined. There is certain presumption made with respect to records or property found during a survey or a search. There is a presumption that the proceeds of crime are involved in money laundering. The conditions of grant of bail after arrest are stricter than otherwise. It is clarified that “the officers authorised under this Act are empowered to arrest an accused without warrant” subject to the satisfaction of specified conditions.

Finally, the non-obstante provision in Section 71 says that the Act will have effect notwithstanding anything inconsistent contained in any other law.

The above overview should be sufficient to indicate that wide powers are given to authorities, that the crimes are defined widely, that there is almost a ‘presumed guilty’ unless proven innocent stance in the law, and finally, the punishment is very stringent and unforgiving.

Now let us see what are the scheduled offences, i.e. the offences in respect of which properties are derived from are deemed to be “proceeds of crime” and the money laundering in respect of which is then punishable under law. While the Schedule is very long, the focus here is on offences under securities laws and certain corporate laws.

SCHEDULED OFFENCES
The Schedule to the Act lists down, in three parts, the offences that are deemed to be scheduled offences. To reiterate, the properties derived from such offences are deemed to be proceeds of crime. Money laundering, which includes mere possession apart from concealment and even use, would be in respect of such proceeds of crime. For example, paragraph 2 of Part A deals with various offences under the Narcotic Drugs and Psychotropic Substances Act, 1985. The property derived from such offences would be proceeds of crime, and their concealment, use, possession, etc., are treated as money laundering and punishable under the Act.

The Schedule contains many other offences. There are offences relating to terrorism and also under the Arms Act. Several offences under the Indian Penal Code are covered. But many relatively lesser serious crimes are covered, such as those under the Wild Life (Protection) Act, Prevention of Corruption Act, Trademarks Act, etc.

However, let us specifically reproduce those offences under the securities/corporate laws, which we can focus on in a little more detail. These are as follows:

1. Section 447 of the Companies Act, 2013 dealing with frauds.

2. Section 12A (r.w.s. 24) of the Securities and Exchange Board of India Act, 1992, dealing with manipulative and deceptive devices, insider trading and substantial acquisition of securities and control.

While it may appear that only two offences are covered, a closer look at the provisions shows that the list of acts contained in these provisions may be much wider.

Section 447 deals with acts of various kinds in relation to a company that are deemed to be fraud and that, provided that the fraud is of at least a minimum amount, are severely punishable. This provision is wide enough. But it is also seen that several other provisions of the Companies Act, 2013 deem certain other acts to be fraud for the purposes of Section 447. Furnishing of false or incorrect particulars or suppression of material information in relation to the registration of a company is liable for action u/s 447. Misstatements of the specified kind in a prospectus, Section 34 states, is liable for action u/s 447. Then there are Section 448 false statements, etc. in returns, reports, certificates, etc., under the Act or rules made thereunder are liable for punishment u/s 447. There are several such other provisions. There could be two views on whether these other provisions which make respective acts/omissions liable u/s 447 can be deemed to be also offences u/s 447 and hence become a scheduled offence for the purposes of the Act on money laundering.

But Section 12A of the SEBI Act lists several acts in the section itself. Various forms of manipulative and fraudulent acts, insider trading, etc., are covered. Section 12A(a) states that the various manipulative and other acts that are in contravention of the Act or even the ‘rules or the regulations made there under’ are covered. The regulations contain offences of a very wide range. Similar is the case of insider trading. These regulations could apply not just to listed companies and intermediaries but practically every person associated with the capital market.

What is more interesting is that the acquisition of control or securities more than the specified percentage of equity share capital are also covered. The SEBI (SAST) Regulations specify various percentage which include 2%, 5%, 25%, etc.

Thus, a wide range of corporate and securities law violations are covered. Dealing with the proceeds of crime from such violations would amount to money laundering and would result in the heavy hand of the law coming down on them. Now let us consider how these provisions could apply to such offences under securities/corporate laws.

APPLICATION TO SECURITIES/CORPORATE LAWS AND CONCERNS
As discussed, a wide variety of violations under the SEBI Act and the Companies Act, 2013 have been included as scheduled offences. Some questions and concerns arise as to their application.

The punishment under the Act would be over and above the penal action under the respective SEBI Act and the Companies Act. For example, a fraud u/s 447 would be punished (and quite severely at that) under that section as also under the Act. This also applies to all the other violations.

A question may arise whether this amounts to punishing the same offence twice? As a matter of principle, it is not. For example, insider trading is a contravention under the SEBI Act read with the relevant SEBI Regulations. However, when it comes to money laundering, it is about the act of concealment of the property, projecting or claiming the property as untainted, etc. So, strictly viewed, these are two different offences. However, in reality, the line is very thin and perhaps non-existent under most circumstances.

Take an example of an inside trader. Mr. A, using unpublished price-sensitive information (UPSI), deals in securities and makes profits of, say, Rs. 10 lakhs. This makes him liable for penal and other actions under the SEBI Act, which action may include disgorgement of the profits made, penalty, debarment and even prosecution. However, the Rs. 10 lakhs profits are also the proceeds of crime. And owing to the wide wording of the offence of money laundering, mere fact of possessing such profits, without doing anything further would make him liable under the Act. Even its use is deemed to be money laundering.

The same concern arises in the case of, say, price manipulation and making profits therefrom. SEBI would act against such persons in various ways, but the mere fact of possessing or using such profits makes him liable under the Act too.

Curiously, acquisition of shares beyond specified limits and acquisition of control of a listed company is also a scheduled offence. It is often difficult to ascertain the gains, if any, on the acquisition of shares beyond specified limits. In case of acquisition of control or takeover, the person who violates the requirement of open offer avoids acquiring the specified percentage of shares at the specified price, and hence there is ostensible gain.

The question still remains. When the person is already punished for committing the original offence, should the same be also punished under the Act? This question indeed applies to the numerous other scheduled offences, which too are relatively of lesser seriousness than, say, drug trafficking and terrorism.

Arguably, the intention of the law against money laundering is to ‘follow the money’ and punish those who hide proceeds of crime or convert them into untainted money and those who help them in the process. But the fact the definition of money laundering is widely worded, the fact that the scheduled offences now cover a wide variety of violations and also the fact that the authorities are given very wide powers, and punishment is very serious, makes the law near draconian, it is submitted. Such a fear factor can only inhibit business activity. Also, the authority’s resources get diluted and spread over instead of focussing on very serious crimes. It is time that the law is taken a close second look and rewritten.

SUPREME COURT ON PLEDGE OF DEMATERIALIZED SHARES

BACKGROUND
Recently, on 12th May 2022, the Supreme Court of India, gave a detailed judgement on issues relating to the pledge of dematerialized shares and its invocation. Apart from minutely going into the process of the pledge of shares in such form, and making certain rulings on it, it also highlighted that dematerialized shares (“demat shares”) have raised several other issues which SEBI and other regulators will need to clarify or regulate. These include issues of accounting, taxation, Takeover Regulations, etc. Importantly, the Court has taken a harmonious view of the Indian Contract Act, 1872, and the Depositories Act/ Regulations and, for this purpose, overrules certain decisions of the High Court. This decision is in the case of PTC India Financial Services Limited vs. Venkateswarlu Kari & Another ((2022) 138 taxmann.com 248 (SC)).

PECULIARITIES OF PLEDGE OF DEMAT SHARES AND ISSUES THE NEW FORMAT AND PROCESS RAISE
Barring very few exceptions, shares (and even other securities) of listed companies (and even some unlisted companies) are held in dematerialized form. A pledge of such shares is quite common and carried out by many shareholders. In the simplest form of a pledge, a shareholder may want to borrow monies against such shares and would thus pledge them to the lender. Promoters typically pledge their shares for borrowings by the listed company they have promoted or even for their own borrowings. When shares were in paper form, the pledge could be carried out in different ways with each having their own implications. However, the process of pledge of dematerialized shares has its own benefits and challenges.

Briefly stated, the Depositories Act/Regulations provide for a specific procedure in which the pledge (or hypothecation) needs to be carried out. The shareholder intimates the depository participant (“the DP”) of his desire to create a pledge in favour of the pledgee. The depository participant then records the pledge and intimates the pledgor and the pledgee.

If the purpose for which the pledge was created is satisfied, the record of the pledge can be removed with the concurrence of the pledgee. If, however, the pledge is required to be invoked (say, due to default in repayment of the loan), the pledgee intimates the DP who then transfers the shares in the name of the pledgee after, of course, removing the record of the pledge. The pledgee is then free to sell the shares or transfer the shares back to the pledgor in case he complies with the purpose for which the pledge was carried out (e.g., typically by repaying the loan with interest and other charges as per the terms of the loan). However, as this case also illustrates, this is where the complications arise and this is why the matter went all the way to the Supreme Court.

The primary issue arises from the fact that on invocation of the pledge, the shares are transferred to the name of the pledgee. Does this mean that the pledgee has become the clear owner of the shares with its risks and rewards? Or does this mean that the pledgee continues to retain the same merely as security? Can the pledgor argue that the amount of loan should be reduced to the extent of the value of the shares on the day of such invocation/transfer? Should the pledgee account for the shares in its books as owned by it? Does such transfer (and the re-transfer) have tax implications? Would the transfer (or the re-transfer) amount to an acquisition under the SEBI Takeover Regulations (and other applicable Regulations of SEBI) and thus possibly result in an open offer and/or disclosures? The Supreme Court answered some questions but, on other issues, placed the issues on record and referred the matters to the appropriate regulators to deal with them.

BRIEF FACTS AND ISSUES
The facts of the case, simplified and summarized, were as follows. In respect of a loan taken by a group company, another group company pledged shares of an unlisted company, held in dematerialized form, with the lender. There was a default on the loan. After due notice, the lender invoked the pledge. The DP transferred the shares in the name of the lender.

The lender claimed that the full amount of the loan, interest, etc. remained unpaid and sought the payment of the amount while stating that the shares transferred to its name were being retained as security in accordance with the Indian Contract Act. The borrower, however, claimed that on account of the transfer of shares, the amount of loan got reduced to the extent of the value of the shares as on the date of invocation of the pledge/transfer. Further, it claimed to have stepped into the shoes of the lender and thus itself had claims to that extent from the original borrower. There were disputes also as to the value of the shares also and this was not unexpected since the shares were unlisted and thus not having regular quotes/transactions on a stock exchange.

The lender could not persuade any of the authorities up to the National Company Law Appellate Tribunal (the matter under the Insolvency and Bankruptcy Code) that its stand was correct. Hence, it appealed to the Supreme Court.

The Supreme Court had several legal issues before it, the primary being whether the Depositories Act/Regulations effectively replaced the Indian Contract Act and thus the provisions of the latter Act did not apply to pledge of demat shares? Or could they be read in a harmonized manner with both the laws being applicable? Was the 150-year-old Contract Act obsolete to modern digital times or the principles so wisely drafted to be nearly timeless? Having decided on that, some other issues became redundant but then some other fresh issues cropped up.

SUMMARY OF THE RELEVANT PROVISIONS OF THE INDIAN CONTRACT ACT
The Indian Contract Act provides for, in great detail, the pledge of goods, invocation of pledge and related aspects. Pledge is considered a form of bailment. Simplified and summarized, the provisions are as follows. A person can pledge goods to another by delivering the same to the pawnee/pledgee. When the purpose of the pledge is satisfied, the pledgee returns the goods. Till that time, generally, the goods remain with the pledgee but at the risk and reward of the pledgor. To take examples, in the context of shares, this means that rise and fall in the value of the shares pledged is for the benefit/loss of the pledgor. So are usually accretions to it, say, in the form of bonus shares or dividends. The pledgee, however, has only certain specific and limited rights with regard to such pledged goods, unlike, say, a mortgage.

If the pledge has to be invoked, the goods continue to remain with the pledgee. However, after giving due notice, the pledgee can sell the goods and adjust the proceeds against the loan amount. If the proceeds are higher than the amount of loan, interest, etc., the excess is to be paid to the pledgor. If there is a deficit, he can claim the same from the pledgor. The pledgor is generally entitled, right till the time the goods are actually sold, to repay the loan and get the goods back.

RULING OF THE SUPREME COURT
As discussed above, the primary issue arose about the implications of the transfer of the shares from the name of the pledgor to the pledgee. Did this amount to a purchase/acquisition of the shares by the pledgee whereby, firstly, the loan got reduced to the extent of the value of the shares? Secondly, the shares were then at the risk and reward of the pledgee? Furthermore, the pledgor could not thereafter repay the loan and claim back the shares?

The Hon’ble Court minutely analysed the provisions of the Indian Contract Act and the Depositories Act/Regulations and several rulings in this regard. It noted the peculiarities arising out of shares being held in demat form and also how provisions were made under the relevant law to deal with pledge of such shares. However, it held that this did not negate/override the general principles of the Depositories Act and the two laws need to be read in a harmonized manner. The Court also held as incorrect the view of the Bombay High Court (in JRY Investments (P.) Ltd vs. Deccan Leafine Services Ltd (2004) 56 SCL 339) that demat securities cannot be pledged under the Contract Act as it is not possible to transfer physical possession. However, the view in this decision that the pledge of demat shares requires compliance of the procedure laid down in Depositories Act/Regulations was endorsed as correct, though to be read in light of the present decision.

The Court further held that when the shares were transferred to the pledgee on invocation of the pledge, it continued to hold them as a pledgee and not as an owner. Indeed, it would be a violation of the law if the pledgee transferred the shares to himself as full owner. The loan thus did not get reduced on the day of such invocation/transfer to the extent of the value of the shares. The pledgee could continue to retain such shares and yet claim the full amount of its dues. If it desires to transfer the shares, the provisions requiring giving of due notice under the Indian Contract Act before the sale continue to apply. The right of the pledgor/borrower to pay the dues and seek transfer of the shares back to it continues till the shares are actually sold.

Thus, it ruled in favour of the pledgor/lender and set aside the order of NCLAT.

PECULIARITIES ARISING OUT OF PLEDGE OF DEMAT SHARES, PARTICULARLY AFTER INVOCATION
As discussed above, the Supreme Court noted that holding shares in demat form resulted in peculiarities that, while it did not rule on since these questions were not before the court for ruling, it asked the relevant regulators to consider and provide on.

The issues arise because of certain steps involved in the pledge process. First is the transfer of the shares in the name of the pledgee on invocation of the pledge. The second is when the shares are sold by it after due notice. The third situation is that before the sale, the pledgor pays the dues and this requires transfer of the shares from the pledgee to the pledgor.

Firstly, how should the pledgee account for such shares that were now in their name in its books? This perhaps is an easier question to answer but a little more difficult is the tax implications of the transfer and retransfer/sale. Even more difficult is the answer under the SEBI Takeover Regulations which though deal with pledge to an extent does not cover all situations and all pledgors/pledgees. The Hon’ble Court asked the relevant regulators to ponder and provide for these.

CONCLUSIONS
It is almost amusing to note that a 150-year-old law does not require any change or even any major crease to be ironed out but more recent laws such as the Takeover Regulations and other laws are found to be wanting.

The implications, or at least the issues raised and the approach of how they were solved, of this decision could possibly apply even to other forms of digital assets whose number and variety are fast growing. These could include cryptocurrency, non-fungible tokens, etc. many of which do not as of now even have basic laws specifically dealing with them. Laws governing them thus will have to be well thought out and comprehensive and deal with the issues that arose before the Court in the present matter.
 

SUPREME COURT ON INSIDER TRADING – PUTS GREATER ONUS OF PROOF ON SEBI, EFFECTIVELY READS DOWN PRECEDING DECISION

BACKGROUND
Recently, vide decision dated 19th April 2022, the Supreme Court reversed the order of disgorgement and penalty of about Rs. 8.30 crores and the parties’ debarment, in a case of alleged insider trading. In doing so, it laid down important principles of proof in insider trading cases. More importantly, it is submitted that it effectively read down its own decision in an earlier case that required lesser levels of proof in cases of civil actions (as against criminal actions). It is submitted that insider trading cases will now require not just greater levels of proof by SEBI for action, but it will be subjected to a greater level of scrutiny. The Supreme Court had earlier held (in SEBI vs. Kishore R. Ajmera (2016) 6 SCC 368) that the standards with which to see civil proceedings were ‘preponderance of probability’ and not ‘beyond reasonable doubt’, which is so in criminal proceedings. By a curious observation, as we will see later herein, the Supreme Court in the present case distinguished Kishore Ajmera’s case as a case of fraud/price manipulation while the present case was of insider trading. The decision is in the case of Balram Garg vs. SEBI ((2022) 137 Taxmann.com 305 (SC)).

It is submitted that this decision will thus now require greater efforts of investigation and legal reasoning by SEBI to take penal action in cases of insider trading, such that these actions meet the test of law and hence are not reversed in appeals. This would be so even if the penal action being taken is of civil actions in the form of penalty, disgorgement or debarment and not prosecution.

INSIDER TRADING LAW GENERALLY – A SERIES OF DEEMING PROVISIONS
While the SEBI Act, 1992, provides for the extent of penal actions in the form of penalties, etc. that can be taken in cases of insider trading, the substantive and procedural details are laid down in the SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘the Regulations’). The Regulations lay down what constitutes the offence of insider trading and also provide several incidental requirements to prevent insider trading, give disclosures of holdings/acquisitions, etc.

The core offence of insider trading is easy to understand as a concept. It is dealing in securities by an insider who is in possession of unpublished price sensitive information (UPSI). It also covers communication, otherwise than for permissible purposes, of such UPSI. A simple example can be taken to illustrate this offence. Say, the Chief Financial Officer, who sees the financial results being far better than expected, buys shares before such financial results are published. And then he sells them when the price of the shares predictably shoots up once the results are published. Or, instead of dealing himself, he may have communicated the results to his relative, who carried out similar dealings and made such illicit profits.

While this is a simple example that may not require elaborate investigation/proof, insider trading is generally seen to be carried out in far more devious ways with near-criminal sophistication. Too often, front persons (termed as ‘mules’ or ‘name lenders’) are found in whose names the trades are carried out. The profits are then funnelled back to the insider with great circumlocution, often using the parallel economy. Technical advancements in the internet, mobile telephony, cryptography in messaging, etc., are also available to the criminally minded. As the bestselling book Den of Thieves by James Stewart lays down in detail, even several decades ago, sophisticated methods were used, including offshore accounts, for insider trading. The investigation led to the fall of large financial firms, and some well-known names in the industry went behind bars. The cases of Raj Rajaratnam and Rajat Gupta have also been the subject of other best-selling books.

To make the job of SEBI easier, a series of deeming fictions have been introduced in the Regulations on insider trading. For example, the definition of UPSI itself has two deeming fictions. Information published otherwise than in the prescribed manner is deemed to be unpublished. Certain events, including even some ordinary occurrences, are deemed price sensitive – e.g., financial results, dividends, mergers and acquisitions, etc. The term ‘insider’ also contains multiple deeming fictions on who are deemed to be insiders. Evidence collection is also helped by the automated generation of information and reports of surveillance of trading on stock exchanges, particularly around the time when price-sensitive information is published. One would then expect that the job of SEBI would be quite easy. However, in reality, it is often seen that rulings of SEBI are reversed on appeal. The present case now holds that the benchmarks of proof are higher than what is presumed, and if the investigation and legal reasoning fall short of these benchmarks, the orders would be reversed.

SUMMARY OF THE PRESENT CASE
To provide a simplified summary of this case, SEBI found that certain persons allegedly close to a listed company/management sold shares while certain price-sensitive information was unpublished. The listed company had made an announcement about the decision of its Board to buy back shares at Rs. 350 per share. However, since this proposal was rejected by its bankers, the Board decided to withdraw the offer. Clearly, the information about the buyback of shares and thereafter its withdrawal was price sensitive and even specifically deemed to be so under the Regulations. If, for example, one knows that there would be a buyback at Rs. 350 while the ruling market price was much lower, such information could boost the price. Also, information that the buyback would be withdrawn would do the reverse, leading to a fall in price. And a person having knowledge of such information may be tempted to sell shares held by him and avoid loss. The temptation may even be to further deal in futures by selling now and reversing the trades once the information is published and making further profits. This, to summarise, is what was alleged by SEBI to have been carried out by relatives of those in the top management. Consequently, it ordered the parties to disgorge the amount of such gains (being notional losses avoided/profits made) with interest at 12% p.a., aggregating to about R8.30 crores. It also levied a penalty of Rs. 20 lakhs on the parties. Furthermore, it debarred the parties from the
securities markets in the specified manner and for a specified time.

It rejected the arguments of the parties that though they were near relatives, the family had undergone a partition both on a business and personal level, and hence there was no communication. SEBI laid emphasis on the fact that the sales were made during the time when there was UPSI. The transactions of sales thus avoided losses. SEBI also gave importance to the fact that the parties stayed on the same plot of land, even if in separate residences. Moreover, one of the parties was made a nominee for shares held by a person from the other family group. Based on these and other facts, SEBI took the view that these circumstances were sufficient to take a reasonable view that there was insider trading, and hence penal action was warranted. The parties appealed to the Securities Appellate Tribunal (SAT), which confirmed SEBI’s order. The parties then appealed to the Supreme Court.

ORDER OF THE SUPREME COURT
The Supreme Court held that the SEBI took an incorrect view of the events and made assumptions of foundational facts instead of establishing them by evidence. The deeming provisions did not apply to the present facts and that SEBI was required to show that there was communication between the parties in management and the parties that sold the shares, and SEBI could not presume it to be so, nor it could the mere fact that the two groups were near relatives could result in the assumption that there was a communication of the UPSI.

SEBI had held that though there was a commercial separation with one group leaving the business and management and even residing separately, this was an arrangement and not an estrangement. However, the Supreme Court considered the facts, including some facts that SEBI did not lay adequate emphasis on. It highlighted that though they stayed on the same plot of land, the plot was very large, and the parties had separate entrances. Importantly, the party was continuously selling the shares held well before the UPSI came into existence, having sold predominantly during this earlier period. Thus, the sales during the UPSI period had to be seen in the light of these earlier sales.

The important point that the Court made was that even between such near relatives, communication could not be assumed, and the onus was on SEBI to establish this foundational fact of there being communication. Even the definition of ‘immediate relatives’ had a condition that one party was financially dependent on the other or that it consulted the other in its investment conditions. That the parties were financially independent was seen from the record. As regards whether the parties had consulted the others in investment decisions, it was SEBI who had to prove this by cogent evidence. Further, the conclusions that SEBI draws from such foundational facts it proves have to logically follow leaving no other reasonable conclusion possible. SEBI had neither provided cogent evidence of communication nor did it give sound reasoning to come to its conclusion such that no other view could be reasonably possible.

The Court also observed that the SAT did not do what was expected of it as the first appellate authority and that is re-examining the facts and law. Instead, the Court observed that it did not apply its mind and merely repeated the alleged findings of SEBI.

In conclusion, the Supreme Court set aside the orders and directed that the amounts paid be refunded.

IS THE LOWER BENCHMARK OF ‘PREPONDERANCE OF PROBABILITY’ STILL VALID FOR INSIDER TRADING CASES?
As discussed earlier, the Supreme Court in Kishore Ajmera’s case had laid down what is now referred to as the test of ‘preponderance of probability’ in civil cases in securities laws. Applying this test, it had held that the conclusion that a reasonable man would make from the available facts should be drawn. While not expressly dissenting with this ruling, the Supreme Court, in the present case, made a curious observation. It said, “Suffice it to hold that these cases are distinguishable on the facts of the present case, as the former is not a case of insider trading but that of Fraudulent/Manipulative Trade Practices; and the latter case relates to interests and penalty rather than the subject matter at hand.” (emphasis supplied). It can now become an interesting issue what weight in law this observation should be given. Should it mean that the test applies only to cases of fraudulent and manipulative trade practices and not others such as insider trading? Or should this remark be treated as obiter dicta or just as an observation on specific facts and in context? The author submits that since there is no express departure or dissent, the observation should be seen only in context and perhaps more to emphasise that SEBI has to establish some foundational facts. But what muddies the water further is that even the ‘latter case’ (Dushyant N. Dalal vs. SEBI (2017) 9 SCC 660) was also distinguished on the ground that it dealt with ‘Interests and Penalty’.

Insider trading cases, as discussed earlier, are difficult to catch due to the level of criminal sophistication adopted. This decision, it is respectfully submitted, will require SEBI to climb a steeper hill of detection, investigation, establishment of facts and punishment in such a way that these tests are met and the orders upheld.

RIGHT OF ACCUSED TO RECEIVE RELEVANT DOCUMENTS FROM SEBI – SUPREME COURT LAYS DOWN IMPORTANT PRINCIPLES

The Supreme Court has, by a recent decision of 18th January, 2022 (T. Takano vs. SEBI (2022) 135 taxmann.com 252), gave a decision that has an important bearing on the information that SEBI is required to provide to persons accused of wrongdoing in securities markets. It has effectively held that, barring very specific exceptions, SEBI must provide the full investigation report to the person against whom proceedings for debarment, disgorgement, etc., are initiated. There can be only limited exceptions to this general rule, and even in respect of these exceptions, SEBI is required to provide reasons. Where information is not provided, the accused is entitled to demonstrate that the withholding of such information is not valid as they do not meet the criteria laid down by SEBI. In terms of upholding principles of natural justice, transparency and fairness, this decision can be said to be a landmark. Instead of limited disclosure being the rule and full disclosure being the exception, non-disclosure would now be the exception, and comprehensive disclosure would be the general rule. Moreover, the Court has made certain nuanced points on what information SEBI can be said to have relied on or even influenced by. A mere and bald denial that SEBI has not relied on certain documents as a ground for refusal to provide them is also not enough.

A classic bone of contention between SEBI and persons against whom it initiates penal proceedings is whether all the information relied on by SEBI or otherwise relevant to the proceedings has been duly provided to the person accused of violations or not. Principles of natural justice, which do not even have to necessarily be coded in the law in detail, require that all the information that is relied on by SEBI to make accusations needs to be disclosed so that the person can study it and give his response. On request that certain information be provided, while SEBI often does provide relevant information, the response is often that the information or document sought is not relevant or not relied on. At times, also depending on the efforts (and deep pockets!) of such person, this issue is pursued in appeal/writ petition. In some cases, it is seen that the appellate authority/Court requires SEBI to provide the requested information and then provide a reasonable opportunity for the person to respond and also a personal hearing. In some cases, the order is set aside totally or remanded back to SEBI. The important question is what are the guiding principles for deciding whether the information is relevant or relied on and what are exceptions to the rule of full disclosure. The Supreme Court has now comprehensively laid them in this decision, at least as far as most SEBI proceedings are concerned.

BRIEF AND SUMMARIZED FACTS OF THE CASE
This matter concerned Ricoh India Limited, a public listed company. The appellant was the Managing Director for the financial years 2012-13 to 2014-15. The Audit firm, appointed in 2016, expressed reservations over the veracity of the financial statements for the two quarters ending 30th June, 2015 and 30th September, 2015. The company’s Audit Committee appointed a firm to conduct a forensic audit, whose preliminary report was submitted on 20th April, 2016, which the company shared with SEBI with a request to carry out due investigation for fraud, etc. The forensic auditors submitted their final report on 29th November, 2016. SEBI initiated investigations and summoned the then senior management, whom the company also accused of wrongdoings. Thereafter, SEBI passed an interim order cum show cause notice making a finding that certain persons including the appellant were responsible for the misstatements in the financial statements. As far as the appellant was concerned, SEBI stated that the company had restricted the investigation only to the six months ended 30th September, 2015 and not for 2012-13 and later, when the fraud was started when the appellant was the MD. It was also stated that the forensic audit was limited to the half-year ending 30th September, 2015 to “ring-fence the earlier MD & CEO, T. Takano.”. Since SEBI recorded a finding that there was a fraud during this extended period, it passed adverse orders against the appellant and others, debarring them from the securities markets. An independent audit firm was appointed to conduct a detailed forensic audit. The interim order also served as a show cause notice (“SCN”) seeking a response as to why adverse directions, including debarment should not be passed in a final order. The interim order was later confirmed after considering the representations of the appellant. When the appellant appealed to SAT, the order was set aside on various grounds. However, liberty was given to SEBI to issue a fresh SCN on receipt of the final report of the forensic auditor.

SEBI then issued the fresh SCN, which was the cause of contention that finally resulted in the decision by the Supreme Court. To focus on the core issue, which was the subject matter of the decision, the question was whether SEBI was bound to provide a copy of the investigation report as sought by the appellant. SEBI replied that the investigation report could not be provided as it was an ‘internal document’. The appellant filed a writ before the Bombay High Court which held that such investigation report is solely for internal purposes, and relying on the decision of the Supreme Court in Natwar Singh’s case ((2010) 13 SCC 255), concluded that the report does not form the basis of the SCN and hence need not be disclosed. The appellant filed a review petition before the Division Bench, which too was rejected. The appellant then filed a special leave petition before the Supreme Court, resulting in the present decision.

RULING BY THE SUPREME COURT
The Supreme Court reviewed the law relating to how proceedings are to be conducted, particularly under the relevant SEBI PFUTP Regulations. It highlighted the core importance of the investigation report in these provisions and the proceedings thereunder. It also made some very important observations about the documents that would influence an authority’s mind in his decision, even though he may not specifically rely on them. All in all, it is submitted that the Court took a broader and more realistic view of the matter, particularly in the light of fairness, transparency and principles of natural justice.

First, the Court reviewed Regulations 9, 10 and 11 of the SEBI PFUTP Regulations. It noted that the core process laid down by law was fairly simple and clear. SEBI conducts an investigation in case of a suspected violation of securities laws by a person. If such an investigation reveals a violation, then SEBI initiates proceedings and issues an SCN. Regulation 10 specifically states that it is only “after consideration of the (investigation) report, if satisfied that there is a violation of these regulations, and after giving a reasonable opportunity of hearing to the persons concerned, issue such directions or take such action as mentioned in regulation 11 and regulation 12.” (emphasis supplied).

The Court highlighted the importance of the investigation report as the sheer basis for deciding whether or not there is a violation of the Regulations. The penal/adverse directions also arise as the next step. These directions that can be issued under Regulations 11 and 12 are fairly wide and carry grave consequences. Trading of the concerned security can be suspended. Parties may be restrained from accessing the securities markets and dealing in securities. Proceeds of transactions or securities can be impounded/retained. And so on. Thus, as the Court noted, the sequence was as follows: an investigation is conducted; the authority reviews the report of such investigation based on which, if satisfied, it initiates proceedings, grants a hearing; and then issues directions that have serious consequences. It is evident, then, that the investigation report is the core basis for the proceedings and action, and denying the person a copy of it is unjust, unfair and against the principles of natural justice. It is hardly a mere internal document, as SEBI contended.

The Supreme Court highlights three other important points. The argument often put forth is that certain documents sought by the person have not been ‘relied on’ while issuing the SCN, which makes the allegations. Hence, there is no requirement or need to provide such documents. The Court noted a distinction between what documents are relied on and what is relevant to the proceedings, which is a broader term.

Further, the Court noted that there might be documents reviewed by the authority though not ‘relied on’ while issuing the SCN. The nuanced point made by the Supreme Court (for which several precedents were also cited) was that such documents do influence the mind of the authority. That being so, such documents are also relevant and hence need to be provided to the person accused so that he may defend himself.

Then the Court pointed out that a mere bald denial by the authority that it has not relied on the document sought is insufficient. The actual facts would have to be seen.

The Court pointed out that the principles of reliability of evidence, fairness of a trial, and transparency and accountability are relevant for such quasi-judicial proceedings so that such proceedings do not become opaque, without accountability and thus unjust and unfair.

Thus, the Court held that relevant parts of the investigation report need to be shared with the appellant, though bearing in mind certain exceptions as discussed below.

EXCEPTIONS TO THE GENERAL RULE OF PROVIDING ALL RELEVANT DOCUMENTS TO AN ACCUSED
As mentioned earlier, the decision in a way reverses the general practice often seen in such proceedings. Disclosure is almost an exception, and non-disclosure is the general rule. Selective disclosure is commonly seen with requests to provide documents sought for, often rejected. The Court has now said, of course, in the context of the SEBI proceedings under such Regulations, that disclosure ought to be the general rule and non-disclosure has to be only under certain specific exceptions. Even for the exceptions, reasons would have to be provided why those parts are not disclosed. And in such a case, the onus then shifts to the accused, who still can provide convincing reasons why such information said to fall under such exception should still be provided. The Court held that the accused could not seek a roving disclosure of even documents unconnected to the case. The right of third parties may be balanced with the requirements of disclosure. Information of a ‘sensitive nature bearing upon the orderly functioning of the securities markets’ is another exception.

Thus, the Court laid down certain specific exceptions but also kept the authority accountable.

CONCLUSION
This decision will have a significant bearing on how proceedings are conducted by SEBI and would obviously impact not just future proceedings but even presently ongoing proceedings. This decision would also guide appeals before appellate authorities. Accused have far better rights of justice. This decision is thus a boost for transparency and fairness making disclosure the general rule.  

SOME RECENT DEVELOPMENTS – SEBI’S GUIDANCE ON CROSS-REFERRALS, NSE RULING AND AMENDMENT TO FUTP REGULATIONS

Securities laws continue to remain interesting by constant tweaking of the regulations by the SEBI to keep them with times, even if some of which may be ill-considered. Some SEBI orders too create good precedents and, at times, place on record happenings in companies which can be disturbing and even disillusioning. Then there are informal guidances handed out, which are akin to advance ruling in substance which, even if they do not have binding effect, usually reflect the view that SEBI is likely to take even in other cases. Let us discuss some of such developments in recent weeks briefly.

SEBI’S INFORMAL GUIDANCE – EARNINGS BY INTERMEDIARIES FROM REFERRALS OF CLIENTS TO OTHERS
Providing as many services as possible under one roof makes business sense and good customer service, helping common branding and savings in costs in the financial services industry. However, this also presents scope for conflicts of interest. For example, a merchant banker who manages an issue could face a conflict with other departments which recommend investments to clients. An investment adviser who must give an impartial recommendation to clients on their investment portfolio faces a potential conflict with other entities in the group, such as mutual funds. SEBI’s general approach to dealing with such conflicts has been multi-pronged. Firstly, full disclosure must be made of all conflicts by various intermediaries. Secondly, certain conflicts are wholly prohibited and cannot be cured even by disclosure. Yet another method is requiring that entities in the same group will not give the same client two types of conflicting services.

Introducing many such provisions initially resulted in resistance, but this was eventually accepted as good practice for all. A recent informal guidance by SEBI (in the case of HDFC Securities Limited, dated 14th February, 2022) presents an interesting way of how one organization proposed to deal with the issue in the interests of all. It proposed that it would recommend and refer selected external investment advisors to its clients. The advisor then would pay a referral fee to the organization. This would appear to be a win-win situation for all. The organization would earn from the referral of a client who otherwise would have consulted an investment advisor in their own group. The investment advisor would get a client. The client would be saved from hunting afresh for yet another intermediary for services he needs. In its informal guidance, SEBI allowed this, stating that this is a correct interpretation of the law and, hence, permissible.

However, this, in the author’s submission, creates an imbalance amongst intermediaries. An investment advisor, for example, faces far more and stricter restrictions under Regulation 15, 22 and other provisions of the Regulations governing investment advisors. He absolutely cannot earn directly or indirectly any fees, commissions, etc., from providing any distribution service to its clients. For example, if he advises his clients to invest in certain mutual funds, it cannot act as an agent of such fund and sell units of such fund to the client and earn commission thereon. Indeed, even a family member cannot provide such distribution services to that client. As stated above, while some restrictions can be cured by disclosures to client, the restrictions generally on investment advisors are far wider and more strict.

Indeed, this problem has wider ramifications, particularly since there are multiple intermediaries and even multiple regulators – SEBI, IRDA, PFRDA, etc. So there are even further potential areas of conflict that could be detrimental to investors. It is perhaps time that a holistic view is taken by individual regulators of their multiple regulations and even together as regulators so that cross-regulator arbitrage is eliminated.

SEBI’S RULING – NATIONAL STOCK EXCHANGE AND OTHERS
SEBI passed a final order (Reference No. WTM/AB/MRD/DSA/21/2021-22 dated 11th February, 2022) in the case of Chitra Ramkrishna, National Stock Exchange (NSE) and others levying penalties on them for violations of various regulations governed by SEBI. While there are several perspectives from which the order can be seen, it is also the factual matrix asserted in the order which deserves attention. The order talks of events that have allegedly taken place in the Exchange which are bizarre on one hand but, on other hand, in the submission of the author, not uncommon. But they do present a disturbing state of affairs of management of large companies and question whether well-meaning practices of corporate governance which are mandated by law actually exist in practice or are flouted easily. It is possible that the order may be contested in appeal and that some of the factual assertions made or directions may be rejected/set aside. But taking at face value, let us discuss what the order asserts.

Firstly, the Order says that the Managing Director and CEO of NSE appointed a deputy of sorts and gave extremely wide powers to him and huge remuneration that was reviewed substantially upwards over his tenure. In the opinion of SEBI, this was not only unreasonable considering his background and qualifications but did not even pass through the regular performance appointment and review processes mandated for senior management (e.g., review and recommendation by the Nomination and Remuneration Committee). Further, though having such wide powers, which even resulted in several very senior executives reporting to him, he was not given the designation of Key Managerial Personnel (KMP). Appointment of a person as KMP involves certain approval and review processes and places him accountable in terms of being directly liable for defaults in areas falling within his purview. As asserted by SEBI, what was also disturbing is the alleged silence of the various persons who could have been aware of this and who would then be expected to play the role of checks and balances in such a large organization. It was asserted that the MD/CEO took these decisions single-handedly. Such revelations raise yet again questions whether the elaborate provisions in law (and at times voluntarily adopted) exist primarily on paper or can otherwise be easily flouted?

On the other hand, in the author’s submission, it is common not just in corporates but also in different fields, including politics, that an executive assistant is appointed to assist the top leader. Such executive assistant often has the total trust of the leader and is given wide powers to execute on behalf of the leader. Such executive assistants could individually become very powerful and command authority far beyond his status and accountability. The question then is how corporate governance and law requirements and their actual practice should ensure that they do not become power centers without the requisite supervision and accountability.

The second major and perhaps more disturbing aspect in the order is that the MD/CEO regularly consulted a ‘Spiritual Guru’ on important matters relating to the running of NSE. She even allegedly shared confidential corporate information with such a person. The said Guru not only had no official connection with NSE but was asserted by the MD not even to have physical coordinates and could manifest at will! But equally curiously, the Guru could still access emails sent to him and reply to them. Further, he gave detailed advice on important policy matters relating to the running of NSE and even used sophisticated corporate management jargon in such emails. Thus, instead of running NSE through modern corporate practices and teamwork, such a person appeared to have a decisive say on important matters. It is again surprising that the checks and balances in the organization and the corporate governance framework did not detect/prevent these alleged happenings.

Now, again, it is indeed a tradition in India to seek the guidance of spiritual Gurus. Perhaps a leader faces the proverbial loneliness at the top, which makes the compulsion to seek out advice even more. Such Gurus are also known to be approached to resolve family or business disputes. But it is one thing to seek advice and solace on personal life outlook and spiritual matters. It is totally different when blind reverence leads to them having a vital say in running a large organization. Saddeningly, this also places even corporates in the global stereotype of India being a place of snake charmers and superstitions. And, finally, yet again, the question arises whether the checks and balances of good corporate governance either do not exist beyond paper or whether they can be flouted and thus provide false assurance?

SEBI REGULATIONS AMENDMENT – FRAUD AND UNFAIR TRADE PRACTICES
SEBI has amended the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 2003 (“the Regulations”) with effect from 25th January, 2022 by replacing the existing clause (k) to Regulation 4(2). What is interesting is the wide wording and hence implications of this revised clause. The clause forms part of a list of those acts/omissions which are deemed to be manipulative, fraudulent or unfair trade practice. This short clause is worth reproducing verbatim here so that its implications as analysed can be appreciated:

“(k) disseminating information or advice through any media, whether physical or digital, which the disseminator knows to be false or misleading in a reckless or careless manner and which is designed to, or likely to influence the decision of investors dealing in securities;”

While the earlier clause in substance had a similar objective, certain additions/changes expand its scope and possibly overcome some legal hurdles faced in preventing such practices.

The clause intends to prevent the dissemination of false/misleading information that would influence investors in entering into dealing in securities. It has been found that persons spread rumours, tips, etc., to influence investors into transactions in securities. This could be done fraudulently, to earn profits at the cost of investors who may, sometimes, end up holding dud securities. A practice referred of this type, referred to as ‘pump and dump’ has been found in several cases by SEBI. Social media such as messaging services have also been found to be used for such fraudulent practices.

However, SEBI has now sought to expand the scope, particularly by adding “in a reckless or careless manner”. This apparently could lower the bar of proof and perhaps even shift the onus at least partly on the person who shares such information. Thus, he may have to demonstrate that he had shared such information after due diligence/care. He may even be required to show documentation to prove such care.

Sharing ‘tips’ casually with friends/relatives/colleagues, etc., is indeed quite common. Such tips/information may not necessarily be a product of documented analysis of the scrip. They can often be just a gut feeling based on the reading of some news or developments. Whatsapp and other social media/messaging services are replete with groups where investments are discussed and recommended. Recently, discussions on certain groups on Reddit were widely reported in media, particularly involving the scrip Gamestop.

While fraudulent practices certainly need a stop, the question is whether the new clause goes too far? The clause still retains an important pre-requisite for a person to be charged with violating it – that such a person should know that the information is false or misleading. But yet, the question is whether adding the words “in a reckless or careless manner” could cover even casual discussions. Price discovery in stock markets is the sum result not just of informed and expert analysis but also a continuous process of such analysis coupled with informed guesswork. The question is whether having such a widely worded clause would stifle otherwise healthy discussions.

IPO FINANCING – RECENT DEVELOPMENTS

Initial Public Offers (IPO), as public issues of shares/securities are commonly known, have been in the news for several reasons. One is the handsome profits made by allottees in many cases due to the shares listing at a price far higher than the issue price (though some showed losses too). Then expectedly linked to this is that many IPOs have been oversubscribed many times. The other factor is the rapid rise of IPO financing, which also incidentally came to attention recently due to an alleged abusive call made by a prospective borrower to a bank officer who allegedly failed to provide the promised IPO finance. What became widely known was the enormous leverage being available through IPO financing to subscribers. SEBI has also decided to amend some IPO related provisions in the SEBI ICDR Regulations. Finally, the Reserve Bank of India has recently decided to place some very stringent restrictions on IPO financing by NBFCs, so much so that it is very likely that IPO financing could drop down to a miniscule level of what exists today. Further, the question repeatedly raised is whether there is an IPO bubble, that IPOs are priced too high and that the market boom is being taken advantage of by making IPOs. This subject generally also has a colourful history, and it is worth seeing some aspects of the past and the most recent developments.

EARLIER BOOMS IN IPOs
Many may remember the massive rise in IPOs during the Harshad Mehta times. The boom in the stock market also made new issues by companies attractive. Numerous IPOs were oversubscribed. There was actually a grey market for IPOs functioning, albeit with no legal backing, and the grey market quotes were often published in pamphlets and quoted elsewhere. To increase the odds of getting allotment in shares, it was commonly known that people resorted to multiple applications by using names of their family members and even staff and making applications in different combinations of names of such persons. The technology at that time was not advanced enough to weed out such multiple applications. Of course, those were also the times when many companies with dubious backgrounds made IPOs and then ‘vanished’.

DEMATERIALISATION OF SHARES
Dematerialisation of shares and other changes eliminated the earlier practice of multiple applications by the same person. However, a new abuse came to light, particularly surrounding the SEBI rules mandating allocation for retail investors. It was found that lakhs of Demat accounts were opened in Benami or even fake names. Amusingly, for this purpose, some names with photographs were reported to have been picked up from matrimonial sites! Applications were made in such names, financed by others. When shares were allotted, they were sold, and the sale proceeds with the profits paid to the financier. These cases became famous by one of the allegedly involved – Roopalben Panchal. Such persons whose name is ‘borrowed’ for carrying out transactions in shares by others now even have a term – ‘mules’. SEBI’s action in such cases, which saw prolonged litigation though, supplemented with other efforts such as know-your-client verification, stronger penal provisions for using fake names, etc., dealt with this abuse.

CURRENT BOOM IN IPOS AND RESPONSE OF SEBI
Very large amount of money is being raised through IPOs of several companies in recent times. New age web-based companies have finally come to roost, and some of them have offered shares to the public at a significant premium. Apart from this, several other companies have joined the party. What has been particularly notable has been the generally massive response to such issues from the public. Several public issues have seen applications that are many times the issue size.

SEBI has long moved from having a say in determining the pricing of issues. The emphasis is on due disclosure of information sufficient for the investor to make an informed decision, supported by due diligence by merchant bankers and others. Other safeguards include eligibility requirements, minimum holding and lock-in requirements, etc. But other than that, the issue price is generally not controlled.

However, this time, considering factors such as there being offers for sale by existing holders too and for other reasons, SEBI has decided to make certain amendments to the SEBI ICDR Regulations at its Board Meeting held on 28th December, 2021, followed up by formal amendments to the Regulations. The following are some of the important amendments:

a. If an object of the issue is for future inorganic growth, but specific acquisition or investment targets are not identified, in that case, the amount raised for such objects, including for ‘general corporate purposes’ shall not exceed 35% of the total amount being raised. Of this, the amount earmarked for such use for inorganic growth shall not exceed 25% of the issue size.

b. In the case of an offer for sale by companies without a track record, certain limits have been laid down for specific categories of existing shareholders. A shareholder (along with persons acting in concert) who holds more than 20% of the pre-issue shareholding (on a fully diluted basis) shall not offer more than 50% of his pre-issue shareholding. Other shareholders cannot offer more than 10% of their pre-issue shareholding.

c. Credit Rating Agencies will now act as Monitoring Agencies in place of presently recognized monitoring agencies. They will monitor the use of issue proceeds until 100% is utilized, compared to the present 95%.

d. For Anchor Investors, the lock-in now will be 30 days for 50% of shares allocated to them and 90 days for balance shares. This will apply for issues opening on or after 1st April 2022.

e. Modifications have been made to the allocations made regarding Non-Institutional Investors with effect from 1st April 2022.

The amendments thus appear to be intended to ensure only partial exit for existing shareholders in some instances or to anchor investors and generally make other fine-tuning.

HIGHLY LEVERAGED IPO FINANCING AND RESERVE BANK OF INDIA’S RECENT RESTRICTION
Earlier, we referred to financing persons who acted merely as front or were even fake to subscribe for IPOs, which is an abuse of the law. However, what is widely prevalent is also financing by lenders to subscribers to IPOs. The objective of obtaining such finance can be many. One is to acquire a higher quantity of shares of a company whose issue price is perceived by the subscriber/borrower as low, leaving scope for quick profits. However, considering that many issues are heavily oversubscribed, applying for a larger quantity of shares boosts the chances of getting a higher quantity of shares than otherwise. IPO financing thus has become quite common. Thanks to the ever-shortening gap between the date of application for shares and payment and allotment/refund, IPO financing is thus for a very short period – about a week or so. This increases the attractiveness of the finance since the attendant costs are also lower. Further, lenders have shown willingness to lend an amount that is many times the amount contributed by the borrower. Thus, there is enormous leverage. The consequence is that the profits would also be magnified, and so would the losses. The risk of losses is as much to the borrower as is to the lender since if there are huge losses (owing to, say, the price of the allotted shares being quoted far below the issue price), there could be concerns of recovery if there is not adequate other collateral.

The matter of borrowing and lending is under the purview of the Reserve Bank of India, which has taken a strong – and possibly drastic – action. It has issued guidelines dated 22nd October, 2021, stating that, from 1st April 2022, “There shall be a ceiling of Rs. 1 crore per borrower for financing subscription to Initial Public Offer (IPO). NBFCs can fix more conservative limits.”. Thus, non-banking financial companies (‘NBFCs’) shall lend a maximum of Rs. 1 crore per borrower for IPO. While Rs. 1 crore by itself does sound to be a significant sum, considering that IPO financing has been of massive amounts, this would significantly affect IPO financing. To take just one example, in the recent case referred to earlier, which came widely in the news because of an abusive call allegedly made, the amount of IPO financing said to be involved in just this one case was Rs. 500 crores that too for one single IPO. The absolute limit of Rs. 1 crore stated by the Reserve Bank of India thus sounds relatively puny in comparison. Of course, questions are raised about the interpretation of the guidelines. Whether the limit is per IPO and hence a borrower can raise Rs. 1 crore separately for each IPO? Whether the IPO is per NBFC and hence the borrower can borrow Rs. 1 crore each from different NBFCs? And so on. While clarity on this may hopefully come from RBI before the date when it will come into effect, the fact remains that the amount of IPO financing may go down substantially. The concerns of RBI are, of course, valid – that giving of huge financing may be risky for the sector itself, apart from allowing borrowers to take huge unhealthy risks. But whether the answer to this was to place such an absolute limit or whether other solutions were possible? For example, the limit could have been placed in the form of margin – say, 50% whereby the borrower would have to put in as much amount himself as he borrows. Alternatively, the borrower could provide adequate collateral of such nature that may not present difficulties in realizing if recovery has to be made. One will have to see whether RBI makes any changes before the rule comes into effect.

CONCLUSION
There are views that, retail investors are more involved in the stock market, particularly due to the pandemic with numerous people working from home. Apart from acquiring shares in the secondary market, acquisition through IPOs has also seen a rapid rise. Time only will tell us whether this is a bubble or not. But if the restriction on IPO finance comes into effect, that would also contribute to a reduction in amounts subscribed through IPOs.

BOMBAY HIGH COURT ON RIGHTS OF SHAREHOLDERS – A RULING RELEVANT TO CORPORATE GOVERNANCE

BACKGROUND
A recent decision of the Bombay High Court not only lays down and confirms important principles of law but also has implications for corporate governance and rights of shareholders (‘activists’ or otherwise). The decision has seen differing views and reactions. Some support it as laying down correctly the law. Others hold that a more purposeful view of the provisions could have been taken as they believe the conclusions drawn impact the spirit of good corporate governance. Be as it may be, these important legal conclusions of the court are valuable to review. This decision is in the matter of Zee Entertainment Enterprises Ltd. vs. Invesco Developing Markets Fund ((2021) 131 Taxmann.com 321 (Bom.)).

This ruling is under appeal before the Division Bench of the Bombay High Court. Interestingly, parallel proceedings are also pending before the National Company Law Tribunal/National Company Law Appellate Tribunal for the same matter. Indeed, the core question of whether the NCLT has sole jurisdiction over such matters to the exclusion of the High Court is itself being pursued. Thus, we are likely to see further developments, including possibly a different view of the facts and/or law, in the matter.

SUMMARY OF CORE FACTS AND ISSUES
The core issue is whether shareholders have the unfettered right to call a general meeting and place resolutions for consideration by shareholders? Does the Board of Directors have any discretion or power to review and reject any of such resolutions or they are bound to call (or, in default, the shareholder group would itself call) such general meeting? Is the only thing the Board is expected to check is whether the procedural requirements of calling such general meetings are complied with? Or can the Board consider the merits of such resolutions in terms of their legality, whether such resolutions could result in violations of law by the company, etc.?

The matter concerned Zee Entertainment Enterprises Ltd. (ZEEL), a listed company. Two shareholders (‘the Shareholders’), holding, in the aggregate, 17.88% of the equity share capital of ZEEL, served a requisition under section 100 of the Companies Act, 2013 on ZEEL to convene an extraordinary general meeting (EGM) to consider primarily two categories of resolutions (aggregating to nine resolutions in all). The first three resolutions proposed the removal of three existing directors. The remaining six resolutions proposed the appointment of six specified individuals as independent directors. Two of the first three resolutions became redundant since two of the specified directors resigned voluntarily. Interestingly, the promoters of the company held only 3.99%.

The independent directors of ZEEL met and considered the matter. The Board of ZEEL considered various legal opinions and concluded that the notice of EGM was invalid and hence decided not to call the EGM. The reasons for holding that the notice was invalid were several and which were considered by the High Court. Since, under section 100, if the Board does not call the EGM, the Shareholders themselves could call it, ZEEL approached the High Court with three prayers. The first was to declare that the notice was illegal, ultra vires, invalid, bad in law and incapable of implementation. The second sought a declaration that the rejection by ZEEL to convene the EGM was valid in law. The third prayer sought an injunction against the Shareholders from holding the EGM themselves.

These prayers, including the grounds for rejection of such requisition, became the issues for consideration by the Court.

DOES THE HIGH COURT HAVE ANY JURISDICTION TO ENTERTAIN SUCH PETITIONS OR DOES THE NCLT HAVE SOLE JURISDICTION?
The Shareholders claimed that, in view of Section 430 of the Act, the High Court had no jurisdiction and the NCLT/NCLAT had sole jurisdiction over this matter. The Court rejected this contention stating that the relevant Rules that set out the provisions which NCLT has sole jurisdiction on does not include Section 100 and other relevant provisions. Thus, the Court concluded that it did have jurisdiction over such matters.

CAN SHAREHOLDERS PASS RESOLUTIONS WHICH HAVE LEGAL INFIRMITIES? CAN THE BOARD REJECT A REQUISITION ON SUCH GROUNDS?
This was the core and substantive issue before the Court. The Shareholders claimed that so long as the requirements of Section 100 are complied with, the Board was bound to call the EGM. Indeed, it was argued that Section 100 mandated the Board to do this by use of the word ‘shall’. The only principal substantive requirement the Board of Directors are required to check is whether the procedural requirements of Section 100 are complied with (e.g., the minimum percentage of shareholders specified (10%) have sought the holding of such EGM). This is the sole test that is relevant to decide whether the requisition is ‘valid’ (as specified in section 100(4)) or not. Effectively, the argument, as the Court highlighted, was that even if the resolutions could have resulted in ZEEL committing illegalities, the Board had no say and was bound to call the EGM.

ZEEL countered this by pointing several issues in the resolutions which made them illegal to be proceeded with and would also mean committing illegalities by ZEEL if such resolutions were passed. The appointment of six independent directors could possibly exceed the limit of 12 directors on the Board. ZEEL operated in areas that were regulated by Ministry of Information and Broadcasting (‘MIB’). Any change in the Board required prior approval of the MIB. The resolutions, however, proposed the appointment first and made it subject to approval, meaning the approval, if received, would be a post-facto approval. Thus, the removal or appointment of directors would mean violation of the MIB rules for which the company would suffer.

Appointment of independent directors could be made, in law, only by following a specified procedure. The Nomination and Remuneration Committee is required to review the merits of the proposed independent directors and recommend them to the Board. The Board thereafter, at their discretion, appoints such directors and this appointment has to be then approved by the shareholders. Thus, it was a three-step process mandated by law. ZEEL contended that the requisition sought to bypass the first two steps and, thus, again, the company would be held to commit violation if it allowed the resolutions. Indeed, it was contended, the shareholders could only ‘approve’ an appointment already made and not directly appoint an independent director itself.

ZEEL even questioned whether the directors proposed for appointment by certain substantial shareholders could be held to be ‘independent’, despite their respective merits and qualifications. In the ordinary course, nominee directors are by definition, not independent directors.

Thus, ZEEL contended on these and other grounds that if the EGM was allowed to be proceeded with and the resolutions passed, ZEEL would be committing several violations of law.

The High Court, in the very eloquently written judgment, held that the Board could not proceed with a requisition that would, if implemented, result in the company committing violations of law. Citing early precedents from the UK (where the law had thereafter changed, but the rulings still had merit) and also elsewhere, as well as decisions of Indian courts, the Court held that the Board was not bound to convene an EGM if the resolutions resulted in the company committing illegalities. Particularly for listed companies (and ZEEL was a listed company), there were certain specified requirements to be followed for the appointment of independent directors, and these could not be bypassed. The prior approval of the MIB for changes in the Board was required while the resolutions proposed that it could be obtained later on.

An issue arose whether the Board of Directors could consider extreme situations and possibilities to decide whether the resolutions may end up in the company committing illegalities. The Court held that the Board could and cited the philosopher Karl Popper and held that the test of illegality was to be checked from every angle, even extreme ones. It observed, ‘Any hypothesis has to be tested, repeatedly, for failure; including testing at the margins or extremities. It is no use saying that a hypothesis fits a median situation. The question is whether the hypothesis survives a test or collision against a polarity? If it does, then it is sound; if not, it must fail throughout and considered unsound’. To demonstrate this, the Court asked the counsel for the Shareholders whether a resolution proposing that the company engage in gambling business (illegal in India) could be allowed? The counsel replied that this was an extreme or outlandish proposition. The Hon’ble Court held that even such extreme tests were necessary to test the proposition raised. If the argument of the Shareholders was accepted, even a ‘madcap resolution’ would end up being allowed.

The Court also made another important point. It observed that even the Board of Directors itself could not propose such resolutions in the manner in which they were proposed as there would be violations of law. The shareholders are not on any higher pedestal, and the same criteria are applied. Had the Board proposed such resolution, could a shareholder object before a court against such proposals and seek injunctions? The Court answered in the affirmative.

Thus, the Court affirmed the decision of the Board of ZEEL to reject the requisition and granted the injunctions prayed. The EGM was directed not to be held by the Board or by the requisitioning shareholders.

IMPLICATIONS ON RIGHTS OF SHAREHOLDERS AND ON CORPORATE GOVERNANCE GENERALLY
With due respect, some aspects are worthy of consideration and debate. Concerns have been raised whether the court ruling would disempower shareholders and put brakes on even healthy shareholder activism. It could, it is argued, excessively empower an existing board having support of a small minority of shareholders and exclude the majority shareholders from exercising their rights. In particular, the issue raised was whether the process of screening prospective directors through the Nomination and Remuneration Committee was for the benefit of shareholders or could be used to supplant and exclude them? Indeed, this would mean that the shareholders could not even appoint directly those board members who would form this Committee. These, it is respectfully submitted, are valid points but it is also respectfully submitted that the answer lies in an amendment of the law, which, perhaps in hindsight, does seem to have lacuna which the present decision has thrown up.

In any case, it is respectfully submitted, that the Hon’ble Court is right in holding that the Board could not allow resolutions to be passed and implemented resulting in the company violating legal requirements. As the Court pithily observed, ‘Sometimes, it happens that a company must be saved from its own shareholders, however well-intentioned’.

AMENDMENTS TO PROVISIONS RELATING TO RELATED PARTY TRANSACTIONS

The Securities and Exchange Board of India has amended, vide Notification dated 9th November, 2021, certain provisions concerning related party transactions as contained in the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the LODR Regulations). These amendments will come into force from 1st April, 2022, except for certain specific provisions which shall come into effect from 1st April 2023. These amendments are a follow-up to the decisions taken at SEBI’s Board Meeting held on 28th September, 2021. Those decisions, in turn, are partial / modified implementation of the recommendations made by the Working Group constituted by SEBI on related party transactions vide its report dated 22nd January, 2020 (released by SEBI on 27th January, 2020). Let us take a look at these amendments.

BACKGROUND
Related party transactions, generally stated, are specified transactions between a company and certain parties related to it in a manner defined under the relevant law. Related party transactions are a sensitive issue where there is scope of benefit to the company but which also carry serious potential of abuse. Hence, not just company law and securities laws, but even tax and other laws provide for safeguards against abuse in such transactions.

In the case of companies, the concerns are special. The scheme of management of a company is that shareholders appoint a Board of Directors to run the company. While the Board oversees the running of the company and meets regularly to review the progress, lays down strategy, etc., the actual day-to-day running is carried out by full-time employees. Hence, there are layers between the actual owners – the shareholders – and those who run the company. If transactions are carried out between the company and directors / senior management (or entities connected to them), there is obviously a conflict of interest. Steps and controls would have to be laid down in law to ensure that this conflict of interest does not prejudice the company / its shareholders. The matter is further complicated by the fact that, usually, in Indian companies, there is a dominant group of shareholders, referred to as the promoters, who have ownership and management control over the company. Transactions with such promoters (or entities connected to them) would also have a similar conflict of interest which needs to be resolved.

At the same time, considering the manner in which businesses are generally run, related party transactions are unavoidable. Arguably, related party transactions could actually result in more efficiency and other benefits. Hence, related party transactions do not deserve a total ban. Both the Companies Act, 2013 (the Act) and the LODR Regulations have elaborate provisions to regulate related party transactions. As often pointed out earlier in this column, it is unfortunate that both the Act and the LODR Regulations regulate related party transactions in differently worded provisions. Thus, questions such as who are related parties, what is a related party transaction, how should they be regulated, etc., are answered differently by the Act and by the LODR Regulations.

What makes it worse is that SEBI keeps amending and reforming the LODR Regulations at a rapid pace – and thus the gap widens further. While there have been attempts earlier to narrow these differences, these are far from adequate. SEBI has now made some further amendments which we will discuss here. Note that the LODR Regulations apply to companies whose shares (and, in certain cases, debt securities) are listed on stock exchanges.

AMENDMENT TO THE DEFINITION OF RELATED PARTIES
The present definition, inter alia, deems only those members of the promoter group who hold 20% or more of the shares of the company as related parties. This part has been amended and now all members of the group shall be deemed to be related parties. The definition of promoter group itself is quite widely framed. Each of the members of the group, whether holding shares or not, will now be deemed to be a related party (as discussed earlier, with effect from 1st April, 2022).

The definition is amended even further whereby any person holding 20% or more of the equity share capital at any time during the immediately preceding financial year shall be deemed to be a related party. And with effect from 1st April, 2023 this limit will be lowered to 10% for a person to be deemed to be a related party. It appears that SEBI considers a higher, even if non-majority, shareholding a source of influence sufficient enough to consider a person as a related party and thus transactions with such persons requiring to be regulated!

The shareholding of 20% / 10% should be by a person and the concept of ‘group’ or ‘persons acting in concert’ is not made applicable. That said, it is also provided that the 20% equity shareholding (or 10% with effect from 1st April, 2023) may be held by such person directly or on a beneficial interest basis as provided in section 89 of the Act. Section 89, as amended a few years back, now has a more elaborate definition of what constitutes beneficial interest. A concern may arise here. It is stated that the holding may be direct or on a beneficial interest basis. While this results in clarity that transactions with such an entity shall be related party transactions, the question is whether the transactions should be with such beneficial owner or the company. Let’s take an example. In listed company L, a company A holds 25% shares. The beneficial owner in company A, as per section 89, is one Mr. P. Thus, Mr. P would be deemed to be a related party. The question is whether transactions with only Mr. P would be deemed to be a related party transaction and not transactions with the company A?

AMENDMENTS TO DEFINITION OF RELATED PARTY TRANSACTIONS
The present definition considers any transaction involving transfer of resources, services or obligations between a company and a related party as a related party transaction. It is now provided, to simplify things a little, that transactions between the holding company and related parties of its subsidiaries will be related party transactions for the holding company. Similarly, transactions between a subsidiary and the related party of the holding company would also be deemed to be related party transactions.

However, with effect from 1st April, 2023 a further twist is given to this to widen the scope even further. If the effect of any transaction is such that it is for the benefit of any related party as now defined (i.e., related parties of the holding company / subsidiaries), even then it will be deemed to be a related party transaction. While the intention seems to be clear, that is, to cover structuring whereby related parties get the benefits indirectly, the amendment does not give any further guidance as to how does one ascertain that a particular transaction is for the benefit of such newly-deemed related parties? This may create challenges for the Audit Committee and the Board.

The definition is further amended whereby certain transactions are now explicitly excluded. An issue of specified securities on a preferential basis that is in compliance with the SEBI ICDR Regulations will not be a related party transaction. Payment of dividends, bonus or rights issues, buybacks, etc., will not be related
party transactions if they are uniform across all shareholders in proportion to their shareholding. Acceptance of fixed deposits by banks or non-banking financial companies will not be related party transactions if the terms offered are the same as offered to all shareholders / public, provided that disclosure of such transactions is made to the exchanges every six months in the prescribed format.

AMENDMENTS TO PROVISIONS RELATING TO MATERIAL RELATED PARTY TRANSACTIONS
The scheme of the LODR Regulations is that related party transactions above the specified threshold are deemed to be material transactions requiring approval of shareholders. While such thresholds are laid down, the Board of Directors is also required to lay down a policy on materiality of related party transactions and how they should be dealt with, including clear thresholds. At present, a transaction with a related party would be considered as material if it, taken together with previous transactions in the financial year, exceeds 10% of the annual consolidated turnover as per the audited financial statements of the preceding financial year. It is now provided that if the transaction (taken along with earlier transactions in that financial year) exceeds Rs. 1,000 crores, then, too, the transaction will be deemed to be a material transaction. Thus, if the amount crosses 10% of such annual consolidated turnover or Rs. 1,000 crores, whichever is lower, it would be treated as material. This amendment will affect relatively large companies.

The present Regulations provide that related party transactions shall require prior approval of the Audit Committee. An amendment now requires that even ‘subsequent material modifications’ to related party transactions shall require such approval. The Regulations, however, do not define what constitute ‘material modifications’. Instead, the Regulations require the Audit Committee to define this term and make it a part of the policy on materiality of related party transactions.

It is now also provided that a related party transaction to which the subsidiary, and not the holding listed company, is a party and which transaction exceeds 10% of the consolidated turnover as per the preceding financial year’s audited financial statements, then the prior approval of the Audit Committee of the listed company would be required. With effect from 1st April, 2023, this clause will have effect if the value of such transaction exceeds 10% of the standalone turnover of the subsidiary.

The purpose of making a separate category of material related party transactions is to make them subject to approval by shareholders. It is now provided that even material modifications to related party transactions shall require approval of shareholders. Moreover, all approvals of shareholders of related party transactions will now have to be prior approvals.

CONCLUSION
This latest series of amendments to related party transactions seems aimed more towards expanding the scope to ensure that transactions are not structured in a manner that in substance they benefit related parties but in form they do not get caught in the net. The broad structure and scheme, however, remains the same. That is to say, non-material transactions may be approved at the level of the company and material transactions would require approval of the shareholders. Thus, there continues to be no outright ban on related party transactions. Also, no approval of any authority such as the Government or SEBI is required. The approvals remain internal and there are also elaborate disclosure requirements. Thus, stakeholders have a say in and have knowledge of such transactions.  (Also refer detailed analysis on Page 26)

SAT SETS ASIDE INSIDER TRADING ORDERS

As discussed several times earlier in this column, SEBI has been investigating stock market frauds, insider trading, etc., by tracking the use of social media / messaging applications. About a year back, we also discussed certain SEBI orders where it was held that some persons shared unpublished price-sensitive information through the popular chat application WhatsApp. Stiff penalties were levied on such persons under the Insider Trading Regulations. Those who were penalised appealed to the Securities Appellate Tribunal (‘SAT’) which has now reversed those orders. SAT has held that, on the facts, there was no violation of the SEBI Regulations on insider trading.

This decision of SAT has several interesting aspects. Has SAT made any significant interpretation of the law that has far-reaching implications as suggested by some reports? When can a person, who shares unpublished price-sensitive information (‘UPSI’), be held to have violated the Regulations? Is it necessary that a link be established between the person having the UPSI and the source within a company who had leaked such information? There are also lessons generally for persons using social media applications. Let us consider this decision (Shruti Vora vs. SEBI, dated 22nd March, 2021) in greater detail.

BROAD SCHEME OF SEBI (PROHIBITION OF INSIDER TRADING) REGULATIONS, 2015 AS RELEVANT HERE
The Regulations seek to prohibit and punish insider trading. They prohibit what is commonly understood as insider trading – that is, trading by an insider who is in possession of, or has access to, UPSI. However, they also prohibit several other things like communication of UPSI except where permitted under the Regulations. The Regulations also have further requirements of disclosure of holdings and dealings by certain insiders, prohibition of trading during periods when the trading window is required to be closed, etc.

In the present case, the relevant provision is related to the sharing of UPSI. Insiders are prohibited from sharing UPSI. The reason for this prohibition is obvious. Sharing such information may result in the recipient dealing and profiting out of it. However, such recipient may also further pass on such information to others. Such sharing is also covered by the offence of ‘insider trading’.

However, as this case shows, three interesting questions arise: Is it required to show that a person who shared UPSI had received it from a particular person within the company? Is it required that he should know that such information was UPSI? Would the offence of insider trading also cover sharing of UPSI by a person who is not aware that it is UPSI?

The first question has been answered by a deeming provision in the Regulations itself. It is provided that a person would be deemed to be an insider even if he is in mere possession of UPSI. Thus, it is not required that his source of such information be traced within the company (a little more on this later). He is deemed to be an insider. If he then deals in the securities, or shares such UPSI, he would be deemed to have committed the offence of insider trading.

The second question is interesting and indeed became, as we will see, the core issue in this case. Should a person know that the information in his possession is UPSI? The Regulations have not made an express provision on this. SAT has held that a person should be aware that such information is UPSI and it is only in such a case that the person would be deemed to be an insider. However, the equally critical question is how does one establish whether a person knows that the information he possesses is UPSI? This can be tricky as this would be something in the person’s mind. This aspect will be discussed further while analysing the decision.

The third question would be answered by implication from the answer to the second question although, again, the Regulations have no express provision about it. If a person does not know that the information he possesses is UPSI, then sharing of such information would not make him guilty of the offence of insider trading.

With this brief background, let us consider the case and then discuss what SAT has held.

FACTS OF THE CASE AND SEBI’S ORDER
It appears that SEBI was alerted especially by media reports that financial results of reputed companies were being leaked and shared in advance on social media through chat applications like WhatsApp. It conducted investigations and amongst its findings was some data relating to two appellants in the present case. It was found that they worked in the industry and had forwarded financial results through WhatsApp to many persons, including clients. The financial results forwarded were eerily accurate and very closely matched the actual results published soon after. However, SEBI could not trace who had sent this information to such persons. Even the companies concerned could not find any leak that could have happened internally from within the companies themselves.

SEBI, however, held that the law was clear. Possession of UPSI made the person an insider. The law also prohibited insiders from sharing UPSI with others. Since these persons did share the UPSI, they committed the offence of insider trading. It levied stiff penalties on such persons. Since similar orders were passed separately for sharing of results for each company, the penalties cumulatively rose to an even larger amount.

The parties had argued that not only these messages but several others were also forwarded in the same manner. And these messages were forwarded to groups of numerous persons. The messages were sent almost as soon as they were received. The other messages had information which was not UPSI and in any case often did not even match with the actual financial results in those other cases. However, SEBI stuck to its position and held that they had indulged in insider trading and levied penalties.

APPEAL BEFORE SAT
In the appeal before SAT, the appellants made several arguments. It was pointed out that they were not aware that what they had was UPSI. They had received numerous such messages and those were also forwarded along with the ones under question. They had no means to verify the authenticity of any of the information. The messages / information so received could be compared to ‘heard in the street’ columns common in media and while such pieces are read by many, it was accepted that their authenticity was not assured. Indeed, some could be just rumours or informed guesses. The appellants also pointed out that the specific messages that were of concern were not differently coded while being forwarded. So the recipients could not distinguish those messages from the others.

DECISION OF SAT
SAT accepted the arguments of the appellants and set aside the orders of SEBI levying penalties. It also made some important points about the interpretation of the law.

At the outset, SAT confirmed that possession of UPSI did make a person an insider under law and sharing of such UPSI by such person would be an offence under the Regulations. SEBI did show that the person was in possession of the UPSI and hence it may appear that one part was fulfilled. The information was shared, too.

However, and this was the crucial point, did such person know the information received and shared was UPSI? And, if not, would the information still be UPSI qua such person? The law is silent on this point. However, this did matter because it is from the perspective of the person accused of insider trading. If such person did not know it was UPSI, then that person cannot be held to be in possession of UPSI and hence is not an insider. And if this was so, his sharing of the information was not insider trading.

It was apparent from the record itself that the persons had received numerous bits of information and had forwarded the same to many other persons. Neither the persons sending them nor the persons receiving them could have had any way of knowing that the information was authentic and hence UPSI. SAT observed, ‘The above definitions of the “unpublished price sensitive information” and “insider” would show that a generally available information would not be an unpublished price sensitive information… The information can be branded as an unpublished price sensitive information only when the person getting the information had a knowledge that it was unpublished price sensitive information’. Thus, the information was not UPSI. One could take the example of the numerous WhatsApp forwards many of us receive. We have become used to examine them with so much scepticism that we generally have stopped even reading most of them.

While it is true that possession of UPSI was sufficient to make a person an insider, there were sufficient circumstances to doubt that it was UPSI and thus the onus shifted back to SEBI. It was now up to SEBI to prove, even with a reasonably low benchmark of proof or of the preponderance of probability, that the persons knew it was UPSI. SEBI could not and it did not so prove.

SAT also noted that SEBI has not connected the information to any source within the companies and even the companies did not have any such findings of leakage.

The order was thus set aside.

CONCLUSION
The important legal point thus is that UPSI is from the perspective of the person who is in possession of the same. If I have a pile of stones with me and I do not know that a couple of the ‘stones’ are really diamonds, I may give the same to someone else for a low value. And even he may do the same with them.

That said, this does not mean one should be lax with the law. The law provides for serious consequences for insider traders and the benchmark of proof remains relatively low. In this particular case, the facts were peculiar and hence did not allow any wider generalisation. One should remain ever vigilant while forwarding information. The law has sufficient deeming provisions. Chartered Accountants are typically and even otherwise deemed to be insiders as auditors, advisers, CFOs, etc. They are also expected to know the importance of figures and it is even possible that information shared by them may be given more weightage by the recipient, and thereby also by SEBI while deciding guilt. Thus, this case should induce even more caution.

A LEG-UP FOR INDEPENDENT DIRECTORS – WILL SEBI’S PROPOSALS IMPROVE CORPORATE GOVERNANCE?

SEBI has proposed several changes to the rules relating to corporate governance, mainly to strengthen the status of Independent Directors. The major changes include giving a bigger role to minority shareholders in the appointment / removal of such directors, proposing higher remuneration to them, strengthening the Audit Committee / Nomination and Remuneration Committee (‘NRC’) even further, etc. Views have been sought from the public at large through the release of a Consultation Paper.

The Consultation Paper notes how the requirements relating to corporate governance, introduced formally for the first time in 1999, have, over the years, seen several expert reviews and amendments in law to successively upgrade the requirements. As the paper notes, the Companies Act, 2013 / Rules made thereunder too have corporate governance requirements generally for specified listed and unlisted companies, many of them overlapping with the SEBI requirements. Hence, the fresh proposals are yet another step in that direction, though this time more focused on Independent Directors.

Independent Directors are seen as a pillar that balances the interests of all stakeholders with the primary focus on those of the minority shareholders vis-à-vis promoters. The worry is that promoters with their controlling stake should not be able to usurp the interests of others. This requires that they should not be able to influence the watchdog group – the Independent Directors.

APPOINTMENT AND REMOVAL OF INDEPENDENT DIRECTORS
The first of these important proposals looks at how Independent Directors are appointed and removed. At present, they are usually recommended by the NRC. The next step is appointment by the Board and the validity of their tenure is till the next annual general meeting. At such annual general meeting, the appointment is placed and confirmed by approval of the majority of shareholders who vote. Their removal is also by majority shareholder approval.

It is seen that the promoters who usually have a controlling stake can influence – perhaps decisively – the process at every step. This would mean that at every step they have a direct say and even decision-making ability. Thus, there are fair concerns that their independence may be influenced by the promoters. Hence, adopting the UK model almost wholly, it is proposed that this be corrected and that the appointment at shareholder level should pass two tests; first, approval by a majority of all shareholders including the promoters, and second, approval by the majority of the minority shareholders. Minority shareholders for this purpose would mean shareholders other than the promoters.

Let us understand this better through an example. Say, the promoters of a company hold 60% equity shares. The first test would be achieved when 50.01% of all shareholders approve (the percentage in each case is of shareholders who actually vote). Since promoters hold 60%, they would control this outcome. The second test is majority of the public (40%) shareholding and thus more than half of these – say 20.01% of the total – would also have to approve. If either of these tests fails, the appointment is rejected. There are then two ways out for the management. The first is that it can propose a new person as Independent Director and put him through these tests. Or, it can put the same candidate through a slightly different agni pariksha of sorts after a cooling period of 90 days, but before 120 days. If at least 75% of shareholders (including the promoters) approve, the appointment would be through. A similar process is proposed for the removal of Independent Directors. This ensures a significant role for the public shareholders and the strong influence of the promoters is mitigated to an extent.

SHORTLISTING OF INDEPENDENT DIRECTORS TO BE MORE TRANSPARENT
Even the shortlisting of Independent Directors is given a fillip by requiring more disclosures on how they came to be shortlisted. The process and requirements have to be laid down first and thereafter it is to be seen how each candidate fits these requirements. There have to be extensive disclosures to the shareholders, too.

Higher proportion of Independent Directors in the NRC
Moreover, the NRC that recommends Independent Directors will now have a higher proportion (two-thirds) of Independent Directors instead of just a majority as at present. A higher 67% ratio of Independent Directors would mean even more say to them in the NRC.

Appointment of new Independent Directors only by shareholders
At present the appointment of Independent Directors is made first by the Board and it is only at the later annual general meeting that shareholders get a chance to approve. During this period – which could be as long as a year – the Independent Director functions in office. To avoid this even interim say of the promoters on such appointments, it is now proposed that the appointment of Independent Directors shall only be by shareholders. If an Independent Director resigns / dies, his replacement too has to be made by shareholders, now within three months.

Resignation of Independent Directors to be more transparent and subject to restrictions
Concerns are often expressed that some Independent Directors having issues with the company may prefer to exit quietly without creating a fuss. To tackle this, several proposals have been made. Firstly, the complete resignation letter is required to be published by the company.

Further, if an Independent Director resigns stating ‘personal reasons’, ‘other commitments’ or ‘preoccupation’, he won’t be able to join any other Board for a year. This obviously makes sense since one cannot claim being busy, resign and then promptly join elsewhere. This may encourage them to be more forthright, if that was the real issue.

There is another concern. The management may have offered full-time employment to an Independent Director. This may be for bona fide reasons such as the management being impressed with his work. But obviously there are also concerns that this would affect his independence. A new proposal now states that if an Independent Director desires to join the company as a Wholetime Director, he will have to wait for one year after his resignation. Interestingly, as we will see later, the cooling period to become an Independent Director after having been an employee or KMP is three years, while in this case only one year’s cooling period is given.

Audit Committee to have no promoter / nominee directors or executive directors
The Audit Committee has an important role in approving related party transactions, accounts, etc. At present it is required that two-thirds of the committee should be Independent Directors and the rest can be any director, including promoter directors. Now, several categories are excluded even for the balance one-third of the committee. These may be non-independent directors but cannot be executive directors, nominee directors or those related to the promoters. The influence of both promoters and management is thus sought to be removed.

Excluding further categories of Key Managerial Persons
Persons who may have, in the immediate past, been employees / Key Managerial Persons (or their relatives) of the company and its holding / associate / subsidiary companies, or having material pecuniary relationships with them, may still have loose ties and may be subject to influence, and hence there may be concerns about their independence. Therefore, cooling periods are prescribed whereby they can join as Independent Directors only after specified periods. Two changes are now proposed. Firstly, now, past employees / KMPs of even promoter group companies will have to be subject to the cooling period. Secondly, the cooling period for all categories would now be uniform at three years.

ENHANCED REMUNERATION OF INDEPENDENT DIRECTORS
Finally, there is the proposal to enhance the remuneration of Independent Directors. The dilemma here is that if you pay too little, the Independent Director does not have the incentive to devote sufficient time to the affairs of the company. And if you pay too much, the concern is about him being influenced by the remuneration which may affect his independence. At present, a maximum Rs. 1 lakh per meeting is permitted as sitting fees. Commission based on profits is allowed but this has issues for loss-making companies. Besides, commission linked to profits has obvious concerns of conflict in approving accounts since there is a link between higher profits and higher commission.

A compromise of sorts is now proposed in two ways. One is by increasing the sitting fees, but this would have to be decided by the Ministry of Corporate Affairs. Hence, this proposal would be forwarded to them for their consideration.

The second is by permitting grant of employees stock options (‘ESOPs’) with at least five years vesting period. Thus, those who stay on for five years can possibly be rewarded through appreciation in the value of shares. However, this solution may not resolve the issue well. ESOPs are generally not very common in companies. Apart from this, a waiting period of five years could be too long and many may not benefit.

CONCLUSION
All in all, the changes are positive. However, much more is needed to be done. The powers and liabilities of Independent Directors have not been touched upon. Individually, Independent Directors have very little power. But the liability, on the other hand, is significant and the enhanced status may raise it even more. The remuneration of Independent Directors is still not resolved satisfactorily on at least two counts. First, the amount would still be decided by the Board and thus the promoters would still have a significant, often decisive, say. Second, the amount and manner may still be found to be insufficient to attract the best of talent. The proposal of dual approval tests giving minority shareholders a bigger role could also be applied for appointment of auditors who represent another pillar of safeguards.

It will also have to be seen how companies are required to transition to the new requirements. Will the provisions be effective immediately? Whether only large companies will be required first to change, with later dates being given for successive categories of smaller companies? Will the existing directors be allowed to complete their terms or will they have to be subject to this test immediately?

It is also seen that two laws – the SEBI LODR Regulations and the Companies Act, 2013 – have simultaneous requirements of corporate governance which overlap and even conflict. Perhaps the first step could be to require that listed companies would be regulated in this regard only by SEBI.

There is also another thought. Many principles of corporate governance are borrowed from the West, including a few significant ones from the UK, even in these proposals. India is different in a very vital way. Promoters typically hold a very significant stake, often more than 50%. Investors traditionally invest on the faith of the reputation and entrepreneurship of the promoters, though there would be cases where this trust is broken. While a check on them is always advisable, it should not happen that adopting a relatively alien concept tilts the balance so much that it actually becomes a hindrance.

CONTRADICTIONS BETWEEN COMPANIES ACT AND SECURITIES LAWS: COMPOUNDED BY ERRANT DRAFTING

BACKGROUND
A listed company is subject to dual regulation. First, by the Companies Act, 2013 which is the parent act under which it is incorporated and which lays down the basic rules about how companies should be governed. And second, the multiple regulations notified under the SEBI Act. The regulator under each of these sets of laws is also different.

It is not as if the objectives of the two laws are clearly distinct and non-overlapping. Unfortunately, however, neither regulator would like to cede to the other and agree that some areas are best regulated exclusively by the other. Thus, several areas are regulated by both the regulators. And these areas actually keep increasing. Whether the concept and requirements relating to Independent Directors, whether the issue of shares and debentures, whether the setting up of various committees, their constitution and scope, etc., each regulator makes its own set of provisions.

This article attempts to look at this overlap and the resultant consequences. It also highlights the attempts made periodically to harmonise and even cede control. It also differentiates the nature of enforcement by the two regulators.

But this article arises primarily out of a recent informal guidance issued by SEBI. In this case, not only is there dual regulation, but owing to what appears to be poor drafting, certain harsh consequences have arisen which SEBI has merely reinforced without accepting.

AREAS OF DUAL GOVERNANCE

The objectives of the Companies Act, 2013 (‘the Act’) / Rules notified therein and the Securities Laws (consisting of the SEBI Act and several regulations notified by it) do have common areas. Both have as one of their objectives the governance of companies, even if SEBI primarily regulates companies that have listed, or propose to list, their securities. Both regulate the issue of securities, even if SEBI basically regulates the issue of securities to the public.

Thus, for example, the whole area of corporate governance is regulated minutely by both the laws. The definition of ‘Independent Directors’ is enunciated elaborately and separately by each of the two regulators. The constitution of committees such as the Audit Committee and the Nomination and Remuneration Committee is similarly laid down independently by the two laws. And the manner of issue of securities is also regulated independently by each of the two sets of laws.

Both sets of laws also regulate related party transactions. However, the definition of related parties, the nature of related party transactions governed, the manner of their approval, the quantum limits beyond which special approvals are required, etc., are all framed with differences, some major and some minor.

The result obviously is many differences, big and small, which companies have to carefully navigate through.

CONSEQUENCES OF DIFFERENT PROVISIONS

What happens when the same issue has differently-worded provisions under the Act / Rules and the Securities Laws? For example, the minimum number of Independent Directors required. The Act has made a simple rule which may result in a lower number of minimum Independent Directors, while the Securities Laws (the LODR Regulations) would require more. Or, say, the definition of related party transactions. The definition of related parties under the SEBI LODR Regulations is wider and covers groups of persons who are not covered as related parties under the Act. Similarly, the definition of related party transactions under the SEBI LODR Regulations is wider. So, again, the question is how will the differences be reconciled?

Primarily, the answer is that (i) both the sets of provisions have to be complied with, and (ii) in case of overlap / difference, the narrower or stricter provision will apply. If the LODR Regulations require more Independent Directors while the Act prescribes a lower number, the LODR Regulations will apply. Similarly, the wider definition of related party transactions under the SEBI LODR Regulations will apply.

But while this may be a good basic principle, the provisions of each set of laws should be carefully examined.

ATTEMPTS TO HARMONISE AND CEDE CONTROL

It is not as if the two regulators are always deliberately confrontational and engaged in a turf war. There is actually a tendency to carefully review what the other regulator has already provided in its corresponding provisions. Indeed, from time to time reviews are carried out and attempts are made to harmonise wherever possible. However, often a fresh set of amendments is made which widens the gap further. Since the provisions governed by SEBI are generally in the Regulations which can be easily amended, SEBI is able to update the provisions to current requirements and also take care of the difficulties faced. The amendments to the Act require approval of Parliament, although, interestingly, we have also seen a series of amending acts over the years.

DUAL ENFORCEMENT ACTION

Each of the two sets of laws has differing consequences in case of violation. Even the process of enforcement can be different. A violation of the provisions in the Act may result in fine and / or prosecution and, at times, other action. SEBI, however, generally has a wider arsenal of actions. It may be in the form of levying a penalty, directing persons not to deal in securities, barring persons from accessing securities markets, disgorgement, etc.

Companies and other persons in default alleged to have violated the provisions may face dual proceedings, one by each regulator, even for substantially the same violation!

Interestingly, under section 24 of the Act, certain specified provisions of the Act relating to listed / to be listed companies are to be ‘administered’ by SEBI. Ideally, such a provision would have ensured not only that dual provisions are either eliminated or harmonised, but even the action is by a single regulator. However, the provisions of this section have a narrow scope.

MANAGERIAL REMUNERATION – DUAL PROVISIONS AND CONSEQUENCE OF POOR DRAFTING

Let us take up a specific case that provides a good example of overlapping provisions with certain anomalous results owing to poor drafting. This case relates to payment of ‘managerial remuneration’, i.e., remuneration paid to directors. Traditionally, the Act has regulated payment of managerial remuneration in fair detail. The persons who can be appointed as Managing / Wholetime Directors, the manner of their appointment, the upper limits of their remuneration, etc., are all regulated in detail. Earlier, payment of remuneration beyond the specified limits required approval of the Central Government. However, now the Act requires approval of the shareholders instead. But even the shareholders cannot grant approval for remuneration that exceeds certain limits. The Act places limits on managerial remuneration in terms of percentage of net profits (as calculated in a prescribed manner) and, in case where profits are inadequate, or there are losses, in absolute terms.

SEBI had, till recently, not provided for limits on managerial remuneration but dealt with the subject by requiring the Nomination and Remuneration Committee to recommend managerial remuneration. However, with effect from 1st April, 2019 it made several requirements relating to certain managerial remuneration. One such requirement related to Promoter Executive Directors and became an area of confusion and a company approached SEBI for an ‘informal guidance’. It may be recalled that SEBI grants ‘informal guidance’ on provisions (for a relatively small charge) which, although it has limited binding effect, often helps know the view that SEBI may generally take.

The relevant provision is Regulation 17(6)(e) of the SEBI LODR Regulations which reads as under:

(e) The fees or compensation payable to executive directors who are promoters or members of the promoter group, shall be subject to the approval of the shareholders by special resolution in general meeting, if –
(i)    the annual remuneration payable to such executive director exceeds rupees 5 crore or 2.5 per cent of the net profits of the listed entity, whichever is higher; or
(ii)    where there is more than one such director, the aggregate annual remuneration to such directors exceeds 5 per cent of the net profits of the listed entity:

Provided that the approval of the shareholders under this provision shall be valid only till the expiry of the term of such director.

Explanation. – For the purposes of this clause, net profits shall be calculated as per section 198 of the Companies Act, 2013.

As can be seen, the provision states that the upper limit on annual remuneration in case of one such Promoter Executive Director is Rs. 5 crores or 2.50% of the net profits, whichever is higher. In case there is more than one such director, the corresponding limit on the aggregate remuneration to all such directors is 5% of the net profits.

The anomaly is apparent. The limit on remuneration in case of one director is given in an absolute amount as well as in a percentage. However, in case of more than one such director, the limit is given only in percentage terms. To take an example, if the net profit is Rs. 50 crores, then the company may pay Rs. 5 crores as managerial remuneration to one such director, being the higher of Rs. 5 crores and Rs. 1.25 crores (2.50% of Rs. 50 crores). If there are two or more such directors, however, the company can pay only Rs. 2.50 crores, since in such a case the company cannot pay more than 5% of its net profits as aggregate remuneration to all such directors. Thus, even the single director, who could have otherwise received up to Rs. 5 crores, would now get a far lesser remuneration since the aggregate limit for all the directors put together is Rs. 2.50 crores! Of course, if the net profits are very large (say, beyond Rs. 100 crores), the difficulty arising out of such an anomaly would be diluted. But if the profits are less, the anomaly becomes even more glaring.

For a company that needs more than one such director, the provision creates difficulties. When SEBI was approached for an informal guidance on this, it confirmed the above view and said that the remuneration would be limited to 5% of net profits (see informal guidance dated 18th November, 2020 to Manaksia Aluminium Company Limited). Thus, the company would be required to approach the shareholders for a special resolution.

To be fair, SEBI could not have resolved a drafting anomaly through an informal guidance since this would generally require an amendment.

CONCLUSION


A careful consideration is needed whether at all there is a need for dual sets of provisions on the same subject which result in overlap, conflict and even confusion, apart from double proceedings and double punishment. A fleet-footed SEBI could be given exclusive jurisdiction over listed / to be listed companies in several areas. This will ensure that companies have a single set of provisions to apply and that there is a single regulator who will take action in case of violation and the regulator is one who has several different enforcement actions that it can take that are suited to the violation/s.

FIT AND PROPER PERSON (A widely worded test to refuse entry in the securities market)

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.

TRADING ON SELF-GENERATED RESEARCH – SEBI’S ORDERS MAKE IT ILLEGAL UNDER CERTAIN CIRCUMSTANCES

BACKGROUND
One would think that trading in shares based on one’s own research based on publicly available information is the commonest and the most logical thing to do and cannot imaginably be held to be illegal. Of course, many also trade on the advice of others such as professionals or even friends; equally obvious now is that trading on the basis of inside information is self-evidently illegal. And so is front-running illegal. But it would seem absurd to say that if one does meticulous research from publicly available information and then trades on it, it could be held to be illegal – and invite serious consequences! But, curiously, that is precisely one of the legal conclusions that the Securities and Exchange Board of India (SEBI) has drawn in at least two recent orders. To be clear, the facts as found by SEBI are peculiar. But, as a ruling in law, it does sound to be flawed. There are a couple of other similar issues in these orders which are also of concern.

The cases relate to recommendations for trading in scrips by persons (‘Hosts’) on a financial news channel and dealings by persons alleged to be closely associated with such hosts. The primary questions are three: Whether dealing by such persons (the host / persons closely associated with such host) themselves with advance knowledge of such recommendations is illegal under securities laws and hence punishable? Whether creation of momentum in the market by dealing in advance of such recommendations is illegal? The third question, which partly overlaps with the earlier two, is whether such dealings and practices are so unethical and unfair that they amount to violation of securities laws?

THE SEBI ORDERS
There are primarily two orders that SEBI has issued in this matter. The first order, an interim one, is in the case of Hemant Ghai (the host) and his relatives (order dated 13th January, 2021). This interim order and directions issued thereunder were confirmed by an order dated 2nd September, 2021.

The second order (dated 4th October, 2021), also an interim one, is in the case of Pradeep Pandya and certain members / HUFs of the Furiya family.

It may be added that these orders are / may be further contested and in any case be under further investigation / response from parties, being interim orders. Hence, the alleged findings of SEBI as discussed here are as per the SEBI orders. The focus here is to highlight the important and interesting legal issues involved and the possible ramifications of such cases.

SUMMARY OF ISSUES AND ORDER PASSED
Television channels (and even social media / streaming services) commonly have programmes where a host discusses and often makes recommendations to buy / sell a particular security. The recommendation is usually accompanied by a detailed presentation / graphics, etc., giving the justification for such recommendations. This recommendation may be made in an exclusive show by such a host who is associated with such channel or in general news where an ‘external expert’ is interviewed and who gives his recommendation.

As stated, there were two orders. In the first case, Hemant Ghai hosted / co-hosted various shows on news channel CNBC Awaaz. Recommendations about buying or selling a particular scrip were made on one such show. It was observed that as soon as the recommendation was made, the price of the scrip moved sharply in the direction recommended. That is to say, for example, if the recommendation was to buy a particular scrip, the price of that scrip immediately rose sharply in the market, obviously, as SEBI pointed out, because of such recommendation. Even the volumes rose very significantly on that day. The rise in price was far higher than the comparative movement in the stock index and there was no specific news from the company whose shares were recommended justifying such a rise. SEBI compared the price before and after the recommendation and noted that the rise in price (and volumes, too) was highest on the day of such recommendation. Similar findings were made by SEBI in the second order in the case of Pradeep Pandya’s show.

What was, however, found was that certain persons alleged to be associated with such hosts (‘associates’) repeatedly carried out trading to profit from such recommendation. Such persons bought (in the case of a buy recommendation) on the day before (or earlier on the same day) of the recommendation. When the price of the shares rose sharply after the recommendations, the associates sold the shares and made handsome profits.

Furthermore, such trades were carried out under the Buy-Today-Sell-Tomorrow (BTST) mechanism. This ensured that there was no need to even make payment for the purchase and take delivery.

SEBI made detailed inquiries on how the hosts and the respective associates were linked by taking into account family relations, call data records, addresses, etc. Accordingly, it held that the associates were aware in advance what recommendation was going to be made and hence traded in advance of such recommendation. When the price moved in the desired direction after the recommendations were released, the trades were reversed and profits made.

In the order in the matter of Hemant Ghai, calculations were made alleging that aggregate profits of about Rs. 2.95 crores were generated. In the case of Pradeep Pandya, similar calculations were made alleging profits of Rs. 8.39 crores.

The parties concerned were directed to impound these profits and deposit them in an escrow account. The hosts were also debarred from continuing to make any such recommendations till further orders. The parties were also debarred from dealing in securities till further orders. As stated earlier, the interim order in the matter of Hemant Ghai was confirmed after giving the parties a hearing.

INTERESTING POINTS ARISING OUT OF THE ORDERS
SEBI held, under the interim order, the parties (the hosts / associates) prima facie guilty of violation of multiple provisions of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Markets) Regulations, 2003 (‘the Regulations’). It was held that they traded on the basis of advance information that was not public. It was further held that trading in such manner, particularly without intimating the public that they have carried out such trades, was an unethical / unfair practice which in the light of several rulings amounted to violation of the Regulations. It was also held, in the Pradeep Pandya case, that by trading in advance, a momentum was created which contributed to price movement which, too, was in violation of the Regulations.

SEBI held, on the basis of the preponderance of probability, that the parties were guilty. For this purpose it relied on the decisions of the Supreme Court in the following cases: SEBI vs. Rakhi Trading (P) Ltd. [(2018) 143 CLA 15 (SC)]; and SEBI vs. Kishore R. Ajmera [134 SCL 481 (SC)].

SEBI also relied on the decision of the Supreme Court in SEBI vs. Kanaiyalal Baldevbhai Patel [(2017) 141 CLA 254 (SC)] for taking a broader and contextual view of what constitute unfair trade practices under the Regulations. Accordingly, it held that the practices alleged to have been carried out by the parties were in violation of the Regulations.

A few interesting points arise. The primary issue is whether trading on material self-generated information / analysis can be a violation of the Regulations? Can it be said that to have such advance information and trading on it amounts to such violation?

It is respectfully submitted that such ruling is absurd. Persons trading in markets, particularly informed and expert persons, often collate information of a wide nature and arrive at their own conclusion. There is no duty in law to publish such self-generated analysis and conclusions in advance to the public before carrying out trading on their own account. Investing and speculation in the market would, it is submitted, come to a standstill if this was held to be a requirement. Let us compare this aspect with two other types of dealings which are now well settled to be violations – insider dealing and front-running. In case of insider dealing, a person has access to unpublished price-sensitive information about a company and he deals on the basis of such information. It does not need elaborate explanation as to why this is illegal and indeed specific regulations make such dealings illegal. In the case of front-running, persons entrusted with price-sensitive information carry out trades on their own account first and then carry out the trades of the persons who have entrusted them with such information. They, too, thus profit and now such dealings are well settled to be violations of the Regulations.

In the case of self-generated information, there can hardly be a case of having advance information illegitimately obtained on the basis of which trades were carried out and that this is violation of the Regulations. It is submitted that this finding of SEBI has no basis in law or logic and the order needs to be reconsidered on this point.

Let us take the next issue which is a bit more contentious. The parties did not disclose to the public that they had already carried out the trades in advance of the time when they made the recommendations. To begin with, SEBI has not pointed out any specific provision in law which requires them to make such declaration. Interestingly, in most of the transactions, it was not even as if the parties made trades opposite to what they recommended. In other words, it was not as if the parties were, for example, selling while recommending to the public to buy. They did sell but after having bought first and after the price rose.

It was not even the case of SEBI that the price fell sharply after the parties sold the shares. Indeed, SEBI gave data in several cases which did not show any fall and the only point which was made was that the price did not rise as much in the days after the day of the recommendations. So it was not even a case of what is commonly known as ‘pump-and-dump’, which is a well-known fraudulent practice where unscrupulous persons by various means make the price rise to artificially high levels and then offload the shares, leaving the buyers in the lurch as the price falls soon thereafter.

Moreover, SEBI has not even claimed that the recommendation was deliberately manipulative and there was no informed basis for the recommendation. Indeed, as the SEBI orders point out, often the scrips recommended were large, well-known companies.

The allegation that in the Pradeep Pandya order the parties carried out heavy trades with an intention to thereby (even without the recommendation) result in an artificial momentum in one direction and this is thus a violation of the Regulations, of course does make sense. It would indeed be a case of pump-and-dump.

CONCLUSION
It would indeed be disturbing for the public to know that hosts of TV shows buy (or sell, as the case may be) first for themselves the scrips they recommend and sell when the price rises when there is a heavy rush to buy following the recommendation. Cynics would, of course, argue that there is no free lunch and indeed their own buying the very scrips they recommend to buy is actually having faith in their own recommendations. But holding that this is illegal and hence punishable is, it is submitted, a flawed view.

The matters are under further investigation. There could be prolonged proceedings resulting in a final order which could then be appealed against at various levels. It would be interesting to see how SEBI and appellate authorities deal with the issues. A wide range of persons, formally and informally, make recommendations about scrips. The final ruling could make such persons change the manner in which they make recommendations, what disclosures they make and perhaps debar certain types of trades.

INDEPENDENT DIRECTORS AND QUALIFYING TEST

BACKGROUND
Independent Directors are meant to be the pillar of corporate governance many of whose tenets are now mandatory in specified large / listed companies. In principle, every Director is expected to exercise a level of independence and even act akin to a trustee while discharging his duties. This is expected even from a Promoter or a Working Director. However, there are conflicts of interest, the reality of which cannot be denied. A Promoter Director or a Working Director cannot, in all fairness, be expected to be able to exercise the level of independence than one who is not so. Hence, a category of Directors was needed who had no connection or conflict that could impinge on their independence. Independent Directors, thus, have to pass through a series of negative conditions to ensure that there is no conflict of interest.

However, merely being independent is not sufficient for a person to discharge the onerous responsibility of acting as a Director when the Board of which he is a member has to oversee at a very senior level. Hence, apart from prescribing a series of disqualifications, the law also lays down that he should have certain knowledge that would enable him to discharge his responsibilities. To be precise, it is passing a certain online self-assessment Test in certain areas that are relevant to his functioning as an Independent Director. He is also required to register his details with a databank in a prescribed manner. The provisions relating to such a Test and for the databank have undergone amendments, including one most recently on 19th August, 2021 which gives exemption from the Test for professionals, including Chartered Accountants of certain standing. We discuss this subject in detail in this article.

OVERVIEW OF QUALIFICATIONS AND DISQUALIFICATIONS OF AN INDEPENDENT DIRECTOR
There are more disqualifications that make a person ineligible to become an Independent Director than there are qualifications that make him eligible! Being connected with the company or the Promoters in a variety of specified ways makes a person disqualified to be an Independent Director. However, the qualifications / qualities laid down are largely generic and even vague, thus making most people eligible and qualified. Rule 5 of the Companies (Appointment and Qualification of Directors) Rules, 2014 (‘the Rules’) provide that an Independent Director ‘shall possess appropriate skills, experience and knowledge in one or more fields of finance, law, management, sales, marketing, administration, research, corporate governance, technical operations or other disciplines related to the company’s business.’ However, it is up to the Board to assess whether the proposed Independent Director has the required expertise / knowledge. Section 149(6) of the Companies Act, 2013 requires that the Board should assess whether in its opinion he ‘is a person of integrity and possesses relevant expertise and experience.’

However, there is also a specific requirement whereby the Independent Director has to pass an online Test which tests his knowledge on a variety of regulatory and related areas which are relevant for him to perform his functions as a Director.

BROAD SCHEME OF THE REQUIREMENT RELATING TO MAINTENANCE OF DATABANK AND PASSING OF ONLINE TEST
There are two sets of requirements linked to each other that an Independent Director has to comply with. Firstly, he has to ensure that his name is entered into a databank maintained in the prescribed manner by the specified Institute. Secondly, he has to pass the specified online self-assessment Test.

Some of these requirements came into force when the provisions relating to Independent Directors were already on the statute. Hence, these provisions had to be introduced giving a transition period for Independent Directors already existing in office. Those aside, the broad scheme is as follows: A person desiring to be appointed as an Independent Director shall, before such appointment, apply to the Institute for inclusion of his name in the databank maintained by it. He may apply even if there is no immediate proposal of his being appointed as such. He also needs to pass the specified online Test within two years of inclusion of his name in such databank. If he does not pass, his name would be removed from the databank. There are categories of persons who are exempted from passing such a Test. Recently, by an amendment made to the Rules on 19th August, 2021, more categories of exempted persons have been added. The overall scheme for this purpose, partly by non-application of mind and partly by a series of amendments, is a little clumsy and also leaves several ambiguous areas.

Note that the requirement of appointment of an Independent Director under the Act applies not only to listed companies but also other categories of public companies, such as those with paid-up capital of at least Rs. 10 crores, turnover of at least Rs. 100 crores, etc.

Requirement of passing Test for being eligible to be appointed as an Independent Director
Rule 6(4) of the Rules requires an Independent Director to pass the specified ‘online proficiency self-assessment Test’ (‘the Test’). This Test has to be passed within two years of inclusion of his name in the databank maintained by the specified Institute. If he does not pass, his name will be removed from the databank.

The Institute in this case is the ‘Indian Institute of Corporate Affairs at Manesar’ as notified under section 150 of the Act.

He has to obtain a score of at least 50% in the aggregate in the Test. He can appear as many times as he wants for the Test, though he should pass it within the time limit of two years from the date on which his name is included in the databank.

Requirement of passing the Test applicable only to Independent Directors
Curiously, the requirement of passing such a Test and even of entering the name in the databank is required only for an Independent Director. Other Directors, who may form half or more of the Board, are not required to pass such Test.

Categories of Independent Directors who are exempt from passing the online Test
While the Test is not exceptionally difficult to pass, it still means that many otherwise highly qualified and / or experienced people would need to take this Test. There may be persons who may be specialists for years or even decades in their respective fields and yet would have to pass the Test. Recognising this, the Rules have been progressively amended and several categories of persons are now exempt from passing it. However, no exemption has been provided from the requirement of entering the name and details in the databank.

The categories that are exempt from passing the Test are described below.

Persons who have been Directors or key managerial personnel of certain types of entities for at least three years are exempted. These entities include listed companies, unlisted public companies with a paid-up capital of at least Rs. 10 crores, bodies corporate incorporated outside India with a paid-up capital of at least US$ 2 million, etc. This exemption will be particularly helpful for Promoters, Working Directors and even key managerial personnel, etc., who have already been associated with listed companies and who would otherwise have been required to take the Test.

Then there are persons who have worked at a senior level with the Government. Those persons who have acted at such a senior level for a period of three years in the pay scale of Director or equivalent or above in any Ministry or Department of the Central or State Government and having experience in specified areas such as commerce, corporate affairs, etc., are exempted from passing the Test.

Similarly exempted are persons who have acted for three years in the payscale of Chief General Manager or above with regulators like SEBI, Reserve Bank of India, the Pension Fund Regulatory and Development Authority, etc., and having experience in handling matters relating to corporate laws, securities laws or economic laws.

Further, persons who have been, for at least ten years, advocates of a high court or in practice as a Chartered Accountant / Company Secretary / Cost Accountant, do not need to pass the Test. This will be helpful to professionals who by virtue of their long standing have adequate knowledge and experience in fields that would be relevant entities requiring the appointment of Independent Directors.

WHAT IF THE DIRECTOR DOES NOT PASS SUCH TEST WITHIN THE SPECIFIED TIME?
The law requires a person to appear for and pass the Test within the specified time. However, what would happen if he does not bother to appear or he appears and does not pass within the prescribed time? Rule 4 says that ‘his name shall stand removed from the databank of the institute’. The intention of the law seems to be that only those persons who have passed such Test or who pass the Test in the specified time should be appointed as Independent Directors.

However, the clauses are not happily worded. There are no clear answers to questions such as (i) Will it make such person ineligible to be appointed as an Independent Director? (ii) Will he immediately vacate his office as Independent Director? (iii) Will he have to pay any penalty for continuing to act as an Independent Director despite not passing the Test? (iv) What is the role of the company in this regard and whether it is required to remove such Director?

CONCLUSION
By these recent amendments, the law now rightly exempts more categories of persons who have long experience and good knowledge of their respective fields but would still be required to pass the online Test. However, it must be said that the governance of the Board and the regulatory requirements relating to them have over the years become quite complex and elaborate. The exempted categories are generally those having experience / knowledge of specialised areas while governance of the Board can require different skills, knowledge and exposure. Thus, knowledge of various laws and procedures would be helpful and it would be advisable to study the relevant laws. Further, it is necessary to appear for the Test and to pass it to confirm his knowledge. Clearly, the Test is one-time and at present there is no requirement to periodically re-appear for it or undergo some refresher course. But here, too, it may be advisable that even those who have passed the Test earlier may keep updating themselves and even voluntarily appear for it again.

    

SUPREME COURT FORMULATES GUIDELINES FOR COMPOUNDING; HOLDS THAT CONSENT OF SEBI NOT REQUIRED

BACKGROUND
An interesting feature of the SEBI Act, 1992 is that one can potentially be prosecuted u/s 24 for violating any provision of the Act and even any of the rules and regulations made thereunder. Further, the punishment can be in the form of imprisonment for as long as ten years, or a fine of up to Rs. 25 crores. Non-payment of the penalty imposed is also punished stringently, with a minimum prison term of one month and a maximum of ten years; or with a fine of Rs. 25 crores. This is quite unlike other laws under which only specified serious violations can be prosecuted as offences. In a sense, the provisions of the SEBI Act, at least on paper, sound more stringent than even the Indian Penal Code that has varying punishments for different offences.

Fortunately, prosecution is not generally initiated indiscriminately under the SEBI Act. However, the fear of being prosecuted remains. The question that arises is how does a person, who is willing to make amends for the wrong he has committed get relief from prosecution? For this purpose, the SEBI Act has enabling provisions for compounding of offences. Section 24A provides that offences, other than those punishable with imprisonment only or with both imprisonment and fine, can be compounded by the Securities Appellate Tribunal or the court before which the proceedings are pending.

Considering that there is no violation in the Act that is punishable by imprisonment only or by both imprisonment and fine, the conclusion is that all offences are compoundable and thus any prosecution proceeding can be compounded (see later herein for certain remarks of the Supreme Court). This is because there is a common provision for prosecution u/s 24, unlike other laws that have separate punishments prescribed for different violations.

The question that came up before the Supreme Court in Prakash Gupta vs. SEBI (order dated 23rd July, 2021, [2021] 128 taxmann.com 362 [SC]) was whether, for compounding an offence by a Court / SAT, the consent of SEBI is a prerequisite? In other words, if SEBI vetoes the application for compounding and does not grant consent, can the offence still be compounded? The Supreme Court, while dealing with this question, ruled on several aspects and thereafter even laid down guidelines for compounding. These were made, the Court said, in the absence of explicit provisions in the law which gap it attempted to fill. Thus, the ruling has relevance on several aspects of the subject.

PROVISIONS OF LAW
As stated earlier, section 24A of the SEBI Act enables compounding of offences and the authority for this purpose is the SAT or the court before which the proceedings are pending. SEBI has notified settlement regulations which deal with settlement of civil proceedings and compounding of offences. The Regulations provide that the principles as applicable for settlement of civil proceedings would also apply for compounding. General principles have been laid down for three categories of proceedings. In respect of the offence of non-payment of penalty, such amount of penalty with interest and legal charges as deemed appropriate by SEBI would be proposed before the court. Generally, the amount for compounding the offence would be as per the guidelines laid down in the Schedule to the Regulations. If the application for compounding is made after framing of charges by the court, then this amount would be increased by 25%, apart from legal charges and other terms as approved by the whole-time panel of SEBI as set up under the Regulations.

However, there are many areas where there is silence or lack of clarity. Is there an inherent right to compounding? Can all offences be compounded as a matter of right? If there are some offences which cannot be compounded, which are those and who decides this? Whether such a decision can be questioned and, if so, on what grounds?

If the person rights the wrong, compensates the party that is wronged, etc., does compounding become a matter of right? In this context, is compounding of offences under the SEBI Act at par with compounding with, say, under the Negotiable Instruments Act for dishonouring of cheques?

Finally, is the consent of SEBI necessary for compounding or is it solely at the discretion of the court to compound the offence? What is the relevance and weight of the views of SEBI in the matter?

These are some of the issues discussed in the decision.

IS THE OFFENCE OF NON-PAYMENT OF PENALTY COMPOUNDABLE?
Section 24(2) treats non-payment of penalty levied under the Act as an offence over and above the violation in respect of which the penalty is levied. The question is whether this offence is compoundable. In principle, considering that the offences of violation of the provisions of the Act / Regulations / Rules are compoundable, the answer should have been yes. However, the Court dwelt on what seem to be ambiguous words used in the provision. It appeared to the Court that since there was a minimum prison term of one month provided, one view could be that imprisonment is mandatory. Section 24 says that an offence punishable with imprisonment and fine cannot be compounded. In which case, as per this view, the offence of non-payment of penalty cannot be compounded. However, since this specific issue was not before the Court, it did not give a final ruling on it and kept it for consideration at a future date. In the author’s opinion, considering the framework not only of the section but also of the settlement regulations, the better view should be that non-payment of penalty should also be compoundable.

HISTORICAL ORIGIN OF COMPOUNDING OF OFFENCES
In passing, and as a matter of academic interest, it is interesting to note that originally compounding itself was an offence and continues to be so to a certain extent. Compounding generally meant a person accepts consideration for not prosecuting an offence. This could be even by a police officer, or others in authority, and could thus be a bribe. However, the position has changed over time. There were less grave situations where it may not be worth the effort to prosecute a person. For offences such as under the Negotiable Instruments Act, the intention may be to make dishonouring of cheque an offence a means to make such a person honour the cheque. Hence, if the party is willing to pay off its dues, the court may generally be inclined to allow compounding. There may also be situations where the offence is not very grave, the offender may have realised his wrong and regretted it, and even the injured person may be willing to let the matter go (perhaps also on receipt of some compensation). Hence, compounding of offences could be lawfully done if the law provided for it. Different laws have provided for compounding in different ways and hence the question was how should the provisions of the SEBI Act be interpreted.

Serious wrongs that cannot be compounded
The Court noted that there may be offences that are not cured merely by compensating the injured person or even if the injured person is not interested in pursuing the proceedings. There are wrongs that are public in nature and have wider implications. The yardstick applied cannot be a single and uniform one.

WHETHER CONSENT OF SEBI IS NECESSARY FOR COMPOUNDING
In the matter before the Court, the appellant had applied for compounding before a lower court. When the views of SEBI were sought, SEBI refused to grant consent to such compounding and the Additional Sessions Judge before whom the proceedings were initiated thus rejected the application. The appellant approached the High Court which, citing earlier precedents, affirmed the decision.

The Supreme Court held that the wording of section 24A is clear. There is no mandatory requirement of consent of SEBI for the Court to allow compounding. The Court would consider the views of SEBI but the decision of whether or not to compound the offence would rest with the Court. The important question, however, is what weight should the Court assign to the views of SEBI.

VIEWS OF SEBI ON WHETHER OR NOT TO ALLOW COMPOUNDING
The Court elaborately discussed the object of the SEBI Act and the role of SEBI as an expert body in the securities markets. It noted that SEBI has a duty to protect the interests of investors and generally the capital market. It also reviewed the mechanism laid down by SEBI for consideration of applications for compounding and also the independent High-Powered Advisory Committee (‘HPAC’) set up to provide advice on the matter. The Court held that the views of SEBI on whether or not compounding should be allowed should be respected and followed unless the view taken can be shown to be arbitrary or mala fide.

The Court also considered the aspects that SEBI takes into account and as laid down in the guidelines issued by SEBI. In particular, the matters in respect of which compounding / settlement would ordinarily not be allowed were noted.
All in all, the Court held that while the consent of SEBI is not a prerequisite, the views / recommendations of SEBI would ordinarily be followed.
GUIDELINES LAID DOWN BY THE COURT FOR CONSIDERING COMPOUNDING APPLICATIONS
As if to not only give the last word but provide a comprehensive framework for compounding, the Court laid down specific guidelines that would effectively fill the gap existing today. The Supreme Court laid down four guidelines that the Court / SAT should consider while disposing of applications for compounding:
a. The factors enumerated by SEBI in its Circular of 20th April, 2007 and accompanying FAQs should be considered, though not as exhaustive.
b. The application for compounding has to be made to SEBI which places the same before the HPAC. The recommendation of HPAC should be placed before the Court / SAT which should give due deference to such opinion. It should differ if it has cogent reasons and only if the reasons provided by SEBI / HPAC are mala fide or manifestly arbitrary.
c. The offences under the SEBI Act are not comparable with other laws where restitution of the injured party is a strong ground for allowing compounding. Most offences under the SEBI Act are of a public character and restitution may not always be enough. In any case, for this purpose the opinion of SEBI should be relied upon.
d. Finally, and this point is an extension of the third one, the Court / SAT should consider whether the offence is private or public in nature. If of a public nature, it would affect the public at large. Such offences should not be compounded even if restitution has taken place.
CONCLUSION

Not only has the Supreme Court given a categorical ruling on the role of SEBI and its views on compounding, it has also given a detailed framework on how compounding applications should be considered and what principles and considerations ought to be followed in the matter. The Court applied these principles also to the case before it and held that the matter did not deserve to be compounded, considering the facts and also the views of SEBI. With a fairly comprehensive framework laid down including the weight to be assigned to the opinion of SEBI, one can trust now that applications for compounding will be more transparent and reason-based.

TO BE OR NOT TO BE A PROMOTER

BACKGROUND
As the securities laws increasingly seek to lay down sound principles of corporate governance and also push towards greater professionalisation of company management, a question has arisen whether the unique concept of promoters in securities and corporate laws needs a close relook. So much so, that even SEBI has realised this and is considering whether this concept should be dropped or re-conceptualised.

In India, promoters have been given a central role, focus and obligations in listed companies owing to historical and other reasons. While on their own they have hardly any special rights, they have multiple and even onerous responsibilities and it is increasingly felt that they need to be reconsidered considering the changing reality. The present law is so stringent that even reclassification of a person from promoter to non-promoter is a lengthy, difficult and complicated affair. It is almost as if being a promoter is a one-way street, i.e., till death do you part!

In a recent major proposed public issue, the question came up yet again about who should be classified as a promoter and why would this status be so keenly shunned. It was reported that certain top investors / management did not desire to be termed as ‘promoters’. The question is when and how is a person deemed to be a promoter and when can he claim that he is no longer a promoter.

HOW DID THE CONCEPT OF PROMOTER COME INTO BEING?

To appreciate this, we need to understand the term and then consider how various laws define and treat promoters. Promoters, traditionally, are those enterprising persons who conceive a business idea, set up a company and seek investors to finance the business. They would run the business and later even hand it over to another management. The investors would participate in the ownership / profits / appreciation. Thus, they could be seen as persons with ideas but without the financial means to implement them. They need investors who are willing to share the risk for what they expect to be substantial rewards, without usually participating in the day-to-day management of the company.

In western countries, promoters / management typically hold a small share in the capital. Their returns would come as appreciation of such holding and remuneration for running the company. In India, traditionally, promoters are families who typically own a substantial part, usually 50% or more, of the equity. Thus, they have very substantial control in the company by virtue of their own investment. As we will see, even the law expects them to have a significant own stake, or what is termed nowadays as ‘skin in the game’. Their control over the company would usually continue through succeeding generations. Since the promoter family would have dominant control, the challenge for the regulator is more of balancing the interests of these family promoters with those of the public / minority shareholders.

Thus, a multitude of provisions under the Companies Act, 2013 and various SEBI regulations have focused on identifying these promoters and placing various responsibilities and liabilities on them.

THE LEGAL CONCEPT OF PROMOTERS AND OBLIGATIONS ON THEM

To begin with, the term is defined very widely. Persons who are in ‘control’ of the company are deemed to be promoters. The term ‘control’ is also given a very wide definition. While majority shareholding is usually enough to give them ‘control’, even certain special rights under agreements are deemed to be ‘control’. Once such promoters are identified by these criteria, specified relatives and entities connected with them in the specified manner are also deemed by law to be part of the promoter group. The list of such persons is usually quite long.

The promoters are required to have a minimum significant percentage of capital after a public issue. Thus, the public issue cannot be a means of their exit. Further, their shareholding is subject to a lock-in for one to three years. Extensive disclosures are required about the history and background of each of the promoters. They have to make regular disclosures of their shareholding and changes or charges (such as pledge, etc.) made thereon.

Interestingly, they are also the fulcrum around which the independence of directors is tested. Any person who is connected with them in any of the specified ways is deemed to be not independent. This is again an extension of the presumption that the promoters are in control and hence if one is connected with them, one loses one’s independence.

Importantly, if anything goes wrong in the company, they could be very likely seen as the primary suspects for blame and punishment. This, again, is linked with their being presumed to be in control. Of course, in many situations those who are not directly involved in the day-to-day management may not be presumed to be liable.

Deeming as promoters starts with a public issue
One facet of this subject, the complications of which we will discuss later, is that the deeming of persons / group(s) as promoters begins with a public issue under securities laws. This category becomes defined and even frozen at this stage and the persons who form part of this group are identified. Unlike being in active management, being a promoter is not necessarily a choice. Being a relative or connected in one of the many specified ways is sufficient for a person to be deemed a promoter.

EXITING FROM THE PROMOTER GROUP

While it is easy to become a promoter, often even without a choice, the difficulty is in exiting. One cannot just ‘resign’ as a promoter or exit the group through a mere declaration. Even severing of financial or other ties may not always help one to get out of the category.

It is not as if a promoter is trying to escape responsibility. There may be members of the family who have no connection with the company. There may even be separations / divisions in the family. The promoters themselves could have so low a shareholding that they have literally no say, whether as directors or shareholders. Yet they continue to be promoters and remain subject to multiple restrictions, obligations and liabilities.

Regulation 31A of the SEBI LODR Regulations lays down the procedure for declassification from promoter to non-promoter. It requires, to begin with, the fulfilling of several conditions demonstrating that the person is no more connected with the promoter or even the company. The next step is obtaining the approval of the Board of Directors of the company. Then the approval of the shareholders is required. Finally, the stock exchange has to approve the reclassification. This process may easily take months and its outcome is quite uncertain. The process becomes even more difficult if the promoters seeking exit have disputes with the other promoters, which is something that is often seen in families.

Of course, it can be argued that in cases where some of the qualifications or connections that made a person a promoter no longer exist and so the person ought to thereby become a non-promoter. However, one wished there were specific and clear provisions regarding this.

COMPANIES WITHOUT PROMOTERS

Fortunately, there are provisions in the SEBI Regulations for companies with ‘no identifiable promoters’. This is particularly so in case of companies with professional managements. However, to qualify for this one would have to escape the wide net cast by the very broad definition of ‘promoter’ and ‘promoter group’.

SEBI’S ATTEMPTS TO CHANGE THE LAW


SEBI has been making attempts to address some of these issues. Indeed, two consultation papers have been recently issued by SEBI to discuss how to simplify the reclassification and how to narrow down the definition. These, however, at best scratch the surface. So the only way out is to squarely avoid becoming a promoter. And the best way is to do this, as stated earlier, at the time of the public issue.

But even that is not easy! The definition of promoters is very wide and even persons having a significant say in management, whether by way of shareholding or by agreements or otherwise, could be classified as promoters. Litigation on this issue (e.g., the decision of SAT in the Subhkam Ventures case, dated 15th January, 2010, read with the ruling of the Supreme Court on appeal) has been inconclusive. SEBI had attempted to specify some bright line tests in this regard to lay down specific criteria / clauses in an agreement which could make a person a promoter. But nothing real came out of this either.

The problem is further complicated because multiple laws have placed requirements on promoters. These include the Companies Act, SEBI Insider Trading Regulations, SEBI Takeover Regulations, SEBI Listing Regulations, the SEBI ICDR Regulations, certain laws made by the RBI, etc. Thus, there are multiple regulators involved. All this makes a change difficult and complex.

However, such changes are now the need of the hour. As SEBI has rightly pointed out in its recent consultation paper dated 11th May, 2021 on redefining the term ‘promoter’, the holding of promoters has decreased steadily from 58% in 2009 to 50% in 2018 in the top 500 companies. More importantly, the holding of institutional investors has substantially increased from 25% in 2009 to 34% in 2018. Many companies capitalising on new technology are professionally managed companies with no identifiable promoters. Hence, now the responsibilities and obligations are increasingly sought to be placed on the Board of a company rather than on the promoters.

Robust corporate governance with active involvement of institutional investors would be a better long-term objective rather than focusing on family-centred promoters. However, considering that these consultation papers propose small changes rather than a proper overhaul, the concerns remain. Hence, for now, even if not easy, prevention would be a better strategy for management / investors of new companies than the very difficult cure.  

NEW FAQs ON INSIDER TRADING

SEBI has released in April, 2021 a comprehensive set of Frequently Asked Questions (‘FAQs’) on the SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘the Insider Trading Regulations’). Several aspects of the subject have been clarified. A few important ones are discussed here.

BRIEF BACKGROUND OF THE INSIDER TRADING REGULATIONS

Insider trading is an evil of stock markets that is unacceptable across the globe and stringent laws are made against such acts. The concept of insider trading is simple enough. A person close to a company is entrusted with material information about the company and he is duty-bound not to abuse it for profit. It may be information about, say, substantial growth in profits of the company. Yet he goes ahead and buys shares of the company while the information is not yet public. When the information is released, the share price expectedly rises and he thus profits. Insider trading is condemned on several grounds. It reduces faith in the markets as there arises a feeling that the market is rigged against ‘outsiders’. It also amounts to a moral wrong by such a person against the company itself which also loses. The persons who actually invest in the company and thus put their money at risk may be at a loss. Therefore, there are comprehensive regulations against insider trading.

This evil is tackled in various ways under the law. The primary policy of course is to ban trading on the basis of Unpublished Price Sensitive Information (‘UPSI’). Communication of UPSI is also prohibited. Detailed rules are laid down for control over it. A comprehensive and very wide definition of an ‘insider’ is laid down. Several categories of persons who are connected with the company or even connected with connected persons are deemed to be insiders. Further, apart from the ban in law, the company itself is required to self-regulate trading by certain insiders by a code of conduct.

It is not surprising that many areas exist where the law does not appear to be clear. SEBI has now released a comprehensive set of FAQs on the Regulations.

MULTIPLE SOURCES OF GUIDANCE – NOTES, INFORMAL GUIDANCE AND FAQs

Before we proceed to some specific and important FAQs, it is interesting to note the several attempts made to give guidance in various forms to the admittedly complex set of Regulations. The Regulations have this fairly interesting feature of ‘Notes’ to some of them. The notes attempt to explain the nature of that particular regulation. The legal status of such notes is not wholly clear.

Then we have Informal Guidance issued by SEBI in reply to specific queries raised by market participants from time to time. Coincidentally, SEBI has compiled important Informal Guidances on insider trading and released them almost simultaneously with the FAQs. But the legal status of Informal Guidances, too, is ambiguous at best.

And now we have the FAQs which again are specifically stated to be not law and not binding!

Yet, the Notes, Informal Guidances and FAQs do throw light on the complex and loosely worded Regulations and also show the mind of SEBI on how it views the Regulations. The Regulations will, of course, always rule as law but in the field of Securities Laws such supporting material has always been relevant and indeed they enrich the law.

Let us now consider some important FAQs.

DO THE REGULATIONS APPLY ALSO TO DEALINGS IN DERIVATIVES, DEBENTURES, ETC.?

The common understanding of insider trading may be that the Regulations cover dealings in equity shares. This also makes general sense since it is typically equity shares that are affected by release of material information. For example, a jump in the performance of the company affects the price of its equity shares.

However, the Regulations refer to ‘securities’ and not merely to ‘equity shares’. The term ‘securities’ is very widely defined and includes shares of all types, derivatives, debt securities, etc. Thus, the FAQs clarify that such other types of securities (except units of mutual funds) are also covered by the Regulations. Dealings in ADRs / GDRs are also clarified to be covered.

CREATION / INVOCATION / REVOCATION OF PLEDGE AND OTHER FORM OF CHARGE ON SECURITIES

It is common for shareholders to raise loans against their securities or otherwise offer such securities as security for various obligations. The securities are thus subjected to a charge which may be a pledge, a hypothecation, etc. The question is whether the creation (as also the invocation / revocation) of such a charge would amount to ‘dealing’ which is regulated?

On first impression, it would appear counter-intuitive that such acts should be regulated. Pledging of the shares does not result in transfer of risk and reward. If the price of the shares rises or falls, it would be on account of the shareholder; unlike a sale where the risks and rewards get transferred. However, an insider in possession of UPSI may, for example, pledge his shares and obtain a loan. Once the UPSI is released, which, say, is seriously negative news, the price of the shares may fall sharply. The lender thus may suffer as he will not be able to recover his loan even if he had kept a margin.

A ‘Note’ to the definition of ‘trading’ clarifies that this would include pledging, etc., while in possession of UPSI. The FAQs make this clear even further. Thus, creation, etc., of such a charge while in possession of UPSI would amount to dealing that is prohibited. However, the FAQs clarify that under certain specified circumstances such acts are permitted but it would be up to the pledger / pledgee to demonstrate that they were bona fide and prove their innocence.

CONTRA TRADES

As explained earlier, the Regulations attack the evil on several fronts. One of them is by way of ban on short-term trading by insiders which is also known as entering into contra trades within a specified period.

The basic rule is that an insider should not deal in the securities of the company on the basis of UPSI. However, to find him guilty of such an act, SEBI would have to prove several aspects. To avoid this, certain designated insiders have been banned from entering into contra trades within six months. To put this a little simply, if he purchases shares today, he cannot sell shares for six months. And vice versa. This places a brake on insiders doing quick trading which can expectedly be on the basis of UPSI.

However, some aspects are not clear and the FAQs have been released to clarify them.

Can such an insider buy a derivative and then reverse it within six months? The FAQs say he cannot, unless the closure of the derivative is by physical delivery. In other words, if he buys a future for, say, X number of shares, he can close the future by taking delivery and making the payment. However, he cannot close the future by selling it. This again makes sense because buying and selling futures / options may expectedly be on the basis of UPSI.

Can such an insider acquire shares by exercise of ESOPs and then sell them within six months? The FAQs says he can. The FAQs make some further clarifications. If he buys equity shares from the market on, say, 1st January and then acquires further equity shares by exercise of ESOPs, he can sell the shares acquired through ESOPs any time but he cannot sell the shares acquired from the market till 1st July. This would appear a little strange since usually both the categories of shares may be in the same demat account and hence not capable of being distinguished.

Then, the question is would the acquisition of shares through rights issues or public issue also amount to acquisition whereby one cannot sell the shares for the following six months? The FAQs clarify that you cannot sell the shares for such period.

Further, it is clarified that the ban on contra trades would apply not just to the designated insiders but also to their immediate relatives collectively.

IMMEDIATE RELATIVES

It is common, particularly in India, that family investment decisions are made by one person or at least jointly. One person may thus take decisions for himself / herself and other family members such as spouse, parents, children and even further. It would also be very easy for an insider to avoid the ban on trading on himself by trading in the name of a family member. Thus, the definition of insider for specified categories includes trading by ‘immediate relatives’ and they, too, are subject to certain similar regulations.
The question then is, who is an ‘immediate relative’? The definition under the Regulations creates two categories. One is the spouse, the other category is of the parent, sibling and child of such person or his / her spouse who is financially dependent on such person or consults such person while making an investment decision. The ‘Note’ to this definition clarifies this is a deeming fiction and hence rebuttable. The FAQs further emphasise this.
This clarification is important because often, being a mere relative does not necessarily mean that their dealings are in consultation with or even known to other members. A parent may not even know what are the dealings in securities of the child, particularly when the child is an adult, maybe with his own family. The same principle extends to siblings. Even spouses may want to carry out their own dealings. Hence, it would not be fair to extend an inflexible rule covering dealings of all relatives. Nevertheless, it would be more reasonable to expect, particularly in circumstances in India, that dealings of relatives are more likely based on information accessed by the insider. However, the insider can rebut this deeming fiction and establish that such persons do not consult him for their investment decisions and are not financially dependent on him.
CONCLUSION

Insider trading is not only an evil in the securities markets, but being held guilty of insider trading carries its own stigma. A person with such a track record may not get a job again in a reputed company. Investors, particularly those who are close to listed companies, would have to be familiar with the intricacies of these widely-framed Regulations so that they are not held liable under them. A Chartered Accountant in his professional dealings is very often an insider or deemed to be so by legal fiction. He may be a statutory or internal auditor, Independent Director, Adviser, Chief Financial Officer, financial adviser, merchant banker, etc., of listed companies. With his financial expertise, he would also typically deal in securities. Or he may simply park his savings in securities for his retirement. He would have to be even more careful in his dealings. The FAQs issued by SEBI thus help particularly the conservative investor who would educate himself and wade through the minefield of these Regulations safely.
 

ACCREDITED INVESTORS – A NEW AVENUE FOR RAISING FINANCE

SEBI has, at its Board meeting of 29th June, 2021, taken some baby steps to introduce and recognise a new category of investors – the Accredited Investors (‘AIs’) who are persons of high net worth / income. This has been followed up by amendments to the respective SEBI regulations on 3rd August, 2021. These changes should open up a new and wide channel of raising finance from informed and capable investors, particularly in areas where the present regulations are too restrictive.

This is not a new concept internationally. Many countries such as the USA, Canada, Singapore and even China have provisions for such a category of persons who are deemed to be well aware, if not sophisticated, and also having sufficient net worth so as to be able to bear losses in risky investments. Many rules are relaxed for such persons and issuers / intermediaries are able to issue complex, high risk / high return products to such persons at terms that are mutually agreed rather than statutorily prescribed. Thus, on the one hand, entities that cannot otherwise raise finance without crossing many hurdles can now raise finance more easily from such persons, on the other hand, such persons have wider avenues of investments to aim for higher returns at risks which they understand and can even manage.

In other words, AIs are expected to be sophisticated high net worth investors who do not need elaborate hand-holding by the regulator. They can evaluate complex, high risk / high return products / services and negotiate terms flexibly to protect their interests.

COMPLEX SEBI REGULATIONS AIMED AT THE NAÏVE AND UNSOPHISTICATED INVESTOR
SEBI’s regulations generally are models of micro-management. Having seen small investors repeatedly suffering in their investments, and perhaps also considering the reality of Indian markets, the rules in capital markets tend to bend towards elaborate controls. Parties generally cannot, even by mutual agreement, waive the many requirements of law enacted for the protection of investors.

A portfolio manager, for example, cannot accept a client with less than Rs. 50 lakhs of investment even if the client is well informed / capable. He also cannot invest more than 25% of the portfolio in unlisted securities under discretionary management, even if the client is agreeable to this. Similarly, Alternative Investment Funds have restrictions which cannot be avoided. Investment Advisers, too, face a very elaborate set of rules which govern almost every aspect of their business, including even the fees that they can charge. Thus, even if an informed client is willing to pay higher fees to get expert advice, the investment adviser is limited by the regulations.

The result of all this is that needy issuers are starved of funds and well-informed investors deprived of avenues with the potential of higher returns.

CONSULTATION PAPER ISSUED IN FEBRUARY, 2021
SEBI had initiated this process in February, 2021 by issuing a consultation paper proposing a framework for AIs and seeking public comments. This has now been finalised and amendments accordingly made to the regulations relating to Alternative Investment Funds, Portfolio Managers and Investment Advisers.

Who would be recognised as Accredited Investors?
As per the new framework, a person can obtain a certificate as an AI on the basis of net worth / assets or income, or a combination of the two. For example, an individual / HUF / family trust can be an AI if its annual income is at least Rs. 2 crores or net worth is at least Rs. 7.50 crores, with at least half of it in financial assets. Or it can be a combination of at least Rs. 1 crore annual income and net worth of Rs. 5 crores (with at least half in financial assets).

For other trusts, a net asset worth of at least Rs. 50 crores can qualify them as AIs. For corporates, too, a net worth of Rs. 50 crores is necessary. A partnership firm would be eligible if each partner is individually eligible. Similar parameters are provided for non-residents such as non-resident Indians, family trusts / other trusts, corporates, etc. Government departments, development agencies and Qualified Institutional Buyers, etc., would be AIs without any such minimum requirements.

Interestingly, a further category of AIs has been specified, viz., Large Value Accredited Investors. This would apply in case of Portfolio Managers and would be persons who have agreed to invest at least Rs. 10 crores.

A strange aspect is that, unlike some countries in the West, SEBI has not permitted educated / experienced investors to qualify as AIs. Indeed, having qualification or experience is not deemed to be even relevant! Thus, for example, Chartered Accountants or even CFAs, though trained to be well-versed with finance, cannot only by virtue of the fact of being qualified and competent, be recognised as AIs. They can act as advisers to AIs, but not be AIs themselves, unless they have the minimum size of assets / income.

Further, again unlike many western countries, merely having a minimum income / net worth is not enough. A formal certification as an AI is needed from certain bodies recognised for this purpose. A fee would have to be paid to them for grant of such a certificate. Curiously, although the details have not been notified, it appears from the Consultation Paper that the certificate is likely to be valid only for one year at a time and will have to be renewed annually.

The Consultation Paper had proposed yet another strange condition. Persons who desire to provide financial products / advice to AIs would not only need to obtain a copy of such a certificate from the AIs, but will also need to additionally approach the certifying agency and reconfirm with them. This would be a needless additional hurdle. Hopefully, the process may actually end up being simpler with such confirmation being quickly provided online on an automated basis after due verification by the certifying agency. However, it would be best that this requirement is not mandated when the further details are notified.

Nature of relaxations from regulations available for transactions with AIs
While ideally, an informed and capable investor should not face any hurdles in his decision-making power for making investments, even if the provisions are meant for protection, there will not be total relaxation. Instead, perhaps with the intention of testing the waters and going in gradually, SEBI has given partial relaxation from the regulations. In fact, the relaxations as proposed are few and far between. The minimum investment required, the terms on which contracts of providing services can be made, the fees that can be charged, the extent to which investments in unlisted securities can be made, etc., are some relaxations proposed.

The amendments are primarily made in the SEBI regulations governing Alternative Investment Funds, Portfolio Managers and Investment Advisers. The Consultation Paper / SEBI Board meeting has talked of amendments to other regulations, too, and it is possible that more changes may be made in the near future.

BENEFITS OF THE NEW CONCEPT
The new scheme can be expected to benefit intermediaries, investors and indeed the market. They would have more freedom to enter into arrangements and investments with risks and complexities that they are comfortable with. It should also result in availability of far more funds, from many more persons and by many more issuers. Today, many such investments simply cannot take place because of protective legal requirements. There would also be more flexibility for the parties involved. The amendments also create a sub-category of AIs called Large Value Accredited Investors, as also a separate category of fund called Large Value Fund for Accredited Investors. These would enable further flexibility to larger investors who expectedly can undertake more informed risks.

Can an AI opt out of the scheme either generally or on a case-to-case basis?
There are a few other concerns. Even if a person is an AI, he may not always want to waive the regulatory protection. He may have more than the prescribed size of net worth, etc. However, in certain cases, he may prefer not to invest as an AI. It seems that there is no bar on him from opting out.

However, care would have to be taken in the paperwork / agreements to ensure that there is no inadvertent waiver. It is common, however, that investors end up signing on the dotted line on long documents containing fine print. This is even more important considering that the benchmark for being an AI is only financial and not knowledge / qualifications.

An interesting issue would still remain as to whether, in case of disputes, his being an AI could be used against him and he be assumed to be an informed and sophisticated investor.
Whether SEBI would be available as arbiter in case of disputes / malpractices?

The intention clearly is that parties should be able to negotiate their own terms and formulate such structures, even if complex and high risk, as they are comfortable with. The regulations that otherwise provide for mandatory detailed terms would not apply. The question then would be what would be the role of SEBI in case of disputes between AIs and issuers / intermediaries? In particular, whether SEBI would still be available as arbiter in case of malpractices? Or will the parties have to approach civil courts which are expensive and time-consuming? One hopes that at least in case of frauds, manipulations, gross negligence and the like, recourse to SEBI would still be available as SEBI continues to be an expert and generally swift-footed regulator.

CONCLUSION


Despite some concerns, the amendments are still a major reform in the capital markets. Considering that the relaxations are generally partial, the level of complexity may actually increase. One can now only wait and see how the experience turns out to be over the years and how SEBI deals with the issues that would arise.
(You can also refer to the Article on Accredited Investors on Page 31 of BCAJ,  August, 2021) 

SEBI: REVISING ITS OWN ORDERS AND ENHANCING PENALTIES

BACKGROUND
One of the many penal powers that SEBI has under the SEBI Act, 1992 (‘the Act’) is to levy fairly hefty penalties on those who have violated the provisions of various securities laws. The penalty is often up to three times the gains or Rs. 25 crores, whichever is higher. A person on whom a penalty has been levied can appeal to the Securities Appellate Tribunal (‘SAT’) and, if he does not succeed, further to the Supreme Court.

However, the question is, can SEBI review and revise its own orders?

The penalty is levied by an Adjudicating Officer (‘AO’) who, though subordinate to SEBI, is expected to act independently. It may happen that the ‘AO’ has, in the eyes of SEBI, made an error and thus the alleged wrongdoer escapes with a lower or even no penalty. Can this error be corrected? An incorrect order not only lets a wrongdoer escape but also creates a precedent for related matters in similar context and future cases.

The Act provides for a review and revision of the orders passed by the ‘AOs’. The Act was amended in 2014 with effect from 28th March, 2014 and sub-section (3) was introduced to section 15-I to permit such revision. Broadly stated, SEBI can initiate proceedings to revise an adjudication order and enhance the penalty if the order is found erroneous and not in the interests of the securities markets. The review proceedings have to be initiated within three months of the original order, or disposal of appeal by SAT against such order, whichever is earlier.

SEBI has passed several review orders under this provision. In fact, it recently enhanced the penalty on credit rating agencies in the matter of IL&FS from Rs. 25 lakhs as per the original order to Rs. 1 crore. Let us analyse the provision in more detail and consider briefly some pertinent cases.

SECTION 15-I(3) ANALYSED

Section 15-I of the SEBI Act lays down the procedure for adjudication by an ‘AO’ under various provisions that prescribe the penalty for specific wrongs. Section 15-I(3) lays down the provisions relating to revising orders passed by the ‘AO’ and reads as under (emphasis supplied):

Power to adjudicate
…
(3) The Board may call for and examine the record of any proceedings under this section and if it considers that the order passed by the adjudicating officer is erroneous to the extent it is not in the interests of the securities market, it may, after making or causing to be made such inquiry as it deems necessary, pass an order enhancing the quantum of penalty, if the circumstances of the case so justify:

Provided that no such order shall be passed unless the person concerned has been given an opportunity of being heard in the matter:

Provided further that nothing contained in this sub-section shall be applicable after expiry of a period of three months from the date of the order passed by the adjudicating officer or disposal of the appeal under section 15T, whichever is earlier.

Specific aspects of this provision are discussed in the following paragraphs.

ORDER SHOULD BE ‘ERRONEOUS’

This is the basic and most important prerequisite for enabling SEBI to take up revision of such orders. There has to be a manifest error in the order. The error may be of fact or of law. The error may be of not levying a penalty where the law requires it, or levying a lower penalty. An error must also be distinguished from taking a different view from amongst two or more views plausible. It is submitted that the view taken by the ‘AO’ has to be erroneous in the sense that such view could not possibly be taken. An error may not be very difficult to identify and demonstrate. However, in case of law there may be some subtleties. If two views are possible on reading the relevant provision of law, merely because the ‘AO’ took one of the plausible views does not mean that the order is erroneous. However, if the view in law is not possible to be taken, then the order is erroneous.

The other issue is, when can the amount of penalty levied be said to be erroneous? Certain provisions levy a minimum penalty and thus if the ‘AO’ levies penalty below this statutory minimum, the order is obviously erroneous. There can be other similar errors. The interesting question is that if the ‘AO’ levies penalty within a certain range permissible under law, can the order be held to be erroneous and a higher penalty be levied? As we shall see later, SEBI has levied higher penalty, albeit on facts, in certain orders.

THE ORDER IS ‘NOT IN THE INTEREST OF SECURITIES MARKETS’

The error should be of such a nature that it is not in the interests of securities markets. This provision is obviously very broad in nature and gives a wide brush for the SEBI to paint with. The securities markets consist of investors, companies, various intermediaries, exchanges, etc. There is also generally the credibility of the securities markets. Further, and more importantly (as also pointed out in orders under this provision), an error whereby a wrongdoer escapes with lower or no penalty creates an unhealthy precedent for others and indirectly serves as a disincentive for those who scrupulously follow the law.

The two conditions are simultaneous
The order should be erroneous and such error should be one that is not in the interests of the securities markets. Both these conditions have to be shown by SEBI before it can take up review of such an order and pass a revised one.

Opportunity of being heard
This is a basic principle of natural justice and is inbuilt in the provision. The party should be given a fair opportunity of being heard since the revision may result in enhancement of the penalty.

Enhancement of the quantum of penalty
The order can be revised and the amount of penalty can be increased. An interesting contention was raised in a couple of cases that enhancement means that the earlier order should have levied at least some penalty. And, therefore, if there was no penalty levied, there is no question of enhancement! SEBI has rejected this technical argument and has held that a penalty can be levied even if no penalty was levied earlier.

Interestingly, SEBI has even taken a view in some orders that the revision need not necessarily be for enhancing the penalty. It may even be for correcting a wrong interpretation of law by the ‘AO’.

Time limit
The provision shall not apply after a period of three months from the date of the original order or disposal of the appeal by SAT in relation to such order, whichever is earlier. While the wording is not wholly clear on this point, SEBI has taken a view that the time limit applies to initiation of the proceedings and the final revised order may be passed in due course even after such time.

Whether appeal to SAT against original order would bar such revision till appeal is disposed of?
SAT has refused to bar the continuation of such proceedings for revision even when the original order was under appeal before it (in the case of India Ratings and Research Private Limited vs. SEBI, order dated 1st July, 2020). However, it also ordered in that case that the revised order should not be given effect to.

Whether the provisions relating to revision under the Income-tax Act, 1961 are pari materia with the provisions under the Act?
A stand often raised by parties when faced with such revision proceedings is that the provision under the Act should be interpreted and applied in the same strict manner as the provision for revision of orders under the Income-tax Act for which there are numerous precedents laying down principles. However, SEBI has rejected this stand generally. It has taken a view that the scheme, object and even wording of the provision under the Income-tax Act are sharply different. Hence, section 15-I(3) of the (SEBI) Act has to be viewed independently and broadly.

SOME ORDERS PASSED UNDER THIS PROVISION

Over the years, SEBI has passed several orders revising the original order. Some of those orders are worth reviewing briefly.

In an order dated 13th November, 2014 in the case of Crosseas Capital Services Private Limited, no penalty was levied in a certain case of self-trades through automated trading. On facts, SEBI reviewed this order and held that a penalty was leviable and also directed the party to review its systems to ensure that such acts are not repeated. SEBI also rejected the argument that ‘enhancement’ can be only where the earlier order had levied at least some penalty. Orders of similar nature were passed against a stock-broker and his client in two other cases –

a) In the case of broker Adroit Financial Services Private Limited and its client AKG Securities and Consultancy Limited, vide order dated 13th January, 2015, and
b) In the case of broker Marwadi Shares and Finance Limited and its client Chandarana Intermediaries Brokers Private Limited, vide order dated 13th October, 2015.

Vide order dated 11th January, 2017, in the matter of Saradha Realty India Limited, SEBI passed an interesting direction. The original order of the ‘AO’ had let off certain directors of the company who had resigned although they were directors at the time when the violations took place. The penalty was thus levied, jointly and severally, only on the existing directors. SEBI passed a revised order levying such penalty on all the persons who were directors at the time when the violations took place. The amount of penalty itself was not enhanced.

In a recent order (dated 20th November, 2020 in the matter of Oxyzo Financial Services Private Limited), SEBI held that the ‘AO’ had made a wrong interpretation of the applicable provision and thus revised it as per the correct interpretation. However, since even otherwise there was no violation by the party of the applicable law, no penalty was levied even in the revised order.

In three recent orders, all dated 22nd September, 2020, SEBI enhanced the penalty levied from Rs. 25 lakhs to Rs. 1 crore in each case. These were the cases of credit rating agencies in respect of credit rating in the matter of IL&FS. SEBI held that, especially in view of the significant amounts involved and the impact on investors, a higher penalty was deserved.

CONCLUSION


Often, adjudication proceedings are initiated many years after an alleged violation. These proceedings themselves may take a long time to conclude. The revision proceedings would then add yet another layer to the time and proceedings. Thankfully, there is a short time limit of a maximum of three months of the original order to initiate such proceedings.

However, the wordings of the provision for revision are broad and even vague at places. The scope ought to be narrow particularly considering that the original order has to be ‘erroneous’. Merely because SEBI holds another, different view should not result in invocation of this provision if the view in the original order is also an alternate and acceptable one. Further, merely because a higher penalty was leviable by itself should not result in invocation of this provision. One hopes that, in appeal, clearer principles would be laid down.

INTERIM ORDERS – POWERS OF SEBI RESTRICTED BY SAT

BACKGROUND

Three
consecutive recent rulings of the Securities Appellate Tribunal (SAT) have
placed limitations on the powers of SEBI to pass interim / ex parte
orders which restrain parties from accessing stock markets, require them to
deposit allegedly illegal profits in escrow accounts, etc. These precedents
also lay down guidelines and specify the circumstances under which such powers
may be exercised by SEBI and hence will help other parties obtain relief when
faced with similar arbitrary orders passed based on little or no credible
evidence. One of the decisions of SAT has been affirmed by the Supreme Court on
facts.

 

SUMMARY
OF RELEVANT LAW

SEBI does have
wide powers to pass penal, remedial and other orders / directions against those
who have been found to have committed violations of securities laws. Such
violations may include fraud on markets, insider trading, front-running, etc.
SEBI may pass orders to disgorge illegally made profits. However, there may be
concerns that while the investigation and due process is ongoing, the parties
may continue the frauds or other violations. They may even transfer the assets,
illegally made profits, etc., in such a way that their recovery later may not
be possible. SEBI has powers to pass interim orders to prevent such things from
happening and thus may restrain parties from continuing such violations,
transfer assets, etc. SEBI may also pass interim orders to impound the
estimated amounts and require that such monies be deposited in an escrow
account pending final orders of disgorgement.

 

Such interim
orders may be passed after giving an opportunity of hearing, or even without
such opportunity which may instead be given after the interim order. The
interim order in the case may be confirmed, modified or reversed after the
hearing. If confirmed, it may stay in place till the investigation is
completed, show cause notices issued to parties and after giving due opportunity
to respond, including a personal hearing, and then a final order may be passed.

 

Such interim
orders may be of various types and SEBI has wide general and specific powers in
this regard. SEBI may prohibit a person from accessing the securities markets.
It may prohibit a person from dealing in securities in such markets. It may
impound the proceeds or securities in respect of transactions that are under
investigation. Usually, such orders to impound such amounts are accompanied by
orders to freeze assets of such persons till such impounded amounts are duly
deposited in escrow accounts.

 

However, orders
that stop access to or stop dealing in securities markets may be economically
fatal. The amounts directed to be impounded may be far higher than the actual amount
later found to be correct, or may be directed on the wrong persons. Depositing
of such amounts at such short notice may be difficult or even impossible.
Considering that such orders are usually accompanied by directions freezing the
assets of parties, the effects may be even more far reaching.

 

Such orders are
also indefinite in nature in the sense that there is no statutory outer time
limit by which time the final orders have to be passed. Thus, the restrictions
may continue indefinitely. It is no solace to the parties if it is found later
that they have not committed any violations, or no or a lower amount can be
disgorged. At best, the amounts in the escrow account would be returned with
the minimal bank interest paid by nationalised banks, the parties being allowed
to resume their activities.

 

As the three
case studies summarised here will show, the orders have been arbitrary with
harsh consequences which SAT had no hesitation in setting aside or modifying.
In one case where the interim order has been finally disposed of, SEBI has
actually reversed the order stating that no purpose would be served in issuing
such interim directions. The Supreme Court affirmed the view that such orders
can be passed only in urgent cases, which the facts must bear out.

 

Case 1 – Cases
relating to ‘trading in mentha oil contracts’ on a commodity exchange

A unique
concern of commodity exchanges is the cornering of the market in a commodity by
a person / group. Such dominance may result in price distortion which could
also harm other participants in the market. In this case, SEBI had concerns
that a group of parties had accumulated a substantial percentage of mentha
oilstock [North End Foods Marketing (P) Ltd. vs. SEBI (2019) 105 taxmann.com
69 (SAT)]. It was prima facie believed that this was done to
manipulate the mentha oil market and dominate the price of mentha oil futures.
SEBI passed an interim order prohibiting the parties from dealing in or
accessing the securities markets and from being associated with it.

 

The parties
filed an appeal before SAT which recorded several findings. It noted that there
was no prima facie finding that the parties had accumulated large
quantities of mentha oil or that they had dominated the market. There was
merely suspicion to that effect. Further, no urgency was found for passing of
such orders. In any case, the order was passed at a much later stage when the
execution of trades was over and the facts did not show the alleged
manipulation. SAT thus set aside the said interim order.

 

This decision
of SAT has become a precedent for future cases and lays down guidelines,
restrictions and also circumstances under which such interim orders may be
passed.

 

At the outset,
SAT recognised that SEBI has wide powers to pass such orders. SAT also
confirmed that the opportunity to respond / of personal hearing may be given
later. That said, SAT noted that such orders can have serious consequences and
hence have to be passed only in urgent cases and sparingly. In particular,
there has to be prima facie evidence and finding of wrong-doing and its
continuance. Since none of this was present in the present case, SAT set aside
the order.

 

SAT observed, ‘In our opinion, the respondent is empowered to
pass an ex parte interim order only
in extreme urgent cases and that such power should be exercised sparingly.
In the instant case, we do not find that any extreme urgent situation existed
which warranted the respondent to pass an ex parte interim order. We
are, thus, of the opinion that the impugned order is not sustainable in the
eyes of law as it has been passed in gross violation of the principles of
natural justice as embodied in Article 14 of the Constitution of India.’

 

Interestingly,
SEBI, after the interim order was set aside, re-examined the matter and
confirmed that there was no urgency or purpose served for passing the interim
directions. Hence, it desisted from passing any fresh interim order and also
vacated the interim order against those who had not gone in appeal. The
investigations, of course, continue.

 

Case 2 –
Alleged insider trading case

SEBI found that
the Managing Director of Dynamatic Technologies Limited (DTL) had sold some
shares during a time when it was alleged that there was unpublished
price-sensitive information of reduced profits. SEBI computed the reduction in
market price after such information was made public and accordingly computed
the losses allegedly avoided which amounted to Rs. 2.67 crores. SEBI added
interest thereon from such date and passed an interim order that an aggregate
amount of Rs. 3.83 crores be impounded and accordingly deposited by such person
in an escrow account. Till such time as this amount was so deposited, his
accounts were frozen.

 

The MD appealed
to SAT. SAT applied its own ruling in the North End Foods case (Supra),examined
the basic facts and noted that the sale of shares was in 2016. The
investigation commenced in 2017 and the interim order was passed in 2019. No
evidence was put forth on how the appellant had tried to divert the alleged
notional gains. SEBI in its order had expressed a mere possibility of diversion
of such gains. SAT affirmed that such orders can be passed only if there is
some evidence to show and justify the action taken. Accordingly, SAT set aside
the direction but it asked the appellant to file a reply within four weeks and
that SEBI shall give a personal hearing and thereafter pass a final order
within six months. However, SAT also required the appellant to give an
undertaking that he shall not alienate 50% of his holding in the company
[Dr. Udayant Malhoutra vs. SEBI (2020) 121 taxmann.com 326 (SAT)].

 

SEBI appealed
to the Supreme Court against the SAT order and the Court affirmed the decision
on facts [SEBI vs. Udayant Malhoutra (2020) 121 taxmann.com 327 (SC)].
It affirmed the view of SAT that such orders could be passed only in urgent
cases. Since the facts of this case did not demonstrate such urgency, the Court
refused to interfere with the SAT order.

 

Case 3 –Prabhat
Dairy Limited

In this case the company had sold its holding in its subsidiary and a
unit to another company. The sale proceeds were substantial and the company
had, while seeking approval of shareholders for such sale, stated that it will
use the net proceeds for distribution to its shareholders in an appropriate
form. It appears that such distribution was delayed. In the meantime, the
promoters of the company, who held about 51% shares, proposed to acquire the
shares held by the public and thereby de-list the shares of the company. This
de-listing proposal was approved by 99.13% of the shareholders and the
application was pending disposal by stock exchanges / SEBI.

 

SEBI received
complaints about this and there were media reports, too. SEBI asked stock
exchanges to examine the matter; the exchanges expressed some concerns and also
recommended appointment of a forensic auditor. The primary concern was whether
the proceeds may have been diverted.

 

SEBI appointed
a forensic auditor who inter alia reported that several matters of
information / documents were not made available to them. The company responded
that inter alia the pandemic had slowed down responses. SEBI,
considering all these factors, passed an interim order directing the company to
deposit Rs. 1,292.46 crores, being sale proceeds less certain adjustments /
expenses, in an escrow account. Since this direction was not complied with in
the time given, SEBI attached the bank / demat accounts of certain promoters.

 

The company /
promoters appealed to SAT. SAT found several issues with the SEBI order. It
noted that SEBI itself had recorded that a sum of Rs. 1,002 crores was already
lying in fixed deposits. Secondly, SEBI had ordered the whole sum of Rs.
1,292.46 crores to be deposited in an escrow account when the fact was that
more than half of it would go to the promoters who held about 51% shares. The
de-listing offer itself could have resulted in an attractive price paid to
public shareholders. Mandating deposit of such an unreasonably high sum in the
escrow account would cause severe disruption in the company and bring it to its
knees. It also found issue with the fact that SEBI had kept the de-listing
application on hold.

 

Taking all this
into account, SAT ordered the company to deposit Rs. 500 crores in an escrow
account which would not be used till the forensic audit was completed and SEBI
gave a decision regarding distribution of the amount and / or the de-listing
application. It directed the company to provide information to the forensic
auditor within ten days and he would thereafter give his report within four
weeks. SEBI was also directed to process the de-listing application within six
weeks. On deposit of the said Rs. 500 crores, the bank / demat accounts of the
promoters were directed to be defreezed (Prabhat Dairy Limited and others
vs. SEBI, order dated 9th November, 2020).

 

CONCLUSION

The series of
fairly consistent rulings of SAT has substantially settled the law relating to
the powers of SEBI to pass directions by interim orders. SEBI will have to
balance the interests of the securities markets / investors with the
inconvenience caused to those who are given such directions and also pass
orders in exceptional cases only where at least prima facie evidence is
available. Further, as the Supreme Court also affirmed, urgency for passing
such orders would have to be demonstrated.

 

However, it continues to be seen that such interim orders are being
passed and restrictions / impounding directed. Not all such parties can afford
to quickly approach SAT for relief. One hopes that SEBI itself will exercise
self-restraint and pass orders in accordance with the guidelines laid down by
the Supreme Court and SAT in their rulings.

 

FINALLY, ACCOUNTING / FINANCIAL FRAUDS ARE OFFENCES UNDER SECURITIES LAWS

Finally, SEBI has
specifically recognised accounting frauds, manipulations and siphoning off of
funds in listed companies as offences. It sounds surprising that such acts were
not yet offences under Securities Laws and that the law-makers / SEBI took so
long, actually, several decades, to do this. Indeed, there have been rulings in
the past on such cases where parties have been punished. Now, however, such
acts attract specific provisions and will be punishable in several ways – by
penalty, debarment, disgorgement, even prosecution and more (vide amendment
to SEBI PFUTP Regulations dated 19th October, 2020).

 

The new provision is
broadly – albeit clumsily – worded. It is put within a strange context
in the scheme of the regulations. One would have thought that a separate and
comprehensive set of regulations would have been made to combat corporate
frauds just as, for example, in the case of insider trading cases, regulations
that would have given proper definitions, covered specific types of accounting,
financial and other corporate frauds, specified who will be held liable and
when, etc. Instead, the new provision has been introduced in the form of an Explanation
to a provision in a set of regulations which are generally intended to deal
with frauds and the like in dealings in securities markets. Interestingly, the
intention seems to be to give retrospective effect to this provision.

 

Certain
basic questions will need to be answered. What are the specific acts that are
barred? Who are the persons to whom these provisions apply? What is the meaning
of the various terms used? What are the forms of penal and other actions that
can be imposed against those who have violated these provisions? Is there a
retrospective effect to the new provision? Let us consider all these issues in
brief.

 

SUMMARY
OF PROVISION

The new provision, framed
as an Explanation, bars acts of diversion / siphoning / misutilisation of
assets / earnings and concealment of such acts. It also bars manipulation of
financial statements / accounts that would in turn manipulate the market price.

 

The principal provision is
Regulation 4(1) of the SEBI (Prohibition of Fraudulent and Unfair Trade
Practices relating to Securities Market) Regulations, 2003 (the PFUTP
Regulations). Regulation 4(1) prohibits fraudulent, manipulative and unfair
practices in securities markets. The newly-inserted Explanation to it says that
the acts listed therein (of diversion, siphoning off, etc.) are deemed to be such practices and thus
also prohibited.

 

What type
of acts are barred?

The following are the acts
barred by the new provision:

 

(a) ‘any act of diversion, misutilisation or
siphoning off of assets or earnings’,

(b)        any concealment
of acts as listed in (a) above,

(c) ‘any device, scheme or artifice to manipulate
the books of accounts or financial statement of such a company that would
directly or indirectly manipulate the price of securities of that company’.

 

To which
type of entities do the bars apply?

The acts should be in
relation to those companies whose securities are listed on recognised stock
exchanges. This would cover a fairly large number of companies. The securities
may be shares or even bonds / debentures. The securities may be listed on any
of the various platforms of exchanges.

 

Who can be
punished?

The Explanation makes the
act of diversion, concealment, etc. punishable. Hence, whoever commits such
acts can be punished. Thus, this may include the company itself, its directors,
the Chief Financial Officer, etc. Any person who has committed such an act
would be subject to action.

How are
such acts punishable?

The provisions of the SEBI
Act and the PFUTP Regulations give SEBI wide powers of taking penal and other
actions where such acts are carried out. There can be a penalty of up to three
times the profits made, or Rs. 25 crores, whichever is higher. SEBI can debar
the persons from being associated with the capital markets. SEBI can order
disgorgement of the profits made through such acts. The person who has
committed such acts can also be prosecuted. There are other powers too.

 

ANALYSIS
OF THE ACTS COVERED

Acts of diversion /
misutilisation / siphoning off of the assets / earnings of the company are
barred. The terms used have not been defined. If read out of context, the term
diversion and misutilisation may have a very broad meaning. But taken in the
context of the scheme of the PFUTP Regulations and also the third term
‘siphoning’, a narrower meaning would have to be applied.

 

The act of concealment
of such diversion / misutilisation / siphoning is also barred by itself. The
word ‘concealment’ may have to be interpreted broadly and hence camouflaging
such acts in various forms ought also to be covered.

 

The third category has
three parts. There has to be a device, scheme or artifice. Such
device, etc. should be to manipulate the books of accounts or financial
statement of the company. The manipulation should be such as would directly or
indirectly manipulate the price of the securities of the company. Essentially,
the intention is to cover accounting frauds / manipulation. However, since such
acts should be such as would result in manipulation of the price of securities,
the scope of this category is narrower. A classic example would be inflating
(or even deflating) the financial performance of the company which would affect
the market price. The definition of ‘unpublished price sensitive information’
in the SEBI Insider Trading Regulations could be usefully referred to for some
guidance.

 

Taken all together,
however, the three categories cast the net wide and cover several types of corporate
/ financial frauds. There is no minimum cut-off amount and hence the provisions
can be invoked for such acts of any amount.

 

RETROSPECTIVE
EFFECT?

It appears that the
intention is to give retrospective effect to the new provision. The relevant portion
of the Explanation reads:

‘Explanation – For the removal of doubts, it is clarified that
any act of… shall be and shall always be
deemed to have been considered as manipulative, fraudulent and an
unfair trade practice in the securities market’ (emphasis supplied).

 

Thus, a quadruple effort
has been made to give the provision a retrospective effect. The amendment is in
the form of an ‘Explanation’ to denote that this is merely an elaboration of
the primary provision and not an amendment. The Explanation states that it is
introduced ‘for removal of doubts’. It is also stated to be a ‘clarification’.
It is further stated that the specified acts ‘shall always’ be said to be
manipulative, etc. Finally, it is also stated that these acts are ‘deemed’ to be
manipulative, etc.

 

While the intention thus
seems more than apparent to give retrospective effect, the question is whether
acts as specified in the Explanation that have taken place before the date of
the amendment would be deemed to be covered by the Regulations and thus treated
as fraudulent, etc.? And accordingly, whether the various punitive actions
would be imposed even on offenders who may have committed such acts in the
past?

 

Giving
retrospective effect to provisions having penal consequences is fraught with
legal difficulties. While siphoning off of funds, accounting manipulation, etc.
are abhorrent, there have to be specific legal provisions existing at the time
when such acts are committed and which prohibit them and make them punishable.
It may also be remembered that the Regulations are subordinate law notified by
SEBI and not amendments made in the SEBI Act by Parliament. Of course, the
amendments are placed before Parliament for review and for amendments to them,
if desired.

 

There is another concern.
When a fresh provision is introduced, a fair question would be that this may
mean that the existing provisions did not cover such acts. Hence, if the
retrospective effect of the provision is not granted, then there can be an
argument that the existing Regulation 4(1), which otherwise bans all forms of
manipulative and other practices, be understood as not covering such acts.

 

However, it is also
arguable that if the existing provision, before the amendment, was broad enough
to cover such acts, then there is really no retrospective effect. SEBI has in
the past taken action in several cases of accounting manipulation / frauds,
etc.

 

The Supreme Court has held
in the case of N. Narayanan vs. SEBI [(2013) 178 Comp Cas 390 (SC)]
that accounting manipulation can be punished by SEBI under the relevant
provisions of the SEBI Act / the PFUTP Regulations. In this case, SEBI recorded
a finding that the accounts of the company had been manipulated by inflating
the revenues, profits, etc. The promoters had pledged their shares at the
inflated price. SEBI had debarred the directors for specified periods from the
securities markets. On appeal, the Supreme Court did a holistic reading of the
SEBI Act along with the Companies Act, 2013 and held that such acts were subject
to adverse actions under law. However, it was apparent that the general objects
of the law, the generic powers of SEBI, etc. were given a purposive
interpretation and the SEBI’s penal orders upheld. Interestingly, the Court
even observed that, ‘…in SEBI Act, there is no provision for keeping proper
books of accounts by a registered company.’ Thus, while this decision is
authoritative on the matter, it was also on facts. There was thus clearly a
need for specific provisions covering financial frauds, accounting
manipulation, etc. The new provisions do seem to fill the gap to an extent, at
least going forward.

CONCLUSION

The
amendment does serve the purpose of making a specific and focused provision on
accounting and financial frauds that harm the interests of the company and its
shareholders and also of the securities markets.

However, there is also
disappointment at many levels. It took SEBI almost 30 years to bring a specific
provision. Arguably, such frauds are as much, if not more, rampant and serious
as most other frauds including insider trading. However, while insider trading
is given a comprehensive provision with important terms defined, several
deeming provisions made, etc., financial frauds have a clumsily drafted and
clumsily placed provision, almost as a footnote. Such frauds not only deserve a
separate set of regulations but also a specific enabling provision in the SEBI
Act and a provision providing for specific punishment to the wrongdoers.

Giving the provision
retrospective effect may appear to be well intended but it may backfire if
there is large-scale action by SEBI for past acts.

Nonetheless,
finally, despite the warts and all, our Securities Laws now do have a specific provision
covering financial frauds in listed companies. One can expect to see action by
SEBI on this front in the form of investigations and punitive orders against
wrongdoers.  

 

 

 

 

 

INFORMAL GUIDANCE – A REFRESHER USING A RECENT CASE STUDY

BACKGROUND

Informal guidance has not been discussed in this column recently. A
recent informal guidance by SEBI gives an opportunity to refresh this useful
method of obtaining guidance of the regulator and in a fairly interesting
manner.

 

Informal guidance is a speedy way to know the mind of SEBI – or at least
of the relevant department – on a regulatory issue one is facing in an actual
case. One may be proposing to enter into a transaction or may be facing an
issue on interpretation of legal provisions. One then approaches SEBI with an
application giving the facts and the regulatory issues involved / queries and
SEBI gives its informal guidance. One could compare this with the advance
rulings as available under other laws, but the analogy should not be taken too
far. Informal guidance has a limited binding effect. In law, it can even be
reversed / ignored by SEBI itself, as will be seen in some detail later in this
article. Nevertheless, it has been useful in several cases.

 

WHAT IS INFORMAL GUIDANCE AND WHAT IS THE REGULATORY
BACKING?

SEBI introduced the Securities and Exchange Board of India (Informal
Guidance) Scheme, 2003 (the Scheme) in June, 2003. It is issued u/s 11(1) of
the SEBI Act and is thus a kind of measure in relation to securities markets
that SEBI has implemented. It does not have the status of a formal regulation
or rule and thus its legal status is limited. As we shall see, the Scheme
itself repeatedly mentions that the guidance given under it has limited binding
effect.

 

Nevertheless, it is a useful form of seeking guidance or ruling from
SEBI on how the relevant department of SEBI would view a particular situation
in the context of the relevant provisions of the securities laws. The person
desiring it approaches SEBI giving all relevant facts and the precise issue on
which he desires clarification. A fairly time-bound reply is generally given.

 

Who can approach SEBI for informal guidance?

Specified persons associated with capital markets can approach SEBI for
informal guidance. Those eligible include registered intermediaries (i.e.,
stock brokers, portfolio managers, etc.), listed companies (and also companies
proposing to get their securities listed and that have filed their offer
document / listing application), an acquirer / prospective acquirer under the
SEBI Takeover Regulations, etc.

 

What are the types of informal guidance that may be applied for?

There are two types of informal guidance that can be applied for. One is
a ‘no-action letter’. A person lays down the detailed proposed transaction he
desires to undertake and seeks guidance from SEBI on how it would view it. The
department concerned at SEBI may provide a ‘no-action letter’ whereby it would
not recommend any action to be taken under the applicable securities laws if
such a transaction is undertaken.

 

The second type is an ‘interpretive letter’ where again the SEBI
department concerned provides an interpretation and answer on an issue of law
under any of the securities laws in the context of the specified facts /
proposed transaction.

 

What are the fees?

A sum of Rs. 25,000 is to be paid as application fees. If the
application is rejected because it pertains to a matter where informal guidance
cannot be given, the fees are refunded after deducting Rs. 5,000 as processing
fee. If the application is rejected because the request for confidentiality
(discussed later herein) is not accepted, the fee will be refunded.

 

What is the time period for issue of informal guidance by SEBI?

The application has to be disposed of as early as possible, but not
later than 60 days of its receipt.

 

What are the situations under which informal guidance will not be
granted?

Applications have to be based on factual situations, even if proposed.
Thus, applications with hypothetical situations or in which the applicant has
no direct / proximate interests are rejected. If the matter is already covered
by an earlier informal guidance, the application may be rejected giving a
reference to the earlier one. In particular, if enforcement action is already
taken on the matter (investigation, inquiry, etc.) or any connected matter is sub
judice, then the application would be rejected.

 

However, the grant of informal guidance is not a right and SEBI may not
respond at all and also does not have to answer why it has not responded.

 

Confidentiality of application / informal guidance

The application and response thereto is published for public viewing by
SEBI. A party may have reasons to keep the application confidential and may
make such a request in its application. SEBI may consider this request and
either accept it or reject it and refund the application fees. If it accepts
the request for confidentiality, the response of SEBI would be kept
confidential for a period of up to 90 days.

 

WHAT IS THE BINDING NATURE OF AN INFORMAL GUIDANCE?

The informal guidance, while comparable in concept, is not an advance
ruling by SEBI and hence does not have an element of finality. It is issued by
the particular department of SEBI and although SEBI may act generally in
accordance with it, the view is not binding on SEBI. It is not conclusive and
cannot be appealed against. It is also on the facts provided, and if the
proposed transaction deviates from such facts, the informal guidance may not
cover it.

 

As we shall see later, there has been a case where SEBI issued a
different guidance in a later case. SAT has also had occasion to examine the
nature of an informal guidance and the extent to which it is final, appealable,
etc.

 

These factors are surely to be noted. However, despite this, the utility
of informal guidance cannot be understated. It can be quite helpful and even
the limited assurance that the department / SEBI will generally act according
to the guidance would be helpful in most cases.

 

Case study of a recent informal guidance in the matter of Takeover
Regulations and Insider Trading

The case shows how relatively simple transactions can have several implications
under detailed and complex laws. This is in the matter of proposed transactions
by the promoters of HEG Limited (SEBI informal guidance dated 4th
June, 2020).

 

The core issues were relatively simple. Some of the promoters of a
listed company had dealt in the shares of such company in the market. Now, they
desired to transfer some shares among themselves. Such inter se transfer
would mean that the overall holding of the Promoter Group would remain the
same, even if the holdings of individual promoters could rise / fall.

 

However, this
proposal of inter se transfer raised several issues. The first related
to certain provisions in the SEBI insider trading regulations which prohibit
‘contra’ trades on specified insiders for six months. Thus, if such a person
has bought shares, he cannot sell the same for six months. And vice versa.
As stated earlier, some promoters had dealt in the shares and hence concern
arose whether there would be a bar on further transactions. The question thus
was whether such prohibition would apply to the whole Promoter Group or
only to those persons who had earlier traded in the shares. SEBI replied that
it would apply only to those who had traded in the shares and not to the whole
Promoter Group.

 

An incidental question was whether transactions inter se the
Promoters would attract the ‘trading window’ restrictions. Insiders are
prohibited from trading during the time when the ‘trading window’ is closed.
This is usually so when there is unpublished price sensitive information which
is very likely to be accessed by the insiders. SEBI replied that since the
transfer was within the Promoter Group where both parties could be said to be
aware and thus would make a conscious and informed decision, the transaction
was covered by a specific exception in the Regulations. Hence, such transfer
would not attract the prohibition.

 

The third and final question was whether the inter se transfer
would be exempt from open offer requirements? A person / group holding more
than 25% shares can acquire up to 5% shares in a financial year. If the
acquisitions are more than this limit, an open offer is required. Inter se
transfers are exempted, but subject to certain conditions. However, in the
present case it was stated that the proposed inter se transfer was less
than 5%. Subject to compliance with the other conditions, the reply was that
the proposed transfer would not attract the open offer requirements.

 

Thus, a simple proposed transaction that could have serious consequences
was resolved by clear guidance from SEBI. If the transactions are completed in
the manner described in the application, there is a reasonable, even if not
conclusive, assurance that SEBI will not take a different view and initiate
proceedings having serious repercussions.

 

SAT DECISIONS WHERE INFORMAL GUIDANCE HAS BEEN
EXAMINED

In Deepak Mehra vs. SEBI [2010] 98 SCL 126 (SAT-Mum.), a
question arose that in the context of a takeover transaction involving a
complex restructuring / issue of securities, would the requirements of open
offer be attracted? SEBI was approached for informal guidance and the relevant
department opined that, on the facts, the open offer requirement would be
attracted only at a later stage on conversion of securities. A shareholder
filed an appeal to the Securities Appellate Tribunal (SAT) against such
informal guidance. SAT answered some basic questions on informal guidance.
Firstly, it described the nature of informal guidance and whether it can be
appealed against. It observed, ‘Clause 13 thereof also makes it clear that a
letter giving an informal guidance by way of interpretation of any provision of
law or fact should not be construed as a conclusive decision or determination
of those questions and that such an interpretation cannot be construed as an
order of the Board under section 15T of the Act… The informal guidance given by
the general manager is not an “order” which could entitle anyone to
file an appeal.’

 

Thus, the informal guidance is not a conclusive decision on the issues,
nor is it an order of SEBI.

 

There is also the case of Arbutus Consultancy LLP vs. SEBI [2017]
81 taxmann.com 30 (SAT–Mum.) where an interesting point arose. SEBI had
given an informal guidance earlier and in the appeal before SAT, the appellant
sought to rely on it and claimed that SEBI could not depart from it. Several
questions arose. How much weightage should be given to an informal guidance by
SEBI in another case and also by SAT? Secondly, can SEBI give a different informal
guidance in another matter? And if so, can an appellant still claim that the
first informal guidance should be relied upon in his case? SAT held that an
informal guidance that is erroneous can be rejected by SEBI itself and, of
course, also by SAT. A mistake by an officer of SEBI cannot be taken advantage
of. And the fact that another informal guidance with a different view was
available should have been noted by the appellant.

 

CONCLUSION

Carefully used, and in the spirit in which the Scheme has been conceived,
informal guidance can be a useful method to resolve legal issues in a fairly
speedy manner and with a reasonable degree of assurance. Informal guidance
given in the past in other cases also provides a window to the mind of SEBI in
respect of certain issues. The possible pitfalls should, however, be noted.

 

It’s almost always possible
to be honest and positive

 — 
Naval Ravikant

 

Be willing to be a beginner every single morning

—  Meister Eckhart

  

 

FRONT-RUNNING: SEBI RUNS EVEN FASTER AFTER PERPETRATORS

BACKGROUND

A recent order
of SEBI (dated 7th August, 2020 in the matter of dealers of Reliance
Securities Limited) on front-running is noteworthy on several grounds. Firstly,
it has been rendered in less than four months after the alleged front-running
took place. The transactions in question took place from December, 2019 to
April, 2020; SEBI completed the preliminary examination which, as we shall see,
involved numerous aspects and passed its order on 7th August, 2020.

 

Secondly, as the
order shows, a lot of detailed detective work has been carried out wherein the
alleged connections between more than 25 parties have been detected and
demonstrated. The connections are in various ways. They are through
transactions in bank accounts, they are through calls made to each other, there
are social media connections and also through family relations between the
parties concerned. SEBI then passed an interim order banning from the capital
markets the parties allegedly involved in the front-running and also ordered
them to deposit the profits made until a final order has been passed.

 

Front-running
cases, like insider trading, are notoriously difficult to detect. Investigation
and demonstration of guilt is even tougher. In view of this, the meticulously
detailed order at a preliminary stage is credit-worthy.

 

This order is in
the matter of certain dealers of Reliance Securities Limited in respect of
transactions by Reliance in their capacity as stockbrokers for Tata Absolute
Return Fund, a scheme of Tata AIF, a SEBI-registered Alternate Investment Fund
(‘Tata Fund’). The interim order finds these parties, along with various
associated persons, to have been involved in front-running and allegedly making
profits by trading ahead of the large orders of Tata Fund.

 

WHAT IS FRONT-RUNNING?

There have been
several cases of front-running in the past and in respect of which SEBI has
passed orders. However, earlier what amounted to front-running and even whether
it was a violation of securities laws, was in question. Indeed, the Securities
Appellate Tribunal had even held that front–running did not amount to violation
of the securities laws then existing [e.g., Dipak Patel (2012) 116 SCL
581 (SAT)], [Sujit Karkera (2013) 118 SCL 84 (SAT)]. However, the
Supreme Court decision in the case of SEBI vs. Kanaiyalal Baldeobhai Patel
[(2018) 207 Comp Cas 416 (SC)] laid the matter more or less to rest and
held that it was a violation of specified provisions of the securities laws.
Further, the relevant clause in the SEBI PFUTP Regulations has also been
amended to explicitly include front-running as it is generally understood.
Hence, today, it is more or less well settled that front-running is a violation
punishable under the securities laws.

 

However, there
is no specific definition in the Securities Laws of the term ‘front-running’. There
are clauses that do describe what is understood as front-running. There are
also several other dictionary definitions and also a fairly detailed
description in the decision of the Supreme Court. For guidance, although in a
different context, there is also a definition of front-running in a SEBI
Circular (dated 25th May, 2012).

 

Front-running is
also known as trading ahead. It essentially means that, armed with valuable
information of a proposed large transaction which would result in a change in
the price of a security, a person, in breach of trust, trades before such a
transaction takes place and makes personal illicit profits. To take an example,
a stockbroker has been given an order to buy a very large quantity of shares of
a particular company by his client. The experienced stockbroker knows that this
order will result in a rise in the price of that scrip in the market. He then
proceeds to first buy for himself these shares at the then prevailing price.
After doing this, he places the order of his client at the increased price.
Simultaneously, he sells the shares that he has just acquired, at this higher
price. The result is that his client ends up paying a higher price for the
shares – and the difference is pocketed by the stockbroker.

 

This is breach
of trust of the client. This also affects faith in the markets and its
integrity because, if permitted, there would be concerns that such malpractices
can happen on a regular basis and cause losses to the public. SEBI has alleged
in this case that front-running harms not just the client but the market and
the public in general.

 

Front-running is
thus similar to insider trading. In insider trading, a person in possession of
price-sensitive information which has been given to him in trust, abuses such
trust and trades and makes a profit for himself. So also in front-running.
However, interestingly, there are comprehensive regulations for insider trading
that define various terms, have several deeming provisions, etc. This, at least
in theory, should help inside traders to be caught and punished. It is another
thing that insider trading is still notoriously rampant and yet difficult to
catch. Front-running, in comparison, has just one specific provision under the
PFUTP Regulations. There are no definitions, no deeming provisions, no
explanations of how persons may be deemed to have been connected as insiders,
etc. In this context, the SEBI order in the present case is thus a good case
study for all on how the violation has been established, albeit by an
interim order.

 

WHAT ARE THE ALLEGED FINDINGS OF THIS
CASE?

As discussed
earlier, the Tata Fund used to carry out trades through its stockbrokers,
Reliance Securities Ltd. The orders were large and expectedly would result in a
change in the price of the ordered scrip. A large purchase order would thus be
expected to result in rise in prices, and vice versa in case of an order
of sale. The Fund also dealt heavily in derivatives where, again, the impact of
the orders would be similar.

 

Front-running in
such a circumstance, as the order also explains in detail, follows two
strategies. In case of a purchase order, it is the Buy-Buy-Sell (BBS) strategy.
In case of a sale transaction, it is the Sell-Sell-Buy (SSB) strategy. If the
Fund had placed a buy order, the front-runner would buy ahead, and then place
the order of purchase for the Fund. Against such purchase order of the Fund,
the front-runner would sell the shares bought by him earlier.

 

SEBI found
through its surveillance that transactions suspiciously of the nature of
front-running were taking place. An analysis of the data followed and the
various parties who allegedly did the front-running were investigated. Their
connections with the dealers of the stockbroker who had executed the
transactions of the Fund were looked into by checking the bank transactions,
inquiry with the brokers, their phone records and even their Facebook accounts.
Personal connections and relations were also looked into. It was established
that three such dealers had connections directly or indirectly with various
parties who had actually traded ahead of the orders of the Fund. This was seen
in the equity segment as well as the derivative segment. The timing of these
orders and how they matched with the orders of the Fund were analysed. Analysis
was also done of the volume of trading of such persons, particularly in the
derivatives segment before and during the period when such alleged
front-running took place. It was alleged that a significant proportion of the
transactions of such parties matched with those of the Fund and a large amount
of profit was made in a short time by these parties.

 

In view of these
findings, SEBI passed an interim order and prohibited the parties from dealing
in or being associated with the securities market.

 

SEBI also
ordered these parties to deposit the profits allegedly made from front-running
– of nearly Rs. 4.50 crores – pending further investigation, a hearing to the
parties and a final order. The parties have been required to deposit this
amount within 15 days of the order. Their assets have also been frozen.

 

SOME ISSUES IN THE ORDER

As stated
earlier, the order is credit-worthy on several grounds. It has detected, even
in an interim way and through an ex parte order, a difficult case of
front-running. Not only this, the speed of detection and investigation is indeed
very fast. It is expected to act as a warning to those who indulge in such
activities.

 

However, there
are some concerns, too. To begin with, the connections alleged are on
relatively flimsy basis. A few phone calls between the dealer and the alleged
front-runner have been held sufficient to establish a connection. Transfers of
funds of relatively small amounts between parties have also become the basis of
the connection. What is surprising is that even being a Facebook friend is seen
as a connection. While checking the Facebook profiles of persons is surely good
use of modern technology to go behind the scenes, it is also unrealistic. It is
very common for people active on social media to have hundreds or even
thousands of so-called Facebook friends. Facebook, Twitter and even LinkedIn
are generally used for exchange of information and ideas and do not necessarily
mean that there is also an off-line connection between the parties.

 

Interestingly,
this is not the first time SEBI has used online connections to allege
‘connections’. In another case of alleged front-running, SEBI had noticed a
‘connection’ through a matrimonial site and passed an interim order (dated 4th
December, 2019). There have been other cases, too, where a Facebook connection
has been relied upon to allege ‘connections’.

 

The connection
alleged on account of the calls made between parties may also not be sufficient
to uphold such serious allegations. Unless the calls are timed with the
transactions it may be difficult to say that this meant such a connection that
parties are engaged in front-running together. In this case, of course, SEBI
has also tabulated the data of transactions and alleged that the timing also
matched.

 

Then there is
the connection alleged on account of financial transactions. Being an interim
order, it appears that no further information has been collected as to the
reason for entering into such transactions. It may be possible that such
financial transactions may be for genuine reasons having no connection with
front-running and also not establishing any connection sufficient for
front-running.

 

Nevertheless,
all these parties have been debarred even in the interim by this order. They
have been made to deposit a very large sum of money being alleged profits of
front-running. Their assets are also barred from sale, etc.

 

There is another
angle here. As stated, at least on first impression, the basis for alleging
connections is shaky. What is possible is that in the future such parties may
ensure that even such connections are not there, or not evident. After all,
these are white-collar crimes committed by educated people having a level of
sophistication. Indeed, if such flimsy connections are relied on, it may mean
that many persons perpetrating front-running would not come under the radar.

 

To conclude,
being an interim order, it may happen that the explanation given by the parties
may result in it being set aside either wholly or in part. Nevertheless, this
order is a wake-up call and a warning to persons operating the markets that
SEBI by its market surveillance collects and analyses information that may
throw up white-collar frauds. The fact that such white-collar frauds have been
tackled in a timely manner should make one hope that other less sophisticated
orders would also be caught in larger numbers.

 

 

Do not wait; the time will never
be ‘just right.’
Start where you stand and work with whatever tools you may have at your
command, and better tools will be found as you go along

— 
George Herbert

 

DISGORGEMENT OF ILL-GOTTEN GAINS – A US SUPREME COURT JUDGMENT AND A SEBI COMMITTEE REPORT

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.

 

SEBI’S RECENT ORDER ON INSIDER TRADING – INTERESTING ISSUES

SEBI recently passed an interim
order in an alleged case of insider trading and ordered impounding of profits
running into several crores of rupees, along with interest on it. This order
was apart from other adverse directions in the form of restrictions and also
such further other action that may be initiated later in the form of penalty,
etc. While the order by itself has several points which are analysed here,
there are certain other issues arising out of this order, as also a settlement
order in a related matter of the company, which also need a look.

 

Insider trading is something that
every securities regulator across the world seeks to prevent and strictly
punish and, as an offence, stands second perhaps only to blatant market
manipulation. Insider trading is a breach of trust by insiders with
shareholders and the public generally and by itself also leads to loss of faith
in stock markets. When persons are placed in positions of power and access to
sensitive information, they are duty-bound not to profit illegitimately from
it. If, for example, a Chief Financial Officer learns something from sensitive
information relating to accounts / finance made available to him due to his
position of power and trust, he is duty-bound not to exploit it for his
personal profit. For instance, if he comes to know that his company has made
substantial profits, he is expected not to buy shares based on this information
that is not yet public and also not to share such information.

 

The
offence of insider trading – whether dealing on the basis of such unpublished
sensitive information or sharing such information – is so difficult to prove,
that the law has been drafted very widely and presumptively. Many aspects are
presumed in law even if some of these presumptions can be rebutted by persons
accused of insider trading. The tools of punishment for insider trading
available with SEBI are varied and far-reaching. The profits made can be
disgorged, penalty up to three times the profits made, or Rs. 25 crores,
whichever is higher, can be levied, the guilty persons can be debarred from
capital markets and so on.

Let us examine and analyse a recent
order which is a good test study of how the legal concepts are applied in an
actual case (Order No. WTM/GM/IVD/55/2019-20 in the matter of PC Jeweller
Limited, dated 17th December, 2019).

 

BASIC FACTS

SEBI has made certain allegations of
findings relating to this listed company, PC Jeweller Limited (‘PC Jeweller /
Company’). These allegations of findings are given below as the basic facts and
then we will see how SEBI established the guilt of insider trading, how the
alleged illegitimate profits from insider trading have been calculated and what
initial directions have been issued.

 

To
broadly summarise, the company had proposed a substantial buyback of its shares
and obtained approval of its board of directors. The announcement resulted in a
sharp rise in its share price. Later, however, when the company approached the
lead banker / lender for approval, it was rejected. The rejection was
reconfirmed when the lender was approached a second time. Consequently, the
company had no choice but to withdraw the buyback decision. In the meanwhile,
during this period certain insiders not only sold shares in the company at the
then ruling high price but even squared off certain buy futures and also
entered into fresh sell futures. Each of these resulted in the insider
allegedly avoiding significant loss and even profited. The buy / long future
was for purchase of shares and if squared off at the ruling high price, it
saved the insider from suffering loss that would have arisen when the share
price fell after the announcement of withdrawal of the buyback decision.
Similarly, the put option was for sale of shares at the ruling high price and
when squared off when the price fell, profits were made.

 

Several issues arose. Whether the
company should have initiated the buyback proposal without duly disclosing that
it was subject to approval of lenders? Whether this was a case of insider
trading and, if yes, what action should be taken?

 

The following are some specific
facts as per findings in this interim order (note that the interim order is issued
without giving parties a hearing, which is given after the order and
which may result in modification of facts / directions):

 

(i) There
were two directors who were brothers and promoters. There was another brother
who was ex-Chairman. There were certain relatives of such persons who were the
sons and wives of such sons. There was also a private limited company (QDPL) in
which a family member held 50% shares. One of the brothers passed away by the
time this order was passed;

(ii) The company initiated the buyback proposal on 25th April,
2018 after internal discussions followed by discussions with auditors and
merchant bankers. Thereafter, it convened a Board meeting on 10th
May, 2018 when the Board approved the buyback;

(iii) The buyback proposed was at a significant price and of a
significant amount. It was for 1.21 crore shares at a price up to Rs. 350 (the
ruling market price of shares just before the Board meeting was about Rs. 216).
The total buyback consideration would have been approximately Rs. 424 crores;

(iv) The company also had in the meantime initiated approval of
shareholders for the buyback through postal ballot. However, it appears that
the outcome of the voting of the ballot was not announced, although it appears
that more than 99% of votes were in favour of the buyback;

(v) However,
on 7th July, 2018, the lead banker rejected the request to allow the
buyback of shares. A request to reconsider was also rejected. Consequently, the
company convened a Board meeting on 13th July, 2018 to withdraw the
buyback proposal and duly announced the decision;

(vi) Certain relatives of the promoter-directors and QDPL (the
private company in which a relative held 50% shares) entered into certain
transactions during the time after the announcement of the buyback
proposal but before the announcement regarding the withdrawal of the
buyback. Fifteen lakh shares were sold. A long position in futures of 2.25 lakh
shares was squared off by a similar put future. A fresh short position of three
lakh shares was also entered into.

 

FINDINGS BY SEBI

SEBI made the following findings in
its interim order: The relations and transactions between the
promoter-directors and the relatives / QDPL who traded in the shares / futures
were laid down in detail. These relatives / QDPL were thus held to be insiders
/ beneficiaries of inside information. The timing of the transactions was
specified as being during the time after the buyback was announced and
information about the rejection by the lead banker, but before the time
when the announcement of withdrawal of buyback was published.

 

SEBI worked out the notional gains /
losses avoided by such transactions by taking the price when such transactions
were undertaken and the price quoted in the markets after the announcement of
withdrawal of buyback was made. This was calculated at about Rs. 7.10 crores.
To this, interest @ 12% per annum was added till the date of order which
amounted to Rs. 1.21 crores. The total came to Rs. 8.31 crores.

 

ORDERS BY SEBI

SEBI held that the
promoter-directors were insiders and they communicated the price-sensitive
information to persons connected to them who traded in the shares / futures.
Thus, there were two sets of alleged violations. One was by the
promoter-directors who were alleged to have shared the price-sensitive
information to persons connected to them. The second was by such connected
persons who dealt in the shares / futures based on such information and avoided
a large amount of losses.

 

SEBI directed the persons who traded
in the shares / futures to deposit the notional gains along with interest in an
escrow account pending final orders. Till that time, no transactions were
allowed in their bank, demat and other accounts and they were not allowed to
dispose of any of their other assets, except for complying with such directions
and till such deposit was made.

 

Further, they were asked to show
cause why such notional gains should not be formally disgorged, along with
interest, and why they should not be restrained from accessing securities
markets / dealing in securities for an appropriate period. The
promoter-director was also asked to show cause why he should also not be
restrained similarly from accessing securities markets / dealing in securities.

 

SETTLEMENT ORDER

Interestingly, a settlement order
was passed a few weeks before the interim order. Vide this, the company agreed
to pay Rs. 19,12,500 as settlement charges for certain alleged defaults in
disclosures. These mainly related to not informing in time about the objections
of the lenders to the buyback offer which was stated to be material information. SEBI had initiated
proceedings to levy a penalty. However, the company came forward for a
settlement and paid the agreed amount.

 

OBSERVATIONS

There
are several interesting issues here. Some are lessons for companies and persons
associated with such companies generally. The other is about concerns over such
interim orders and findings and their implications.

 

It
is critical that companies and managements should consider carefully the
implications of major decisions and disclose to public meticulously all
relevant information in that regard. In this case, the issue was not so much
that the buyback had to be cancelled because of lack of approval from the lead
lender, but that such condition was not disclosed beforehand. It may be that
often such approvals ordinarily do come in due course. But in this particular
case, it mattered significantly, so much so that the buyback had to be called
off and the share price seems to have crashed because of this.

 

Promoters
/ insiders need to be generally very careful in dealing in shares. There are
many safeguards provided in law. For example, prior approval of the Compliance
Officer ensures a check on whether any price-sensitive information remains
undisclosed. However, even in such cases, the promoters / management may have
as much, if not more, knowledge of what critical issues may arise.

 

There
are also concerns about such an interim order and some very general
observations can be made for academic analysis. In this case, it appears that
the promoters held more than 60% shares and even after the sale, the holding
was 57.59%. It is not as if a very significant portion of the shares was sold.
One does not know whether there was a particular reason for such sale other
than what SEBI has alleged for the sale of the shares. Interim orders, it is
well settled, have to be made sparingly. The SEBI order states that if an
interim order is not passed, it would ‘result in irreparable injury to the
interests of the securities markets and the investors’. From the facts stated
in the order itself, the promoter holding is very significant even after such
sale. It is not clear how then such an order would have prevented such
‘irreparable injury’. An interim order of such a nature is stigmatic and
restrictions placed can affect day-to-day business. One wonders whether first
issuing a show-cause notice giving all alleged facts as presented and giving
due opportunity to the parties would have been a better course.

 

Be that as it may, such orders continue to
provide and reinforce lessons for companies, promoters and insiders generally
for exercising due care.

REGULATION OF RELATED PARTY TRANSACTIONS – PROPOSED AMENDMENTS

BACKGROUND AND CURRENT STATUS OF
REGULATION OF RELATED PARTY TRANSACTIONS


Related party transactions are
transactions by a company with parties that are related to it or to certain
persons having some control over the company. Such transactions present a
classic case of conflict of interest where persons in control of the company
are in a position to approve such transactions where they have interest or
benefit. Related party transactions can thus be termed as a kind of corporate
nepotism. The objective of regulation is to ensure that there is oversight over
such transactions by independent persons, or that they are approved by other stakeholders,
or both. There are requirements also for extensive disclosures.

 

Thus, the Companies Act, 2013 (‘the
Act’) and the Rules made under it contain elaborate provisions for regulation
of related party transactions. SEBI, too, aims at regulating such transactions
independently through the SEBI LODR Regulations (‘the Regulations’). Since both
these sets of laws govern companies, there is obviously some concern about
conflicting provisions and even duplication / overlap which could result in
excessive compliance needs. Although attempts have been made to harmonise the
two sets of provisions,  differences
still remain.

 

SEBI has recently undertaken an exercise
to review the provisions and a report has been released containing
recommendations for change. After receiving feedback and consultation, SEBI
will notify the final changes.

 

SCHEME OF PROVISIONS


While this article concerns itself with
the proposed changes in the SEBI LODR Regulations, it is worth reviewing
briefly the scheme of provisions both under the Act and the Regulations.

 

To begin with, there is the definition
of a ‘related party’. Several persons and entities are listed specifically or
descriptively as related parties. These include relatives and also various
parties with which specified persons in management have control or association.
The Regulations, too, provide a definition which takes the definition under the
Act as the starting point and adds the definition under the relevant accounting
standard.

 

Then there is the definition of related
party transactions. The Act provides a list of transactions which, if
with a related party, would be subject to regulation. The Regulations, however,
provide a generic descriptive definition and thus are wider in nature.

 

Next, we have the manner of regulation.
This is in two forms. The first is the manner of approval required. This is
broadly at two levels. All related party transactions require approval of the
Audit Committee and generally the Board. Certain transactions also require the
approval of shareholders. Where approval of shareholders is required, related
parties cannot vote to approve such transactions. Secondly, there are
requirements for disclosures of such transactions which are extensive and also
supplement the disclosures required under the applicable accounting standard.

 

CONCERNS


The provisions have seen repeated
reviews and changes over the short period since they have been in existence.
SEBI had set up a committee under the Chairmanship of Mr. Ramesh Srinivasan, MD
& CEO of Kotak Mahindra Capital Company Limited, which submitted its report
on 27th January, 2020. SEBI has invited feedback on this by 26th
February, 2020 after which one may expect SEBI to implement the changes by
suitably amending the Regulations.

 

The Committee has reviewed nearly every
major area of the provisions including the definitions of related party and
transactions, the threshold limits, the manner of approval, disclosures, etc.
Amendments, major and minor, have been suggested. The report, apart from giving
a detailed background and reasoning for proposing the changes, also gives the
exact language of the amendments. There are several advantages of these. One
will be able to know the exact language of the proposed amendments in course of
time. Concerns over ambiguities, difficulties, etc. can thus be pointed out
well in advance. Importantly, it will be easier for SEBI to notify the
amendments quickly.

 

Let us see in the following paragraphs
some of the important amendments proposed.

 

DEFINITION OF RELATED PARTY TO NOW
INCLUDE ALL PROMOTERS


Unlike many countries in the West, India
has a very large proportion of its companies promoted and controlled by family
groups. They hold a significant percentage of the total share capital, often
nearly half. Needless to add, generally they control the company for all
practical purposes on most matters.

 

At present, the Regulations define a
related party in two parts. One is the definition under the Act / or applicable
accounting standard, which itself is broad and includes many entities with
which directors / others may be associated. The second part consists of any
promoter who holds 20% or more of the share capital of the company.

 

However, there is an important lacuna
here. Even these wide definitions may still not include many entities connected
with the promoters. It is proposed that all promoters and members of the
promoter group would be now treated as related parties. Further, any entity
that directly / indirectly, along with relatives, holds 20% or more of the
share capital would also be treated as a related party.

 

Interestingly, to be considered as a
related party, the promoter will now not have to hold any shares.
Further, the person holding 20% or more may be a total outsider not connected
with the management at all.

 

There could be difficulties for the
company to compile a comprehensive list of these newly-covered entities. The
list of promoters, of course, should be readily available. However, identifying
persons who hold 20% or more may present some difficulties. Fortunately, a good
starting point would be the disclosures received from persons holding 5% or
more of the shares under the SEBI Takeover Regulations. However, the
definitions under the two laws are different in detail and hence it may still
be difficult for the company to prepare an accurate list of related parties
covered by these amendments.

 

TRANSACTIONS BETWEEN RELATED PARTIES OF
PARENT AND SUBSIDIARIES


Currently, transactions between the
company and its related parties are covered and to some extent between the
company and its subsidiaries. The concern is that certain sets of transactions
may get left out.

 

It is now proposed that transactions
between subsidiaries of the company and a related party either of the company
or its subsidiaries will be deemed to be related party transactions. Thus, the
following would now be related party transactions:

 

(i) Between the company and its related party;

(ii) Between the company and any related party
of any of its subsidiaries;

(iii) Between the subsidiaries of the company
and any related party of the company; and

(iv) Between the subsidiaries of the company
and any related party of any of its subsidiaries.

 

TRANSACTIONS WHOSE PURPOSE IS TO BENEFIT
RELATED PARTIES


It is now proposed to
cover transactions with any parties, ‘the purpose and effect of which is to
benefit a related party of the listed entity or any of its subsidiaries’.

 

The intention
obviously is to cover those transactions ostensibly carried out with a
non-related party but the intention and also the effect is to benefit related
parties. In a sense, the intention seems to be to cover indirect transactions.
The requirement is that not just the actual effect, but even the purpose
of the transaction has to be benefit to a related party. Arguably, a
transaction with an unintentional benefit to a related party ought not to be
covered. However, this aspect may need clarification.

 

No guidance is given
as to how to determine or even detect such transactions. It is very likely that
the management or person who is the related party would know about the benefit
and thus the onus would be on such person to inform the company.

 

It is also not clear
whether the benefit should be for the entire amount of the transaction or part
of it. For example, a contract may be given to a non-related party X, who may
sub-contract a part of the contract to a related party. If other conditions are
met, it would appear that such a contract should also get covered.

 

MATERIAL MODIFICATIONS LATER TO RELATED
PARTY TRANSACTIONS


Related party
transactions may be approved and transactions initiated but later they may
undergo modifications. At present, unless the modification is in the form of
entering into a de novo transaction, the modification may not get
covered. To ensure that material modifications also get covered, it is provided
that they require approval in the same manner as original transactions. It is
not clear what does the word ‘material’ mean. As this term is not defined, one
will have to adopt alternative definitions and interpretations of this term.

 

In case where the
transaction is by a subsidiary with a related party, the modification will
require approval only if certain specified thresholds are exceeded.

 

PRIOR APPROVAL OF SHAREHOLDERS


Certain material
transactions with related parties that are above the specified thresholds
require approval of shareholders at present. It is proposed that such approvals
should be taken prior to undertaking such transactions. This requirement
will also extend to material modifications to such transactions.

 

MODIFICATION IN CRITERION FOR DETERMINING
MATERIAL RELATED PARTY TRANSACTIONS


Transactions above a
certain threshold are deemed to be material. It is now provided that the
threshold shall be the lowest of the following:

 

(a) Rs.
1,000 crores;

(b) 5%
of consolidated revenues;

(c) 5%
of consolidated total assets;

(d)  5%
of consolidated net worth (if positive).

 

This will
particularly affect very large companies for whom, as per the present
thresholds, even Rs. 1,000 crores of transactions were not ‘material’.

 

REVIEW REQUIREMENTS BY AUDIT COMMITTEE
AND DISCLOSURES TO SHAREHOLDERS


The Audit Committee
will now be required to mandatorily review certain aspects of the related party
transactions that are placed before it for approval. This, on the one hand,
provides guidance to the Audit Committee as to what specific factors to take
into account. On the other hand, it places responsibility on the Audit
Committee to go into these details.

 

It is also proposed
that the notice to shareholders for approval of material related party
transactions should give specific items of information. This again increases
transparency and enables the shareholders to take an informed decision on the
transactions. Interestingly, whether or not the Audit Committee approval was
unanimous has to be stated.

 

CONCLUSION


There are other
amendments proposed, too. And there are some other aspects of the amendments
apart from those discussed above. The final amendments as notified would be
worth going into in detail taking into account all the amendments.

 

As mentioned earlier,
SEBI has given some time for feedback on the proposed amendments. Considering
the past track record of SEBI, it is likely that the amendments may be notified
soon thereafter. It will have to be seen whether the amendments are put into
place immediately or phased out and also whether they are made applicable to
all companies or only to some.

 

The
responsibility of the company, and particularly of the Audit Committee, will
only increase after such amendments. Related party transactions are a source of
concern and even wrongdoings such as siphoning off profits / assets of
companies. The amended provisions may result in increased accountability by all
parties concerned.

 

For the Board
generally and for the Independent Directors / Audit Committee in particular, it
is not easy to determine whether all related party transactions are covered.
Ideally, the primary onus should be on the management / promoters and
particularly those persons with respect to whom the related party connection
exists with a counter party. If they fail to disclose their interest and
connection, it is possible that others may not even come to know. However, this
is not readily accepted in law and the Board / Independent Directors / Audit
Committee and even the Auditors will have to exercise diligence and care as
expected respectively from them. Their responsibility, and hence liability,
will only increase.  

 

IS BEING A PROMOTER A ONE-WAY STREET WITH NO EXIT OR U-TURN?

BACKGROUND – CONCEPT OF FAMILY/ PROMOTER-DRIVEN COMPANIES
IN INDIA

A peculiar and important feature of Indian companies and even
businesses in general is that the ownership and management is largely
‘promoter’-driven. There is usually a ‘founder’, an individual who starts a
business which is then continued by his children / extended family for many
generations. The founder family (which may be more than one) usually holds
controlling stake, often more than 50%. The company and group entities are
usually referred to as the ‘X group’ with X representing such family. This is
unlike most companies in the West where, even if founded by an individual whose
family may continue to hold substantial shareholding, the management is often
‘professional’.

 

Securities laws in India have rightly acknowledged this
feature and there are a multitude of provisions specifically recognising them
and creating an elaborate set of obligations for them. These persons are called
promoters and the various entities (family members, investment companies held
by them, etc.) are called the ‘Promoter Group’. Thus, for example, Independent
Directors are by definition those who are not from or associated with the
Promoter Group. The promoters may be treated as insiders and their trades in
shares of the company regulated. The ‘Promoter Group’ is required to have a
minimum shareholding (at the time of a public issue) and also a maximum
shareholding. It cannot occupy more than a certain number of Board seats. It
has to make regular disclosure of its shareholding. Indeed, the ‘Promoter
Group’ would generally be deemed to be in charge of the company and the buck
for any violation of laws will usually stop at them.

 

However, there is one curious and difficult area: How can a
person / entity, once designated a promoter, cease to be a promoter? How does
he get an exit and reclassify himself as a non-promoter? As we shall see, and
as particularly highlighted by a recent ‘informal guidance’ by SEBI, it is
relatively easy to become a promoter but extremely difficult to stop being one.

 

WHO IS A PROMOTER AND WHO BELONGS TO THE PROMOTER GROUP?

There is an elaborate definition of the terms ‘Promoters’ and
‘Promoter Group’ prescribed in the SEBI (Issue of Capital and Disclosure
Requirements), 2018. The Group includes the promoter family and even many
members of the extended family. It also includes specified investment entities
/ group companies / entities. Over time, this list can turn quite long as the
family expands and various new entities are formed and which are covered by the
definition.

 

The Promoter Group usually gets defined and identified when a
public issue is made, leading to listing of the shares of the company and all
those who are in control of the company are included. Their specified relatives
and group entities are also included. However, as time passes, new relatives
and new entities would get added. But as we will see later, while inclusion is
easy and even automatic, removing even one person is extremely difficult.

 

REASONS FOR GETTING OUT OF THE PROMOTERS CATEGORY

It has been seen above how easy and automatic it is to become
a promoter. Just being born in the promoter family or otherwise being related
in any of the specified ways could be enough. However, for several reasons, a
person (or an entity with which he is associated in specified manner) may
desire not to be part of the Promoter Group and be saddled with several
obligations and liabilities. There is, of course, the liability of compliance
and even of violations that he remains subject to just by the fact that he is
on the promoter list. If he is in control of the relevant company, this cannot
be escaped.

 

But there are various reasons why a person may want to be
excluded. He or she may have left the family and may be in employment elsewhere
or carrying on a separate independent business. He may have actually had
disputes with the company and thus no more be part of the core group. He or she
may have married and now not be connected with the company. He may not be
holding any shares or holding insignificant shares and have no say in the
company. In fact, even the whole Promoter Group or a sub-group thereof may have
reason to be excluded if they are reduced to a minority with someone else
taking a higher stake. There would, of course, be the obvious case where a new
promoter acquires most or all of the existing group’s shareholding in a
transparent way (usually by an open offer) and thus takes control of the
company.

 

There can be many more situations. The question is can an
existing promoter get his name removed from the list of promoters? If yes, how
and what are the conditions?

 

CONCERNS OF SEBI IN ALLOWING PROMOTERS TO LEAVE THE
CATEGORY

Certain obligations are imposed on promoters who are in
control of the company. If a person who is otherwise in control of the company
or closely connected with persons who are, and is allowed to represent himself
as not a promoter, he would escape this liability. Shareholders, too, perceive
a particular group as the promoters and take decisions accordingly. Thus,
generally, the regulator would want sufficient assurance before allowing the
exclusion of a person from the Promoter Group. However, as we will see below,
the conditions placed are extremely stringent and it may often be difficult for
persons to exclude themselves even for bona fide reasons.

 

ONCE A PROMOTER, ALMOST ALWAYS A PROMOTER

As mentioned earlier, a person and entities related to him
are required to be declared as promoters at the time of a public issue. Many
entities / persons connected with him in specified ways would also be deemed to
be part of the Promoter Group. Death would do him apart, but then the successors
to his shares would be deemed to be promoters. Thus, the person to whom shares
are willed or even gifted during the (deceased’s) lifetime would become a
promoter.

 

REQUIREMENT FOR RECLASSIFICATION FROM PROMOTER TO PUBLIC

The requirements relating to reclassification from promoter
to public category are contained in Regulation 31A of the SEBI (Listing
Obligations and Disclosure Requirements) Regulations, 2015 (‘the LODR
Regulations’). These are the outcome of several changes over time and also the
consequence of several discussion papers / committee deliberations. The Kotak
Committee’s report of 2017 on corporate governance had also made detailed
suggestions. SEBI is in the process of proposing yet another round of revision
of the requirements.

 

There are several conditions that a promoter has to comply
with to be allowed to be reclassified into the public category. Some of these
are obvious and make sense. Such a person (and persons related to him) should
not be holding more than 10% shares in the company. He should not exercise
control, directly or indirectly, over the company. He should not be a director
or key managerial person in the company. He should also not be entitled to any
special rights with respect to the company through formal or informal arrangements.

 

However, there are further stringent conditions and
requirements if he seeks reclassification. The promoter needs to apply to the
company and needs to demonstrate that he has complied with the other conditions
(i.e., holding 10% or less, not being a director, etc.). The Board of the
company then has to consider this request and place the reclassification
request before the shareholders with its comments. The matter has to be placed
before the shareholders after three months but before six months of the date of
such Board meeting. At such meeting of shareholders, the promoter seeking
reclassification and promoters related to him cannot vote. An ordinary
resolution has to be passed by the remaining shareholders approving such
reclassification. Once so approved, the stock exchanges would then consider the
application and if the requirements are duly complied with, approval would be
granted for reclassification.

 

Thus, the primary onus and even the decision have been placed
on the Board and the shareholders. In principle, the safeguards may appear
warranted. Leaving the matter to internal decisions also ensures avoidance of
an arbitrary decision by the regulator and also smooth implementation in many
cases. However, the elaborate requirements can make ordinary cases for
exclusion difficult. A family member, for example, may move out of India and
yet he would continue to be a promoter and hence in control unless this
procedure is followed.

 

There may be disputes
within the family and thus persons seeking exclusion may find their efforts
being sabotaged, even if in principle their requests have to be processed. The
10% shareholding requirement is also too low. At 10% holding, a person / group
has practically no say in the running of the company.

 

In a recent case (in
re: Mirza International Limited, Informal Guidance dated 10th June,
2020) it was seen that a promoter gifted shares aggregating to more
than 10% to his daughters who were married and otherwise not involved with the
company. This made them part of the Promoter Group. An informal guidance of
SEBI was sought whether such persons could be reclassified as public instead of
being included in the promoter / Promoter Group. SEBI opined that the fact that
they held more than 10% shares went against the condition prescribed and hence
they could not be reclassified as public.

 

CONCLUSION AND SUMMARY

There are several
businesses that have seen multiple generations. The businesses may have been
divided. Off-spring may not be interested in the family-controlled companies.
There may be disputes. There may be members of the family who have no say or even interest in the company. The stringent requirements and procedures are
elaborate and have hurdles which seem unjustified when the primary facts may
show that a person does not have any control or even say in the company.
Indeed, they may not even hold a single share. Thus, many persons may continue to be deemed to be
promoters and bear the burden of liability in matters in which they have no
say. Such persons may not be promoters by choice and have no easy avenue to get
out. It is high time that the requirements are changed to make them simple and
practical; it is hoped that the coming set of proposed revisions ensures this.

SAT RULES: WHETHER PUBLIC CHARITABLE TRUSTS CAN BE RELATED PARTIES

Related parties
and transactions with them are a concern of many laws – the Companies Act,
2013, the SEBI Regulations, the Income-tax Act and so on. The core concern is
that when parties are ‘related’, there is a conflict of interest between such
related parties who are involved in taking a decision regarding these
transactions and the interests of other parties who have no say or even
knowledge about it. For example, a firm owned by the daughter of the MD of a
listed company is sought to be given a contract of services. There is obviously
concern whether the terms would be fair, whether such services were indeed
needed by the company, etc. In a sense, thus, transactions with related parties
are a form of corporate nepotism. However, the definition of related parties,
as we will see a little later, is not narrow to include merely relatives of
controlling / deciding person/s. It includes subsidiaries, parent companies,
group entities of a certain type, etc. Business realities require that certain
activities are carried on by the same group in different entities, and even
otherwise transactions between groups or related entities are inevitable. Yet,
concerns would remain about the conflict of interest and whether the
arrangement is on commercial arm’s length terms.

 

The Companies
Act, 2013 (the Act) and the SEBI (Listing Obligations and Disclosure
Requirements) Regulations, 2015 (the LODR Regulations) both deal with matters
relating to related parties and transactions with them. There is a detailed
accounting standard, too, dealing with this. Generally, these provide for
certain safeguards. There are requirements of approval of shareholders beyond a
particular threshold of materiality, with related parties generally barred from
voting thereon. The Audit Committee also has to approve all related party
transactions. Besides, there are requirements of disclosure of related parties
and transactions with them in the accounts. All of this serves at least two
purposes. Firstly, parties whose interests could potentially be affected would
get a say. Secondly, there is disclosure irrespective of whether such approval
was required. Hence, readers can review the nature and extent of such transactions.

 

Considering these varied safeguards and considering that parties may
still try to avoid them, an understanding of the provisions relating to such
transactions is important. A recent decision of the Securities Appellate
Tribunal (SAT) provides such an opportunity. Essentially, it held inter alia
that a public charitable trust whose managing trustee was father / father-in-law of the promoter directors of a listed company was
not a related party. Thus, although there were significant transactions with such
trust, the relevant provisions of law governing related parties would not
apply. The decision of SAT is in the matter of Treehouse Education and
Accessories Limited vs. SEBI [(2019) 112 taxmann.com 349 (SAT), order dated 7th
November, 2019].

 

BACKGROUND

The facts of
the case are complicated and may even appear to be sordid, involving alleged
criminal acts. The background of what had transpired, as narrated by the
decision of SAT discussed here, an earlier decision of SAT and two orders of
SEBI, is as follows.

 

Treehouse
Education and Accessories Limited, a listed company (the Company) is engaged in
the business of education that it carries out through its own schools,
franchisees and along with certain public charitable trusts. It develops the
course and curriculum for the purpose. The franchisees and the trusts had
certain commercial arrangements with the company. It appears that there were
proposals and negotiations to merge the company with a company of the Zee group
for which an exchange ratio was also determined. For certain reasons, details
of which are not relevant here, there were disputes to such an extent that the
matter went to the police and the courts and the share exchange ratio was
revised substantially downwards.

The company
suffered very large losses which had allegedly questionable issues. There were
media reports about the company as per the SEBI orders which led to SEBI
initiating a preliminary inquiry.

 

Soon
thereafter, after making certain preliminary allegations, SEBI passed an
interim order debarring the company and its directors from accessing the
capital markets and ordered a forensic audit into its affairs. The order of
SEBI was appealed against to SAT which asked SEBI to pass a final order within
a specified time after giving due opportunity to the parties to present their
case. SEBI did so and passed a confirmatory order on 16th November,
2018 imposing the same directions as did the interim order. This order was
appealed again and SAT passed the order which is now discussed here.

 

Two issues of
contention arose. One was whether SEBI was entitled to initiate such
investigations and pass such harsh orders on the facts (more so when they were
admittedly initiated on the basis of media reports). The second issue, and
which is the subject of more detailed discussion here, is whether the company
and the public charitable trust whose managing trustee is a relative of the
promoter directors, can be said to be related parties? And thus, whether the
provisions of disclosure, approval, etc. under the relevant provisions apply to
transactions with them.

 

Whether
transactions with public charitable trust where relative of promoter directors
is a managing trustee are related party transactions?

Owing to, as
the company explained to SEBI, certain peculiar circumstances / laws relating
to educational institutions / schools, the company had to enter into a tie-up
arrangement with public charitable educational trusts to run certain schools.
The company would provide its name and backing and curriculum, etc. More
importantly, it would provide funds (returnable over certain years, with
interest for a part of this time) that can be used to set up the schools.

 

One trust, to which large amounts were provided as security deposit, had
a managing trustee who was the father / father-in-law of the promoter director
couple. Owing to losses by the said trust, security deposits of large amounts
had effectively eroded and hence potentially huge losses were faced. The
question thus arose whether the law relating to related party transactions was
violated. For this purpose the moot question was whether the company and the
trust were related parties as understood in law.

The relevant
provisions for this purpose are contained in the Act and the LODR Regulations.
Section 2(76) of the Act defines the term ‘related party’ exhaustively. On a
plain and literal reading of the definition, it appears that a public
charitable trust would not be covered under the said definition. However, since
the company is a listed company, the provisions of the LODR Regulations would
also be applicable. Hence, if a party with whom the company transacts is a
related party under those Regulations, then the relevant requirements contained
therein would also have to be complied with.

 

Regulation
2(1)(zb) defines related party as follows (emphasis supplied):

 

‘”related
party” means a related party as defined under sub-section (76) of section
2 of the Companies Act, 2013 or under the applicable accounting standards:…’

 

Thus, it
includes, first, a related party as defined under the Act that we have seen
does not include a public charitable trust. However, the definition is wider
and has a second leg and includes a person defined as a related party under the
applicable accounting standards. If we apply the Indian Accounting Standards
(Ind AS 24), the definition therein is fairly wide and indeed worded
differently. It includes categories of persons not included in the definition
under the Act. Thus, for example, it includes entities that are controlled by
the persons who control the company or the ‘close relatives’ of such persons.
There are other categories, too. The relevant question would be whether on the
facts of the case a public charitable trust whose managing trustee is the
father / father-in-law of the director couple said to be in control of the
company is a related party. This would have been an interesting analysis.

 

Here is a case
where a company has commercial relations with a public charitable trust whose
objective is understood to be public welfare. There is a relative of the
promoter director who is stated to be the managing trustee.

 

SEBI had in its
interim as well as confirmatory orders made a preliminary allegation that the
said trust was a related party, the transactions with whom were carried out
without complying with the relevant provisions of law. And on this and other
grounds, ordered debarment of the parties and a forensic audit of the affairs
of the company. The appellants challenged this order and asserted that the
trust was not a related party.

SAT observed as
follows while holding that the trust was not a related party (emphasis
supplied):

 

‘18. Similarly,
we are unable to agree with the contentions of SEBI that a trustee of a public
charitable trust is a related party going by the correct reading of the
definition in the Companies Act as well as in the LODR Regulations, unless
there is evidence to show that those Trusts have been set up or (are) operating
for the benefit of the appellant(s). Moreover, there is nothing on
record to show that Mr. Giridharilal, the trustee, has personally benefited in
any manner not only by virtue of being a trustee or in general by any other
means.’

 

Making this
legal and factual conclusion, the SAT overturned the order of SEBI insofar as
it debarred the appellants.

 

Interestingly,
neither SEBI nor SAT made any detailed analysis of the definition of related
party under the Act or under the Regulations. SAT merely says that on a
‘correct reading of the definition’ under the Act / Regulations, a trustee of a
public charitable trust is not a related party. It did not explain what this
reading was and how was it correct. Curiously, it places its own additional
condition about the trust being set up or operating for the benefit of the
appellants.

 

However, it is
respectfully submitted that such a condition is not part of the law relating to
related party transactions.

 

It is submitted
that the Order of SAT needs reconsideration. The definitions of related party
would need to be analysed, the facts of the case examined in more detail and
only the conditions specified in the law applied. It appears that the second
leg of the definition in the LODR Regulations was not even examined.

 

Reliance on media
reports by SEBI in making adverse orders against parties

Another
observation SAT made is that SEBI initiated the examination based on media
reports which resulted in passing of adverse orders against the appellants that
remained in place for a very significant time. It is submitted that taking
hasty action relying on media reports is a dangerous way of reacting. Media,
particularly social media, have a tendency to quickly build outrage which a
patient regulator may consider letting pass, focusing instead on the surer
method of meticulous examination. It was particularly noted by SAT that the
appellants have suffered debarment for quite a long period and the
investigation and even the forensic audit has not yet been completed.

 

CONCLUSION

The SAT order
is only with reference to the interim / confirmatory order. SEBI is yet to
investigate fully and also yet to receive the forensic report ordered.
Thereafter, it may make formal charges, if any, and pass a final order. This
may happen in the near future. It would be interesting to see how SEBI deals
with the issue of related party in the context of these facts since in the
earlier orders it had made preliminary allegations only. More interesting would
be to see how SEBI deals with the reasoning and ruling of SAT on related
parties, which I submit requires reconsideration.  

 

 

SEBI’S BROAD ORDER ON ENCUMBERED SHARES – REPERCUSSIONS FOR PROMOTERS

In the ongoing Covid-19 crisis,
where the world is reeling and stock markets are crashing three times and then
recovering once, a recent SEBI order on disclosure of encumbered shares could
have widespread repercussions on promoters. Increasingly, over the years, the
regulatory outlook of SEBI has been one of disclosures and self-education
rather than close monitoring and micro-management. Material events relating to
a company should be disclosed at the earliest so that the public can educate
itself and take an informed decision. In this context, an order levying a
fairly stiff penalty in a complex case of encumbrance of shares held by a
promoter company makes interesting reading (Adjudication Order in respect of
two entities in the matter of Yes Bank Ltd. Ref No.: EAD-2/SS/SK/89/252-253
/2019-20, dated 31st March, 2020).

 

BRIEF
BACKGROUND

Disclosure of holding of shares
in listed companies by promoters and certain other persons (substantial
shareholders, etc.), is an important feature of the securities laws in India.
Promoters typically have large holdings of shares, they control the company and
their continued involvement in it as substantial shareholders is an aspect
considered by the public as relevant in investment decision-making. Being
insiders with control of the company, their dealings in shares are also closely
monitored. Thus, movements in shareholding of shares are required to be
disclosed by several provisions of the securities laws. These disclosures are
event-based and also periodical. Quarterly / annual disclosures are mandated.
So are disclosures based on certain types of transactions or crossing of
certain values / quantities / percentage of movement in the shares held.

 

Interestingly, and this is the
topic of this article, disclosure of encumbrance in the shares of promoters and
their release is also a requirement under the provisions of SEBI (Substantial
Acquisition of Shares and Takeovers) Regulations, 2011 (‘the Takeover
Regulations’). Regulation 31 of the Takeover Regulations requires disclosure by
the promoters of the creation, release or invocation of any encumbrance on
their shares.

 

The definition of what constitutes
‘encumbrance’ has undergone changes over the years and the present case relates
to a matter before the recent amendment made in July, 2019, though the
principle would apply even now. The earlier definition was short – ‘“encumbrance”
shall include a pledge, lien or any such transaction, by whatever name called’.

 

It is of particular interest to
shareholders whether and to what extent the shareholding of promoters is
encumbered. The Satyam case is often referred to in this regard.

 

COMPLEXITY
OF ENCUMBRANCES

Pledging and hypothecation of
shares are the classic and most familiar of encumbrances on shares. A
shareholder may, for example, transfer his shares to a lender who would hold
them till the loan is repaid. If there is a default, the lender may simply sell
the shares in the market and realise his dues. But now that shares are held
digitally in demat accounts, a special process has been made to enable pledge /
hypothecation of shares. The shares are not transferred to the lender but a
record is made of the pledge / hypothecation in the demat account.

 

However, encumbrance, as the
definition shows, is a wider term rather than mere pledge / hypothecation. The
definition is inclusive and also has a residuary clause that says such
transactions ‘by whatever name called’ are also covered. As we will see later,
the parties in the present case, however, claimed that encumbrances should be
limited to pledge / hypothecation.

 

A question arises whether
restrictions placed on the disposal or other transactions in respect of shares
amounts to encumbrance as so envisaged. The classic case is of giving a
Non-Disposal Undertaking, popularly referred to as an NDU, in respect of the
shares. This means an undertaking is given that the shares held shall not be
disposed of till certain conditions (say, loans / interest are repaid) are met.
Even if a plain vanilla NDU is held to be an encumbrance, there are actually
many variants of an NDU or similar encumbrances as the present case shows. The
question is whether the definition should be treated as a generic catch-all
definition or whether it should be given a restrictive meaning. This has been
the core question addressed in this decision. Let us consider the specific
facts.

 

FACTS
OF THE CASE

The matter concerns two promoter
companies of Yes Bank Limited. Broadly summarised, the essential facts (though
there is some variation in details) are as follows: Both took loans by way of
differently structured non-convertible debentures from entities. The total
amount of loans taken was Rs. 1,580 crores. The shares held and which were the
subject matter of the alleged encumbrance, constituted 6.30% of the share
capital of Yes Bank. The debenture documents / terms placed certain
restrictions on the promoter entities. They were required to maintain a certain
cover ratio / borrowing cap. If such limits were violated, there were certain
consequences, principally that the promoter entity could be held to have
defaulted. There was, however, some flexibility. The promoter entities could
make certain variations after the approval of debenture holders in a specified
manner or after complying with certain conditions.

 

SEBI’S
ALLEGATION

SEBI held that the cover ratio /
borrowing cap effectively amounted to an encumbrance on the shares and thus
required disclosures under the Takeover Regulations. It alleged that the
entities would effectively face a restriction on the sale of their shares
because if they sold the shares, the ratios / caps would get exceeded and hence
the terms of the debentures could get violated. It was an admitted fact that no
disclosure of this alleged encumbrance was made as required under the
Regulations. Thus, there was a violation of the Regulations and SEBI issued a
show cause notice as to why penalty should not be levied.

 

CONTENTIONS
OF THE PROMOTER ENTITIES

The promoters gave several
detailed technical and substantive arguments to support their view that there
was no violation and hence no penalty could be levied. Technical arguments like
inordinate delay in initiating the proceedings were given. It was also argued
that since then the structure had undergone substantial changes, and
particularly on revision of terms, disclosure was required and was duly made.

 

It was argued that the definition
of encumbrance effectively limited it to things like pledge, hypothecation,
etc. The principle of ejusdem generis applied for the words used ‘by any
other name called’ considering that they were preceded by the words ‘such
transaction’.

 

Some of the other major arguments
were as follows: It was argued that the structure and terms of debentures did
not amount to encumbrance as understood in law. The caps on borrowings, etc.
were of financial prudence. There were many alternatives for the entities to
sell the shares if they wanted to do so within the terms of the debentures
themselves. References were made to FAQs and press releases where some
clarifications were given about encumbrances. It was argued that examples were
given of the type of encumbrances that were envisaged to be given and the
present facts did not fit those examples.

 

Incidentally, the parties had
earlier applied for settlement of the alleged violations but the application
was returned due to expiry of the stipulated time under the relevant settlement
regulations.

 

REPLY
AND DECISION OF SEBI

SEBI rejected all the arguments.
The debenture documents were made in late 2017 / early 2018 and thus SEBI held
that there was no inordinate delay in initiating the proceedings. The mere fact
that the structure was changed later and the disclosures duly made did not
affect the fact that no disclosure was made originally when the alleged
encumbrance was made.

 

It also rejected the core
argument that ‘encumbrance’ should be given a limited meaning more or less
restricting it to cases like pledge and hypothecation or the like. SEBI pointed
out that the definition was inclusive and even more descriptive than limiting.
The use of the words ‘by any other name called’ could not be restricted to
examples given of pledge / hypothecation. The principle of ejusdem generis
did not apply.

 

SEBI also traced the history of
the regulations and explained the dilemma that was faced regarding identifying
the many types of encumbrances. It was accepted that encumbrances on shares of
promoters needed disclosure in the interest of the securities markets.
Considering the varied and often sophisticated nature of encumbrances, the
definition was made descriptive / inclusive and not exhaustive. It was well
settled, SEBI argued, that securities laws being welfare regulations, needed
wider beneficial interpretation.

 

Although the definition was
modified recently whereby some specific instances were further added, it did
not mean that the earlier definition should be construed narrowly.

 

SEBI noted that the effect of the
conditions regarding limits was that the shares of the entities could not be
sold. This amounted to an encumbrance on shares and hence non-disclosure
amounted to violation of the Regulations.

 

SEBI thus levied a penalty of Rs.
50 lakhs on each of the two entities.

 

CONCLUSION

It goes without saying that
disclosure of encumbrances matters at any stage. Indeed, SEBI has required,
over a period, more and more information relating to encumbrances including,
most recently, the purpose for which the encumbrances were made.

 

However, their effect would be
seen particularly when the encumbrances end up being given effect to with
shares being sold in the market on invoking of the encumbrances, to take an
example. This may particularly happen when the price of the shares goes down
sharply, resulting in a vicious circle. The coverage / margin required by the
encumbrance documents gets violated and there is need to provide more shares as
encumbrance or sale of shares (and) which results in further lowering of price.
This would again affect the interests of shareholders. We are seeing now a huge
crash in share prices. It is possible that there may be many such similar
encumbrances and they may come to light because of the impact of share sale or
other transactions. There may be more cases in which SEBI may have to act.

 

This decision is relevant even
under the amended regulations. It lays down the principles and intent of the
regulations relating to encumbrances. Thus, unless reversed on appeal, it would
matter particularly (if and) for any fresh encumbrance as understood in a broad
manner in the SEBI order is undertaken. Such encumbrances then would advisably
be disclosed duly in accordance within the time limits and manner prescribed.

 

There
may be entities that have not disclosed the encumbrances till now, taking a
stand similar to that taken by the entities in the present case. They may need
to revisit their stand and documents and see whether due disclosures need to be
made, even if belatedly, but voluntarily. Better late than never.

SHARING INSIDE INFORMATION THROUGH WhatsApp – SEBI LEVIES PENALTY

BACKGROUND

On 29th April,
2020, SEBI passed two orders (‘the orders’) levying stiff penalties on two
persons who allegedly shared price-sensitive information. The information they
shared was the financial results of listed companies before these were
officially published.

 

About two years back, there
were reports in the media that the financial results of leading companies had
been leaked and shared on WhatsApp before they were formally released. It was
also alleged that heavy trading took place based on such leaked information.
These orders are, thus, the culmination of the investigation that SEBI
conducted in the matter. It is not clear whether these are the only cases or
whether more orders will be passed, considering that leakage was alleged in
respect of several companies. (The two orders dated 29th April, 2020
relate to the circulation of information concerning Ambuja Cements Limited and
Bajaj Auto Limited.)

 

Insider trading is an issue
of serious concern globally. Leakage of price-sensitive information to select
people results in loss of credibility of the securities markets. However, the
nature of insider trading is such that it is often difficult to prove that it
did happen. This is particularly so because such acts are often committed by
people with a level of financial and other sophistication. Hence, the
regulations relating to insider trading provide for several deeming provisions
whereby certain relations, acts, etc. are presumed to be true. As we will see,
in the present cases the order essentially was passed on the basis of some of
these deeming provisions. However, as we will also see, the application of such
deeming provisions in the context of social media apps like WhatsApp can
actually create difficulties for many persons who may be using them for
constant informal communication.

 

WHAT
ALLEGEDLY HAPPENED?

There were media reports that
the financial results of certain leading companies were leaked in some WhatsApp
groups well before they were formally approved and published by the companies.
Financial results are by definition deemed to be price-sensitive information,
meaning that their release can be expected to have a material impact on the
price of the shares of such companies in the stock market. In the two companies
considered in the present cases, it was alleged that there was a sharp rise in
the volumes of trade after the leakage.

 

It was found that two persons
– NA and SV – had shared the results through WhatsApp in respect of the two
companies. NA shared the information with SV and SV passed it on to two other
persons. SEBI carried out extensive raids and collected mobile phones and
documents. But it could not trace back how the information got leaked from the
companies to these persons in the first place and whether it was passed on to
even more people. In both the cases it was found that the information that was
leaked and shared matched with the actual results later released formally by
the companies.

 

Thus, it was alleged that NA
and SV shared UPSI in contravention with the applicable law. NA and SV were
stated to be working with entities associated with the capital markets.

 

WHAT
IS THE LAW RELATING TO INSIDER TRADING?

While the SEBI Act, 1992
contains certain broad provisions prohibiting insider trading, the detailed
provisions are contained in the SEBI (Prohibition of Insider Trading)
Regulations, 2015 (‘the Regulations’). These elaborately define several terms
including what constitutes insider trading, who is an insider, what is
unpublished price-sensitive information (‘UPSI’), etc. For the present
purposes, it is seen that financial results are deemed to be UPSI. Further, and
even more importantly in the present context, the term insider includes a
person in possession of UPSI. The offence of insider trading includes sharing
of UPSI with any other person. Thus, if a person is in possession of UPSI and
shares it with another person, he would be deemed guilty of insider trading.

 

It is not necessary that such
person may be connected with the company to which the UPSI relates. Mere
possession of UPSI, by whatever means, makes him an insider and the law
prohibits him from sharing it with any other person. This thus casts the net
very wide. In principle, even a person who finds a piece of paper containing
financial results on the road would be deemed to be an insider and cannot share
such information with anyone!

 

WHAT
DID THE PARTIES ARGUE IN THEIR DEFENCE AND HOW DID SEBI DEAL WITH THEM?

The parties placed several
arguments to contend that they could not be held to have violated the
regulations.

 

They claimed that they were
not aware that these were confirmed financial results and pointed out that
globally there was a common practice to discuss and even share gossip, rumours,
estimates by analysts, etc. relating to companies. There were even columns like
‘Heard on the Street’ which shared such rumours. They received such information
regularly and forwarded it to people. They pointed out that there were many
other bits of information that they shared which were later found to be not
accurate / true. But SEBI had cherry-picked this particular item. As far as
they were concerned, these WhatsApp forwards were rumours / analysts’
estimates, etc. like any other and were thus expected to be given that level of
credibility.

 

SEBI, however, rejected this
claim for two major reasons. Firstly, it was shown that the information shared
was near accurate and matched with the actual results later released by the
companies. Secondly, the law was clear that being in possession of UPSI and
sharing it made it a violation. It was also pointed out that the claim that
these were analysts’ estimates was not substantiated.

 

The parties also pointed out
that they were not connected with the companies. Further, no link was
established with anyone in the companies and the information received by them.
But SEBI held that because mere possession of UPSI made a person an insider, no
link was required to be shown between the parties or the source of information
and the companies.

 

It was also pointed out that
they had not traded on the basis of such information. Here, too, SEBI said that
mere sharing of UPSI itself was an offence. Further, SEBI said that it was also
not possible to determine due to technical reasons who were the other persons
with whom the information may have been shared and whether anyone had traded on
the basis of such information.

 

There were other contentions,
too, but SEBI rejected all of them and held that the core ingredients of the
offence were established.

 

ORDER
OF SEBI

SEBI levied in each of the
orders on each of the parties a penalty of Rs. 15 lakhs. Thus, in all, a total
penalty of Rs. 60 lakhs was levied on the two. SEBI pointed out that it was not
possible to determine what were the benefits gained and other implications of
the sharing of information. However, it said that an appropriate penalty was
required to be levied to discourage such actions in the markets.

 

CRITIQUE
OF THE ORDERS

Insider trading, as mentioned
earlier, is looked at very harshly by laws globally and strong deterrent
punishment is expected on the perpetrators. However, there are certain aspects
of these orders that are of concern and there are also some general lessons.

 

The core point made in the
orders is that mere possession of UPSI is enough to make a person an insider.
There is certainly a rationale behind such a deeming provision. It is often
very difficult to prove links between a company and its officials with a person
in possession of inside information. A company is expected to take due steps to
prevent leakage of information by laying down proper systems and safeguards.
If, despite this, information is leaked, then the person in possession is
likely to have got it through some links. Further, where a person is in
possession of such information, even if accidentally, it would be expected of
him to act responsibly and not to trade on it or share it with others. In the
present case, SEBI held that the parties were having the UPSI and they should
not have shared it with others.

 

However, there are certain
points worth considering here, in the opinion of the author. The parties have
claimed that they have been sharing many other items which were not confirmed
or authentic information but merely what was ‘heard on the street’. The persons
who received it would also treat such information with the same level of
scepticism. If, say, 24 items were shared which were mere rumours and then one
such item was shared without any further tag to it, the fair question then
would be whether it should really be treated as UPSI, or even ‘information’? SEBI
has not alleged or recorded a finding that there was any special mention that
these bits of information were unique and authentic.

 

SEBI has stated that the
parties should have noted later, when the results were formally declared, that
the information was confirmed to be authentic. The question again is whether it
can be expected of a person, if, assuming this was so, he or she is sharing
hundreds of such forwards, to check whether any such item was found later to be
true?

 

SEBI has insisted that (i) it
was shown that the information was authentic, (ii) it was deemed to be
price-sensitive, (iii) it was not published, (iv) the parties were in
possession of it, and (v) they shared it. Hence, the technical requirements for
the offence were complete and thus it levied the penalty. It is also relevant
to note that the same two parties were found to have shared UPSI in two
different companies and to the same persons.

 

Be that
as it may, this is an important lesson for people associated with the capital
markets. Social media messages are proliferating. People chat endlessly on such
apps and forward / share information. We have earlier seen cases where
connections on social media were considered as a factor for establishing
connections between people. The lesson then is that, at least in the interim,
people connected with the capital market and even others would need to err on
the side of caution and not share any such items. Just as people are
increasingly advised to be careful about sharing information received on WhatsApp
and the like which could be fake news, such caution may be advised for such
items, too. The difference is that in the former case it is to safeguard
against fake news and in the latter it is to safeguard against authentic news!

 

At the same time, it is
submitted that a relook is needed at the deeming provisions and their
interpretation and exceptions may need to be made. Sharing of guesses, gossip,
estimates, etc. ought not to be wholly banned as they too have their productive
uses. Considering the proliferating nature of such apps and their productive
uses, it may not be possible or fair to expect that people will not discuss or
share gossip and things that are ‘heard on the street’. Something more should
be required to be established to hold a person as guilty than the mere ticking
off of the technical requirements of an offence.

 

 

PROPOSAL FOR SOCIAL STOCK EXCHANGES – BOLD, INNOVATIVE AND TIMELY

Imagine a situation where a humanitarian
crisis or disaster takes place. A cyclone, floods, or, as is happening right
now, the Covid crisis. But even without a crisis there are human misery and
needs of various kinds. In the ordinary course, the government, some Indian /
international charitable organisations do take the initiative to provide
relief. However, often there is confusion and a scramble. Those in need do not
know whom to approach for help. Those who wish to donate funds or services do
not know who needs the funds / services and also which are the reliable
organisations that will really help the needy. Even the relief organisations
may be at a loss to find the needy and / or find those who can fund the relief
measures that they are ready to carry out.

 

Now, imagine if there was a smooth and
seamless system to coordinate the efforts of all such persons – the needy, the
donors / volunteers, the relief organisations, etc. – a system whereby funds
from those willing to help definitely reach the needy. The proposed model of
Social Stock Exchange (‘SSE’) as envisaged by a recent SEBI Working Group
Report, envisages just that. A whole eco-system is proposed in which, in a
variety of innovative ways, funds from those who have and also want to give,
reach those who need those funds. What’s more, there is also scope for
investors to participate in it and earn returns!

 

The objective essentially is to provide not
just information and coordination to all concerned, but also lay down a system
of checks and balances, reliable information, well-defined disclosure standards
and an audit mechanism. The system can use existing and new infrastructure and
systems to help raise funds in the form of securities and other instruments.

 

Such a report has just been released and
comments have been invited on it. However, considering the ambitious goals and
also the numerous structural changes and the set-up needed, it may be years
before they are fully implemented. However, a quick start is quite possible and
some major steps could be taken in a short time.

 

BACKGROUND

The Finance Minister had, in her Budget
Speech for financial year 2019-20, declared the decision of the Government of
India to set up a Social Stock Exchange to help raise funds for social impact
investing. She said, ‘It is time to take our capital markets closer to the
masses and meet various social welfare objectives related to inclusive growth
and financial inclusion. I propose to initiate steps towards creating an
electronic fund-raising platform – a social stock exchange – under the
regulatory ambit of Securities and Exchange Board of India (SEBI) for listing
social enterprises and voluntary organisations working for the realisation of a
social welfare objective so that they can raise capital as equity, debt or as
units like a mutual fund.’

 

Shortly thereafter, a working group was set
up and, after due consultations / deliberations, its report giving
recommendations has been published for public comments.

 

It is a fairly detailed report that makes
several suggestions on how to go about implementing the proposals made by the
Finance Minister. It surveys the global scenario and consciously makes
proposals much beyond most practices in prevalence. It envisages not just the
setting up of an SSE but discusses several other aspects of the eco-system and
also various products / structures that can be developed to ensure a
sophisticated and effective system.

 

The needy

That India has numerous needy sections
requiring relief goes without saying. Rural poverty, medical relief,
educational assistance, etc. are broad needs, while disaster relief is also
often required. The relief does not have to be merely the giving away of cash,
but also assistance in kind and / or service in various forms. Often, such
needy persons inhabit the interior parts of the country and hence it is also
vital that the relief has to be structured in such a way that it reaches them.
Such needy persons are unlikely to have direct knowledge and contact with those
who are able and willing to provide relief.

 

The relief organisations

The report
suggests that in India there are more than 30,00,000 (30 lakh) NGOs and other
organisations, small and large, able and willing to provide relief to the
needy. These include small social service organisations with a tiny set-up, to
large international organisations having extensive manpower, systems and
knowhow. They, however, need information about those who are in need of relief
and also knowledge of those who may provide funds for relief. They also need
knowhow of how to present their credentials to demonstrate that they have been
doing effective work. This would include a language of standardised benchmarks
and parameters to show their effectiveness. That they meet such benchmarks also
needs to be certified by ‘social auditors’ competent in this field.

 

The donors

There are several large international
donors, small and medium-sized donors / trusts, corporate donors (particularly
those who allocate funds for CSR work) and of course the millions of individual
donors who would want to make a difference to the needy. Then there is the
government itself which allocates large amounts of monies for relief work of
various types. However, all these need either direct access to the needy if the
relief provided is simple, or to organisations carrying out relief work to whom
they can donate funds or even provide honorary services. For this purpose, they
would want to be assured that their funds and services are put to the most
effective use so as to have the best social impact.

 

SOCIAL STOCK EXCHANGE – A model that brings together the various parties and helps
set up an eco-system

The report recognises that there are many
scattered organisations of various types who offer relief and provide
coordination and information in this regard. The need, however, is for a
complete and common eco-system whereby the needy, the relief organisations, the
donors and various other service entities are connected with each other. At
present, some bodies do provide part of such services / eco-system. However,
the report suggests that a Social Stock Exchange could serve as a centralised
body for enabling such an eco-system. Internationally, there are many SSEs of
varying kinds. However, the report seeks to go far ahead of such SSEs and
provide not just an information system but also a wide variety of funding
structures including listed securities that are tailor-made to meet such needs.
Some of the suggestions in this regard are described here.

 

Information repository

An accessible database of various relief
organisations would be set up under the aegis of the SSE. It would have
detailed information of the governing bodies, financials, track records of
relief work in a language of benchmarks and parameters that are well
established, well defined and understood by those familiar with the system. The
repository would have other relevant information, too. Anyone, including
donors, can access the information and find the relevant information.

 

Standards / benchmarks and disclosure
standards

Just as financial statements have a language
to present financial information to financially literate users, a similar set
of languages / standards and so on would be needed so that relief organisations
can present the work they have done in objectively understood / measurable
parameters. This would demonstrate their effectiveness.

 

Social auditors

Like auditors of financial statements,
social auditors would be needed to verify that the information disclosed by
relief organisations is fairly and correctly stated. This would give
reassurance to readers of such statements.

 

SECURITIES AND INSTRUMENTS OF VARIOUS
KINDS

While stock exchanges are normally conceived
of as a place / platform for transactions in securities of various kinds, the
SSE would not be focused on equities in the traditional sense. The securities
on the SSE would enable finance to reach relief organisations. The investments
may be in the form of equity or bonds of various kinds. If the projects in
which investments are made achieve the social benefit / impact promised, the
investors would get their monies back, possibly with some returns. Donors and
similar organisations would effectively provide monies for return of the funds.
The securities could also be traded on the SSE. If the project fails wholly or
partially, the amount invested may not be wholly returned. Loans from banks /
NBFCs may also be made in a similar manner. Different structures have been
suggested depending upon whether the organisation is For-Profit or
Not-For-Profit. The varying legal structures of such organisations (e.g.,
trust, section 8 companies or even individual / firm / company) have been noted
in the report and that the funding / securities structure would be different
for each such group.

 

The report also provides a structure for
deployment of CSR funds, including even trading in CSR certificates. Thus, for
example, CSR spends in excess of the prescribed minimum could be transferred to
others who have not been able to find appropriate projects for their own
spends.

 

Alternative Mutual Funds are also expected
to carry out a significant role in helping routing of such funds in the form of
units.

 

LEGAL / TAX HURDLES

The report conceives of an eco-system for
which much would be needed in terms of amendments in securities, tax and other
laws to enable it to fructify. The SSE itself would be under primary regulation
of the SEBI subject to possibly a separate sector regulator at a later point of
time. The SSE could be a separate platform under existing stock exchanges since
they already have the infrastructure.

 

However, several changes would have to be
made in law.

 

The securities laws would have to be amended
to enable the new forms of securities suggested. The Regulations relating to
Alternative Investment Funds would also require amendments. SEBI would have to
be given powers to provide for registration for various agencies, for
supervision, for prescribing disclosure requirements, levy of penalty, etc.

The report emphasises several changes in tax
laws. Requirements relating to registration / renewal of charitable
organisations, particularly the changes made in the recent Finance Act, 2020,
are suggested to be simplified and relaxed. Further, tax benefits for CSR
spends through such SSEs, for donations / investments made through an SSE, etc.
are recommended.

 

CONCLUSION

The implementation of the proposed structure
would take place in stages. It may even otherwise take time for various
organisations and entities to understand and become part of the proposed
eco-system. However, the recommendations do make for an inspiring read. The
system could provide the most effective use of the funds given in the form of
grants, donations and even investments. Organisations that work well would get
formal recognition in a language and in the form of parameters that are
commonly understood in the industry. There would be faith in the system that
would be reinforced by the supervision and discipline of SEBI.

 

Chartered Accountants would obviously have a
major role to play. They would be closely involved in advising corporates,
relief organisations and even donors on law, tax, structuring, etc. Preparation
of financial statements and even reports to present the social impact /
performance of such entities would be a new and refreshing challenge. It is not
expected that their involvement would be purely honorary or as social work.

 

One looks forward to speedy implementation
of the recommendations of this report which could usher in substantial changes
in the present system

 

PENALTY PROVISIONS UNDER SECURITIES LAWS – SUPREME COURT DECIDES

Securities Laws empower
SEBI to levy penalty in fairly large amounts, often even for technical
violations. The maximum amount can extend in some cases to upto Rs. 25 crores
or even more. It is fairly common to see penalties in lakhs or tens of lakhs
and more even for violations such as late filing of returns and making of
certain disclosures, etc.

 

The legal provisions have
seen frequent changes and even suffer from poor drafting. Even court decisions
have seen twists and turns by changes in interpretation by SEBI. SEBI
interpreted an earlier decision of Supreme Court in Shri Ram Mutual Fund
((2006) 5 SCC 361 (SC)) that the court held that penalty was mandatory in
case of violations and no mens rea had to be proved. It was arguable
that the Court did not make penalty mandatory. However, SEBI took a view that
it had no choice but to levy penalty. This had also to be seen in context of
the fact that there were provisions which provided for fairly large minimum
penalties.

 

Finally,
there were two fundamental interpretation issues of certain provisions. One
related to section 15J in the Securities and Exchange Board of India Act, 1992
provided that three factors to be taken into account by the Adjudicating
Officer (“the AO”) while levying penalty. The second question was whether these
three factors were merely illustrative, in which case other factors
could also be taken into account? Or whether they were exhaustive, meaning
that no other factors could be taken into account.

 

A related issue was whether
the AO has any discretion not to levy penalty or levy a lower penalty
than the one prescribed. These questions arose out of seemingly anomalous or
contradictory provision because some sections provided for a minimum and
mandatory penalty while another provision required the AO to consider certain
factors while deciding levy of penalty.

 

Fortunately, all of these
issues have been considered by the Supreme Court in a recent decision in Adjudicating
Officer, SEBI vs. Bhavesh Pabari ((2019) 103 taxmann.com 8 (SC)).

 

Background


The decision with several
separate cases in appeal though all of them had a common theme of penalty. The
Court thus first discussed in detail the legal background in the form of
earlier cases of the Supreme Court and also the provisions of the Act including
the various changes therein over the period.

 

The Court then arrived to
certain conclusions as to how the law should be interpreted and applied with
regard to certain matters and questions. These interpretation were then applied
to the facts of individual cases while deciding the violation.

 

It will be thus necessary
to summarise what the Court decided for each issue before it.

 

Whether
penalty is to be mandatorily levied or is there any discretion/exception
possible?

This has been a fundamental
question and the general stand taken by SEBI was that its hands were tied by
the decision of the Supreme Court in Shriram. Thus, SEBI held that once there
was a violation levy of penalty was mandatory and mens rea has no
relevance. Author submits that the Court in Shriram’s case did not held that
levy of penalty was mandatory. However, the Court in the present case has
reviewed the provisions dealing with penalty and some other issues.

 

It was seen that there were
several provisions dealing with levy of penalty – for example section 15A(a) to
15-HA) each section provided for penalty for the specific violation dealt with
in the section. Curiously, from 2002 to 2014, provisions relating to penalty
made a strange reading. Some provisions provided for a minimum penalty of Rs. 1
crore u/s. 15-A. The questions were : whether minimum penalty was to be
mandatorily levied? Did the Adjudicating Officer have the power to levy a lower
penalty or even waive the penalty? For instance section 15J provided for three
specific factors to be considered whilst levying penalty. The issue was : if
levy of a minimum penalty was mandatory, then would section 15J not become
redundant?

 

The Court pointed this
anomalous consequence and held that such a view usually cannot be taken. It
observed, “…if the penalty provisions are to be understood as not admitting of
any exception or discretion and the penalty as prescribed in Section 15-A to
Section 15-HA of the SEBI Act is to be mandatorily imposed in case of default/failure,
Section 15-J of the SEBI Act would stand obliterated and eclipsed… Sections
15-A(a) to 15-HA have to be read along with Section 15-J in a manner to avoid
any inconsistency or repugnancy. We must avoid conflict and head-on-clash and
construe the said provisions harmoniously. Provision of one section cannot be
used to nullify and obtrude another unless it is impossible to reconcile the
two provisions.”.

 

The court then pointed out
that the law had been amended in 2014 and it was clarified that discretion was
available to the Adjudicating Officer to consider the specified factors before
levying a penalty. The Court held that this clarification put beyond doubt that
discretion was always available with the Adjudicating Officer to consider
various factors and was not bound by the provisions providing for minimum and
mandatory penalty.

 

The Court observed, “The
explanation to Section 15- J of the SEBI Act added by Act No.7 of 2017, quoted
above, has clarified and vested in the Adjudicating Officer a discretion
under Section 15-J on the quantum of penalty to be imposed while adjudicating
defaults under Sections 15-A to 15-HA. Explanation to Section 15-J was
introduced/added in 2017 for the removal of doubts created as a result of
pronouncement in M/s. Roofit Industries Ltd. case ([2016] 12 SCC 125).”
(emphasis supplied). Hence the court reaffirmed that the earlier decision in
Roofit’s case was erroneous.

 

How should
a provision specifying a minimum penalty be interpreted?

There were several
provisions in the Act that provide, even today, for a minimum penalty of Rs. 1
lakh. The Court pointed out that some of these can be even for technical
defaults involving small amounts. The Court highlighted its earlier decision in
Siddharth Chaturvedi & Ors.( [2016] 12 SCC 119), which had held,
“…that Section 15-A(a) could apply even to technical defaults of small amounts
and, therefore, prescription of minimum mandatory penalty of Rs.1 lakh per day
subject to maximum of Rs.1 crore, would make the Section completely
disproportionate and arbitrary so as to invade and violate fundamental rights.”

 

The Court also pointed out
that the law was later amended to provide for a lower minimum penalty. In
short, the court concluded that discretion was available with the AO even with
regard to levy of a minimum penalty taking into account relevant facts of the
case.

 

Whether
the factors specified in section 15J were illustrative or exhaustive?

Section
15J is the general provision that applies to the various specific penalty provisions.
It states that while levying penalty, the AO shall consider three factors. One
was the amount of disproportionate gain or unfair advantage made. The second
was whether loss was caused to investors. The third was whether the default was
repetitive.

 

The
issue was: whether the above three were the only factors to be
considered by an AO or whether the other relevant factors AO could consider. It
was pointed out that section 15-I did provide that the AO shall levy “such
penalty as he thinks fit in accordance with the provisions of any of those
sections.”.

 

The
Court pointed out that there were several penalty provisions where none of the
three factors specified in section 15J would be relevant. Hence, taking a view
that these three factors are the only relevant factors would lead to an
anomalous result.

 

The
Court thus concluded the AO ought to consider not just the three factors
specified in section 15J but such other factors that are relevant. It observed,
“Therefore, to understand the conditions stipulated in clauses (a), (b) and (c)
of Section 15-J to be exhaustive and admitting of no exception or vesting any
discretion in the Adjudicating Officer would be virtually to admit/concede that
in adjudications involving penalties under Sections 15-A, 15-B and 15-C,
Section 15-J will have no application. Such a result could not have been
intended by the legislature. We, therefore, hold and take the view that
conditions stipulated in clauses (a), (b) and (c) of Section 15-J are not
exhaustive and in the given facts of a case, there can be circumstances
beyond those enumerated by clauses (a), (b) and (c) of Section 15-J which
can be taken note of by the Adjudicating Officer while determining the quantum
of penalty.”

 

Application
in individual cases

The Court then applied the
aforesaid conclusions in the various individual cases before it in appeal to
decide whether the penalty levied was in accordance with law and the
conclusions reached by the Court.

 

Can
penalty be levied separately for transactions in a party’s own name and also in
the name of a firm in which he is sole proprietor?

While dealing with individual cases, the
Court was presented with an interesting question. In a particular case, it was
observed that a party carried out transactions in violation of law in two names
– one (Bhavesh Pabari) was in his own name and the other through a firm name
(Shree Radhe) where he was sole proprietor. SEBI levied penalty of Rs. 20 lakhs
each for both the names. The appellant argued only one penalty should have been
levied since the party was the same. The Court rejected this argument on the
facts of the case. It observed, “This contention superficially seems
attractive, but on an in-depth reflection should be rejected as Bhavesh Pabari
had indulged in trading in its personal name and also in the name of his firm
M/s. Shree Radhe.”.



Can the
Supreme Court consider the reasonableness of penalty levied?

This was yet another issue
worth discussing. Can a party pray to the Supreme Court for reconsidering the
amount of penalty levied and argue that it was excessive or disproportionate?
This is particularly relevant since appeals against such orders can be to the
Securities Appellate Tribunal and thereafter straight to the Supreme Court. The
Court rejected this contention, and made the following pertinent observation,
“This court, in the exercise of its jurisdiction under Section 15-Z of the SEBI
Act, cannot go into the proportionality and quantum of the penalty imposed,
unless the same is distinctly disproportionate to the nature of the violation
which makes it offensive, tyrannous or intolerable. Penalty by it’s very
nature of the is penal. We can interfere only where the quantum is wholly
arbitrary and harsh which no reasonable man would award.”

Hence, except in exceptional
case the court, would generally not go into the reasonableness of the penalty.

 

Conclusion

The
decision of the Supreme
Court is very relevant and will need to be considered by SEBI and even
SAT
while considering cases of penalty. Parties would be free to present all
relevant facts of the case and emphasise all relevant factors with
respect to
the alleged violations in penalty proceedings. The AO will have to
judicially consider the facts and is no longer bound to levy ?minimum
penalty’.  

 

 

 

DISCLOSURE OF PROMOTER AGREEMENTS: SEBI’S NDTV ORDER

SEBI recently passed an
order against some promoters of New Delhi Television Limited (NDTV). Under the
order dated 14th June, 2019, it debarred certain promoters from dealing in and
accessing the securities markets, acting as directors in listed companies, etc.
The order concerns itself with certain loan and related agreements the terms of
which were not disclosed to the public. SEBI held that such non-disclosure is
fraudulent and harmful to the interests of the public / shareholders. The order
raises wider concerns since this is a common issue. The question would be
whether there is adequate disclosure of terms of shareholders’ agreements and
similar agreements by major shareholders / promoters of listed companies. On
appeal, the Securities Appellate Tribunal on 18th June, 2019 stayed the SEBI
order for the time being.

 

The bone of contention was
the loans taken by a promoter company under certain terms from two successive
lenders. These terms fell into broadly two categories: One is the grant of
convertible warrants to the second lender such that they could effectively
become almost 100% owners of the promoter company. The second relates to
certain clauses whereby the promoters were obliged to take prior written
permission of the lender before carrying out specified acts in NDTV. This,
according to SEBI, amounted to giving powers to the lender to take decisions in
NDTV. However, these agreements were not disclosed to NDTV or the public in
general. According to SEBI, this amounted to non-disclosure of price-sensitive
information and also fraud, and thus passed the adverse directions against
three promoters.

 

As stated earlier, some of
the terms are commonly a part of agreements entered into by promoters /
companies. This order ought to be of wide concern since it may lead to charges
of non-disclosure or incomplete disclosure and thus result in serious adverse
consequences.

 

BACKGROUND AND FACTS

The relevant promoters of
NDTV were RRPR Holdings Pvt. Ltd. (RRPR) and Dr. Prannoy Roy / Ms Radhika Roy
(together the Roys). The Roys owned RRPR. They held in the aggregate during the
relevant time about 61 to 63% of the equity shares of NDTV. It appears that
RRPR had taken some loans from ICICI Bank Limited. To repay those loans, it
took certain loans from Vishwapradhan Commercial Private Limited (VCPL). The
terms of the loans from ICICI Bank and VCPL and the transactions related to the
loans were the areas of concern.

 

After carrying out certain
internal sale / purchase transactions, RRPR ended up holding 30% shares in
NDTV. As a part of the loan transaction terms with VCPL, share warrants were
issued to VCPL whereby, if such share warrants were fully exercised, VCPL would
hold 99.99% shares in RRPR. Effectively, it would thus become 100% owner in
RRPR. Certain connected agreements also gave an option to associate companies
of VCPL to acquire in aggregate 26% of NDTV from RRPR.

 

Further, the loan agreements
between RRPR / the Roys and ICICI / VCPL provided for certain terms relating to
the management of NDTV. Several specified important decisions could not be
taken in NDTV without the prior written approval of VCPL. RRPR and the Roys
were required to exercise their shareholding in NDTV to ensure that decisions
in NDTV are not taken in violation of these terms.

 

THE ALLEGATIONS

SEBI stated that the
promoters did not make the required disclosures of these transactions and
terms. The information was price-sensitive and would have affected the
decisions of the investors / public. SEBI alleged that this non-disclosure was
fraudulent in nature.

 

The terms of the agreement
whereby share warrants were issued to VCPL amounted for all practical purposes
to transfer of the shares in NDTV by the promoters. Further, agreeing to terms
whereby certain important decisions in NDTV would require prior approval of
ICICI / VCPL also amounted to information that shareholders / public ought to
know. Effectively, decision-making power was transferred / shared with certain
persons of which the public did not have knowledge. They would be looking at
the Roys as the persons in charge.

 

Thus, multiple provisions
of the SEBI Act and the SEBI PFUTP Regulations were alleged to have been violated
by entering into such transactions without due disclosures.

 

THE DEFENCE OFFERED BY THE PROMOTERS

The promoters denied the
allegations. They claimed that the loan agreement was a private one and had
nothing to do with NDTV. NDTV was not bound by the terms of the agreement.
Hence, the terms agreed upon did not affect NDTV and thus the public /
shareholders.

 

Further, it was contended
that these were standard terms in loan agreements.

 

Importantly, a distinction
was made between their role as shareholders and as directors. It was stated
that they were free to do what they wanted as shareholders in respect of their
shares. They stated that their acts as private shareholders did not conflict
with their role as directors. In any case, they were in the minority on the
board as there were so many other directors.

 

SEBI’S CONCLUSIONS AND ORDER

SEBI did not agree with
the defence offered by the promoters. It held the agreements were not bona
fide loan agreements, and indeed were a sham to that extent. Such long-term
loans without interest and without any terms of repayment are not entered into
in the ordinary course of business. The loan agreement was, SEBI concluded, a
sale agreement.

 

The right of ICICI / VCPL
under the agreement to participate in certain important decisions was vital
information that the promoters should have disclosed to NDTV and the public.
SEBI also rejected the distinction made by the promoters between their role as
shareholders and as directors.

 

SEBI also rejected the
contention that as just two directors on the Board of NDTV, they could not have
influenced the decisions of NDTV. SEBI noted, ‘This contention is not tenable
in view of the fact that Noticee No. 2 is not only the Director of NDTV but is
the Chairman of the Board of the Company. Secondly, Noticee No. 2 and 3 were
not only the Chairman and Managing Director, respectively, but along with
Noticee No. 1, which is a private limited company of Noticee No. 2 and 3, were
also the promoters and majority shareholders, holding majority voting rights in
NDTV. Therefore, it is inconceivable that Noticee No. 2 and 3 were incapable of
ensuring compliance with the conditions to which they had agreed under the loan
agreements with respect to the affairs of NDTV.’

 

Further, SEBI pointed to
the code of conduct of NDTV to which the Roys were subject. As per this code,
they were not supposed to put themselves in a position of conflict with the
company. Yet, by entering into such a loan agreement, they had placed
themselves in such a position.

 

SEBI noted that the Roys
had entered into off-market transactions in the shares of NDTV. Thus, they
dealt in shares of NDTV without disclosing relevant information to the public
who dealt in shares without having such information. SEBI observed, ‘In the
absence of availability of material information relating to VCPL Loan
Agreements 1 and 2 in the public domain, investors were not in a position to
take any informed decision while dealing in the scrip of NDTV. Hence, by
concealing such material information from the public shareholders during the
relevant period when the promoters themselves were dealing in shares of the
company, Noticees have allegedly committed fraud on the minority public
shareholders of the company.’

 

The terms of the loan
agreement, SEBI noted, apart from being very liberal, were strange. The share
warrants could be converted even after the repayment of the loan. Thus, the
lender could become effectively the owner of RRPR and hence the 30% shares in
NDTV even after repayment of the loan. Thus, it noted, ‘It is not a loan
transaction simpliciter. It appears an outright transfer of 30% stake and
voting rights in NDTV by the Noticees masquerading as a loan agreement which
did not even possess the basic attributes of a normal secured loan transaction.
In my view, the VCPL Loan Agreements 1 and 2 are sham loan transactions
executed by the Noticees only with a motive to sell their substantial stake in
NDTV.’

 

Accordingly, SEBI ordered
as follows: RRPR and the Roys were debarred from accessing the securities
markets, buying / selling securities or being associated with the securities
markets for two years. Their existing securities, including mutual fund units,
were frozen during this period. The Roys were also debarred from occupying
positions as Director or Key Managerial Personnel in NDTV for two years and in
any other listed company for one year.

 

 

APPEAL TO SAT AND STAY

The promoters immediately
appealed to SAT, which has stayed the order for the time being pending final
disposal. SAT held that the conclusions drawn by SEBI need to be examined in
more detail and a company such as NDTV cannot be kept headless in the meantime.
This would be harmful to NDTV and also its shareholders.

 

IMPLICATIONS AND CONCLUSIONS

It is very common for
parties to enter into shareholders’ and similar or related agreements with
investors / lenders. Certain rights are given to them that include taking their
approval for specified major matters. The SEBI LODR Regulations now do have a
requirement of making disclosures of such agreements. However, this order would
be an eye-opener for parties who would have to ensure that due disclosures are
made. The present case related to events in and around 2008-2010. There may
thus be concerns that even agreements entered into in the distant past may be
covered and SEBI may take action if these have not been disclosed.

 

Though the facts of this
case are peculiar and though the matter is under appeal, a closer look is
required by companies and promoters to their own cases. It is also suggested
that SEBI itself comes out with clearer directions on this and gives time to
promoters / companies to make specific disclosures, irrespective of what has
happened in the past.

CHASING FRONT RUNNERS: SEBI GETS BETTER AT THE GAME

Front running is a serious problem in capital
markets. It is very similar to, and as serious as, insider trading. But unlike
insider trading, which has a full-fledged law devoted to it that makes it
easier for SEBI to prosecute wrong-doers, front running has to be established
by a long and arduous procedure. The difficulty was compounded till now because
whether front running was a prohibited practice or not was itself questioned in
law till the Supreme Court ([2017] 144 SCL 5 {SC}) and an
amendment to the law settled it. Fortunately, as a recent case (order dated 4th
December, 2019 in the matter of various entities of Fidelity Group)
demonstrates, SEBI has shown creativity and initiative in the matter to
establish front running by persons and then taken fairly quick action.

 

WHAT IS FRONT RUNNING?

Front running, as the term may indicate, is similar to a person running
in front of you to take unethical and illegal advantage of you; for example,
you ask your assistant to buy 1,00,000 shares of X company for you. Now, it is
known that buying such a large quantity of shares at one stroke could result in
an increase in the price of such shares. So your assistant is tempted to first
buy shares for himself in his own name or in the names of nominees / friends.
Thereafter, he starts buying shares for you while he or his nominees / friends
are selling shares. Thus, he has bought shares at a lower price and he will
sell you shares at the higher ruling price after his purchases. So you
end up in a loss since you paid a higher price for your shares. The same thing
could happen if you wanted to sell a large quantity of shares, except that the
trades would be opposite.

 

Such unethical and dishonest practices could be carried out not just by
one’s office staff, but even by one’s stock brokers. Or, as in the present case
as discussed in detail later, by authorised traders in mutual funds. In such
cases, the investors in such funds end up bearing the loss. SEBI has, even if
by fits and starts, been increasingly taking action against such front runners
and has progressively amended the law.

 

HOW ARE FRONT RUNNING AND INSIDER TRADING SIMILAR?

Both involve some confidential information that a person has and that is
given generally on trust to a deputed person. Such information in both cases is
valuable in the sense that such a person can exploit it for his own illicit /
unethical profit at the expense of the other.

 

An insider, for example, may be a Chief Financial Officer of a company.
He may have access to the latest financial performance of his employer company
that has not yet been made public. If such results are very positive, he may
buy shares before disclosure of the results and then sell when the price rises.
This in a sense causes loss to those people who were deprived of the
information and also leads to loss of credibility of the company and the stock
markets in general.

 

A front runner may well be a stock broker. A client comes to him and
places an order for a significant quantity of shares which will almost
certainly move the price in a particular direction. The stock broker exploits
this order information and places an order for himself first. Then, while he is
executing the client’s order, places a counter order for himself. The client
ends up suffering a loss.

 

HOW ARE FRONT RUNNING AND INSIDER TRADING LAWS DIFFERENT?

Firstly, there is a separate and comprehensive set of regulations
dealing with insider trading. The SEBI Act too has specific provisions dealing
with it. Insider trading and even front running are both notoriously difficult
to establish. However, the Insider Trading Regulations are fairly detailed and
have several deeming provisions to help establish the guilt. These provisions
may result in a whole group of persons to be deemed as insiders. Certain types
of information are deemed to be price-sensitive. Many other presumptions, some
rebuttable, are also made.

 

In comparison, till recently front running was not technically even an
offence, unless it was by intermediaries. Thus, for example, there were two
views on whether an employee of a mutual fund who trades ahead of orders of
mutual funds could be said to have engaged in front running. The Supreme Court,
however, finally held that even that was front running. But front running still
does not have the helpful deeming provisions as do insider trading related
regulations. Hence, the already difficult task of proving such cases is made
even more difficult.

 

So, in this context, the latest order of SEBI is worth a read. The fact
that SEBI used market intelligence and some out-of the-box methods to establish
guilt makes the order even more interesting.

 

BRIEF FACTS OF THE CASE

The discussion here is academic and hence is on the presumption that the
findings of SEBI are correct. It is possible that these prima facie
findings may be wrong as it is only an interim order and the parties may
provide evidence to the contrary which may result in the SEBI order being
modified.

 

The case presents a typical scenario of front running. There were
certain funds belonging to the ‘Fidelity Group’ that dealt in shares. The
relevant dealings were, as expected, in large quantities. And there was this ‘trader’
who placed orders on behalf of the mutual fund with brokerage houses.

 

SEBI has stated that this trader had two relatives
– his mother and his sister – and the three engaged in front running in
concert. How SEBI found out about this relation is an interesting aspect that
is dealt with separately. SEBI found that these relatives made significant
trades that were similar to the orders placed by the fund through the trader.
The trades by these relatives preceded those of the mutual fund and when the fund
itself placed the orders, the relatives reversed their trades. Thus, to
illustrate, if shares of Company A were to be purchased by the fund, the
relatives purchased shares of A before the fund placed its order, and on the
same day. When the orders of purchase for the fund were placed, the relatives
sold the shares they had purchased earlier. In a short span of a few hours, the
relatives made substantial profits. This was repeated over a period of time and
in case of several scrips.

 

It was also found that trading / bank accounts of these relatives were
opened shortly before such trading. Further investigation found that trades
also took place online through IP addresses located in Hong Kong where the
trader was stationed.

 

Thus, by what clearly appears to be intelligent information gathering,
SEBI noticed these transactions. SEBI held that this was front running.

 

USE OF MATRIMONIAL SITES AND INTERNET TO ESTABLISH THE RELATIONS BETWEEN
THE PARTIES

SEBI has in the past, to check for possible
connections, used social media like Facebook. Social media and many
internet-based social sites can provide possible clues to relations between
parties. These may include being ‘friends’ or ‘relatives’ as per the personal
profiles of persons. Even interactions in the form of reactions on posts /
comments could provide some preliminary basis for further investigation.

 

In this case, a question arose about what was the
relation between the employee of the mutual fund who placed the orders and the
two persons who traded apparently ahead of such orders and made substantial
profits. SEBI checked a matrimonial site for the profile of the trader and
found that he had effectively mentioned one of the persons as his mother. The
surname of these three persons was also the same. SEBI further investigated
using PAN card, KYC, bank account and other details of the persons and held
that the two persons were the mother / sister of the trader. SEBI accordingly
concluded for the purposes of its interim order that they were related.

 

This investigative method may be used increasingly
in future. Countless people are on social media and similar sites, and interact
actively there, put up their profiles, etc. Such profiles of course have varying
degrees of ‘privacy’ and particularly ‘public’ profiles (i.e., those that can
be seen by any person) are easy to investigate. The law relating to accessing
private information is developing and can be an interesting study by itself.
But it is clear that this does provide an opportunity for establishing
connections and gathering information. The connection between parties is
relevant not just for front running or insider trading but even for other
matters in securities laws such as price manipulation, takeovers and other
cases where parties are connected in their actions without formal agreements.

 

FINDINGS OF SEBI

SEBI compared the trades of the funds (through the trader) and his two
relatives and their timings, prices and whether they reversed in a synchronised
manner. SEBI held that the trades were connected and there was no explanation
other than that this was on account of front running.

 

It also found other factors which supported this, such as financial
transactions between the parties, the timing of opening of broker / demat accounts by these relatives, etc. SEBI accordingly
held, by its interim order, that this was a case of front running in violation of the relevant regulations.

 

ORDER / DIRECTIONS BY SEBI

SEBI issued several directions through the interim order. It directed
the parties to deposit in an escrow account the profits of Rs. 1.86 crores made
through this alleged front running. Such a direction to deposit the profits is
usually a prelude to a final order of disgorgement – i.e., forfeiting such
profits, usually also asking for interest. SEBI also directed banks and demat
authorities of the parties to not allow any transactions till the amount was
deposited. They have also been debarred from dealing in, or being associated
with, the stock markets.

 

SEBI has given an opportunity to the parties to present their case
before it against these interim directions. If the offence is proved, it is
possible that the parties may face further penal action that could include
debarment, a financial penalty and a final order of disgorgement of the profits
with interest.

 

CONCLUSIONS

This order is a good example of how SEBI has tried to overcome the
problems of gathering information and evidence for difficult-to-establish
offences of front running and thus even insider trading.

 

Use of internet and social media for investigation and evidence is,
however, a double-edged sword. It does give prima facie clues for
further investigation. But social media connections can be misleading. People
may have thousands of ‘friends’ or followers, who are often made by merely
clicking a button once on a webpage. Many of them may be total strangers.
Information uploaded on such pages may be unreliable and even false, and in any
case not authenticated sufficiently to be usable for legal action. However, as
in the present case, it can provide clues to investigate further. The challenge
would be to access private profiles and this would require a careful balance
between the need for privacy and the needs of public interest.

 

Front running arises out of the classic conflict of loyalty / duty and
greed. There are endless opportunities for persons in organisations or for
organisations themselves to illicitly profit from persons who place trust in
them. It would not be surprising if there are numerous such cases. They cause
losses to investors and harm the credibility of both the intermediaries and the
stock markets. If more are being detected and caught, it is good news.

 

However, it is submitted that the law relating to front running should
be made more comprehensive.  

 

 

SUPERIOR VOTING RIGHTS SHARES: A NEW INSTRUMENT FOR FUNDING

BACKGROUND

After a short
consultation process, the Ministry of Corporate Affairs and the Securities and
Exchange Board of India have, in quick succession, notified the new regime and regulatory
requirements relating to Superior Voting Rights equity shares (SRs).
Essentially, SRs are a special category of equity shares. They provide for
extra voting rights in comparison with ‘ordinary equity shares’.

 

Generally, all
equity shares are equal. They have the same right to dividends, the same rights
of voting and other features. To use the common Latin term, they are all pari
passu.

 

For private
companies, there was considerable flexibility to create several categories of
equity shares, each category having different rights. Typically, the
differences relate to voting and / or dividends. One category of equity shares,
for example, may have multiple voting rights as compared to others. This
enabled the holders to exercise far more control and say, compared to the
‘economic’ interest in the company.

 

Availability of
such flexibility helped companies and their founders / promoters to negotiate
with investors. Investors may be interested in economic returns while the
promoters / founders may be needed to be given assurance of control over the
running and management of the company.

 

However, while
this was well accepted in case of private companies, there was divergence of
views relating to listed companies and even unlisted public companies. On the
one hand, it was argued that such matters should be left for internal
negotiations and decisions of the company, its promoters and investors. If they
desire to have such a structure, the law should not meddle. This is, of course,
so long as there is adequate disclosure of the facts. On the other hand, there
was opposition to allowing any such instrument giving differential rights on
the ground that it would allow a small group of shareholders to control the
company even at the cost of shareholders holding otherwise majority of economic
value. It was argued that such instruments went against the principle of
corporate democracy and governance.

 

SEBI varied its
view over a period of time. It had allowed the issue of one category of such
instruments but there was an approval process that often took months. The
result was that there were barely 4-5 companies that issued such instruments.
Curiously, it was found that in most of the cases, such instruments traded at a
huge discount over the ‘ordinary equity shares’. There was far less trading,
too.

 

Recently,
however, the debate arose again particularly in case of startups that
extensively use technology (internet, digital, biotech, etc.). Such companies
need capital and flexibility and there has been a history of companies that
have seen very rapid growth. Such categories of companies need to be given a
freer hand and also their promoters given a share disproportionate to the
amount of money that they invest. SEBI had recently initiated a consultation
process wherein the current law and practice in India and abroad was
highlighted.

 

After debate
and consultation, the Ministry of Corporate Affairs (MCA) and SEBI have both
made changes in their respective regulations / rules to allow for certain types
of instruments. The features of these instruments are briefly discussed here.

 

What type of
instruments are allowed to be issued?

Equity shares
with extra voting rights than other ‘ordinary’ equity shares are allowed. These
rights are called superior rights and hence such instruments are referred to as
‘Superior Rights’ shares or SRs.

 

Which type of
companies are allowed to issue SRs?

All companies
are given such powers. The MCA has made generic rules applicable to all
companies. However, SEBI has made further regulations applicable to listed
companies.

 

WHAT
ARE SRs?

SRs are a
special category of equity shares with superior voting rights as compared to
other equity shares. No other differential, whether of dividends, share in
property, etc., is permitted. Thus, for example, the SRs – or ordinary equity
shares – cannot be given extra or lesser dividends. It is just that when it
comes to the matter of voting at general meetings, SRs would have extra voting
rights.

 

Note that the
MCA rules applicable to all companies generally provide for a wider category of
instruments not merely restricted to SRs. However, the focus of this article is
on SRs since SEBI has recognised and permitted only this class of instruments.

 

Shares with
‘inferior’ rights not allowed

Only shares
with superior voting rights are allowed to be issued. Thus, a company can have
a share with multiple voting rights or one voting right. It cannot have a share
with voting rights less than one vote per share. At present, companies have
issued shares with less voting rights. Such shares cannot be issued any more by
listed companies.

 

Shares with
other differential rights

Equity shares
with lesser or more dividend rights are not permitted to be issued by listed companies.
No other differential is also possible. The only differential permitted is
issue of shares with superior voting rights.

 

Who can be
issued SRs?

Unlisted
companies can issue SRs to any person. However, if the company wants to list
its shares on exchanges, the promoters / founders to whom SRs are issued should
be acting in an executive position in the company. Further, such SRs holders
should not be part of a promoter group whose collective net worth is more than
Rs. 500 crores.

 

How much extra
voting rights can be given to SRs?

SRs can be
given two to ten times extra voting rights as compared to ordinary equity
shares. At the minimum, thus, one SR can have twice the vote of an ordinary
equity share; and at the maximum, ten times. The multiple has to be in whole
numbers and not fractions (e.g., one cannot issue SRs with two and a half times
voting rights of ordinary equity shares).

What are the
procedures and approvals required for issue of SRs?

There are
several conditions for the issue of SRs. The articles of association should
permit such an issue. The companies’ rules require that an ordinary resolution
has to be passed approving such issue and for this purpose, certain disclosures
need to be made. However, the SEBI regulations require a special resolution
with certain further disclosure requirements. Earlier, there was a requirement
of having a three-year profit track record, but this requirement is now
dropped. As far as unlisted companies are concerned, any company can issue SRs.

 

Classes of SRs

The SEBI
regulations permit only one class of SRs.

 

‘Coat-tail’
provisions

These refer to
those situations where the SRs will have the same voting rights as ordinary
equity shares. In other words, SRs as well as ordinary equity shares will have
one vote per share. These requirements are prescribed for listed companies by
SEBI. Thus, in respect of the specified situations, which relate to important
matters or where there can be major conflict of interest, etc., the extra
voting rights on SRs are not available.

 

Sunset
provisions

Sunset in this context means the period of time after which the SRs
become ordinary equity shares. In other words, the extra voting rights of SRs
are removed. Unlisted companies are not mandatorily required to have sunset
provisions. However, listed companies need to provide that the SRs shall be
converted into ordinary equity shares by the fifth anniversary of listing of
the shares in the public issue of such a company. Such period can be extended
by another five years if a resolution is passed by the shareholders other than
SRs holders. The holders of SRs can, however, convert their SRs to ordinary
equity shares earlier.

 

There are also
mandatory sunset events where on the occurrence of such events the SRs get
converted into ordinary equity shares. These include, e.g., when the SR holder
resigns from the executive position, dies, etc.

 

Who can hold
SRs? What if they transfer the SRs?

Only those
promoters who have an executive position in the company can hold SRs. If the
holder dies, the person to whom such shares devolve will not have any superior
rights in respect of such shares. Generally, sale of SRs will result in the
superior voting rights lapsing and such shares becoming like other ordinary
equity shares.

Lock-in period

Under the SEBI
regulations, the SRs held by the promoters shall be locked in during the period
they are SRs, or for the period of lock-in in accordance with the ordinary
provisions relating to lock-in for minimum promoters’ contribution, whichever
is later.

 

Maximum
percentage of voting rights

The SRs cannot
have voting rights above 74% of the total voting rights. Thus, the ordinary
equity shares need to have at least 26% voting rights. For listed companies,
the ordinary equity shares held by SRs holders are also counted for the
purposes of this limit of 74%.

 

Special
requirements relating to corporate governance for listed companies

A company
having SRs is required to ensure that at least half of its board consists of
independent directors. Its Audit Committee should consist only of independent
directors. And its Nomination and Remuneration Committee, its
Risk Management Committee and its Stakeholders Committee should comprise of at
least two-thirds independent directors.

 

CONCLUDING
REMARKS

The positive
aspect of the new set of provisions is that now, particularly in case of listed
companies, SRs can be issued without formal approval of regulatory authorities
like SEBI. Approval of shareholders is generally enough. The discretion and
also the delay for such approval is thus eliminated.

 

However, it can
be seen that a very narrow type of instruments is permitted to be issued and
that, too, having a limited validity period. The superior rights are not
applicable under several situations. Importantly, though the wording is not
sufficiently clear, it appears that listed companies cannot make a fresh issue
of SRs (except as rights / bonus). Shares with inferior voting rights cannot in
any case be issued.

 

Thus, the
regulators have taken a very conservative position as regards the issue of SRs.
There is of course a worldwide debate on whether such shares with differential
rights be allowed and under what circumstances. While many countries do allow
(and many do not), some countries let companies and their shareholders /
investors decide. There is thus a good argument to allow flexibility to
companies and their investors to decide on what type of instruments can be
issued instead of a blanket ban or very narrow permissibility.

 

One of the
principal objections is that investors do not understand such instruments and
hence may end up acquiring them to their loss. Alternatively, they may simply
not invest. One would have, though, thought that after so many years of debate
on such instruments, there would be knowledge for those who want to make some
effort. After all, even equity investing is for informed investors, more so
when the focus of regulations these days is on more and more disclosures and
transparency.

 

Be that as it
may be, there is now a narrow but fairly clear type of instrument that can be
issued. Time will tell how successful it is with companies, their promoters /
founders and, above all, investors.  

 

NEW RULES FOR INDEPENDENT DIRECTORS: HASTY, SLIPSHOD AND BURDENSOME

The new rules notified on 22nd October, 2019 by the Ministry
of Corporate Affairs under the Companies Act, 2013 require independent
directors to pass a test to demonstrate their knowledge and proficiency in
certain areas for board-level functioning in corporates. They need to score at
least 60% marks to qualify. They also need to enrol their names in a database
maintained for the purpose. The intention appears to be that companies should
choose independent directors from this databank. The above are the principal
requirements notified by the new rules.

 

BACKGROUND

It may be recalled that the Companies Act, 2013 requires listed
companies and certain large-sized public companies (in terms of specified net
worth, etc.) to have at least one-third of their boards peopled by independent
directors. SEBI has made similar requirements but with some differences (its
requirements apply to listed companies and provide for a higher proportion of
independent directors).

 

QUALITIES OF INDEPENDENT DIRECTORS

The qualities that make a person an ‘independent’ director have been
laid down in great detail in the law. However, these focus largely on their
independence from the company and its promoters but do not prescribe any
minimum knowledge, educational qualifications, etc., except when they are a
part of the Audit Committee. They occupy a high position in a company and are
expected to provide well-informed inputs on matters of governance, strategy and
so on to the company and its management. They are also expected to keep a
watchful eye on the finances, accounts and performance of the company by
exercising their skill and diligence. A failure on their part can be harmful to
the company and to themselves, too, since they may face liability and penal
action in many forms.

 

Against this background, the new requirement of minimum knowledge is
surely welcome. A designated institute (the Indian Institute of Corporate
Affairs) will publish the study material for directors to prepare for the test.
It will also conduct the prescribed test.

 

Often, independent directors have a background of law, accountancy,
etc., but there are also many directors chosen for their experience in a
relevant industry, for their technical knowledge and administrative expertise.
But such persons may not have knowledge and experience about how companies are
governed. It is possible that they may not even have rudimentary knowledge of
accounting. Such basic knowledge, duly confirmed by a test which they have to
pass, would help them and the company as well. This is particularly so since
the obligations placed on them are fairly comprehensive.

 

When do the new rules come into force?

The new rules come into force from 1st December, 2019 and are
spread over several notifications, one of which introduces a full set of rules,
another modifies an existing one and yet another notifies the institute that shall
oversee the teaching and the test. Three months’ time has been given to
independent directors to enrol their names in the databank and a period of one
year from enrolment to pass the test. Companies are required to ensure
compliance with this requirement and an independent director is also required
to confirm he is compliant in the filings made by him.

 

Who will administer the tests and maintain databank?

The new rules may be an attempt to provide a basic level of financial
and regulatory literacy. The institute notified (the Indian Institute of
Corporate Affairs) has to serve several functions. It has to release
educational material for independent directors that they can use to prepare for
the exams. It is also required to conduct the online test for them. (The scope
of the test covers areas such as company law, securities law, basic
accountancy, etc.) Apart from the qualifying exam, the institute is required to
conduct an optional advanced test for those who wish to take it.

 

The Institute is also required to maintain a databank of independent
directors containing detailed information of each such person. Companies
seeking to appoint independent directors can access such information on payment
of a fee to the institute. Interestingly, the institute is required to report daily
to the government all the additions, changes and removals from the databank.
This makes one wonder why would the government want to monitor this databank so
closely and so frequently.

 

To whom do these new requirements apply?

The requirement of enrolling in the database and passing the qualifying
test applies to existing as well as new independent directors. Existing
independent directors are given some time to enrol themselves in the database
and thereafter pass the qualifying test. New independent directors will have to
first enrol in the database.

 

Are any persons exempted from the requirements?

A person who has acted as an independent director or key managerial
personnel for at least ten years in a listed company or a public company with
at least Rs. 10 crores of paid-up capital, is exempted from the requirement of
passing the test. However, he would still have to enrol in the database.

 

Independent directors required to enrol in the database

Independent directors are required to enrol by providing the required
information and payment of a fee. Existing independent directors are required
to do this within three months, i.e., by 1st March, 2020. A person
seeking appointment as an independent director is required to enrol before
being appointed. He is required to pass the prescribed test with at least 60%
marks within one year of enrolment. The enrolment can be for one year, five
years or for a lifetime. The test has to be passed only once in a lifetime.
Directors, presumably, will update the knowledge of rapidly changing laws on
their own.

 

Companies are required to ensure and report compliance with these
requirements.

 

IMPLICATIONS OF THE NEW REQUIREMENTS

These new requirements will ensure that a person may be a top lawyer or
a chartered accountant with decades of experience, or a senior bureaucrat, or a
professor of a reputed college, yet he will have to pass this test with at
least 60% marks. Except for persons with ten years’ experience as specified
earlier, there is no exception provided.

 

GREY AREAS IN THE REQUIREMENTS

The law has some gaps and is ambiguous at a few places. Section 150 of
the Companies Act, 2013 pursuant to which these new requirements were
introduced was really for the maintenance of a database of independent
directors. This would help a company to search for such a director from the
database if it so chose. It did not make it mandatory that such a director must
be chosen from this database.

 

It is not clear whether existing directors will vacate their office if
they do not pass the test or if they do not enrol in the database. Will the
appointment of an independent director whose name does not appear in the
register be invalid, or will this be merely a violation of law? A similar
question can be raised for a person who has not passed the test with the
minimum percentage of marks. The intention appears to be that such persons
cannot be appointed; and in respect of existing independent directors, they may
have to vacate their office. However, this is not stated clearly in so many
words. Similarly, the wording of the law is ambiguous on whether a company has
to select an independent director only from the database. The purpose of the
database may get defeated if a company can appoint someone not enrolled, but
this is not specifically and clearly laid down.

 

BENEFITS AND BURDENS OF THE NEW REQUIREMENTS

The new requirements can be praised to the extent that independent
directors will now be required to have minimum relevant knowledge to do justice
to their roles. On the other hand, thanks to the constant tweaking of
requirements, the number of independent directors required is ever increasing.
Their obligations and potential liabilities are also enormous and continue to
increase. Their remuneration, however, is not guaranteed and can often be very
nominal with minimal sitting fees. The new requirements are not expected to be
costly. Even the fees payable to the institute for the enrolment are required
to be ‘reasonable’. It could be argued that the effort and the costs would pay
off in terms of knowledge. Nevertheless, no attempt has been made to increase
the powers of independent directors or ensure that they have at least such
minimum remuneration that makes doing their jobs worthwhile.

 

An independent director today, individually or even collectively, has
very few powers. He is often provided with some minimal information as
statutorily required for board meetings. Some directors can of course attempt
to use their personal and moral force to get their queries answered during
board meetings and sometimes in between, but success is not frequent. If he is
not happy, the eventual recourse he has is to resign. He may go public but he
risks legal action since usually he may not have adequate information and
documentation to back his claims. There is no institutional or legal process he
can take advantage of to express his views (preferably anonymously) and see that
wrongs are corrected. Independent directors may also often be treated with
contempt by managements and as an unavoidable nuisance. I would not be
surprised if the allegations (as yet unsubstantiated) in the Infosys case where
two independent directors are said to have been referred to as ‘madrasis’ and a
lady director as a ‘diva’ are true. Thus, neither from the remuneration point
of view, nor from the personal satisfaction point of view, is the office of
independent director worthwhile.

 

HASTY IMPLEMENTATION?

Then there is the issue regarding the fast-track implementation of these
provisions. As of now, even the institute and database or even the educational
material / test system does not seem to be fully ready for the new
requirements. While some time has been given for the transition, this would
still make it difficult for many to comply.

 

CONCLUSION

If the new rules are taken literally and narrowly, it is possible that
many independent directors would become disqualified and some may vacate their
office. Clearly, some clarification and relaxation both in terms of time and
requirements is needed. Generally, the office of independent directors also
needs a holistic relook, lest most of the cream of the crop quietly leave the
scene being underpaid, underpowered, under-respected and over-obligated.  

 

 

 

 

 

INSIDER TRADING – LESSONS FROM A RECENT DECISION

BACKGROUND


SEBI had levied a penalty of Rs. 40 crores
for insider trading on the promoters against a profit of about Rs. 14 crores.
Recently, SAT confirmed this hefty penalty. The case proves how SEBI is able to
unravel facts to the last transaction and establish relations between several
parties involved in insider trading. The case also establishes SEBI’s intention
to act tough in such cases by levying stiff penalties on promoters acting
through associates. However, the case also has some grey areas. The issues are
as follows:

 

(i) When can price-sensitive information be
said to have arisen, particularly in case of complex transactions?

(ii) Whether purchase on negotiated terms of
a large quantity of shares from a person can be said to be a case of insider
trading?

(iii) How are the profits of insider trading
calculated – profits actually made, or should an attempt be made to quantify
the impact of price-sensitive information on the price?

(iv) Should profits made by insider trading
be disgorged and handed over to the party who may have suffered a loss?

 

The present case was about a tender with
electricity bodies where it may be difficult even for the management to be 100%
sure and whether initial success necessarily means ‘confirmed outcome’.

 

BASIC FACTS OF THE CASE

The case concerns dealings in the shares of
ICSA (India) Limited. The findings were that the promoters (consisting of
husband and wife and certain companies belonging to their group) purchased,
through certain persons, 15.86 lakh shares in February, 2009. These shares were
purchased when certain price-sensitive information was not made public.
According to SEBI’s order the price-sensitive information related to the
company being successful bidders to large contracts aggregating to Rs. 464.17
crores with various electricity bodies. The purchase price was approx. Rs. 75
per share. The shares were sold at a significant profit of about Rs. 14 crores.

 

The transactions were routed through persons
who could be described as ‘associates’. These associates were funded by the
promoters’ group for purchasing the shares. The shares so purchased were either
transferred to the promoter entities or sold in the market and the sale
proceeds transferred to the promoters.

 

SEBI’s penalty also included a penalty for
giving misleading information about the relations between the promoters and the associates and making misleading disclosures relating to
shares pledged by the promoters / associates.

 

The penalty of Rs. 40 crores levied for such
insider trading, etc., has been upheld by SAT.

 

SEBI’s order is dated 15th
October, 2015. The SAT order is dated 12th July, 2019 (Appeal No.
509 of 2015).

 

ALLEGATIONS

SEBI alleged
that there was price-sensitive information related to the company being
successful bidders of contracts with certain electricity bodies amounting to
Rs. 464 crores. Under the SEBI (Prohibition of Insider Trading) Regulations,
1992 (Insider Trading Regulations), insiders are prohibited from dealing in
shares of the company while having access to or being in possession of
unpublished price-sensitive information. The promoters and their group entities
were alleged to be aware of this price-sensitive information and indulged in
the purchase of a large quantity of shares before publishing this information.

 

The purchasers were funded by the promoter’s
group entities. The shares so acquired were either sold by the associates or
transferred to group companies. The profit made was also transferred to group
companies.

 

SEBI further alleged that incorrect
information was given about shares pledged by the group companies and associates.

 

DEFENCE BY THE PROMOTERS

The promoters denied that they had financed the
purchase of shares or that the various transactions through the associates
amounted to insider trading. They stated that only a preliminary outcome had
been received in respect of the bids when the shares were purchased and at that
stage one could not be certain that the contracts would be granted to the
company. They explained the whole process of grant of bids, including
preliminary acceptance and certain processes thereafter, and that until final
award took place, ‘price-sensitive information’ could not be said to
have arisen.

 

They also stated that a large foreign
shareholder had desired to sell the shares and that to avoid a negative impact
on the market his shares were purchased. It was also stated that the reason for
making purchases through the associates was that if the promoters had
themselves purchased the shares, a negative image would have been created
giving an impression of promoters increasing their holding in the company.

 

They also denied that they had given
misleading disclosures relating to promoters or of the relations between the
parties.

 

RULING BY SEBI

SEBI presented detailed facts of
transactions including how funds were transferred by group entities of the
promoters to the associates. It was also shown how shares were sold and monies
transferred or shares were simply transferred to the promoter entities.

 

SEBI also established how the promoter
himself was very closely involved with the contract bidding, and hence it was
clear that he was aware of the progress regarding receiving the contract.

 

On facts, too, from the data provided by the
promoters, it was shown that largely, once the preliminary bids were
successful, an eventual successful outcome was fairly certain. However, even
otherwise, the information at that stage was too price-sensitive.

 

The promoters were also held guilty of
providing misleading information of relations between the parties. Further,
SEBI held that the promoters had given misleading information relating to
pledging of shares by promoters.

Penalties were thus levied on various
entities involved. For ‘insider trading’, a penalty of Rs. 40 crores was levied
on the promoters and group entities / associates. For providing misleading
information, a penalty of Rs. 20 lakhs was levied on the promoters and one
associate. For giving misleading disclosure of promoter holdings, an aggregate
penalty of Rs. 38 lakhs was levied.

 

RULING BY SAT

The Securities Appellate Tribunal (SAT)
after extensively considering the arguments and the facts held that

 

(a) On the matter of price-sensitive
information, on facts, that is, after considering comparable cases and their
earlier rulings, the nature of bids and the awarding process, even the preliminary
outcome of a bid amounted to price-sensitive information and promoters’ dealing
in shares was in violation of the Insider Trading Regulations.

 

(b) On the amount of penalty, SAT noted that
SEBI had powers to levy penalty up to three times the gains made. Thus, the
penalty levied of Rs. 40 crores on profits on insider trading of Rs. 14 crores
was within the limit prescribed under law.

 

However, SAT reversed both the penalties
levied relating to providing of misleading information regarding associates’
pledging of shares.

 

OBSERVATIONS AND COMMENTS

The case presents some interesting aspects –
regarding how trades are done and how meticulous is SEBI’s investigation.
Despite there being some grey areas, the ruling should place promoters on guard
and about the dilemma they face whilst dealing in the shares of a company.

 

The manner in which trading was done was
curious and perhaps added to the complexity of the case. The promoters did not
themselves purchase the shares but provided finance to associates who acted (as
held by SEBI / SAT) more or less as a front / representatives. They used the
funds to buy the shares and then transferred the shares / sales proceeds to the
promoters. Hence, penalty was levied jointly and severally on all the concerned
parties. A side-effect of this was that even the associates, who may have been
parties of small means, were made liable to ensure payment of penalty.

 

The amount of penalty is fairly huge. The
profits made were Rs. 14 crores. The maximum possible penalty was Rs. 42
crores, i.e., three times the profits. Thus, by levying a penalty of Rs. 40
crores, the maximum limit of the penalty was almost touched. And SAT had no
hesitation in upholding it.

 

The grey area is about the time when
price-sensitive information can be said to have arisen. Both the SEBI and the
SAT orders deal with this aspect in detail. However, the dilemma remains as to
at what stage can a company and insiders be held to be confident that the
orders would be received. The matter becomes even more complex since companies
are required to share material information at the appropriate stage. The
dilemma is this: share too early and you may be held to be providing
misleading information if eventually the bid is rejected; share too late and
you may be accused of withholding and delaying release of price-sensitive /
material information. Considering that such analyses are always in hindsight,
the dilemma is compounded.

 

However, at least one aspect is clear – that
insiders should act with caution. Refraining from trading during this period
would be a wise decision because the Insider Trading Regulations themselves
provide for mandatory closure of the trading window for the period when such
information is ripening. For example, a long period of trading window closure
is mandated during the time when financial results of a company are being
finalised. Importantly, even preliminary success in bids is price-sensitive
information.

 

The next question is – should the person who
has suffered because of such insider trading be compensated? Insider trading is
often said to be a victimless crime. However, in some cases the victim may be
obvious. In the present case, can it be said that the foreign seller who sold a
large quantity of shares would not have sold the shares if he was aware that a
large order was virtually possible? In such a case, should not the profits made
by the promoters be disgorged and handed over to the seller?

 

This is the one question that often comes up
also in cases of frauds and price manipulation, etc. In the author’s view, this
is one area where both the law and practice lack clarity.

 

Finally, compliments are due to SEBI for the
meticulous gathering and analysis of information. White-collar violations are
often said to be sophisticated. Insider trading cases are even more notorious
for the sheer difficulty in proving guilt. In this case, though the
transactions were routed through associates, SEBI analysed the data and brought
out the whole linkages of relations and financial dealings between the parties.
This ought to serve as a lesson to promoters, especially in view of the hefty
penalty levied.  

 

TAKE ACTION, BUT TREAD CAUTIOUSLY

SEBI oversees and regulates
dealings in shares and other securities traded on the stock exchanges. However,
for several years now it has also been regulating trading in commodity
derivatives on commodity exchanges. It has replaced the Forward Markets
Commission and the SEBI Act and Regulations / Circulars issued thereunder have
effectively replaced the Forward Contracts (Regulation) Act, 1952.

While the regulator is
common between the two markets now, and although there are fundamental
similarities between trading in securities on stock exchanges and on commodity
exchanges, there are fundamental differences, too. The contracts in derivatives
have broad similarities in both the markets. The regulator also recognises a
fundamental similarity, that is, ensuring fair price discovery in a
regulated market that is free of wrongful influences. Thus, for example,
price manipulation is as much a cause for worry for commodity markets as it is
for stock markets.

The volumes of trades in
commodity exchanges are fairly high. However, other than the much-discussed
matter of NSEL, there have been few orders by SEBI relating to the commodity
market. A recent SEBI order (“the Order”), which has been promptly reversed on
appeal to the Securities Appellate Tribunal (“SAT”), thus becomes a good case
study to review some broad aspects pertaining to the commodity market.

However, apart from
considering issues specific to commodity markets, this order also raises some
important issues relating to the type of orders that SEBI can pass; for
example,

  • What are the situations where SEBI can pass ex
    parte     interim orders?
  • Under what circumstances can SEBI debar parties
    from dealing in the markets?

These questions are
important because an ex parte interim order debarring a person may not
only result in huge losses to him but may even sound the death knell for his
business.

THE BACKGROUND

One of the primary concerns
in the commodities market is the cornering of stocks in a particular commodity.
A person cornering a very large percentage of the stock of a particular
commodity can be in a position to dictate its price. Thus, SEBI has specified
limits on trades by persons and these limits apply to a single person or a
group of persons acting in concert.

To ensure that groups
acting in concert are also brought under this rule, SEBI has specified generic
and specific tests to determine whether a group of persons is acting
independently of each other or is acting in concert. Hence, having certain
specified relations or commonalities would show such persons as acting in
concert. However, the exchanges can use generic criteria based on facts of
individual cases to determine whether ‘persons are acting in concert’.

 

Cornering market beyond the
specified limits, though a violation in itself, can potentially lead to
additional violations.

The case in question, as
seen below, allegedly had both the concerns specified above.

THE FACTS AND THE SEBI ORDER

Vide an order dated 28th
February, 2019 SEBI passed an ex parte interim order against 26 persons
for certain violations while acting in concert. SEBI initiated this action
based on the advice of the commodity exchange concerned. SEBI was informed that
three persons were holding more than 75% of the total exchange deliverable
stock of mentha oil. The exchange had applied the tests specified by SEBI to
determine whether these three persons were acting in concert. These three
persons were found to have been funded by a certain person.

The large holding was
accumulated not only by purchases on the exchange platform, but also through
off-market transactions. They had transferred their purchases to the specified
three persons. These parties were also alleged to be connected with each other
on the basis of findings made by the exchange.

The acquisitions and
holdings of these parties were tabulated by SEBI over nearly a year and it was
found that the deliveries taken by them as a percentage of total deliveries
showed that the cumulative deliveries were almost 75% of the total deliveries.

The order then analysed in
detail the relationship between the parties as well as the flow of funds
between them to demonstrate that they were acting in concert.

Further, the order
highlighted an aspect that strengthens SEBI’s case. It pointed out that some of
these parties traded for the first time. A few opened their trading accounts
during this period itself. Many traded beyond their capacity (i.e., net worth)
– for example, in an extreme case, a person whose declared net worth was Rs. 15
lakhs had taken delivery of goods worth Rs. 34.94 crores, which was 23,293% of
his net worth!

The order also considered
the numerical limits specified for the commodity and noted that such persons, allegedly
acting in concert, violated these limits on most of the days.

SEBI also alleged that NEFM
who ultimately funded the transactions, ‘intentionally created false and
misleading appearance of trades’. Further, the act of concealment was devised
to ‘deliberately mislead the market and hold a dominant stock position’. These
actions were in violation of the SEBI PFUTP Regulations. The registered broker
through whom the transactions were channelled by the parties was also alleged
to have prima facie violated various provisions, including incorrect
reporting and not exercising due skill, care and diligence, etc.

SEBI held that the parties
had not only violated provisions of law and accumulated a dominant position but
such position could put them in a position to manipulate the price of the
commodity.

 

In view of the above facts
SEBI debarred the parties from dealing in or being associated with markets in
any manner till further directions. Post-order hearing was granted to the
parties since this was an interim order.

The appeal and the
order of SAT (North End Foods Marketing (P) Ltd. vs. SEBI {[2019] 105
taxmann.com 69 (SAT – Mumbai)}

The parties so debarred
appealed to the Securities Appellate Tribunal (SAT) against the interim ex
parte order debarring them from trading. SAT set aside the order on several
grounds. Interestingly, the parties sought an interim order from SAT for
immediate reliefs.

The primary appellant
contended that it was involved in the business of procurement of commodities
and warehousing of commodities for which it received orders from its clients
and, in turn, placed orders for such commodities with its agents. These agents
procured such commodities and delivered those commodities to the appellant who,
in turn, delivered such commodities to its clients. Thus, the allegation of
acting in concert was denied.

The presumptions of SEBI
were questioned. For example, it was contended that the basis of presuming the
dominance in market was incorrect. It was argued that the total volume of trades
should be taken as the basis. If that were done, then, even if all the parties
were clubbed together their delivery would be less than 2% of the total volume
of trades. Thus, there was no dominance.

It was also contended that
though the transactions were completed, none of the price manipulations that
SEBI alleged had taken place. Thus, SEBI’s fears had no basis even on facts.

The order even debarred
parties from dealing in other commodities. Many commodities had limited shelf
life and there would be financial and physical loss if these deals were not
completed.

The SAT considered the
contentions and set aside SEBI’s order.

However, SAT upheld SEBI’s
power to pass interim ex parte orders and also highlighted various
pre-conditions to be satisfied before interim ex parte orders should be
passed. There has to be urgency for passing orders without granting a hearing
to the parties and this need particularly has to be justified. Further, SEBI
has to establish that there would be serious consequences if such an order is
not passed.

SAT noted that the events
described in the SEBI order were of the past. No useful purpose would be served
by debarring the parties at this stage. The derivatives contracts entered into
by the parties had already been executed and SEBI had not recorded any finding
of manipulation that it suspected had taken place. The order debarred parties
not only from dealing in mentha oil, but also all other commodities. This
obviously was too broad and too harsh. The order had also frozen the demat
accounts and mutual fund investments of the parties which had no bearing on the
alleged violations. SAT held that no purpose would be served in preventing
their dealings through an interim order.

Thus, the order failed in
complying with the necessary basic conditions of an interim ex parte
order. SAT set aside the order, though allowing SEBI to initiate and continue
such proceedings and inquiries on the matter as it deemed fit.

CONCLUSIONS

Interim ex parte
orders are often passed and it is well settled that SEBI has powers to pass
such orders. The basic features of interim ex parte orders are:

  • No opportunity to explain is given. Restrictions
    are often placed on the activities of the parties that can cause financial and
    reputational losses. Such interim orders often continue for years pending
    inquiry and investigations;
  • Hence, SAT held that SEBI has to establish
    exceptional need to pass ex parte interim orders.

There is another aspect
that is common to all orders of debarment – whether interim or final. Debarment
in ordinary course should be for prevention. Freezing bank accounts and sale of
assets should be done to ensure that funds are not siphoned off in anticipation
of orders of penalty, disgorgement, etc. However, it is often seen that the
debarment operates as a punishment. An order debarring dealings in securities
can result in loss and even closure of business. Hence, unless it can be shown
that dealings by parties would harm the markets, interim ex parte orders
cannot be sustained and should not be passed.

 

In the author’s opinion
SAT’s order lays down certain basic precautions that need to be taken by SEBI
while passing ex parte interim orders.

RULING OF SAT IN PRICE WATERHOUSE / SATYAM CASE: SUMMARY AND SOME LESSONS FOR AUDITORS

BACKGROUND

Recently, on 9th September, 2019,
the Securities Appellate Tribunal (SAT) overturned the SEBI order banning 11
firms of chartered accountants of the ‘Price Waterhouse group’ (PW) for two
years. The ban was on carrying out audits, certification, etc. of listed
companies / intermediaries associated with the capital markets. It was in
connection with the audit by one such firm in the Satyam Computer Services
Limited (Satyam) case where massive frauds were found consequent to a
confession by Satyam’s Chairman. The SEBI order disgorging the fees earned by
PW from the audit of Satyam of about Rs. 13 crores plus interest was, however,
upheld. Essentially, what SAT held was that PW did not participate knowingly in
the fraud though there was negligence involved to an extent. Several other
conclusions were drawn. Whether, when and to what extent are auditors subject
to the jurisdiction of SEBI was something analysed in great detail. Two
important aspects were particularly discussed. Whether SEBI can ban auditors if
they are negligent in their professional duties, or whether this is the domain
of the Institute of Chartered Accountants of India? In case of alleged fraud /
connivance in fraud by auditors, does SEBI have to provide direct evidence or
will it be enough to show this by ‘preponderance of probabilities’, as the
Supreme Court has held in certain cases?

 

Needless to say, this decision will have
far-reaching implications for auditors of listed companies / intermediaries /
entities associated with the capital markets. Many auditors have been banned in
the past and this decision creates a path-breaking precedent for a modified
viewpoint over future cases. It is also possible that SEBI may, apart from
possibly appealing to the Supreme Court against this SAT order, seek amendments
to the law to seek wider jurisdiction over auditors.

 

Some major conclusions and observations by
SAT are discussed in this article.

Quick summary and background of matter
leading to this decision

Readers may recollect that the Chairman of
Satyam, Mr. B. Ramalinga Raju, had, in January, 2009, sent a ‘confession email’
to SEBI of massive frauds in Satyam. This had resulted in its bank balances /
fixed deposits with banks, revenues, debtors, profits, etc. being overstated.
The amount involved was in thousands of crores of rupees. Several criminal and
other proceedings were initiated against the Chairman, directors and certain
officers, the signing partners of the auditors and the Price Waterhouse group.
However, for purposes of this article, the focus is on the proceedings against
the PW group by SEBI. Against these proceedings, PW petitioned the Bombay High
Court claiming, inter alia, that SEBI did not have any jurisdiction over
auditors who are chartered accountants and over whom only the Institute of
Chartered Accountants of India (ICAI) has jurisdiction. The High Court rejected
this contention and upheld SEBI’s jurisdiction over auditors albeit with
certain conditions. Thereafter, SEBI issued an order on 10th
January, 2018 banning the PW group of 11 firms for two years from performing
certain audit / certification work in relation to listed companies, etc. It
made a finding that PW had committed / connived in fraud and was negligent. It
also ordered that the fees earned by it be disgorged – with interest @ 12% pa.
Now, SAT has partially overturned this order.

 

BOMBAY HIGH COURT’S DECISION

PW had filed a petition before the Bombay
High Court claiming that SEBI had no jurisdiction over auditors who, being
chartered accountants, were subject to action only by the ICAI. The Court (Price
Waterhouse & Co. vs. SEBI [2010] 103 SCL 96 [Bom.]) rejected this
contention but with certain riders which can be summarised as follows: It said
that auditors in general were primarily subject to ICAI. If the auditors were
negligent in their duties, it is the ICAI that can take action against them.
However, SEBI is a body that has been formed for the protection of investors
and safeguarding the integrity of capital markets. Auditors perform an
important role of attestation of financial statements that are relied on by
shareholders. If they themselves carry out a fraud or participate / connive in
fraud in the entity they audit, SEBI does have a role – to take action.
However, this has to be established by evidence by SEBI. If the auditor has
been negligent in performance of his duties but it cannot be shown that he has
committed or connived in fraud, SEBI does not have jurisdiction. It is these
comments by the Court that became the core point on which SAT rendered its
decision.

 

What are the tests by which SEBI can
prove a person is guilty of fraud in securities markets?

This was an important aspect discussed in
the decision and indeed was the turning point. SEBI had charged PW with fraud
under multiple provisions of the SEBI Act and Regulations. But what were the
valid criteria that were sufficient to establish fraud under these provisions?
SEBI applied the more liberal criterion of ‘preponderance of probabilities’. It
stated that PW was negligent on so many counts and over so many years, that it
was far more likely than not that it had connived in the fraud.

 

However, the SAT made an important
distinction. It analysed the relevant decisions of the Supreme Court on frauds
under the securities laws. It held that the criteria were different for persons
who dealt in securities and those who did not. In respect of persons who dealt
in securities, the test of preponderance of probabilities applied. However, PW
could not be said to have dealt in securities and hence this test could not be
used to prove fraud. Hence, for such persons direct evidence was needed that
they connived in fraud and that such fraud induced others to deal in
securities. SAT held that SEBI had not provided any such evidence. Negligence,
even if on repeated counts, did not become fraud once this test and standard
was applied.

 

Thus, the SAT held that SEBI had not
provided evidence that PW had committed fraud. The order of banning the PW
group failed on this ground.

 

Whether SEBI can ban 11 firms en masse in the PW group?

 

SEBI had banned 11 firms which according to
it were operating under the Price Waterhouse banner. SEBI also showed several
direct and indirect associations amongst the firms operating under this banner.
There was, for example, sharing of resources, there were common partners
amongst some firms and so on.

 

The SAT
analysed the relations in context of the law relating to partnerships and LLPs,
the relevant guidelines of ICAI, the fact that there were several partners
among those who joined as such much after this event / audit, etc. It also
noted that it was a ‘signing partner’ who certified the audit of companies. SAT
held that in these circumstances, it could not hold the whole group liable for
fraud in Satyam. A blanket ban on the group was thus not warranted.

 

Important concepts like negligence, role of
management / auditors, etc. discussed

SAT discussed extensively on what
constituted negligence and also discussed the role of management and the
auditors. In particular, it highlighted the role of the auditor to display
professional scepticism, to act as watchdog and not a bloodhound, to not be
aggressively looking for fraud all the time which is really the role of a
forensic auditor. It also emphasised that an audit cannot guarantee absence of
all fraud as long as the auditor utilises a process that demonstrates a
reasonable professional skill and approach to the audit. SAT also discussed
various applicable auditing standards. Finally, and above all, it stated that
cleverly designed and implemented fraud cannot necessarily be uncovered by an
auditor. The audit cannot be so extensive and detailed, considering the time
and cost constraints, to uncover all frauds; and the scope for such
sophisticated frauds by persons high in management has to be considered.

 

Remedial orders vs. preventive orders
vs. orders to ban amounting to penalising a person

An order
banning a person from being associated with the securities markets can be for
one or more reasons. The SEBI Act permits directions by SEBI to debar a person
from being associated with the capital markets for preventive or remedial
reasons. Banning a person to punish him for wrongs done by him is, however, a
punitive action.

 

SAT held that debarring a person can, of
course, be for remedial / preventive reasons. If a person has committed such a
wrong that has harmed investors it may be better to keep him away from the
stock markets for a time (or even permanently in appropriate cases) so that
others (more people) are not harmed.

 

On the facts of
the case, SAT held that debarring PW served neither a preventive nor a remedial
purpose. It was seen that more than a decade had passed since the uncovering of
the fraud. PW had continued to serve other entities in the securities market
without any complaints. It had, to the satisfaction of even US authorities who
had initiated proceedings against it, taken necessary corrective actions to
prevent such things from happening again. To prohibit PW now from being
associated with the capital markets did not serve any preventive or remedial
purpose.

 

This is again a relevant test which would
apply to proceedings in other cases against auditors where there may be similar
facts.

 

Disgorgement of fees

As noted earlier, negligence in performance
of professional work by auditors does not by itself amount to fraud under
securities laws. For holding an auditor guilty of having committed such fraud
direct evidence has to be provided. However, SAT affirmed that the auditors
were negligent in performance of their duties as auditors on certain counts. It
thus upheld the direction of SEBI to disgorge the fees earned by PW from the
performance of the audit of Satyam.

 

CONCLUSION

Clearly, the order has far-reaching effects
on auditors and even other persons associated with the capital markets. The
order is of course on the facts of the case which SAT took pains to mention and
repeat. But the circumstances and criteria under which auditors can be
proceeded against are now far clearer than before. The decision of the Bombay
High Court which upheld the jurisdiction of SEBI against auditors was
reconciled with decisions of the Supreme Court and it was shown that SEBI had
power and jurisdiction which was narrower. In these times, when auditors face
multiple regulators, it is a relief that there is clarity on who plays what
role and of what nature.

 

This order will also be relevant for others
who are not directly associated with the capital markets and who do not deal in
securities. These may include independent directors and directors in general,
company secretaries, lawyers, etc. While each group will have to examine how
this decision is relevant for them, there is still some guidance available. For
example, for holding them liable for fraud, direct evidence has to be shown.

 

Partners of firms of auditors will also have
less cause for worry if, despite reasonable efforts and systems, their partners
are negligent and / or commit fraud. The other partners of such firms will not
be held liable and acted against merely for the faults of one partner.  

 

THINK BEFORE YOU SPEAK, MR. CHAIRMAN!

The Securities and Exchange Board of India
(SEBI) recently charged the Chairman of a major listed FMCG company with making
a fraudulent/misleading statement. The reason? He had allegedly said to a
leading newspaper that he was interested in buying out a large competitor
listed company. According to SEBI, this resulted in a substantial rise in the
price of the shares of the competitor. Such rise in price is an expected result
when there is news that an acquisition is likely.

 

But soon, both the Chairman and his company,
as well as the competitor, clarified that no such buyout plans were afoot and
the price of the shares fell. SEBI alleged that this was a fraudulent/reckless
statement. Public shareholders who may have bought the shares on the basis of
the statement would have suffered a loss on account of this. Therefore, SEBI
levied a monetary penalty on the said Chairman.

 

While the Securities Appellate Tribunal
(SAT) exonerated the Chairman pointing out several errors of fact and law in
the SEBI order, this case raises critical issues, reminders and lessons on how
such price-sensitive matters should be handled. There are several provisions of
law that prescribe for care in dealing with price-sensitive information. It has
been found that companies/promoters deliberately and fraudulently “create”
price-sensitive information so that the market price rises owing to public
interest and then they can offload their shares (often held in proxy names) and
profit. Even in cases where there is no fraudulent intent, the concern may be
whether there was an element of negligence or irresponsibility.

 

Securities laws have several provisions for
handling price-sensitive information. These include prohibitions against abuse,
illegal leaking, timely disclosures, etc.

 

Let us consider this case first in a summary
manner and then consider the provisions of the law and also some related,
relevant issues.

 

SEBI’S ORDER LEVYING PENALTY AND THE SAT ORDER REVERSING IT


It appears that the Chairman of a leading
listed FMCG company gave an interview to a large daily newspaper. The reporter
asked whether his company was in the process of acquiring a leading competitor.
This was in the context of significant interest in the shares of the competitor
with there being higher volumes of trading and rapid rise in price; there also
appeared to be rumours of a significant acquisition of shares by a specified
but unnamed entity. The Chairman reportedly said that he would be interested to
buy out the competitor, though he added that he did not know who had acquired
that significant lot of shares in that company. SEBI alleged that the
publishing of this news resulted in a sharp increase in price and volumes.
Later, indeed on the afternoon of the very next trading day, the Chairman, his
company as well as the competitor company clarified that no such buyout was
envisaged. SEBI alleged that the price and volumes immediately fell the day
after that. The Chairman was alleged to have violated the provisions relating
to fraudulent/unfair trade practices and a penalty of Rs. 8 lakh was levied on
him (vide order dated 27.12.2017).

 

On appeal, SAT reversed the penalty [R.
S. Agarwal vs. SEBI (Appeal No. 63 of 2018, order dated 13.03.2019)]. It
was noted that the rise in both price and volumes was much prior to the said
statement. Thus, there was already a market interest. It was pointed out that
analysts had projected higher profits/EPS for the company and that was also a
contributing factor. The Chairman or his company had not acquired/sold any
shares. The SAT even raised doubts about the authenticity of the press report.
Even otherwise, it does not make sense that a potential acquirer would make a
statement that may result in further increase in the price. As an important
point of law, SAT highlighted that the onus of proving such a serious
allegation of fraud in such a background rested on SEBI, which onus it did not
fulfil. In conclusion, SAT reversed the order of penalty.

 

 

IMPORTANT PROVISIONS OF SECURITIES LAWS DEALING WITH PRICE-SENSITIVE INFORMATION


Proper handling of price-sensitive
information is a very important tenet of safeguarding the integrity of capital
markets as provided in securities laws. Price-sensitive information is required
to be carefully guarded. It should be disclosed in a timely manner – neither
too early so as to be premature and thus misleading, nor too late that there
are chances of leakage and abuse and that the public may be deprived of
knowledge of such significant price-sensitive information. It should be clear,
complete and precise, neither understating nor exaggerating anything.

 

Several provisions in the SEBI Insider
Trading Regulations, in the SEBI Regulations relating to Fraudulent and Unfair
Trade Practices (FUTP) and in the SEBI Listing Obligations and Disclosure
Requirements Regulations (“the LODR Regulations”), make elaborate provisions
relating to price-sensitive information.

 

The insider trading regulations have
price-sensitive information at the core. Insiders have access to
price-sensitive information and they are required to carefully handle it. The
Regulations have been progressively broadened over the years. There are several
deeming provisions. The Regulations even require a formal code of disclosure of
price-sensitive information to be made along prescribed lines that the company
must scrupulously follow. One requirement of this code, for example, requires
that selective disclosures should not be made to a section of public/analysts,
and if at all it is anticipated that this may happen, there should be parallel
disclosure for all. Dealings in shares by “designated persons”, who are close
insiders, are required to be carefully monitored and they can deal in them only
after prior permission and that, too, during a period when the trading window
is open.

 

The LODR Regulations require that material
developments be disclosed well in time. An elaborate list has been provided of
what constitute such material developments and an even more elaborate process
by which they should be decided upon and disclosed.

 

The FUTP Regulations particularly have
several provisions that deal with such price-sensitive information and how they
could constitute fraud. There are generic provisions which prohibit “any
manipulative or deceptive device or contrivance” or engaging in “any act,
practice, course of business which operates or would operate as fraud or deceit
upon any person in connection with any dealing in or issue of securities…”.
There are several specific provisions. One such provision, for example,
prohibits “publishing or causing to publish or reporting or causing to report
by a person dealing in securities any information which is not true or which he
does not believe to be true prior to or in the course of dealing in
securities”. Yet another provision prohibits “planting false or misleading news
which may induce sale or purchase of securities”. These practices are
considered fraudulent practices and can result in stiff penalties, prosecution
and other adverse consequences.

 

Thus, price-sensitive information has to be
handled delicately, and with full realisation of the impact it may potentially
have if there is under- or over-disclosure, too early or too late disclosure,
or misleading, fraudulent or even negligent disclosure. While there are
provisions that deal with fraudulent practices, even unintentional
acts/omissions would be severely dealt with. It is not surprising that
companies have — and are expected to have —carefully-laid-down procedures and
systems for dealing with such information.

 

ROLE OF CHAIRMAN / TOP MANAGEMENT IN DEALING WITH THE MEDIA OR OTHERWISE SHARING INFORMATION


The Chairman, the Managing Director, the
Company Secretary, etc., are often approached by the media for their views on
developments or even generally. Such persons may even engage on social media
(as in the recent Tesla case, discussed separately below). Often, even
authorities such as exchanges approach a company for a response to certain
rumours or news. Thus, engaging with outsiders is common and even expected of
the company executives. However, even one loose statement can have disastrous
consequences.

 

It is also important for promoters and
others to be aware that there are elaborate procedures and governance
requirements which have to be complied with. In the present case, the question
is whether the Chairman’s statement could be seen to be that of the company?
This is relevant because even the law requires approval of the Board and
recommendation/clearance of the Audit Committee in important matters. The
public does not view a statement by a Chairman or Managing Director as subject
to such conditions. Internal requirements are presumed to have been complied
with. A declaration by the Chairman, for example, that his company would be
buying out another company would be taken at face value and will have a market
reaction leading to unwanted consequences. Hence, it is important that
statements by such persons should be carefully worded. Ideally, a well-reviewed
press release should be released.

 

 

TESLA’S CASE


The importance for top management to be
careful while interacting with the public becomes even more important in these
days of social media where posts and comments are made several times a day,
often on the spur of the moment and without a second thought. Last year, it was
reported that Elon Musk, the Chairman of Tesla, tweeted that he intended to take
the company private and that funding for this purpose was secured. It was
alleged that this statement did not have sound basis. Eventually, in a reported
settlement, Musk had to resign as Chairman, accept a ban from office for at
least three years and he and Tesla had to pay $ 20 million each.


In addition, the company was required to add two independent directors and the
Board was required to keep a close watch on his public communications.

 

CONCLUSION

Corporate communications are no more meant
to be merely for public relations but have to be increasingly in compliance
with securities laws that require deft treading as in a minefield. Social media
is particularly vulnerable as proved by the Elon Musk episode. We have seen how
SEBI is monitoring and scrutinising social media reports and has even made
adverse orders relying on “friendships” and other connections. Messaging apps
like WhatsApp have also been reported to be used for sharing inside
information. On the other hand, there is often pressure, both internal and
external, to make statements. Exchanges, for example, want prompt responses to
rumours/news in the media to ensure that the official position of the company
is known to the public. The LODR Regulations provide for fairly short time
limits for sharing of material developments. In short, sharing of information,
plans and developments about the company requires more careful handling than
ever before.

 

The moral of the episode is: Think before you speak, Mr. Chairman,
though speak you must!
  

 

CAESAR’S WIFE SHOULD BE ABOVE SUSPICION

BACKGROUND

On 30th 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.

MANAGERIAL REMUNERATION SHACKLES FINALLY REMOVED

Background


Finally, the requirement of
obtaining approval from the Central Government for paying managerial
remuneration by public companies has been removed. The amount of managerial
remuneration that can be paid is now an internal matter with the Board and,
where applicable, the Nomination and Remuneration Committee and the
shareholders. Shareholders consent by a special resolution is also needed wherever
the remuneration is in excess of limits prescribed in section 197 (1) of the
Companies Act, 2013.

 

For over last several decades,
though the laws relating to companies have been progressively reformed and made
liberal, managerial remuneration remained an area where sanction of the Central
Government was required to pay remuneration in excess of the limits prescribed
in section 197 read with Schedule V of the Act.

 

The limits on managerial
remuneration are mainly in the form of percentage of net profits and which
continues except that the approval of the Central Government is now not
required. There are overall limits for total managerial remuneration and then
sub-limits are provided for specified categories of directors. In case of loss
or inadequacy of profits absolute amounts are prescribed upto which a company
could pay remuneration. These are discussed in detail later herein. Paying
managerial remuneration beyond these limits required approval of the Central
Government. This requirement of taking government approval has been dropped
with effect from 12th September 2018. The new rules require
shareholders approval – special resolution. Hence, self governance has replaced
approval of the Central Government.

 

However, for listed companies SEBI
has prescribed additional requirements to ensure that promoters do not over pay
themselves without approval of the shareholders.

 

Summary
of existing provisions


The existing
provisions on limits on managerial remuneration are contained in section 197
read with Schedule V of the Companies Act, 2013. An overall limit for
managerial remuneration is provided at 11% of net profits. In other words,
executive and non-executive directors can be paid in the aggregate not more
than 11% of the net profits, calculated in the manner prescribed in section 198
of the Act. Payment of managerial remuneration beyond these limits required
approval of the Central Government. Within this limit, a single working
director (i.e., managing/whole-time director / executive director / manager)
could be paid remuneration upto 5% of the net profits, and all working
directors together could be paid 10% of the
net profits.

 

All non-executive directors could
be paid commission upto 1% of net profits and, if there was no working
director, then upto 3% of the net profits. The term manager and managing
director and whole-time director are defined in sub-section (53), (54) and (94)
of section 2 of the Act.

 

It is reiterated that sanction of
shareholders and central government was required to pay remuneration in excess
of the prescribed limits.

 

Needless to emphasise, obtaining
approval of the Central Government was a time consuming and possibly an
arbitrary affair. Even if shareholders agreed and approved, they could not take
such decisions. The limits on remuneration in case of inadequate profits were
arbitrary too, based on what the government perceived as fair remuneration.
Companies in need of talent at times were not able to hire the right person.
Moreover, the possibility of existing talent moving to other companies or even
migrating abroad loomed large generally for India and particularly during the
period when a company was going through a rough patch or even when the company
was expanding its activities and / or there existed circumstances beyond the
control of the management – for example – recession, market conditions and
period of restructuring operations.

 

As mentioned earlier, substantial
changes have been made which will ensure that the decisions of managerial
remuneration would be in accordance with good corporate governance practices
rather than government approval. The only approval required is of the
shareholders through a special resolution. This affirms the principle of
shareholders democracy. There have been several recent cases where shareholders
have showed growing disapproval by voting against remuneration they perceived
high. In many cases, this may be represented by substantial negative votes and
in some cases, actual rejection of the resolution itself by sufficient number
of negative votes.

 

Before we go into the specifics of
the changes, let us consider certain basics:

 

To which companies do the limits on managerial
remuneration apply?


The limits on managerial
remuneration apply to public companies, whether listed or not. They do not
apply to private companies, even if large in size.

 

What
is managerial emuneration?


Managerial remuneration is the
remuneration paid to directors, including those who are employees – such as
managing or whole time directors – that is –working directors and those who are
not employees of the company – i.e., the non-executive directors.  Managerial remuneration could be in the form
of salary, perquisites and / or commission. However, sitting fee for attending
board or committee meetings is not managerial remuneration.

 

Further, fees paid to professional
directors for professional services under certain circumstances is not
managerial remuneration.

 

Period
of appointment

The appointment of working director
could be made for a term of upto 5 years.

 

Changes
now made


The limits on managerial
remuneration remain largely as they are. Thus, the limits on managerial
remuneration as a percentage of net profits (including sub-limits for
individual directors) continue. Similarly, the minimum remuneration that can be
paid in case of inadequacy of profits also continues more or less as they
existed previously. However, if remuneration is desired to be paid beyond these
limits, the approval of the shareholders by way of a special resolution is
required. Approval of the Central Government is no more required. Hence,
shareholders now have the final say on managerial remuneration. The management
and the Board will thus have to present a good case to the shareholders for
payment of such higher managerial remuneration.

 

Approval
of lenders, etc.


Section 197 also provides for a
situation where the company has defaulted on payment of dues to banks/public
financial institutions or non-convertible debenture holders or any other
secured creditors. Their prior approval would be required before seeking
approval of the shareholders for paying remuneration higher than the prescribed
limits. Such approval is also required waiving the recovery of remuneration
paid in excess of prescribed limits. This requirement ushers in the concept of
involving consent of other stakeholders whose interests are affected in the
event of loss or inadequate results of operation.

 

SEBI
places further restrictions


SEBI in the meantime has separately
made amendments to Regulation 17 of the SEBI (Listing Obligations and
Disclosure Requirements), 2009, though with effect from 1st April
2019. These are:

 

1.   It
is now required that in a year where the annual remuneration of a single non-executive
director exceeds 50% of the total annual remuneration payable to all non-executive
directors, approval of members by special resolution shall be obtained.

 

2.   Amendments
are made with regard to managerial remuneration to promoters or members of the
promoter group. The amended provisions require that if the managerial
remuneration to a single promoter is Rs. 5 crores or 2.50% of net profits, whichever is higher, then the approval of
the shareholders by way of special resolution shall be obtained.

 

3.   Where
the proposed managerial remuneration to all promoters put together exceeds 5%
of the net profits, then too approval by way of special resolution is required
to be obtained.

 

The above requirements apply to
companies who have listed their specified securities on recognised stock
exchanges. Regulation 15(2) details the applicability giving exceptions.

 

Limits
on remuneration to independent directors


There is no change in the limit of
remuneration of independent directors – the cumulative limit is 1% or 3% of net
profits depending on whether the company has managing / executive / whole time
director or not.

 

Shareholders’ democracy is becoming
visible as in some instances re-appointment of independent directors has been
objected to, even if unsuccessfully. This is the beginning of shareholder
activism.


Approval
of Central Government continues to be required in certain other matters


The approval of the Central
Government will continue to be required in cases of appointment of such
managerial persons where the requirements relating to
qualifications/disqualifications are not complied with.

 

Conclusion

Companies will thus have much
greater freedom and flexibility in paying their top executives. In particular,
companies with lesser profits (for whatever reasons) will find relief. The
requirements of recommendation and review by Nomination and Remuneration
Committee (where applicable) and approval of the shareholders by
ordinary/special resolution will help in providing the required balance.

 

The timing of the amendments,
though, is a little awkward for companies desiring to take benefit of these
relaxations. Most companies may have already convened their annual general
meetings for 2018 and these matters may have not been proposed or proposed as
per earlier law. Thus, companies may need to approach the shareholders again to
seek their approval to take advantage of these relaxations.   

IlI -Advised SEBI Move to Separate Chairman-CEO’s Post in Companies

Background

A recent amendment to the SEBI LODR
Regulations 2015 requires that Chairperson of a listed company shall not
be an executive director or related to the Managing Director/CEO. This applies
to top 500 listed companies in terms of market capitalisation. Such companies
will have to ensure the change is made not later than 31st March
2020.

 

This change looks good on paper as in
principle, it is wrong to concentrate power in one person / family in large
quoted companies in India. However, I submit that this particular requirement
does not make sense in Indian context as many large companies are family
controlled. It will disrupt board structure of such companies and is actually
counter productive. It could also harm the company’s business and public image.

 

While the genesis of this can be traced back
to norms of corporate governance in the West, the immediate trigger for this
amendment is a recommendation of the Kotak Committee’s report on corporate
governance released in October 2017. The Companies Act, 2013, has certain
provisions governing this, but they are not as restrictive and absolute as
these new provisions under the SEBI Regulations. Let us thus review the
provisions under Companies Act, 2013, what the Kotak Committee has recommended
and finally what are the new provisions and their implications.

 

Provisions regarding split of post of
Chairman/CEO under the Companies Act, 2013

Section 203 of the Act, which applies to
certain specified companies, provides certain restrictions on appointing a
Chairperson who is also the MD/CEO. The proviso to this section, which contains
this provision, reads as under:

 

“Provided that an individual shall not be
appointed or reappointed as the chairperson of the company, in pursuance of the
articles of the company, as well as the managing director or Chief Executive
Officer of the company at the same time after the date of commencement of this
Act unless,—?

 

(a) the articles of such a company
provide otherwise; or?

 

(b) the company does not carry multiple
businesses:?

 

Provided further that nothing contained
in the first proviso shall apply to such class of companies engaged in multiple
businesses and which has appointed one or more Chief Executive Officers for
each such business as may be notified by the Central Government.”

 

However, as can be seen, this restriction is
not absolute. A company, can, for example, provide a relaxation in its articles
permitting such a dual post.

 

Kotak Committee on corporate governance

The Kotak Committee has recommended several
changes in the provisions relating to corporate governance.

 

The Committee gives elaborate reasons why
the post of Chairman and CEO should be segregated. Referring to a global trend
on this, the report talks of the advantages of this in the following words:

 

“The separation of powers of the
chairperson (i.e. the leader of the board) and CEO/MD (i.e. the leader of the
management) is seen to provide a better and more balanced governance structure
by enabling better and more effective supervision of the management, by virtue
of:

 

a) 
providing a structural advantage for the board to act independently;

 

b) 
reducing excessive concentration of authority in a single individual;

 

c) 
clarifying the respective roles of the chairperson and the CEO/MD;

 

d) 
ensuring that board tasks are not neglected by a combined
chairperson-CEO/MD due to lack of time;


e) 
increasing the possibility that the chairperson and CEO/MD posts will be
assumed by individuals possessing the skills and experience appropriate for
those positions;

 

f) 
creating a board environment that is more egalitarian and conducive to
debate. “

 

The Report of the Cadbury Committee is also
quoted where it was stated, “…given the importance and the particular nature
of the chairmen’s role, it should in principle be separate from that of the
chief executive. If the two roles are combined in one person, it represents a
considerable concentration of power”.

 

However, no comparative study has been made
in the Indian context. It is presumed that what is good for the West, is best
for the rest!

 

The Report, however, provides for a phased
out implementation of this recommendation.

 

Amendments to the SEBI LODR Regulations
2015

SEBI has, after due consideration, amended
the Regulations by inserting clause (1B) to Regulation 17. This new clause
reads as under:

 

“(1B) With effect from April 1, 2020, the
top 500 listed entities shall ensure that the Chairperson of the board of such
listed entity shall—

 

(a)   be a non-executive director;

 

(b)   not be related to the Managing Director or
the Chief Executive Officer as per the definition of the term
“relative” defined under the Companies Act, 2013:

 

Provided that this sub-regulation shall not be applicable to the listed
entities which do not have any identifiable promoters as per the
shareholding pattern filed with stock exchanges.

 

Explanation.—The top 500 entities shall
be determined on the basis of market capitalisation, as at the end of the
immediate previous financial year.”

 

As can be seen, the new provision goes
beyond the recommendation of the Kotak Committee and it is now an absolute
requirement that this post should be segregated, and the chairperson should not
be related to the Managing Director/CEO.

 

Implications of new provision

The Chairman should not be an executive director,
nor should he be related to the Managing Director or CEO. Effectively, this
means that the Chairperson and the MD/CEO will not be from the same family.
Thus, for example, it would not be possible, for the father to be the Chairman
and the son to be the Managing Director. This will have implications for Indian
companies which are basically family controlled and / or family managed.

 

Do these new provisions make sense for
India?

The significant feature of companies in the
West is that the shareholding is widely held and the CEO is a professional
manager. Persons in control including the Board members normally have
insignificant holding even if their holdings are taken together. A widely held
shareholding could make it difficult for shareholders to get together and
exercise close control over the management. Thus, it matters how the Board of
Directors is structured. In such a situation for the more the checks and
balances, the better it is, for corporate functioning. Having the same person
as chairperson and CEO does result in concentration of power considering that,
as chairperson – CEO controls operations and influences. The issue is: Does
this provision have any relevance in Indian conditions? The answer, it is
submitted, is in the negative as most of large listed companies in India are
controlled by `promoter family’. The family normally has significant holding
and hence full operational control. The public shareholders know it and even
prefer it. Usually, it is the head of the promoter group (typically, the family
patriarch) who is the chairperson and thus the face of the group. For example,
the Bajaj group has Mr. Rahul Bajaj as the chairperson and Reliance group has
Mr. Mukesh Ambani. However, in India, the chairperson is also the CEO. This
really helps in giving a realistic picture of who is / or are the persons in
control of the company. Again, if the company is a first generation promoter
company, the chairperson and managing director is often the Founder – thus
segregating the posts of chairperson and managing director does not make sense
in India. Further the restriction that the relative of the managing director
cannot be chairperson is not relevant in view of fact that the Promoter Group
exerts control over the company. Moreover the family members of the Promoter
Group usually make up a significant part of the Board. The financial
institutions at times prefer this as they seek personal guarantees of the
promoters.

 

Hence, the principle that there should not
be concentration of power in the promoter family goes against the culture,
tradition and reality in India of how companies are founded and have been
governed over generations, for example, Birlas, Goenkas and many others. What
is needed in India is ensuring checks and balances over unbridled control by
the promoter group.

 

Strangely, though, the new requirement does
not apply to companies who do not have identifiable promoters. I feel in
companies which have no identifiable promoter the management should stand split
between the chairperson and the CEO. Further the provision should be in
consonance with section 203 of the Companies Act. It would be relevant to have
a chairperson who is not a relative of the CEO or the executive directors who
are actively managing the company.

 

Does the
Chairman really have any substantial powers under law in India?

Thus the real question then is whether the
chairperson who is not a relative will have any real power in the corporate
setup in India. The answer, I submit, is in the negative. Further the Companies
Act, 2013, and the SEBI Regulations that govern 500 top companies do not give
any real power to the chairperson. Normally a chairperson cannot and does not
take any significant/substantive decision.

 

The chairperson has limited administrative
powers of, say, chairing and conducting meetings, signing minutes book, etc.
Address the shareholders’ meeting. Even in family companies if the chairperson
is a patriarch he is a guide and has a balancing influence. Even the casting
vote, whereby he can break a deadlock, is rarely used.

 

In contrast, in public perception, the
chairperson is the corporate brand ambassador of the company. It makes sense if
the chairperson is from the founder/and or lead promoter group who actually
run, control and manage the operations. Insisting that the chairperson should
neither be the CEO, nor related to him, will result in making a chairperson who
has no real say in the company.

 

This would not make any difference in
corporate governance. Hence, the Kotak Committee rightly stops at recommending
that the post of CEO and chairperson should be split.

 

Conclusion

It is surprising that the corporate circle
has not reacted. However, it will not be surprising that these provisions will be
complied merely in letter, (box ticking), without any substantive benefit.   

SEBI ORDER ON ACCOUNTING & FINANCIAL FRAUD – CORPORATE GOVERNANCE & ROLE OF AUDITOR ETC., UNDER QUESTION AGAIN

Background
and summary of SEBI order


SEBI
has passed an interim order in case of Fortis Healthcare Limited (Order number
WTM/GM/IVD/68/2018-19 dated 17th October, 2018). It has recorded
preliminary findings of accounting and financial frauds whereby, inter alia,
about Rs. 400 crore of company funds that were lent to related parties and
which are now lost. 


The manner of carrying out
such alleged fraud as described in the SEBI order makes an interesting reading.
It makes allegations of false accounting entries, use of allegedly intermediary
entities to make related party transactions without necessary approvals or
disclosures, etc. This raises obvious and grave implications of role and
liability of the Board, the Audit Committee, the auditors, the Chief Financial
Officer, the independent directors, etc.


SEBI has passed interim
directions against specified promoter entities ordering, inter alia,
return of monies with interest. It has given them a post-order opportunity of
hearing and also initiated detailed investigation. 


While there have been other
transactions over which concerns have been raised in the order, the loans of
about Rs. 400 crore to promoters or promoter owned entities could be focussed
on here. There is a complex background to these loans but, essentially, it
appears that Fortis granted loans aggregating to about Rs. 400 crore (final
balance) eventually to three companies through its wholly owned subsidiary.
These three companies were not ‘related parties’ when such loans were first
granted but later on, the SEBI order says, became promoter owned entities.
However, the interesting aspect was that an attempt was made not to show the
amount of such loans as receivable at the end of every quarter. Instead,
circular bank transactions were made for repayment and giving back of such
loans. Thus, on the last day of each quarter, such loans were shown to have
repaid and then paid back on the next day. Thus, as at the end of each quarter,
for several consecutive quarters, the loans did not appear as outstanding.


Even this, the SEBI order
alleges, was false/fake. It was not even as if the loans were first repaid and
then lent again. There was back-dating of entries. The borrowers were first
paid the monies which were then used that money to repay the original loans.
Even these transactions really took place after the end of the quarter. But the
accounting records were made to show as if the repayment of loans happened on
the last day of the quarter.


This continued for nearly
two long years – repeated over several quarters – till it so happened that even
this token repayment/relending could not be made. The auditors of the company
apparently refused to sign off on the accounts for that quarter. This matter
was reported in media and SEBI promptly initiated action. It called the
auditors for discussion and carried out a preliminary examination of the
details. The preliminary finding was that the amount of about Rs. 400 crore had
actually reached the promoters/promoter controlled entities through the three
companies. These amounts were partly used to repay borrowings of the promoters
and partly retained by a promoter controlled entity. It also appears that this
amount has been lost and provided for as a loss.


Based on these preliminary
findings, SEBI has passed an ad interim order issuing several
directions. It has asked the company to recover these monies. It has asked the
specified promoters and certain entities controlled by them not to transfer any
assets till such amounts are repaid. It has also asked specified persons not to
be associated with the company.


It has also initiated a
much more detailed investigation into the affairs of the company in this
matter. It has also given a post-order opportunity of hearing to the parties.
In particular, SEBI has also stated that it will be looking into the role of all
parties including the auditors in this matter. I would also expect that,
considering the preliminary findings, questions may also be raised on the role
of the Audit Committee, Chief Financial Officer, etc.


Other questions have also
arisen. While, apparently, the three companies to whom loans were given were
not ‘related parties’ as on the date of grant of such loans, such companies
served merely as a conduit to pass on the amounts to the promoter entities.
Further, even these three companies, owing to some restructuring, became
related parties. The compliance of requirements of approval of related party
transactions for such loans or for the disclosure of such transactions and
balances were allegedly not made.


SEBI thus made preliminary
findings of violations of multiple provisions of law. And accordingly, has
passed interim directions and will investigate the matter further and pass
final orders, if any.


Let us discuss in more
detail what could be the implications.


Analysis
of the case in terms of implications assuming the facts stated are true


Let us assume that the
facts stated in the Order are true. It is also to be noted that this is a
preliminary ex-parte order. The parties accused of the violations have yet to
present their case. Even SEBI is yet to make a detailed investigation. But yet,
it would be worth examining what are the implications at least on the
hypothetical basis that all these facts and findings as stated therein are
true. What then would be the specific violations of law, who can be held liable
and what would be the punishment? The following paragraphs make an attempt to
do this.


Nature
of transactions and implications under various laws


Essentially, the
transactions related to loans given and, apparently, that too on interest rates
that sound to be reasonable. On the face of it, such transactions would not be
irregular or illegal. However, as seen earlier, there are some unique features
of the present case. The loans were given to certain parties who promptly
handed over the monies to certain related parties. SEBI alleges that the
intermediary entities were used only to hand over the funds to the related
parties and thus the transactions were related party transactions.


Related party transactions
require disclosure that they are so, disclosure of the related parties, etc.,
who are source of such relation and, importantly, certain approvals by the
Audit Committee, shareholders, etc.


According to SEBI, these
‘repayment’ and ‘relending’ transactions at the end of each quarter were effectively
sham. In view of this, then, these were accounting irregularities, false
disclosures and even fraud. These too would result in serious implications
under the Act and Regulations. The consequences, as we will see later, can be
in several forms ranging from debarment to prosecution.


However, let us see who can
be said to be liable if such frauds, wrongful disclosures, non-compliances,
etc., have taken place.


Liability
of the Executive Directors


Transactions of such size
and nature can be expected to have been initiated by Executive Directors (i.e.
the Managing/Wholetime Directors). Unless this presumption can be rebutted,
primary blame may fall on them. It would be also their duty to inform the
various other persons involved such as Audit Committee, Board, etc., of the
real nature of the transactions. Thus, the primary liability and action for
non-compliance may fall on them first.


Liability
of CFO


The Chief Financial Officer
(“CFO”), being in charge of accounts and finance, is the other person who too
could be expected to know – or at least inquire into – the real nature of such
large transactions. This is more so considering that there were entries of
repayment on last day of each quarter and relending on the next day that SEBI
found as sham transactions.


Here again, unless the CFO
rebuts and shows he was not at all aware or involved, he would again be the
first group of persons against whom proceedings could be initiated.


Liability
of internal/statutory auditors


The nature of transactions
and the manner in which they are carried out could validly raise a concern that
the auditors should have been able to detect that there is something seriously
irregular here. Here, again, unless they are able to rebut this presumption,
they could face action.


Liability
of Audit Committee


The Audit Committee can be
expected to go into matters of accounts and audit in more detail than the Board
but less than the executive directors, internal/statutory auditors and the CFO.
They are expected to examine the accounts and matters of compliance more
critically. However, they are to an extent, also subject to what is presented
to them by such executives and auditors. Unless they can show that they had
critically examined the accounts and also they were not informed of anything
irregular in the transactions, they may be subject to action.


Liability of Board and independent directors


Primarily, it can be argued
that the Board and independent directors would examine what is placed before
it. If the accounts, on the face of it, do not show anything irregular, that no
information is passed to them about irregularity in the transactions and that
they have been otherwise diligent, they may not be liable for such defaults.


Liability
of others including Company Secretary


The authorities may examine
the facts and critically examine the role of the Company Secretary and other
executives to ascertain whether they could have been aware of the transactions
and even be involved in the violations. If there is a positive finding, they
too may be subject to various adverse actions.


Implications
of the violations


The findings, as presented
and if assumed to be found to be finally true, indicate violation of multiple
provisions of the Act/Regulations. The accounts are not truly/fairly stated.
There are false statements made in accounts. The provisions relating to related
party transactions including obtaining of approvals, making of disclosures,
etc., have not been complied with. The transactions are in the nature of fraud
and thus may result in serious action under the Act/Regulations.


The authorities including
the Ministry of Corporate Affairs and SEBI would have several powers to take various
adverse actions against the guilty persons. They can debar the auditors,
directors, CFO, etc., from acting as such to listed companies and other persons
associated with capital markets. They can pass orders of penalty and even
disgorgement of fees earned. They can initiate prosecution. The parties may be
required to ensure that the monies are repaid (or they pay the monies
themselves) with interest.


New
powers proposed by SEBI


As has been discussed
earlier in this column, SEBI has recently proposed amendments of several of the
Regulations whereby it has sought powers directly on Chartered
Accountants/auditors, valuers, Company Secretaries, etc. The amendments
provided for specific role of care and other duties by such persons and empower
SEBI to take action directly on such persons if they are found wanting in
performance of such duties. Representations have been made against these
amendments for various reasons including for encroachment powers of other
authorities, making such powers too wide, etc.


However, cases such as
these could make the argument of SEBI even stronger that it needs such powers
to be able to punish errant persons involved so as to restore the credibility
of capital markets.


Conclusion


Such cases are rightly
cause of worry whether the system is strong enough to prevent such things from
happening or at least catch such violations well in time. Further, the
detection and punishment too has to be swift and strong so as to act as
deterrent to others from doing such things.


In the present case, if the
findings are indeed finally held to be true, there has been no prevention and
no timely detection. It appears that the monies may have been lost at least for
now. It will have to be seen whether the action of SEBI is swift and effective
to recover the monies and also punish the perpetrators so as also to act as
deterrent for others.   

 

 

SEBI PROPOSES RULES TO PENALISE ERRANT AUDITORS, VALUERS, ETC. – YET ANOTHER LAW & REGULATOR WILL GOVERN SUCH ‘FIDUCIARIES’

SEBI has proposed regulations that prescribe specific duties
of Chartered Accountants/auditors, cost accountants valuers, etc. (termed as
“fiduciaries”). These duties will have to be performed whilst carrying out
assignments for listed companies and other entities associated with the
securities markets. The “fiduciaries” will face a range of penal actions if
they do not comply with these provisions.

 

A question is often raised whether Chartered Accountants,
should be subjected to action by SEBI and other regulators, when they are
already regulated by the ICAI. The issue is: whether fiduciaries should face
action from multiple regulators for the same default?

 

SEBI has, in the past, taken action against auditors.
However, in the Price Waterhouse/Satyam case, the matter had reached the Bombay
High Court which laid down certain limits to the powers of SEBI. The Kotak
Committee in its report of 2017 on `corporate governance’ has recommended
broader powers for SEBI.  However, the
proposed regulations circulated by SEBI through a consultation paper dated 13th
July 2018 appear to go beyond Kotak Committee’s recommendations. Hence, the
need to review these recommendations to understand their implications.

 

Nature of Amendments Proposed

Over the years of its existence, SEBI has formulated several
Regulations to regulate intermediaries like stock-brokers, etc., and regulate
transactions in the securities markets. There exist regulations relating to
stock brokers, investment advisors, merchant bankers, etc. Then there are
regulations relating to issue of shares, insider trading, frauds, etc. Many of
these regulations require the services of auditors, company secretaries,
valuers, etc., to provide certificates, reports, etc. Clearly, defaults by
these fiduciaries in carrying out their duties can have repercussions for
investors and capital market who rely on their reports/certificates. Through
the consultation paper, SEBI has proposed amendments to 31 regulations to
provide for duties of fiduciaries and for penal action in case of
non-compliance.

 

Who are These Fiduciaries Covered?

The following fiduciaries are specifically covered:

 

1.  Chartered
Accountants including a statutory auditor

2.  Company
Secretary

3.  Valuers

4.  Monitoring
agency

5.  Cost
Accountants

6.  Appraising
or appraisal agency

 

The fiduciary could be an individual, firm, LLP or a
corporate entity. Relevant to this is the concept of  `engagement partner’. Hence, the term
“engagement partner” has been defined as:

 

“Engagement partner” means the partner or any other person
in the firm or limited liability partnership, who is responsible for the
engagement or assignment and its performance, and for the report or the
certificate, as the case may be, that is issued on behalf of the firm or
limited liability partnership, and who, has the appropriate authority from a
professional body, if required;

 

What is the nature of activities by fiduciaries covered?

The regulators cover submission or issue of any report or
certificate by any such fiduciary under the applicable Regulations. Each of the
Regulations provide for an indicative list of such reports/certificates that a
fiduciary may issue under that Regulations. These reports/certificates include
auditors report, compliance report, net worth certificate, valuation report,
etc.

 

What are the obligations of the fiduciaries in relation to
such reports/certificates?

The fiduciary whilst issuing a certificate/report is required
to:

 

“(a) exercise due care, skill and diligence and ensure
proper care with respect to all processes involved in the issuance of a
certificate or report;

 

(b) ensure that such a certificate or report issued by it
is true in all material respect; and

 

(c) report in writing to the Audit Committee of the listed
company, any material violation of securities laws, noticed while undertaking
such an assignment.”    

 

The requirements of individual regulations vary a little. For
example, in (c) above, the report relating to violation of securities laws may
be made to the other relevant party such as merchant banker or compliance
officer, etc.

 

This requirement also underlines the importance of working
papers to establish that ‘due care etc.’, has been exercised in the preparation
of the certificate / report.

 

What are consequences of
non-compliance by the fiduciaries?

If the fiduciary issues any false report/certificate or which
does not comply with any requirement of the applicable Regulations, SEBI would
take “appropriate action” under the general provisions of the securities laws.
Hence, the action that can be taken could include:

  •     Disgorgement of fees earned by the
    fiduciary.
  •     Debarment of the fiduciary from carrying out
    any assignment in relation to listed companies and other entities associated
    with securities markets.
  •     Monetary penalty
  •     Prosecution.

 

Action may be taken against whom?

In case of violation of the regulations in terms of
submission of false reports/certificates, not carrying out the work in the
manner prescribed, etc., the action would be taken “against the fiduciary, its
engagement partner or director, as the case may be.”.

 

The Bombay High Court decision
in case of Price Waterhouse/Satyam fraud

To understand the origin of this consultation paper, the
PwC/Satyam case may be recollected briefly. SEBI had issued a show cause notice
against Price Waterhouse and associate firms in relation to the audit, etc.,
carried out relating to Satyam scam. Price Waterhouse raised several questions
as to jurisdiction of SEBI. One of the objections was whether SEBI had any
jurisdiction to act against Chartered Accountants who are otherwise regulated by the Institute of Chartered Accountants of India.

 

The Bombay High Court (Price Waterhouse & Co. vs.
SEBI ((2010) 103 SCL 96 (Bom.)) partially upheld the jurisdiction of
SEBI. It elaborated on the wide range of powers of SEBI in relation to the
securities market. It also held that SEBI does not and cannot regulate the
profession of Chartered Accountants. For example, it cannot prohibit a
Chartered Accountant from practicing, even if found to be at fault. However,
SEBI could, if facts show a default, debar an auditor from issuing
reports/certificates in relation to listed companies, etc. The Court stated
that SEBI could take action only if the auditor is complicit in the fraud.
Hence, if the auditor is not a party to the fraud, SEBI cannot take action. The
proposed regulations have also to be seen in light of this decision.

 

Kotak Committee on Corporate Governance

The more immediate source of the consultation paper is the
Kotak Committee report on corporate governance submitted in October 2017. In
the report, the Committee had recommended that SEBI should have specific powers
to take action against auditors and other fiduciaries not just in cases of
fraud/connivance, but also in cases of gross negligence. It observed:

 

“Given SEBI’s mandate to protect the interests of
investors in the securities market and regulating listed entities, the
Committee recommends that SEBI should have clear powers to act against auditors
and other third party fiduciaries with statutory duties under securities law
(as defined under SEBI LODR Regulations), subject to appropriate safeguards.
This power ought to extend to act against the impugned individual(s), as well
as against the firm in question with respect to their functions concerning
listed entities. This power should be provided in case of gross negligence
as well, and not just in case of fraud/connivance. This recommendation may be
implemented after due consultation with the relevant stakeholders, including
the relevant professional services regulators/ institutions.” (emphasis
supplied)

 

Two points need to be particularly considered. Firstly, the
recommendation was to extend the powers to cover instances of gross negligence.
Secondly, it appears that the action would require concurrence of the relevant
regulator.  In view of these two issues
the consultation paper goes beyond gross negligence/fraud.

 

Lesser burden of proof to levy
penalty on Auditors

Supreme Court has laid down principles for levy of penalty in
civil proceedings. In SEBI vs. Kishore R. Ajmera ([2016] 66 taxmann.com 288
(SC)), the Supreme Court had held that the bar for taking adverse action is
much lower as compared to criminal proceedings. The Supreme Court observed, “The test, in our considered view, is one of
preponderance of probabilities so far as adjudication of civil liability arising
out of violation of the Act or the provisions of the Regulations. Prosecution
under Section 24 of the Act for violation of the provisions of any of the
Regulations, of course, has to be on the basis of proof beyond reasonable
doubt.”
(emphasis supplied).

 

The test of ?preponderance of probabilities’ was
applied by SEBI in the case of Price Waterhouse (order dated 10th
January 2018). Accordingly, SEBI ordered disgorgement of fees earned with
interest and also debarment from taking up assignments in specified matters
relating to capital markets.

 

Thus, while prosecution would need proof beyond reasonable
doubt, actions such as levy of penalty, disgorgement of fees and debarment
could arguably be taken with a lower bar of `preponderance of probabilities’.

 

This is also to be seen in the light that the new
requirements now do not require that the fiduciaries should have themselves
engaged in or been complicit in fraud. For taking action it is enough if the
`fiduciary’ has not discharged the prescribed duties in the manner required by
the proposed new regulations.

 

Other implications and concerns

The scope of the proposed regulations is limited to
assignments carried out by ‘fiduciaries’ for entities operating in capital
markets. The regulations are broadly framed and comprehensive. Arguably, action
can be taken even in cases that do not involve gross negligence. Thus, it is
likely that action could be taken even in cases where otherwise action may not be attracted by the concerned regulator.

 

Needless to emphasise, parallel proceedings by several
regulators/authorities and double/multiple penal consequences may also be the
consequence.

 

Despite the fact that the ‘fiduciaries’ are experts
specialised in certain fields, the proposed regulations also do not give
guidance on how it would be determined whether the fiduciary has committed
violations. It is not provided, for example, that, in case of auditors, the
guidance and pronouncements of the Institute of Chartered Accountants of India
will be considered to test whether the work has been properly performed. Also,
the person who will decide whether the work has been properly done may not be a
peer or an expert in the field, but will be a SEBI member and / or officer.
Thus, fiduciaries would enter a whole new mine field/unexplored territory where
they would be uncertain as to how and who would determine whether they have
discharged their duties correctly or not.

 

It is likely that fiduciaries would feel
discouraged in carrying out assignments for matters covered under the proposed
regulations. At the very least, costs/professional fees for such work will rise
and will be borne by investors. 

APPLICABILITY OF MONEY LAUNDERING LAW TO SECURITIES LAWS VIOLATIONS

This was launched in April, 2006 by
Jayant Thakur. The aim of this column was to introduce Securities laws to the
readers. After covering the basics, the aim was changed to cover updates along
with analysis. Selection of topics and analysis is done on the basis of
relevance to accounting and tax aspects. 
New laws, court and SAT decisions are covered in this space. Jayant
Thakur says: ”Writing this feature helps and even forces me to read each
development and analyse it for readers, thus adding to my knowledge too.” Well,
reading it gives the same effect too!

 

APPLICABILITY OF MONEY LAUNDERING LAW TO SECURITIES LAWS VIOLATIONS

 

There was a recent report in the media that
action against certain persons, who allegedly carried out price manipulation on
stock exchanges, was initiated under money laundering laws. If found guilty,
such persons would face additional and stringent punishment that could actually
be more than the punishment for even the original violation.

 

This is an eye
opener over how a few forgotten and dormant provisions can be used to levy fairly
serious criminal punishment in connection with violations of Securities Laws.
The parties face at least three years prison, and this is in addition to all
the action of penalty, debarment, prosecution, etc., they may face under
Securities Laws.

 

What can also be seen is that such action is
possible not just for price manipulation, but even for violation of several
other Securities Laws such as insider trading, takeovers, etc., and also for a
wide variety of corporate frauds under the Companies Act, 2013.

 

This raises several issues. What are these
provisions in money laundering laws that provide for punishment for such
securities and corporate laws? What type of such securities laws violations and
corporate frauds are covered? What is the additional criteria that makes such a
securities/corporate laws violation into a money laundering laws violation too?
Is it possible that the mere fact of indulging in such a violation will most
certainly result into violation of money laundering law? And thus, effectively,
result in double punishment?

 

WHAT IS ‘MONEY LAUNDERING’?


Money laundering is often confused with
laundering for tax purpose whereby money on which income-tax has not been paid
(‘black money’) is laundered and brought into books (ie converted into ‘white
money’). Money laundering, as defined and described under the Prevention of
Money Laundering Act, 2001 (“the Act”), is different. It is converting money
earned from certain serious crimes into money shown as earned in other manner.
For example, money earned through selling narcotic substances is shown as
monies earned from, say, sale of steel. The tainted money thus becomes
untainted. This camouflaging constitutes the offence of money laundering.
Interestingly, income-tax may be paid on such earnings. Just the source gets
camouflaged – or rather changed into a different colour. The punishment for such conversion – i.e., money
laundering – could be in the range of least 3 years prison upto 7 or even 10
years. This is apart from fine that may be levied.

 

WHAT ARE THE ‘CRIMES’ COVERED?


The Act lists certain crimes in respect of
which, the act of disguising the proceeds of such crimes is considered to be
the offence of money laundering. Hence, it is necessary to understand and list
what are such crimes.

 

Originally, the intention appears to list
only certain serious crimes such as drug dealing, terrorism, arms dealing, etc.
However, over the years, many more crimes have been added. Now the
offences/violations under various laws that are covered are in the hundreds.
Many of such crimes are what are referred to as white-collar crimes. In this
article, we will focus on four of them – insider trading, price
manipulation/fraud in securities markets, takeovers of companies and related
and corporate frauds. As we will see, these categories themselves have multiple
sub-categories.

 

Insider
trading

This
includes things like dealing in securities on the basis of unpublished price
sensitive information, sharing of such information, etc. The provisions
relating to insider trading are quite broadly defined. These include who are
‘insiders’, what is price sensitive information, what type of transactions or
actions deemed to be insider trading, etc. 

 

Price
manipulation/fraud

Broadly stated, this includes manipulating
price of securities on stock exchanges, indulging in various types of unfair
practices, fraud, etc. These offences are defined generally and to add to that,
a long list of specific items has been listed which are deemed to fall under
this category.

 

Substantial
Acquisition of Shares and takeovers

The SEBI Takeover Regulations provide for
certain provisions to keep a check on change of control in a company. These are
broadly two. One is acquisition of shares or voting rights beyond a particular
limit without making an open offer. The second is acquiring shares beyond
certain specified limits without making disclosures.

 

Corporate
frauds

U/s. 447,
recently introduced vide the Companies Act, 2013, several types of acts/omissions
are deemed to be frauds and punishable under that provision quite strictly.
Once again, the main section 447 describes frauds very widely and generally. If
an act or omission falls under this description, it is fraud. However, there
are several other provisions under the Act that deem certain acts/omissions as
frauds u/s. 447.

 

Others

There are many
other white collar offences listed as specified offences for the purposes of
money laundering. It is possible that in many cases, corporate frauds or
securities related frauds may get covered in such other categories too.
However, this article focuses on the four items listed above.

 

THE SPECIFIED OFFENCE HAS TO BE PROVED FIRST


The first step has to be to prove the
original offence itself. For example, there has to be an offence of, say, price
manipulation. It is only when this offence is proved that there can be any
question of alleging that there was money laundering.

 

THERE HAS TO BE PROCEEDS OF SUCH OFFENCES


Money laundering obviously cannot exist without there
being some proceeds of such crime. In case of price manipulation, for example,
the profits made through such dealings is the proceeds of crime.

 

WHEN AND HOW WOULD SUCH OFFENCES ALSO RESULT IN MONEY LAUNDERING?


The offender may make some earnings from any
of the specified acts. If he shows these earnings as derived from a different
source, he would have committed the offence of money laundering.

 

PROVING THAT THERE HAS BEEN MONEY LAUNDERING


To determine whether the offence of money laundering has
taken place, a clear link would has to be established between the proceeds of
crime and the earnings/assets that were shown after such disguising.

 

DIFFICULTIES IN PROVING MONEY LAUNDERING IN CASE OF SECURITIES/ CORPORATE OFFENCES


It
is difficult enough to prove securities/corporate offences but let us say that
is done. The question, however, is how does one prove that (i) such person has
earned money from such offences (ii) he has disguised the proceeds of such
offences?

 

The difficulties are particularly compounded
in case of securities/corporate offences. In most of such cases, even if the
income is shown without any modification of source, proving money laundering
would be difficult. This is explained by several examples below.

 

Take a case, however, first of a case where
it may be possible to prove money laundering. Take a case of price manipulation
by the so-called ‘operator’. Such person may indulge in price manipulation in
shares. He enters into false transactions that result in rise of the price of
the shares. He is paid ‘fees’ for carrying out such activity. He records it as
fees for some other ‘consultancy’ or the like. Underlying papers show that he
did receive such fees and that it was disguised as having come from other
legitimate source. The offence of money laundering is thus proved.

 

However, take an example of a CFO who comes
to know that his employer company is going to declare good financial results.
He buys the shares at a particular price and then, after the news become public
and the price of the shares rise, he sells the shares at a higher price. The
offence of insider trading might be easily proved here. However, how does one
prove the offence of money laundering here? The CFO may have shown the income
as from capital gains in his books of accounts and tax returns. There is no
disguising involved here.

 

Similar is the case of price manipulation
where profits are made by buying shares at a low price, then indulging in price
manipulation/fraud, and then selling at a high price. Even if the offence of
price manipulation/fraud is proved, the income is still arising from gains on
sale of shares.

 

Violation of SEBI Takeover Regulations may
also have similar issues.

 

Then there is a
whole long list of frauds falling generally u/s. 447 and in many of such cases
too, such issues may arise.

 

WHAT IS THE PUNISHMENT?


The punishment
for money laundering is stringent. Generally stated, the punishment may range
from three years to seven years imprisonment. In effect, it calls for
punishment that is more strict than even the original offence.

 

CONCLUSION


It is possible
that the recent invoking of money laundering law in such white collar crimes is
to make an example in serious cases. This would create an added disincentive on
such people and also people who help them in disguising their earnings.
However, these white collar offences are large in number and varying in
intensity. In most cases, even the punishment for the original offence is
relatively mild. Often, a token penalty is levied. If the law relating to money
laundering is frequently used, then the consequences would be far more serious.
I submit that the list of offences covered here should be narrowed down only to
serious cases and there should be added conditions to be satisfied to invoke
the provisions relating to money laundering.  

 

 

SEBI HOLDS AUDITORS LIABLE FOR NEGLIGENCE/ CONNIVANCE IN FRAUD – DEBARS THEM FOR 5 YEARS

BACKGROUND


Auditors have been the focus of several
regulators, each of whom seek independent and wide powers to take action
against them when they perceive that auditors have not discharged their duties
properly. SEBI has taken action against several auditors of listed companies
where SEBI felt that auditors were negligent, did not discharge duties mandated
by law and / or where there is connivance with the management in fraud, etc.

 

However,
whether and to what extent SEBI has powers to act directly against the
auditors has been controversial. There are several SEBI orders, a report of
consultation committee of SEBI, a detailed decision of the Bombay High Court,
etc., that have differing views. Some of the decisions of SEBI/SAT are under
appeal. SEBI has recently proposed amendments to regulations to prescribe
duties of auditors and the action SEBI can take in the event the prescribed
duties are not discharged. The powers SEBI is seeking may be questioned before
courts particularly on the issue whether the provisions SEBI Act are wide
enough to provide for powers merely by amending the Regulations. Thus, the
coming years will see several developments before a clearer picture emerges.

 

In the meantime, SEBI has passed yet another
order debarring a firm of auditors for 5 years from carrying out any
certification work for any listed company or any intermediary associated with
the capital markets. In the case of C. V. Pabari & Co., (“the Auditors”)
SEBI has passed order No : WTM/MPB/ISD-FAC/57/2018, dated 31st
October 2018 relating to audit of Parekh Aluminex Limited. There are several
findings of erroneous accounting and presentation in financial statements, in
addition to diversion of funds, over valuation, etc., and violations of
provisions of the Companies Act.

The Order also debars for 5 years the
Wholetime Executive Director, who was also earlier the Chairman of Audit
Committee. However, this article focuses on the action taken against the
auditors, on the facts and the reasons provided by SEBI for debarring the
auditors for five years.

 

BROAD BACKGROUND AND SUMMARY OF THE ORDER.


Parekh Aluminex Limited was a company listed
on Bombay stock exchanges. During the period under question (FY 2009-10 to
2010-12), it was alleged that there was wrongful accounting and disclosure in
financial statements, diversion of funds, over valuation of certain assets,
etc. Some time after this period, the main promoter and Chairman/Managing
Director of the Company also passed away. The share price of the Company
plunged from some Rs. 300 to Rs. 10 and the shares were eventually delisted
from the Bombay Stock Exchange.

 

The Auditors who conducted audit of the
accounts during this period resigned. Other firms of auditors were appointed
who too resigned giving reasons such as non-availability of information. It
appears, however, they did submit some reports. A firm was also appointed to
conduct a forensic audit. Based on the interim forensic audit report and other
preliminary findings, SEBI passed an interim order and also served a show cause
notice to the Whole time Director and the Auditors. They were given a hearing
before passing the final order.

 

Let us consider some of the major
allegations made, the defenses given by the Auditors and the order of SEBI and
its reasons.

 

WHETHER SEBI HAS JURISDICTION TO ACT AGAINST THE AUDITORS?

 

An oft made defense by the auditors is that
SEBI does not have any jurisdiction to act against them in respect of their
services to a listed company. However, SEBI rightly cited the decision of the
Bombay High Court in case of Price Waterhouse & Co. vs. SEBI ((2010) 103
SCL 96 (Bom.)). The Court had held, under certain circumstances
particularly where it can be held that the auditors had connived with the
management in fraud, SEBI could take action against the auditors.

 

However, interestingly, SEBI observed that
even if the financial statements have not been drawn up in accordance with the
mandated accounting standards, SEBI could act against the auditors. It
observed, “…if the financial statements have been drawn up without following
the norms and standards of accounting, SEBI has jurisdiction to take regulatory
measures for protecting the investors interest by taking appropriate steps
against the Auditor.”. I submit that this view is not supported by the
decision of the Bombay High Court.

 

ALLEGATION – LOANS / ADVANCES WERE NETTED OFF AGAINST BORROWINGS

 

It was alleged that loans/advances given to
several persons were adjusted against bank loans in the financial statements.
This resulted in loans given and borrowings both being shown lower by more than
Rs. 1000 crores.

 

SEBI sought explanation from the Auditors as
to why such a disclosure was made and whether this was in consonance with
applicable accounting standards.

 

The answer of the Auditors was that the
adjustment and disclosure was made in the financial statements presented to the
Audit Committee and the Board and the final statements were approved by both
without any objections. The Auditor also pointed out that independent audits
were conducted by banks who had not objected to this adjustment. Further, the
banks extended additional loans. It appears, however, they could not provide
any explanation regarding compliance with accounting standards.

 

SEBI rejected the explanations. It stated
that auditors were expected to conduct an independent audit and could not rely
merely on approvals by Audit Committee/Board and ‘rubber stamp’ the accounts.
SEBI, reiterated that the Auditors could also not rely on bank audits as they
are mandated to conduct audit independent of other agencies. Further Auditors
failure to explain how such a practice was in compliance with accounting
standards was also noted.

 

DIVERSION OF FUNDS TO NON- CORE ACTIVITIES

 

The next allegation was that funds of the
company were diverted for non-core activities. It has been alleged that loans
and advances were given for the purposes of real estate which “…is a non-core
activity of the company”. Similarly, it was alleged that “…the company had
transferred money to companies trading in bullion which is diversion of fund as
the company is engaged in the manufacture of aluminum foil related products.”
Other similar diversion of funds was also alleged. In view of this, SEBI
concluded :

u    that the company has
misrepresented its business operations to its shareholders and to the public in
general.”.

u    that PAL has misstated its
accounts in respect of set off of such loans/advances and “diversion” of funds.
?

?

OBSERVATIONS OF SEBI ON ROLE OF AUDITORS

 

While dealing with the defenses offered by
the auditors and generally examining what had happened in the present case,
SEBI made several observations on role of auditors and what acts or omissions
can be held to be actionable:

 

(a)   Auditors are experts in the field of accounts
and finance and should rely on their own expertise and judgment instead of
relying on and accepting accounting treatment by the management. Else, the
whole purpose of certification by them is defeated.

 

(b)  The auditors could not present a due paper
trail for the work they claim to have done in respect of verifying the loan
documents. Hence, their defense on this aspect was rejected.

 

(c)   Auditors should not merely be “rubber
stamping the accounts” and in doing this failed to follow the “minimum
standards of diligence and care as expected of a statutory auditor”.
Auditors thus showed “lack of professional skepticism in auditing the accounts
of the company”.

 

(d)  Considering that in case of listed companies,
public at large, financial institutions (government and private), etc., rely on
report of auditors, “..the duty and obligation of being absolutely diligent
is multiplied manifold and the auditor cannot take such an obligation
casually”.

 

(e)   The investing public relies on the financial
results to make informed decisions. False accounts have direct impact on
securities markets.

(f)   Such alleged large-scale falsification,
following dubious accounting practices for manipulating financial results,
etc., could not happen without “…its statutory Auditor being part of the
manipulative and deceptive device. Even otherwise, by making representations in
a reckless and careless manner whether it is true or false, tantamount to
fraud”. ?

 

Making such observations, SEBI held that
there have been violations of the provisions of the Act and the Regulations
relating to fraud, manipulation etc., and accordingly gave various directions
as mentioned earlier against the auditors.

 

CONCLUSION AND WAY FORWARD

This is just one of several orders passed
against auditors for their alleged participation or connivance in fraud. Most
of the cases are about fraud, the observations and basis for passing of orders
vary and cover a wide area. It needs to be noted that where the auditors have
participated in or ignored fraud/falsification, the provisions in the SEBI
Act/Regulations relating to fraud would get attracted. This area is sought to
be extended to cover cases of negligence, failure to follow accounting
standards, or proper procedures of audit, and lack of professional skepticism.

 

The proposed Regulations by SEBI seeking to
prescribe extend the duties of auditors (and other specified professionals)
discussed earlier will thus need closer attention. These proposed amendments
require auditors to observe the proposed prescribed duties while rendering
services to listed companies and other specified entities associated with the
capital markets. Failure to do so would result in adverse action against them
by SEBI. Thus, SEBI would be able to, if these proposed amendments are made
law, take action against auditors even under situations even where there is no
fraud but there is lack of care, diligence, etc. The issue is : should auditors
face proceedings before multiple regulators and be subject to multiple and
overlapping consequences. It is time that a holistic assessment of the whole
issue is made and action against the auditors is through a single regulator,
under clear pre-defined and rational guidelines.   

 

 

Front Running – iII-Thought Out Law and iII-Considered Orders of SEBIi

Background

SEBI has passed an order on
8th May 2018 in a case of front running in the matter of Kamal
Katkoria. On the face of it, there is nothing distinctive or new in the order.
The law relating to front running has seen ups and downs in the past, with even
contradictory decisions of SAT, but the Supreme Court (SEBI vs. Kanaiyalal
B. Patel [2017] 144 SCL 5 (SC)) largely settled the matter. Yet, this order
raises and reminds of concerns that the law has not been thought through well
and the orders cause injustice and even inequity to parties.

 

What
is front running?

Front running has been
discussed several times earlier herein in this column. Simply stated, it is
about a person having knowledge of impending large trade orders, who then
trades ahead (hence ‘front running’) to profit from such orders.
Large orders usually influence the price. The front-runner buys first and then
sells the shares to the original buyer and profits. The original buyer ends up
paying a higher price and thus suffers. Similarly, in case of large sell
orders, the front runner sells first and then, when the original seller comes
to the market to sell, the front runner squares off his trades by selling. In
the first case, the buyer ends up paying a higher price for his buys and in the
second case, he gets a lesser price for his sale.

 

The legal dispute as to which types of front running
violate the law

Front running, as the
Supreme Court analysed, can be put in three categories. In the first category
are cases where a person comes to know of such proposed large trades and trades
ahead. In the second category are cases where the person, who proposes to carry
out large trades, himself carries out hedging or similar
offsetting trades to protect himself of the effect on price his large trades
would cause. Third case is of an intermediary who comes to know
of a client’s proposed large trades and trades ahead of him.

 

The third category is
specifically prohibited under the SEBI PFUTP Regulations (Regulation 4(2)(q)).
The second category is not considered to be front running or the like. The
prolonged dispute was largely about the first category where a person who comes
to know of such proposed large trades and owes a fiduciary duty not to use it.
The Supreme Court held that merely because there was a specific provision for
front running by intermediaries did not mean that non-intermediary front
running cannot be covered under generic provisions. In other words, such front
running was covered under the general and broad definition of fraud. Hence, the
first category was also deemed to be wrongful.

 

Facts
in the present case

In the present case, the
facts, briefly and simplified, were as follows: A private company, apparently
engaged in jewellery business, had entered into large trades in shares. The
trades were looked after by an employee who coordinated these trades with the
stock broker. However, he traded ahead and made significant profits of Rs. 38
lakh. By an earlier order, he was debarred for a period of three years. By the
present order, he was required to disgorge this profit plus interest
aggregating to Rs. 61.73 lakh.

 

Controversial
issues in the Order

Three issues arise.

 

First,
whether, in such cases, the interests of investors or markets are adversely
affected and thus whether SEBI can and should have any role. To elaborate, the
losses in such cases can be of two types. One are losses specific to a person
who has been directly affected by such front running. In the present case, it
is the employer private company who ended up paying a higher price. However,
certain wrongs could also affect investors generally and also end up harming
the reputation and integrity of capital markets such that investors may
hesitate dealing therein on fear that the markets could be rigged.

 

In the present case, SEBI
asserted, and rightly so, that the question of whether there was violation of
the PFUTP Regulations had attained finality. This is because in the previous
order in the same party’s case, violation of the Regulations was upheld and
affirmed by the decision of the Supreme Court. The earlier order of SEBI where
it debarred the front runner had given detailed reasons and the appeal against it
was dismissed. However, in the current order, SEBI repeatedly stated that
interests of investors and markets generally were harmed. This is curious and
goes to the fundamentals of the question whether such cases should at all be
held to be fraudulent as to be violation of the Regulations.

 

Take a simplified example
of what happens in such cases. A person desires to buy, say, 10 lakh shares of
company A when the price is Rs.100. His purchase would result in increase in
price to Rs. 103. The employee, who is authorised to execute this order, trades
ahead and buys 10 lakh shares for himself resulting in price rising to Rs. 103.
He then asks the broker to execute his employer’s order at the ruling price of
Rs. 103 while he himself sells on the other side. Effectively, he makes a
profit that could be Rs. 3 or more per share. Clearly, this profit is made at
the cost of his employer in breach of trust his employer bestowed on him.
However, can such private breach of trust be treated as such a fraud in dealing
in securities as in violation of the Regulations? That would be stretching the
scope of the Regulations wider than its intention/ spirit and perhaps even the
letter. It is submitted that merely because a fraud involves securities, this
should not result in SEBI taking action unless markets or other investors
generally are harmed.

 

It is also submitted that
there are no losses to investors generally in such cases. As the example given
above shows, it is only the employer who loses. Even without such front running,
the public investors would have got the same price on sale. They would have
sold the shares at the same price to the employer as they did to the employee.
The credibility of the markets too also arguably did not suffer since the fraud
was committed by the employee on the employer and not by the system. Of course,
because of such front running, the volume in shares doubled but that by itself,
it is submitted, is not sufficient reason to extend scope of the Regulations to
private breach of trusts/frauds. Private breaches of trust can be of such wide
and varied nature that SEBI may end up meddling in private disputes.

 

Secondly,
treating such front running as in violation of the Regulations would result in
double punishment of the front runner. Firstly, he would be punished by the
employer. It is very likely that he would lose his job. Secondly, he would be
required to make good the loss to the employer. Thirdly, the employee may lose
his reputation and may not find job easily. It is also possible that the employer
may initiate prosecution against him. However, it is seen that SEBI too is
punishing such a person. In the present case, it is seen that he has been
debarred from the markets for three years and he has already undergone this
term. Secondly, he has been asked to disgorge the profits with 12% interest.
Thirdly, it is possible that he may be asked to pay penalty, which can be upto
3 times the profits made or Rs. 25 crore whichever is higher. There is also a
possibility of him being prosecuted. Such dual punishment does not stand to
reason.

 

Thirdly,
there is inequity and injustice involved here. The loss has been caused to the
employer in this case. However, it is SEBI that has disgorged the profits, none
of which goes to the person who has lost the money. This profit and even
interest fairly belongs to the employer. Interestingly, it is seen in this case
that the employee had very low annual income and these profits from front
running thus were very significant. These earnings enabled even him to buy a flat.
This flat has now been encumbered by SEBI and quite possibly be made to be sold
to pay to SEBI the disgorged profits plus interest. In this case, there may not
be much left for the employer. Even if there was something left, the employee
would be paying the profits plus interest twice. The disgorged amount is
credited by SEBI to Investor Protection and Education Fund. In principle, the
party who has suffered the losses could approach SEBI and request that the
amount disgorged be paid to him. In practice, it is very likely that this
process could be prolonged and cumbersome. Curiously, in this Order, SEBI had
stated, incorrectly I submit, that public investors have also suffered part of
the losses. This is despite the fact that there was a fairly specific finding
that the front runner had traded ahead only for his employer’s trades. Thus, it
is possible that the party may get only part of the money and that too after
considerable effort.

 

When the Order itself is so
clear in its finding, it stands to reason that the Order itself should provide
that the disgorged amount be paid to the employer. This is of course subject to
necessary safeguards for refund in case an appellate authority overturns the
order wholly or partially.

 

This principle should apply
even to cases where intermediaries were involved. It is the client of the stock
broker who suffers and this illegitimate profit disgorged needs to be handed
over to him. Similarly, as it had happened in the case of a reputed mutual
fund, where a senior employee front ran his employer fund’s trades, the SEBI
order should provide for handing over such disgorged profits directly to the
credit of the fund for benefit of the unit holders.

 

Conclusion

To conclude and summarise,
the law relating to front running involving private breach of trust needs to be
revisited. SEBI should concern itself only to cases where the interests of
investors/markets are affected. Even where it takes action, it should ensure
that the persons who have lost monies because of such front running are
compensated. The SEBI order should itself provide for handing over of the
amounts disgorged to the party who has lost on account of such front running.   

 

Beneficial/Benami Holdings In Companies – Disclosure Requirements Notified

Background

Section 90 and related provisions of the
Companies Act, 2013, have finally been brought into force on 13th June
2018 along with related Rules. They apply to all companies, with a small set of
specified exceptions. “Significant beneficial owners” of such companies are
required to make certain declarations. The intention appears to be that those
natural persons (i.e. individuals) who have significant ownership of or
influence in or control of a company need to come forward and disclose their
names. From the point of view of transparency, it would be known who really
controls/owns the company, even if the ownership/control is through holding
entities such as companies, LLPs, Trusts, etc. or through contracts,
arrangements etc. The other major intention and consequence may be that
benami holdings could be identified, or at least required to be.

 

However, as we will see, the wording not
just of the provisions in the Act but also of the Rules has ambiguities and
uncertainties. This is owing to poor drafting, undefined important terms, etc.
which could lead to problems in implementation. Indeed, it is even difficult to
be clear what is the real intention. For example, is the intention to target
only those cases where the real owners are behind the scenes through certain
structures? Or is the intention to require that all persons with significant
ownership/control be brought on record? If the latter is the intention, there
will be a one-time massive exercise since lakhs of companies will have to make
such disclosures.

 

This column had discussed earlier some
issues on section 90, at a time when the new provisions were made part of the
Act through the Companies Amendment Act 2017 but were not brought in force. Now
that they have been duly notified and brought into force and require action,
and that the detailed Rules/Forms too are also released, the provisions and
their implications deserve a fresh and closer study.

 

It may be added that several other
provisions of law such as those relating to money laundering, certain
securities laws, etc. already have provisions requiring disclosures
under certain circumstances. The Benami Transactions (Prohibition) Act, 1988,
too deals with comparable provisions.

 

Relevant provisions

The relevant provisions are section 90 of
the Companies Act, 2013, with a definition of a term in section 89(10), and the
Companies (Significant Beneficial Owners) Rules, 2018. While the sections give
the primary requirements, the Rules provide for further definitions, the
benchmark at which a shareholder would be treated as a significant beneficial
owner, the process to be followed when shareholders are companies, LLPs, etc.
and the forms, records, etc.

 

Definition of a “Beneficial Interest”

Section 89 deals with disclosures by persons
with beneficial interests in shares. A person whose name is entered in the
register of members as the holder of shares but who does not hold the
beneficial interest is required to make disclosures. The term “beneficial
interest” has been defined quite broadly in section 89(10) and reads as
follows:

 

“(10) For the purposes of this
section and section 90, beneficial interest in a share includes, directly or
indirectly, through any contract, arrangement or otherwise, the right or
entitlement of a person alone or together with any other person to—

 

(i) exercise or cause to be exercised any
or all of the rights attached to such share; or

 

(ii) receive or participate in any
dividend or other distribution in respect of such share.”

 

However, while Section 89 requires
disclosure for all cases of shareholding without beneficial interest, section
90 (read with Rules) requires disclosure where there is at least 10% beneficial
shareholding (which would make it a ‘significant beneficial holding’). Section
90 of course applies also to cases where a person has or exercises significant
influence or control.

 

Terms such as “through contract, arrangement
or otherwise” and “alone or together with any other person” are used but not
defined.

 

Requirements relating to disclosure

Section 90 (read with relevant Rules)
requires, to simplify a little, a “significant beneficial owner” to make
disclosure. This includes persons having at least 10% beneficial shareholding
or having the right to exercise or who actually exercises “significant
influence” or “control”.

 

The term “control” has been defined in
section 2(27). The term “significant influence” has not been defined in the Act
or Rules and hence there can be uncertainty. Interestingly, the definition of
the term “associate company” in section 2(6) does define this term, though for
purpose of that clause. It means having “control of at least twenty per cent of
total share capital, or of business decisions under an agreement”.

 

Holding in shares or other securities

While sections 89/90 refer to the beneficial
interest in shares, the Rules extend it also to global depository
receipts, compulsorily convertible preference shares and compulsorily
convertible debentures. However, no further details are given as to how these
will be applied.

 

Holding through companies, LLPs, etc.

The intention appears to be to ascertain
those natural persons (i.e., individuals) who are the real owners of a company
and who control it. If the shareholders are persons other than individuals, it
would be necessary to go behind these entities and find who are the significant
owners behind them. Hence, for this purpose, the Rules essentially require the
natural persons who have at least 10% interest in such entity. However, while
one can gauge the intention here, in practice, the wording does not seem to be
sufficient to unravel complex structure of holdings/control. 

 

The method to determine significant
beneficial owners (SBO) in such cases has been specified as follows.

 

Where the member is itself a company, SBOs
would be the natural persons who directly or indirectly or alongwith other
natural persons or through other persons/trusts hold at least 10% of the share
capital or who exercise significant influence or control through other means.
Where the member is a partnership firm, the principle is the same except that
the holding may be in terms of capital or entitlement to the profits. In any of
these two cases, if the SBOs can still not be ascertained, then the natural
person who is the senior managing official would be deemed to be the SBO. If
the shareholder is a Trust, the persons to be disclosed are the Trustees, the
beneficiaries who have at least 10% interest in the Trust, and any other
natural person “exercising ultimate effective control over the trust through a
chain of control or ownership”.

 

Residence of significant beneficial owner

The significant beneficial owner or
intermediary entities may be in India or abroad.

 

When are disclosures to be made?

The required disclosures have to be made to
the Company within 90 days of the new law coming into force. The Company would
then have to make disclosures to the Registrar within 30 days of receipt of
such disclosures.

 

There is a one time requirement of making
disclosures and thereafter, disclosures have to be made for changes as well as
for acquisition by new acquirers.

 

Applicable to which companies?

The new provisions are applicable to all
types of companies, small or big, public or private. The Rules make exceptions
for shareholdings of certain SEBI regulated entities. Clearly, then, lakhs of
companies will have to examine whether these new requirements apply to them.

 

Do only significant beneficial owners who
are not legal owners have to make disclosures?

Section 89 requires disclosure by a person
who holds shares in his name, but does not have the beneficial holding in them.
Section 90 contains no such limitation. The question then is whether a person
who holds 10% or shares legally and beneficially, would also be required to
disclose? If yes, then practically each and every company will see such
disclosures. The Rules define the term “significant beneficial owner” as a
person specified in section 90(1) who holds at least 10% beneficial holding in
shares, but “whose name is not entered in the register of members of a company
as the holder of such shares”. However, section 90 has much wider scope and,
for example, includes persons having significant influence or control. Hence,
while the Rules may have intended to specify disclosure where there are
beneficial holders who are not legal holders, the wording does not seem to be
clear enough.

 

Disclosure by institutional shareholders

Though the language is not wholly clear, it
appears that shareholders who are pooled investments funds (regulated under the
SEBI Act), such as the following, do not have to make disclosures under these
provisions:

 

1.  Mutual Funds

2.  Alternative Investment Funds

3.  Real Estate Investment Trusts

4.  Infrastructure Investment Trust

 

Obligation on company to inquire
into/report

Obligation has also been placed on the
Company to require persons to make disclosures if it has reason to believe that
such persons are covered by these provisions. If such persons still do not make
a disclosure, the Company has to refer the matter to the National Company Law
Tribunal for directions that may include restrictions over such shares.

 

Implications for non-disclosures/false
disclosures

If the persons who are obligated to make
disclosures – i.e., the significant beneficial owner and the company – do not
make the prescribed disclosures, they will be subject to fines. False
disclosures may result in prosecution that can be stringent.

 

Benami transactions

The provisions will surely apply to
legitimate significant beneficial owners. There may be persons who have reason
to hold shares through companies, trusts, etc. or through other complex
structures. However, they could also apply even to persons holding shares
benami as specified in the Benami Transactions Prohibition Act, if the
requirements of that Act are attracted. Disclosure by such persons may result
in very stringent consequences under that Act.

 

Conclusion

There are several other laws that already
require disclosure of those persons who are the ‘real’ owners/controllers of a
company. The object of each of these laws may be different ranging from
prevention of money laundering, to protection of shareholders, to preventing
tax evasion/corruption, etc. Some such as the Takeover Regulations are
fairly elaborate and while they are complex, the specific nature of provisions
leaves lesser aspects to uncertainty. In other cases, the requirements broadly
describe what is to be ascertained in general terms and then give detailed
clarifications which generally help cover a large variety of situations. The
newly introduced provisions in the Act/Rules make certain well meaning and
significant requirements. However, there are ambiguities in several places that
raise concerns whether the objective would be achieved at all. In many cases,
the provisions may be simple to apply and persons may even err on the side of
caution (even though the disclosures carry the risk of inviting inquiries).

 

There will however be several situations
where the provisions may be difficult to apply on the facts. One hopes that
clarifications/FAQs with examples of several alternative situations are given
so that there is clarity for at least the vast majority of companies.   

 

DIFFERENTIAL VOTING RIGHTS SHARES – AN INSTRUMENT WHOSE TIME HAS COME?

Differential Voting Rights
Shares (DVRS) are in the news again as SEBI has set up a committee to review
the law relating to them. It appears that SEBI may be considering removal of
some of the severe restrictions on them so as to make their issue easier. This
could bring life into this instrument that otherwise is more or less a dead
instrument due to regulatory constraints. 

 

This proposal has
surprisingly seen severe resistance even at this stage when the Committee is
merely set up. Opposition is of near paranoiac proportion. I submit that the
instrument by itself is useful and should be allowed with reasonable
conditions. It is of course not an instrument for all. It is not even anybody’s
case that this instrument will be very popular amongst corporate and/or
investors. But for many – companies, promoters and investors – it could work
well.

 

Let us first briefly
consider what DVRS are, what is broadly the current legal position, what are
the issues and opposition points and their possible answers and what could be
the way forward.

 

What
are DVRS?


DVRS are a variant of equity
shares. In other words, DVRS are equity shares. However, DVRS depart from
the usual equal-vote, equal-dividend features of ordinary equity shares.
Instead, they give differential voting and/or dividend rights. DVRS may thus
carry more – or less – voting rights than ordinary equity shares. Thus, for
example, one DVRS may carry just 1/10th voting right. 10 such DVRS would thus
carry one vote, compared to ordinary equity share which has one vote one share.
Or DVRS could carry more voting rights as for example, one DVRS having 10
votes.

 

Similarly DVRS could carry
more (or less) dividends than ordinary equity shares. DVRS could, for example,
be entitled to, say, 5% more dividends than ordinary equity shares. This helps
to compensate for lesser voting rights.Otherwise, such DVRS may carry all the
other features as ordinary equity shares. They may, for example, carry the same
rights on liquidation. There could be variants other than the normal
voting/dividends right however, this article focuses on variants of voting
rights and dividend rights only particularly in listed companies.

 

Legal provisions relating to DVRS


DVRS have always been
possible for private companies. However, flexible requirements for
public/listed companies have been a relatively recent phenomena. The provisions
relating to DVRS are contained in the Companies Act, 2013, rules made
thereunder, SEBI Regulations, circulars, etc. These have evolved over time.
Hence, the regulations are scattered and are cumbersome and time consuming.
Some features of the law can be summarised, albeit in a simplified manner.

 

Issue of DVRS would
generally require approval of shareholders by an ordinary resolution through
postal ballot. It generally would also require approval by SEBI. DVRS would
have to be offered to all shareholders proportionately – thus, DVRS would have
to be either in the form of right shares or as bonus shares. DVRS cannot be
more than 26% of the equity share capital. Existing equity shares cannot be
converted into DVRS.

 

Importantly, DVRS that have
right to a higher dividend or more voting rights than existing equity shares
cannot be issued. This restriction is obviously for protection of existing
shareholders whose rights would get diluted if new shares having more
dividends/voting rights are issued. These requirements end up being
restrictive, time consuming and even finally uncertain. This may also be one of
the major reasons why DVRS did not pick up in India and that the existing ones
are not successful. Even otherwise, the regulations for issue of DVRS are half
hearted. Most other provisions of law refer and provide for ordinary equity
shares and not DVRS. Thus, there is a legislative vacuum in respect of DVRS.
The Committee considering DVRS will thus need to recommend extensive amendments
to several laws.

 

DVRS
issued


Barely 5 companies have
issued DVRS in India. Except one, the other DVRS trade at prices that are at a
huge discount over the price of the corresponding ordinary equity shares. Tata
Motors DVRS, for example, trade at nearly 50% discount over the price of their
equity shares.

Future Enterprises Limited,
however, has its ordinary equity shares and DVRS trading at very small
differential. Part of this may be ascribed to the fact that their DVRS carry
25% less voting rights with right to 2% more dividends, as compared to ordinary
equity shares. The market liquidity of such DVRS is also generally poor.

 

Opposition
to DVRS and some possible responses


There has been severe
opposition to DVRS amongst certain circles, which is strong almost to the level
of being paranoiac/irrational. I submit that much of this opposition is
unjustified and can be refuted.

 

Much
of the fears and concerns can be dealt with if the DVRS are seen as just
another instrument whose value can be determined by informed parties using
relevant valuation models. Higher or lower dividend or voting rights would be
factored in the valuation. A company desiring to give lower voting rights can
compensate this loss by offering a lower issue price and/or with sweetener of
higher dividend rights. The point is that the market would generally take care
of the handicaps/advantages of differential rights by valuing the DVRS. Hence,
the opposition to DVRS would have to be considered in this light.

 

The core opposition to DVRS
is that it would help entrench existing management without their investing
money proportionate to their rights. Promoters and management would thus invest
lesser amount, take lesser risk and yet get higher control. This is
misconceived. Higher votes would result in higher price for such shares that
the promoters have to pay and lower price for the equity shares (DVRS) issued
to other shareholders. If investors consider the right to remove management as
very important to them, they will either pay a very low price for such shares
with lower rights or may not buy them altogether. So long as transparency is
maintained of the rights and disabilities on DVRS, the parties should be free
to work out the value amongst themselves either directly or through response to
public issue or through open markets.

 

It has been said that very
few companies have issued DVRS and these DVRS except 1 have badly performed.
The explanation for this can be several. One is educating the investors of this
instrument. Second is that the regulations themselves are complex and near
prohibitive. Finally, once again, the markets can be expected to take care of
the situation. If investors perceive that such instruments will give them
lesser return or have lower value, they will value them accordingly in the
market, as they would any other security. Banning or creating near prohibitive
conditions is not the answer.

 

Safeguards of corporate Governance and other provisions


Much has changed since the
time when the provisions relating to DVRS were introduced. We have extensive
corporate governance requirements and other new requirements that provide for
transparency and protection of various stakeholders. We have requirements
relating to a certain number of independent directors. The law provides for
extensive regulations relating to related party transactions. There are various
committees including Audit Committee, Nomination and Remuneration Committee,
etc. which look into certain issues. Shareholders earlier could rarely vote
because they could not attend general meetings physically since such meetings
were often held at remote or far off places. Postal ballot and electronic
voting has changed this situation a lot. Thus, there are many safeguards that
keep some check on majoritarian control.

 

Suggestions


As stated earlier, so long
as transparency is maintained and certain basic conditions are complied with,
DVRS should be allowed to be issued.

Rights on existing
instruments should not be changed without the approval of the holders. Take an
example. Presently a company has Rs. 10 crore of ordinary equity shares (1
crore equity shares of Rs. 10 each face value). Now, let us say the promoters
of the company hold 20 lakh ordinary equity shares of promoters. Thus, they are
entitled to 1/5th of the voting rights. If these 20 lakh ordinary equity shares
are converted into 20 lakh DVRS with each DVRS having 10 votes, the result
would be as follows. Total votes would be 280 lakh (200 lakh votes now held by
the promoters and 80 lakh votes by the others). The promoters would have 200
lakh votes which would be about 71%. Thus, their voting share jumped from 20%
to 71%. This results in loss of voting rights and thus value of the other
shareholders. This should not be permitted and the existing law does not permit
it.

 

In case of fresh issue, the
new shares should be offered to all. If it is proposed that the fresh issue is
to a special group, the issue should be transparently valued and the issue
price should not be lower than such price. SEBI could consider providing
formulae for this. The objective is that the value of existing shareholders
should not suffer because of such issue.

 

In the interim, till more
experience is gained, a cap can be placed on the number of DVRS. However,
unlike the present poorly drafted law that provides a cap on the maximum amount
of DVRS as a percentage of total capital, the cap should be on the maximum
voting rights that such DVRS carry. The cap of 26% of the capital could be
considered. The objective would be that the promoters/management, even if they
allot all the DVRS with higher voting rights to themselves, would be able to
hold only a certain maximum of voting rights through such DVRS.

 

Provisions could be made
whereby certain major decisions require approval by a higher majority. This
would give adequate say to a significant majority of shareholders. This will
help ensure that those in control with DVRS are not able to take such major
decisions that could affect the value of shareholders without their say. Like
certain preference shares, if there is no dividend paid for, say, 3 years, the
DVRS could be made entitled to voting rights.

 

Conclusion


Clearly, then, DVRS are an
instrument whose time has come. One hopes that, firstly, the Committee
wholeheartedly endorses this instrument. Further, it should propose extensive
rehaul of the various laws that deal with issue of securities and ensure that DVRS
are also provided for. They may also provide for conditions to ensure fair
play. In particular, there should be transparency and also education of
investors. Thereafter, the parties – companies, promoters and shareholders –
should be permitted to structure instruments as per their needs and desires and
at a value they mutually decide.   

 

SEBI’s proposal to regulate Algo/Hi frequency trades

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Background
The Securities and Exchange Board of India has put up a discussion paper on 5th August 2016 for regulating algorithmic trading, hi-frequency trading, co-location and some related matters. It has described the background of the subject, highlighted the issues and has invited comments from the public, on certain measures for regulating such matters.

This has resulted in a vigorous debate in media, amongst stock brokers/investors and the public. There have been some views that SEBI should not regulate such matters at all since, amongst others, this creates hurdles in the development of technology . The suggested methods have also been critically analysed. On other hand, there have been other views that SEBI should indeed regulate such matters on ground such that some parties obtain  certain special and unfair advantages through such trading. There are also concerns that these are being abused in a manner that the public and perhaps even SEBI does not realize such abuse, considering the sheer complexity involved.

Algo trading has increased exponentially. Indeed, the volumes are so large that just two figures should highlight it. As per SEBI, 80% of all orders and 40% of all trades are now generated through computer algorithms.

However, algo/hi-frequency trading have a dark side too. There has been a history in the United States of it being abused by certain traders to make huge profits at the cost of investors. There has been a huge debate over this in India too when SEBI is said to be investigating the alleged role of National Stock Exchange in a similar context.

Algorithmic/hi-frequency trading (“Algo trading”) is also said to have resulted in market crises (notable amongst these is the so-called Flash Crash of 2010 in the USA).

On other hand, there are obvious advantages of Algo trading including that of higher liquidity, lower spreads, etc.

These types of trades are also not understood well by investors and the public generally. Hence, the recent SEBI consultation paper can be a good opportunity to consider the background of the subject and some related matters.

Some concepts
Algo trading is conceptually simple to understand though, in practice, the manner in which such trades are carried out can be quite complex. The SEBI paper has explained some basic terms that are worth a review. This will also help one understand the various measures suggested by SEBI for regulating them.

Algorithmic Trading
The paper describes it as – “Algorithmic trading (for brevity, Algo), in simple words, is a step-by-step instruction for trading actions taken by computers (automated systems). Typically, trading algorithms enable the traders to automate the process of taking trading decisions based on the preset rules / strategies.”.

To put it simply, in Algo trading, the process of placing trades is automated using computers. Software is developed incorporating detailed instructions when to buy/sell, etc. and it monitors market data and places trades accordingly. There is nil or minimal human intervention. There are several advantages. The first, obviously, is very high speed. The time taken by a human operator to press a few keys is in computing time astronomically higher than the time the algo trading software takes to place/execute the order. Secondly, in case of repetitive situations, where the decision making follows standard parameters, it does not make sense using human intermediaries. Further, this also enables traders to carry out large trades usually at microscopic margins.

Hi-frequency trading (HFT)
Hi-frequency trading is really a type of Algorithmic trading. Algo trading as explained earlier is software-based trading with nil or minimal human intervention. HFT involves carrying out of extremely fast trades in very small fraction of seconds often taking advantage of the edge in information over others. The paper explains HFT as:-

“High Frequency Trading (HFT) is a subset of algorithmic trading that comprises latency-sensitive trading strategies and deploys technology including high speed networks, colocation, etc. to connect and trade on the trading platform. The growth and success of the high frequency trading (latency sensitive version of algorithmic trading) is largely attributed to their ability to react to trading opportunities that may last only for a very small fraction of a second.”

Co-location
Co-location (“Colo”) is considered to be a contentious issue. It basically means providing stock market intermediaries/hi-frequency traders’ servers a physical location that is very near stock market servers. Often, the servers are in the same building that the servers of the exchange are located in. Physical nearness to the exchange servers that receive and process trade data is critical since nearer the physical location to such servers, the faster can a intermediary/hi-frequency trader can receive and send back data. And thus act and profit on it, particularly if one is a hi-frequency trader.

High order-to-trade ratio
This means that the ratio of orders placed over actual trades executed is very high. The rest of orders are cancelled. This again is a common feature of HFT.

Issues faced
SEBI has identified the following issues that arise out of Algo trading and related aspects:-

(i) Unfair access or denial of faster access to persons not having co-location facility. To take a simple example, a person from New Delhi is physically quite far from the stock exchange servers in Mumbai and thus suffers a time disadvantage (even if of fraction of seconds) as compared to a person in Mumbai.

(ii) There is more price volatility.

(iii) HFT imposes costs on other market users

(iv) Algo trading results in a technological arms race.

(v) In times of high volatility, SEBI would get limited opportunities to intervene etc.

Solutions suggested by SEBI
SEBI has placed for discussion certain solutions. These are explained below with their advantages/disadvantages  including experience in regard to these solutions in other countries.

(i) Minimum resting time for orders:- Under this method, each order is not allowed to be modified/cancelled till a minimum resting time elapses. This will ensure that the order will be available for some time for execution and thus fleeting orders would be reduced. It is interesting to note that the resting time proposed is 500 milliseconds (1 second = 1000 milliseconds). Thus, this would affect only those parties whose orders undergo change in fractions of seconds.

(ii) Frequent batch auctions:- Orders for a specified period of time of 100 milliseconds will be grouped together and matched, instead of the continuous order matching mechanism. Thus, the advantage of time that a person may have over others owing to co-location, better technological equipment, etc. would be neutralised to an extent.

(iii) Random speed bumps:- This involves delaying orders randomly by a few milliseconds. The result is that this neutralises to some extent the speed advantages.

(iv) Randomization of orders received during a specified period of say 1-2 seconds:- Thus, the orders received during this period would be shuffled randomly and their time sequence altered. All orders within a specified period would have an equal chance and once again the speed advantage is neutralised.

(v) Maximum order to trade ratio:- This will ensure lesser fleeting orders and also that orders are entered into the system with a greater opportunity of their being converted into trades.

(vi) Separate queues for co-location and non-co-location orders:- One order from each queue would be taken alternatingly. Once again, the objective of neutralising speed advantage may be achieved to an extent.

(vii) Providing tick-by-tick feeds to all market participants:- Tick-by-tick data feed, as SEBI describes, “provides details relating to orders (addition+ modification + cancellation) and trades on a real-time basis”. This data is provided by exchanges for a fee. SEBI has suggested that data of top 20/30/50 bids/asks, market depth, etc. be provided to all. This would create a level playing field to all participants irrespective of their technological or financial strength.

Consideration of solutions
The opposition to regulating Algo trading is on various grounds. The first, of course, is that SEBI would be putting hurdles to technological developments and this would not be a wise thing to do. Further, each of the methods suggested create their own inequities. There would also be software and other changes required to provide for such solutions. There would need to be regulatory check to ensure that these solutions are in place. Interfering with such trading would also result in higher ask-put price differences, lower liquidity, etc. Some of the solutions offered, as SEBI itself points out in the paper, have been rejected in some places where they were originally proposed or adopted.

Having said that, there are abuses that need to be considered. While SEBI has already mandated fair, transparent and equitable rules in granting nearness to exchange servers, there have been concerns about this in one way or the other. Further, the sheer complexity of algo trading may result in a group of insiders abusing it to their advantage by prior arrangement particularly if the exchange or its staff plays truant. Thus, the measures suggested may, even if indirectly, help control such abuses. Further, SEBI may also need to regulate such trading to prevent such abuses.

Abuse of hi-frequency trading
Serious abuses have been pointed out from HFT arising out nexus between HFT traders on one hand, and brokers/exchanges on the other. Through a complicated mechanism including giving preferential treatment to HFT traders, it has been found internationally (and allegedly in India too to an extent) that HFT traders hugely profited at the cost of investors. By monitoring quotes on multiple stock exchanges, they came to know in advance impending orders. Effectively, they thus bought (or sold) cheap and sold high (or low) to investors who were not only slower but were also duped by alleged unfair underlying understanding. This has been described in lucid detail in the bestselling book Flashboys by Michael Lewis.

In India too, there is a shadow of this. A whistle blower wrote to SEBI and Moneylife (a financial magazine) about alleged irregularities by National Stock Exchange. It appears that SEBI is looking into this matter.

Thus, abuse of HFT trading can be a serious issue. The HFT traders, as described in the book Flashboys, do not profit in large amounts per trade. Their skimming is small amounts. But on a cumulative basis, they would make large amount of profits. There is a cascading effect of this. Investors end up paying higher price. In turn, this raises the cost of capital for companies seeking to raise capital from the markets. Generally, this would harm the crediblity of markets too.

Conclusion
In the author’s view, SEBI is wrong in proposing measures to slow down the speed of trades/data exchange. This would be restraining developments in technology. Indeed, it is submitted, this is not the real issue at all. The real issue is alleged inequitable access to speedy information and alleged abuse of algo trading through irregular means. For this purpose, SEBI would have to understand and keep pace with the technical developments in algo trading and closely monitor such trading and provide for mechanism to monitor trades and uncover abuses. While the existing Regulations of SEBI relating to frauds and unfair trade practices are general and perhaps broad enough to cover such abuses, SEBI may consider providing for certain matters specifically, describe them in detail and provide for punishment.

Withdrawal of Open offer – lessons from Supreme Court/SAT/SEBI decisions

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Background
What happens when an open offer is made under the SEBI Takeover Regulations and thereafter the offerer, for some reason, changes his mind? Should he be allowed to withdraw his offer? If yes, under what circumstances? Can it be a unilateral withdrawal at his discretion or should it be under certain conditions only? Or should he be required to take approval of SEBI? Should SEBI have wide powers – and hence duty – to allow such withdrawal? What is the criteria SEBI should follow for permitting such withdrawal?

The stakes involved in such a case are large. For example there is a listed company whose market capitalisation is Rs. 1000 crore. The market price of its share is Rs. 100. An offerer believes that the shares are under priced and decides to acquire control and makes an open offer at Rs.150 per share. However, sometime later, for reasons such as new information coming to light, fresh developments or even change of mind, he wants to withdraw the open offer. However, the offer would have had consequences on the market. There may be persons who would have bought shares from the market at higher price. The Company would have faced restrictions in carrying out certain activities during the offer period under the Regulations. Further, withdrawal without regulation may make the whole process frivolous since offerers may make offers, disrupt the company and the market, perhaps profit from such disruption and then withdraw. Open offers thus may lose sanctity. At the same time, an absolute bar from withdrawal may result in heavy costs for the offerer even where there were genuine reasons for withdrawal. In the example, the offerer would have to pay about Rs. 390 crore to acquire the 26% from the shareholders. The offerer would thus be stuck with a huge lot of shares, whose value may have diluted for reasons beyond his control and perhaps not gain control of the company too.

Considering the huge stakes involved and also considering that this issue could often arise, the matter has been subject matter of serious litigation. The matter has twice reached the Supreme Court and litigated before the Securities Appellate Tribunal. Recently, once again, SEBI has passed an order (dated August 1, 2016 in respect of open offer for Jyoti Limited) which is under the latest SEBI (SAST) Regulations 2011 (“the Takeover Regulations”). Curiously, in each of these cases, the application to withdraw the open offer was rejected, but for differing reasons/facts. Study of these issues has importance for persons acquiring large stakes in companies to know whether and when they may be allowed to withdraw. They would carefully need to structure and prepare for their transactions since an inadvertent lapse may result into an irreversible open offer and huge losses. At the same time, the Regulations, which have been drafted in the interests of investors, are such that open offer is triggered off at a very early stage.

This issue is also relevant because the relevant provisions for withdrawal have been tweaked in the 2011 Takeover Regulations as compared to the 1997 Regulations. While these changes have not affected the outcome in each of these matters, they are relevant to future open offers.

Provisions of the Regulations for withdrawal of open offer Regulation 23(1) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, deals with withdrawal of open offer. Regulation 23(1) provides 3 specific reasons and one general/residuary one under which an open offer can be withdrawn. Amongst the specific reasons, the first permits withdrawal where statutory approvals required for the open offer/acquisitions have not been received, provided due disclosures were made. The second reason permits withdrawal where the offerer, a natural person, has died. The third sub-clause provides for a situation where the agreement to acquire shares contained a condition that the acquirer/offerer could not meet for reasons beyond his reasonable control and provided that conditions were disclosed in advance, and that lead to rescinding of the agreement, withdrawal of offer is allowed.

Finally, there is the general/residuary ground, which is also the ground under which litigation has arisen. SEBI has discretion to grant withdrawal pursuant to “such circumstances as in the opinion of the Board, merit withdrawal.”. The question is whether this means there has to be an impossibility, taking color from the previous three grounds, as contended by SEBI? Or whether withdrawal can be permitted on other grounds such as the offer becoming uneconomical or other reasons, as contended by offerers? On this aspect, the law under the 1997 Regulations, on which preceding decisions have been rendered, is the same as under the 2011 Regulations on which the latest decision of SEBI has been rendered.

Decisions of the Supreme Court
The Supreme Court has on two occasions to dealt with this issue. In Nirma Industries Limited vs. SEBI (2013] 121 SCL 149 (SC) (“Nirma”), the offerer, a lender company, had lent monies to certain promoter entities of a listed company against pledge of shares of such listed company. On default, it exercised the pledge and thus acquired the shares which in turn resulted in obligation to make an open offer. However, it was claimed that later investigation brought to light that the Promoters of such listed company had allegedly siphoned off huge amount of funds, there were undisclosed liabilities, etc. and, thus, the value of the shares suffered in value. Yet, the lender was now stuck with the open offer at a price being as per the formula under the Regulations. Obviously, this would result in huge losses to the lender. It approached SEBI seeking withdrawal. SEBI rejected such application. Finally, the issue came before the Supreme Court. The core issue was whether the power of SEBI to grant withdrawal under the residuary clause was wide. Thus, whether it could allow withdrawal under varying circumstances at its discretion? Or whether it had very narrow powers, limited, on principles of ejusdem generis, to the nature of circumstances under the first three clauses under which withdrawal was permitted? In essence, thus, the issue was, whether power of SEBI to grant withdrawal was only if the offer was impossible to be proceeded with? The Supreme Court considered the facts of the case and the nature, scheme and purpose of the Regulations and held that SEBI could grant withdrawal only if there was impossibility in proceeding with the open offer. In the case before it, the offerer could still go ahead with the open offer and it has not become impossible merely because of changed circumstances.

The Court thus concluded that “Therefore, the term such circumstances in clause (d) would also be restricted to situation which would make it impossible for the acquirer to perform the public offer. The discretion has been left to the Board”. Merely because the offerer may suffer losses does not make the offer impossible to make or to be proceeded with. In the words of the Hon’ble Supreme Court, “The possibility that the acquirer would end-up making loses instead of generating a huge profit would not bring the situation within the realm of impossibility.” Thus, the plea of the lender/offerer was rejected.

The Supreme Court had soon thereafter again to deal with a similar matter. In SEBI vs. Akshya Infrastructure (P.) Ltd. (126 SCL 125 (SC)(2014))(“Akshya”) too, the question was whether, if the open offer becomes uneconomical owing to changed circumstances (curiously, this was allegedly owing to huge delay by SEBI in approving the open offer document), should it be allowed to be withdrawn? The Court followed Nirma and observed that:-

“This impossibility envisioned under the aforesaid regulation would not include a contingency where voluntary open offer once made can be permitted to be withdrawn on the ground that it has now become economically unviable.”.

The Court also explained the rationale of this conclusion as follows:

“Accepting such a submission, would give a field day to unscrupulous elements in the securities market to make Public Announcement for acquiring shares in the Target Company, knowing perfectly well that they can pull out when the prices of the shares have been inflated, due to the public offer.”

Decision of SAT
A similar issue was agitated in case of an open offer for shares of Golden Tobacco Limited (“GTL”) (in Pramod Jain vs. SEBI [2014] 48 taxmann.com 226 (SAT – Mumbai)). Here too, an open offer was made to acquire shares at a certain point of time. However, during the intervening time (which again included a huge delay allegedly caused by time taken by SEBI in approving the offer document), the offerer alleged that owing to acts by the Promoters of GTL, the shares of the Company lost hugely in value. The offerer thus sought to withdraw the open offer. Following and applying Nirma and Akshaya, the SAT, in a majority decision, refused to allow the offer to be withdrawn since there was no impossibility in proceeding with the offer.

Decision in case of open offer for shares of Jyoti Limited. In this latest case, SEBI had occasion to consider a peculiar case though with underlying similar issues. The offerer had made an open offer to acquire 75% of the shares and thus control of the listed company at a price of Rs. 63 per share. However, it came to light that the Company was a sick industrial company, having lost its net worth. The BIFR ordered status quo on operations/controlling stake and change in control of the Company was prohibited in the interim. Appeal of the offerer against such order of BIFR was dismissed by the Appellate Authority for Industrial and Financial Reconstruction. The question was whether, since the open offer could not be proceeded with, this was a fit case for permitting withdrawal of open offer. SEBI noted that the BIFR had not prohibited the open offer, but had merely given a stay to it, pending final decision. It was thus possible for the offerer to proceed with the open offer post such decision. In other words, the pre-condition of impossibility did not exist. Hence, applying Nirma and Akshaya, SEBI rejected the application of the offerer to withdraw the open offer.

Conclusion
It would be a rare case, thus, that an open offer would be allowed to be withdrawn. The offerer will have to demonstrate that either one of the three specific circumstances as laid down in Regulation 23(1) existed or there should be some other impossibility in proceeding with an open offer. If something happens in between, even if caused by SEBI’s delay or actions by the Company/its Promoters, or other unavoidable circumstances, so long as it is possible to proceed with the open offer, SEBI will not allow withdrawal. As explained earlier, the Regulations have sensitive triggers for the open offer to arise and once a trigger is set off, it is more or less irreversible. The offerer would thus have to proceed warily and with adequate planning to ensure that (i) either the open offer does not arise (ii) if it does arise, he is prepared to proceed through it till completion, whatever arises in between. Apart from difficulties in negotiated takeovers, this can make hostile open offers near-infeasible. Even in negotiated cases, often owing to delayed processing by SEBI, disputes in the interim with the Company/Promoters, changed circumstances, etc. could create problems. Nevertheless, there is an underlying sensible principle involved here. Offerers should not be given a broad leeway that offers can be made and withdrawn at their discretion. This would, inter alia, play havoc with markets and harm interests of investors.

Disgorgement of profits – profits made in violati on of SEBI directions vs. profits made in violation of law

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SEBI has passed an order dated 16 June 2016 in the case of Beejay Investment & Financial Consultants Private Limited and others that has interesting implications. SEBI now has power to forfeit profits made through illegitimate transactions in securities markets. Generally, SEBI directs that such illegitimate profits made by parties through price manipulation, insider trading, etc. should be forfeited.

In the present case, however, there is an interesting twist. To put it simply , in this case, the profits were made in the ordinary course of business. Hence, the profit made can be said to be legitimate. However, the transactions were carried on during a time when SEBI had debarred the parties from carrying on such transactions. SEBI ordered forfeiture of such profits.

Background of case
The rationale behind forfeiting (i.e., disgorging) of illegitimate profits needs discussion. SEBI often finds manipulations and other illegalities in the securities market. Profits made are illegitimate or losses are avoided. Such profits are usually made at the cost of persons such as investing public, the company, etc. The credibility of markets also suffers. SEBI has considerable powers to penalise and prosecute such persons. It also has powers to issue directions such as ordering such persons not to access the capital markets, not to trade in such markets, suspend/cancel registration of intermediaries, etc. The monetary penalty can be a multiple of such profits.

However, a question arises about the profits made by such persons through such wrong doings. Clearly, allowing them to retain such profits would be allowing them to keep the rewards of their wrongful acts. Thus, irrespective of other actions taken, it is in fitness of things that such profits are taken away from the wrong doers. Such forfeiture is called disgorgement. At one time, there were two views whether SEBI had power to disgorge such profits. However, a recent amendment has clarified that SEBI has and did have the power to disgorge profits and issue directions restricting their operations.

For example, a person may buy shares of a company at a low price, manipulate the share price of the company by various means to a higher level, and then sell the shares to unsuspecting investor. Such profits are clearly illegitimate. SEBI thus requires power to disgorge these profits. This is of course apart from other adverse action SEBI would take. For example, one such other adverse action is debarring such a person from dealing in securities markets for a specified period.

If a person, who has been so directed not to deal in securities for a specified period, yet violates it and deals in securities, there are obviously consequences under law. Such a person can be, as will be seen, penalised under law and even prosecuted.

However, there can be an interesting situation. A person has been held to have carried out price manipulation in the capital market. He has then been directed not to deal in the capital market for a specified period of time. He yet carries out such dealings by buying and selling shares. The dealings are, however, in the ordinary course of business and no manipulation is alleged or even suspected. In such a case, still, there is violation of SEBI’s directions. The issue is whether profits made out of such trades be disgorged? Even if the person has not committed any violation while carrying out such trades?

Facts of the case
In this case, SEBI had passed orders against certain persons whereby it had “prohibited them from buying, selling or dealing in the securities market, directly or indirectly.”. While such directions were in force, such parties allegedly dealt in shares in the securities markets indirectly and earned profit of nearly Rs. 19 crore. SEBI alleged that these parties carried out such trades by transferring funds to other parties to enable them to carry out trades and earn / make profits.

However, in dealings carried out during this prohibition period, SEBI had not alleged, nor even suspected that such persons had carried out any price manipulation or committed any other wrong act. Since the dealings were carried out despite of such prohibitions, SEBI passed an order impounding such profit and levying interest of Rs. 8.45 crore, viz., in all seeking payment of Rs. 27.44 crore. To give effect to such impounding, it asked such parties to deposit the amount in an escrow account with a lien in favor of SEBI. Till the amount was deposited, SEBI directed that they shall not alienate any of their assets. Their bank/demat accounts were frozen, in the sense that the banks/depositories were ordered not to allow debits except for purposes of creation of the escrow account. They were also directed to submit a list of their assets to SEBI presumably so that SEBI can keep track of their assets and perhaps freeze them too.

This order is an interim and ex-parte order pending completion of investigation after which SEBI may pass final orders for disgorgement of such profits. If the finding of such investigation is that the allegations are true, then the profits would be disgorged and interest will be charged i.e., effectively forfeiting the gain made through a third party.

The question thus to be examined is whether SEBI can in law can pass such orders forfeiting profits made through legitimate deals, albeit in violation of orders not to deal in securities.

Are prohibitory orders preventive or penal?
In this context, it would be relevant to examine whether prohibitory orders are preventive or penal. A person is found to have committed price manipulation in capital markets. He should obviously be punished. However, it may also be in the interest of market that such person be prevented from carrying out trades. Thus, the order prohibiting him from dealing may be prevention, though in practice it works as a penalty / punishment.

The distinction is important because a penal order requires specific powers. A similar question arose before the Supreme Court in SEBI vs. Ajay Agarwal ((2010) 3 SCC 765) albeit in the context of whether power to issue such directions given by an amendment can have a retrospective effect. If it was a penal power, then obviously SEBI could not have issued preventive directions. However, the Court held that it was not a penal power.

The relevance here is that if the parties were issued prohibitory directions not to trade as a preventive measure to avoid repetitive manipulation. That does not make the wrong of disobeying such directions right, but at least the spirit of the original direction was not seriously violated since there was no manipulation that the direction intended to prevent.

Can and should such profits be disgorged?
Having considered the above, the question is whether SEBI can order disgorgement in such a situation and whether it should order such disgorgement? In the first instance, the question is whether SEBI has powers in law to order such disgorgement. In the second instance, the question is whether it would be right to do so.

Can SEBI order such disgorgement?
As mentioned earlier, the power of SEBI to disgorge profits made in violation of the law was contentious. The SEBI Act, 1992, however, was amended in 2014 by way of adding an Explanation. This Explanation to section 11B of the SEBI Act clarifies that SEBI has power to order disgorgement of “wrongful gains” (or loss averted) made “by indulging in any transaction or activity in contravention of the provisions of this Act or regulations made thereunder”. Thus, it can be seen that the requirements for disgorging profits are as follows:-

a. There have to be wrongful gains.

b. Such gains should be by indulging in any transaction or activity.

c. Such transaction or activity should be in contravention of the provision of the Act or Regulations made thereunder.

Thus, there have to be specific provisions in the Act/ Regulations and the profits made should be arising out of transactions/activity in contravention of such provisions. For example, the SEBI Prohibition of Insider Trading Regulations prohibit dealing in shares by insiders while in possession of unpublished price sensitive information. If a person still carries out such insider trading, such trading would be in contravention of the Regulations. Such profits are thus liable for disgorgement.

However, what if, as in the present case, the profits are made in violation of the directions of SEBI and not directly in violation of the Act/Regulations? Can SEBI thus disgorge profits made in violation of its directions? On one hand, it is arguable that provisions granting powers to disgorge money should be interpreted strictly. Thus, if the law does not expressly provide for forfeiture of profits made in violation of directions, such forfeiture cannot be made. On other hand, the question may be whether the law could be purposively and broadly interpreted. Thus, if powers to give such directions are given under the Act, then violation can of such directions be treated as violation of the Act?

It is also noteworthy that SEBI does have power to levy penalty where any person does not comply with directions of SEBI. Section 15HB provides for a penalty of upto Rs. 1 crore on persons “fails to comply with any provision of this Act, the rules or the regulations made or directions issued by the Board”.

Should SEBI disgorge such profits?
Whether SEBI should disgorge such profits is an interesting question! Needless to clarify, this is not to say that what is right is necessarily legal. However, it is seen that a person who violates directions not to trade can suffer a penalty of a maximum amount of Rs. 1 crore. He can also be prosecuted. However, in the meantime, as is alleged in the present case, he could make a profit of several times the maximum penalty leviable. Thus, it is submitted that SEBI should have power to disgorge such profits or, alternatively, levy a penalty that is related to the profits made. Such power to levy penalty that is related to the profits already exists in cases where there is price manipulation, insider trading, etc.

Conclusion
One looks forward to the final order in this case. The issues, as explained earlier, are not just of law but also of power of SEBI to effectively prevent blatant disregard of its directions. Hopefully, if SEBI does order disgorgement, it will give detailed reasoning and legal basis for disgorgement.

SEBI Order Now Enables Investors To Recover Losses From Fraudsters In The Securities Markets

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Can the Securities and Exchange Board of India make a fraudster or other wrong doer in the securities markets compensate the wronged persons? The answer, generally, is that SEBI cannot do so. This question is important because the parties are normally required to approach other forums which could include courts, Consumer Protection Forums, etc. However, a recent order of SEBI, following an order by the Securities Appellate Tribunal, has opened the door to this aspect to a little extent. This order is significant for several reasons. SEBI is an expert body in the securities markets with fairly broad powers. It has a huge infrastructure at its command to investigate, adjudicate and punish. The groundwork for determining whether a person has committed such a fraud, etc. would be laid down by SEBI through such orders. SEBI also has, as we will see later, the powers to disgorge gains made by wrongdoers. In some cases, such as in the alleged scams in initial public offerings, SEBI even went the extra mile and made arrangements for distribution of these illegal gains to those at whose cost such gains were made. The next logical step ought be to allow such things on a general basis and perhaps even allow persons who have suffered losses to approach SEBI.

However, this has not happened mainly because of certain inherent limitations on SEBI under the law. SEBI is not an adjudicator of disputes. It would surely punish fraudsters. It may debar them from markets. It may make them pay penalty, though such penalty goes in government coffers and not to help those who lost monies. It may prosecute such persons too. It also orders parties who have illegally collected monies to refund them , with interest. However, an aggrieved person could not approach SEBI and require it to make a wrongdoer compensate the loss he had suffered. Indeed, till recently, it was a little uncertain whether SEBI had powers even to disgorge illegitimate gains. A clarificatory amendment was however made in 2014 to explicitly give such powers to SEBI.

However, compensating loss caused by fraudsters continued to remain out of SEBI’s legal powers. The investors were thus forced to approach the long drawn procedures in courts. An investor may get some satisfaction when such fraudsters are punished, but he still would remain short of his hard earned monies. However, thanks to persistent efforts of an investor who lost money to a company and its Promoters through fraud, there is a glimmer of hope that SEBI may be required to do broader justice in such matters. By a recent decision of SEBI, which indeed was following the directions of the Securities Appellate Tribunal (“SAT “), SEBI has acknowledged such responsibility. A final order is awaited, since calculation of ill-gotten monies is in progress. While it would be interesting to see the legal reasoning SEBI provides for passing such final order and also see its fate in appeals, if any, it would be worth to consider this decision.

SEBI’s decision

The decision was in case of the applicants Harishchandra and Ramkishori Gupta (“the Applicants”) in the matter of Vital Communications Limited (“Vital”)(SEBI Order dated 1st April 2016).

To summarise from the facts as narrated in the Order, Vital, a listed company, had made a preferential issue of equity shares to certain parties. SEBI found that a significant portion of the funding for such preferential issue was made by Vital itself. Many of the preferential allottees were also found to be connected to Vital/its Promoters. Thereafter, a spate of catchy advertisements were issued of proposed buyback of shares at a high price, preferential issue at even higher price, and for issue bonus shares. None of this actually took place in the manner described in the advertisements.However, along with such advertisements, certain preferential allottees sold a substantial quantity of shares. Effectively thus, the advertisements helped the parties to sell equity shares at a high price to unsuspecting investors. Since the ruling price then was much lower than the price that could be expected if the promises as per the advertisements had actually been carried out, investors rushed in and bought the shares. SEBI investigated and uncovered the facts and took action against the parties by debarring them, etc.

However, this left the investors with losses. The Applicants approached SEBI praying that their losses should be compensated. SEBI refused to do claiming that it had no powers under SEBI Act to order the company and/or its directors to compensate the Applicants. The Applicants filed an appeal to the SAT. SAT ordered that if SEBI found Vital guilty of fraud, “…it may consider directing the concerned entity or Vital to refund the actual amount spent by the applicants on purchasing the shares in question and with appropriate interest”.

SEBI undertook final investigation and did find wrongdoing and fraud. SEBI passed various directions against the parties. However, still, it did not pass orders providing for compensation to the investors who were duped into making investments. The Applicants once again appealed to SAT . SAT once again passed an order asking SEBI to do the needful. SEBI then passed an order that it will look into quantification of ill gotten gains and thereafter pass orders for disgorgement and restitution. It then thus finally gave a proper hearing to the Applicants on the issue of compensation. However, on review, SEBI found that its own orders/investigation had not made a proper calculation of the ill gotten gains by the Company/ Promoters. Accordingly, finally SEBI undertook vide this recent and latest order to determine the amount of ill gotten gains to take the matter to its next and final step of ordering such parties to return (i.e., effectively compensate) the gains made to the Applicants, who suffered losses. Interestingly, while the original fraudulent advertisement & sale of shares took place in 2002, it is only in 2016, after several petitions and appeals by the Applicants that SEBI has initiated action. It will still be some time before the amount of ill gotten gains would be calculated, then hopefully recovered from the parties and paid to the Applicants who have suffered losses.

Disgorgement – a history of uncertainties

Disgorgement, simply stated, is taking away ill-gotten gains from the wrong doer. A person may, for example, make gains from insider trading in violation of the applicable Regulations. SEBI may order such person to disgorge such gains and pay them over to SEBI. Till very recently, whether SEBI could, in law, order disgorgement was debated. However, the SEBI Act was amended vide the SEBI (Amendment) Act, 2014, with effect from 18th July 2013, specifically giving it power to disgorge gains made in violation of specified provisions of law. However, even these amendments expressly permit only disgorgement. The objective is only to ensure that the wrong doers do not keep their ill gotten gains. They do not specifically expressly provide for payment of these disgorged amounts to those who were at the losing end (though SEBI has passed some orders of such type). Further, it was still unclear law whether an investor can initiate such action. Now, this order creates a precedent that SEBI can undertake such exercise of disgorging such ill-gotten gains and then reimburse them to those whom they belonged.

Limitations

An important distinction to be made here is that this case is no precedent for investors being able to approach SEBI to get general disputes resolved and get the whole of their losses recovered. It only means that SEBI will disgorge gains made from acts/omissions in violation of specified securities laws. And that only such gains will go back to the hands of investors. The investors may have suffered a higher loss, but if its flow cannot be traced to the pockets of such wrong doers, then there may be nothing to recover to that extent. Thus, the investor may not get the whole of their losses compensated.

In any case, if SEBI cannot recover such monies as for example when the fraudsters do not have sufficient assets, the investors would still have lesser amounts to receive.

However, SEBI/SAT has ordered that interest shall also be disgorged and paid, irrespective of whether the fraudster had earned such interest or not. This, though an extension of the power of disgorgement, does give relief for the time element.

There is another type of situation where there may be fraud but the amount of gains made by the fraudster may not match with the losses of the investor. For example, a broker/adviser may give wrongful/fraudulent advice to gain commission fees. The investor may invest monies and then end up losing a large sum of money. However, disgorgement permits forfeiture of ill-gotten gains. In such a case would include only the brokerage/fees, which would be a small fraction of the loss. A purely contractual or similar dispute will not be covered. These continue to remain within the domain of civil courts, stock exchanges, etc.

Scope of disgorgement

As the amended Section 11B makes it clear, disgorgement is of all gains made from violations of SEBI Act and Regulations. Thus, gains made not just from fraud but from any violation of specified securities laws. Thus, even though the decision in this case related to a fraud, the principle would clearly extend to gains from any other violation of Securities Laws. And thus, those who suffer on account of violation of Securities Laws may get compensated.

Conclusion

A fresh, even if hesitant and incomplete, chapter has opened in the history of Securities Laws. While it is too early to draw final conclusions, investors now do have a better measure to recover their losses that is formal, speedier and effective. However, much depends on the final order, the manner in which losses are determined and recovered and also the legal reasoning SEBI adopts for such order. It will also have to be seen whether such orders are appealed against and what appellate Tribunal/ courts decide. The fact that the orders of SAT and SEBI both talk of restitution to be “considered in accordance with the provisions of the SEBI Act, 1992 …and the regulations framed thereunder” is also interesting since there could still be some legal uncertainties about the whole process

SEBI imposes restrictions on Wilful defaulters – concerns also for independent directors & auditors

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The Securities and Exchange Board of India has joined and followed the Reserve Bank of India in imposing restrictions on `wilful defaulters’ from raising monies from the public. The step is laudable. Defaults, while a necessary risk of lending/investing, are a problem enough for lenders and investors. The tedious laws relating to taking action against them aggravate these problems. However, when persons default not due to difficulties but out of deliberate defiance, law does need to go an extra mile. Naming and shaming them is of course one step. However, now, SEBI, following RBI, has imposed certain restrictions on them from raising capital from the markets.

There are, however, difficulties. The definition of `wilful defaulter’ is felt to be a little too broad. The process for labelling a borrower a `wilful defaulter’ too has raised questions. There are concerns about independent and non-executive directors as to how they will be affected, though at least on paper there is some relief. As will be seen later, such matters have gone in litigation and Court had already read down the rules to some extent. These concerns are more since labelling as `willful defaulter’ would have a cascading effect on companies where such persons may be directors. Generally, auditors too of `wilful defaulters’ would be affected since there are provisions for debarring them from being given more work, etc. if they are found at fault.

Summary of new requirements
There already exist some restrictions on `wilful defaulters’ in the SEBI Regulations. However, now, SEBI has amended its Regulations relating to raising monies by issue of securities and also taking control of companies by `wilful defaulters’.

An issuer who is a `wilful defaulter’ is debarred from making any public issue of its equity securities. This bar will also apply if any of its directors or promoters is a `wilful defaulter’. Public issue of convertible debt instruments or debt securities are also barred in such cases. Further, if it is in default of repayment of principal amount of it debt instruments/debt securities or in payment of interest thereon for more than six months, then too such bar will apply. Certain disclosures are also required in respect of the `wilful default’ where issue is by way of private placement. This will ensure that subscribers know about such past defaults.

The bar does not cover issue of equity securities on `right basis’. However, certain disclosures would have to be made to ensure that the subscribers are made aware of the fact that the issuer is a `wilful defaulter’. Further, the promoters or the promoter group cannot renounce their rights except within the promoter group.

SEBI has also debarred `wilful defaulters’ from making open offers for acquiring shares under the Takeover Regulations. They are also barred from entering into any transaction that could result into attraction of obligation of making such an open offer. However, if someone else makes an open offer, then the `wilful defaulter’ can make a competing bid by way of an open offer. The intention is apparent. `Wilful defaulters’ would thus be prevented from taking control of a listed company or consolidating their stake therein.

Definition of `wilful defaulter’
The SEBI Regulations that impose restrictions on `wilful defaulters’ define the term as follows:-

“wilful defaulter” means an issuer who is categorized as a `wilful defaulter’ by any bank or financial institution or consortium thereof, in accordance with the guidelines on `wilful defaulters’ issued by the Reserve Bank of India and includes an issuer whose director or promoter is categorized as such.”

Thus, SEBI will effectively follow lead of the Reserve Bank  of India. Hence, if a person is categorized as a `wilful defaulter’ by the banks/financial institutions in accordance with the guidelines of RBI, he would also become a `willful defaulter’ for the purposes of SEBI Regulations. Promoter or director of a wilful defaulter would also be categorized a `wilful defaulter’. 

The Master Circular of the Reserve Bank of India on `Wilful Defaulters’ dated 1st July 2014 has defined `wilful default’ as follows:-

“A “wilful default” would be deemed to have occurred if any of the following events is noted:-

(a) The unit has defaulted in meeting its payment / repayment obligations to the lender even when it has the capacity to honour the said obligations.

(b) The unit has defaulted in meeting its payment / repayment obligations to the lender and has not utilised the finance from the lender for the specific purposes for which finance was availed of but has diverted the funds for other purposes.

(c) The unit has defaulted in meeting its payment / repayment obligations to the lender and has siphoned off the funds so that the funds have not been utilised for the specific purpose for which finance was availed of, nor are the funds available with the unit in the form of other assets.

d) The unit has defaulted in meeting its payment / repayment obligations to the lender and has also disposed off or removed the movable fixed assets or immovable property given by him or it for the purpose of securing a term loan without the knowledge of the bank/lender.

There are some points that can be observed from the above definition. For a person to be held to be a wilful defaulter, he needs to have made a default in meeting his payment/repayment obligations to the lender. This is a primary and obvious pre-condition. Such a defaulter would thus become a `wilful defaulter’ if he is found to have done one or more additional wrongs. For example, he may have capacity to honor his obligations and yet he defaults. He may have not utilised the finance for the specific purpose for which it was raised but diverted the funds for other purposes, or he has siphoned off the funds and such funds are not available with the unit in the form of other assets. Finally, he has disposed of or removed assets given as security without the knowledge of the lender.

The term diversion or siphoning of funds has been elaborated further and the meaning seems to go not just beyond the ordinary meaning but also to a situation where there can be serious difficulties. For example, “transferring borrowed funds to the subsidiaries / Group companies or other corporates by whatever modalities;” is also deemed to be diversion/siphoning. Now it is of course true that funds are often siphoned off through the subsidiary/group companies route. However, bonafide investments are also needed to be made through such entities. Deeming such investments in hindsight to be siphoning off can be harsh. A similar difficulty arises in respect of another category of deemed siphoning which reads “investment in other companies by way of acquiring equities / debt instruments without approval of lenders”. One trusts that these words are read in context of the original definition and that such deeming would apply only if such investments were in violation of the specific terms on which the finance was given.

Where Independent Directors/Nonexecutive directors are declared as `wilful defaulters’
The SEBI Regulations specifically provide that a person is declared as a `wilful defaulter’, then the companies where he is a director or a promoter would also be deemed to be a `wilful defaulter’. This is irrespective whether the director is a non-executive director or an independent director. This thus would have a wider effect. However, fortunately, this deeming is not the other way round too. If a company is held to be a `wilful defaulter’, its directors are not automatically deemed to be `wilful defaulters’.

As regards independent/non-executive directors, the RBI’s Master Circular does require that the principles for determining whether such a person is a `officer in default’ under the Companies Act, 2013 would be applied here. Thus, unless such an independent/non-executive director can be so held, he would not be considered a `wilful defaulter’.

However, once a persons is held to be a `wilful defaulter’, there is a cascading effect. The other companies where he is also a director would be required by its lender banks/ financial institutions to remove him.

It is interesting to note that the original wide reach of the Rules has been reducedto an extent by the Gujarathas been reducedto an extent by the Gujarat High Court, in Ionic Metalliks vs. Union of India (128 SCL 316 (Gujarat)[2015]), the court has held that the Master Circular, so far as it said that all the directors of the `wilful defaulter’ company would also become `wilful defaulters’ is arbitrary and unreasonable. To this extent, the Circular has been declared as ultra vires the powers of RBI and has been declared to be violative of Article 19(1)(g) of the Constitution of India. The Master Circular now provides for caution and requires, that the conditions under the Companies Act, 2013, for holding a director as officer in default should be applied.

Cut off amount of Rs. 25 lakhs of lending for categoriSation of `wilful defaulters’
Wilful defaulters of any amount would attract various consequences as applicable under law. However, the Master Circular provides that “…keeping in view the present limit of Rs. 25 lakh fixed by the Central Vigilance Commission for reporting of cases of `wilful default’ by the banks/FIs to RBI, any wilful defaulter with an outstanding balance of Rs. 25 lakh or more, would attract the penal measures stipulated at para 2.5 below. This limit of Rs. 25 lakh may also be applied for the purpose of taking cognisance of the instances of ‘siphoning’ / ‘diversion’ of funds”.

Process of declaration of a person as a `wilful defaulter’
An elaborate, transparent and multi-level process has been laid down in the Master Circular to declare a person as a wilful defaulter. A Committee consisting of an Executive Director and two other senior officers of rank of general manager/deputy general manager would examine the evidence whether there was a case of `wilful default’. If it is so concluded, a show cause notice would be issued to the company and its whole-time directors/ promoters and their submissions, including in personal hearing if deemed fit to be given, would be noted. Finally, another Committee headed by Chairman/CEO/MD of the Bank and consisting of two independent directors would review and take a final decision. While this process does sound reasonable, concerns are also raised since the process can be subjective and that it is the lender itself who takes the final decision. In this context, the Gujarat High Court, in the matter of Ionic Metalliks vs. Union of India (ibid) can be usefully referred to for its observations.

Conclusion
`Wilful default’ is something that cannot be generally defended. However, it is necessary that, considering the disclosure, restrictions, etc. that the process of declaring entities and individuals as willful defaulters is fair, transparent and objective. The consequences on persons having no direct role can be devastating in terms of reputation and business both. At the same time, it serves as caution to directors of companies to be extra vigilant in companies on whose board they serve. Considering, the already heavy responsibilities of non-executive/ independent directors under the Companies Act, 2013 and SEBI’s norms on corporate governance, like other laws, this is yet one more reason deterring individuals from coming forward to serve on Board of companies.

Tax Planning/Evasion Transactions On Capital Markets And Securities Laws – Supreme Court Decides

Background

Carrying out
transactions on stock market to avoid tax is practiced. Using capital market
for tax evasion has recently been in news, for example, cases involving
long-term capital gains. A person may, for example, sell shares and book exempt
gains and soon thereafter buy such shares again from the market. At times, such
shares are sold within the family/group and therefore after some time,
transferred to the seller. In particular, what has also been alleged is that
transactions are carried not only with the sole purpose of generating capital
gain but also for manipulating volume and price on stock exchanges. The
question whether such transactions will get concessional tax treatment in tax
assessments is of course an important question. However, in this article, the
question is : how are such transactions treated under the Securities Laws?

 

Take a common
modus operandi to have been typically employed in the so-called long-term
capital gain transactions. A small listed company with low or non-existent
operations is used. A large quantity of shares is issued by way of preferential
allotment. The quantity of shares may be further increased through bonus issue.
During the period of one year for which such shares have to remain locked-in
(which is also the period of holding for availing of long term capital gains
benefits), the price of the shares is artificially inflated by a small group of
persons who trade within themselves at progressively higher prices. At the end
of this period, by which time the price of the shares is many times (often
50-100 times) more than the original price, the preferential allottees sell the
shares at such higher price. The initial buyer is alleged to have organised all
this. The preferential allottee thus obtains tax free long-term capital gains
(Finance Bill 2018 though seeks to charge 10% capital gains tax). However, in
the process, the capital market system is abused. Fake turnover at artificial
prices is recorded. If unchecked, this not only harms the credibility of the
capital markets but can also result in loss to investors. Several provisions of
Securities Laws specifically prohibit such artificial trading and manipulation.

 

There were
decisions of the Securities Appellate Tribunal that held, in effect, that the
mere fact that transactions were undertaken for purposes of obtaining tax
benefits, penal action will not necessarily follow. However, while such
decisions could be arguably held to be limited to their facts, it still leaves
an uneasy feeling.

 

Now, the
Supreme Court has given a detailed ruling. While we will consider the facts
before the Court and also what the Court said, it is important to note that the
Court did not specifically rule on the intent tax planning or even evasion in
such transactions. It did not consider the question whether the capital markets
can or cannot be used for such purposes. It, however, dealt with violation of
Securities Laws that often takes place in such cases and whether and when they
can be said to fall foul of Securities Laws. Hence, the decision has direct
relevance.

 

Facts of the
case

There were
several parties in the case before the Court but they fell in two broad
categories – the parties who carried out the transactions and the stock brokers
through whom such transactions were carried out.

 

The parties
entered into transactions that resulted in some persons making profits and
others making losses. This was said to have been done by entering into
transactions in the following manner. In the futures and options markets, one
party (or group) bought futures (or similar derivatives) from the other party
through the stock market mechanism at a particular price. These same parties
then entered into reverse transactions at a higher price, thus resulting in one
side earning profits while the other side was making losses. Take an example. A
transaction in futures of scrip X could be carried out by Mr. A purchasing 1000
futures at a price Rs. 100 each from Mr. B. This transaction would later be
reversed by selling such 1000 futures at a price or Rs. 140. Mr. A would earn a
profit of Rs. 40000 while Mr. B would make a loss of about the same amount.

 

These
transactions would be synchronised well and rarely, if at all, any other party
would – or even could – transact. Effectively, these persons would be almost
the only persons trading in such scrip.

 

SEBI found out
what was happening and penalised the parties and the brokers. The parties were
penalised for carrying out artificial trading and price manipulation. The stock
brokers, who are expected to act as gate keepers to the capital market and
exercise due diligence, were penalised for allowing such transactions to happen
through them.

 

The question
before the Supreme Court was whether such transactions violated the Securities
Laws and whether the parties and their stock brokers could be so punished ?

 

Ruling of
Court

The Supreme
Court had to deal with several aspects. The Court had to focus on how the
capital markets get affected by such transactions. Even if the purpose was
legitimate, the issue was whether the transactions contravened the Securities
Laws, if so, penal action would follow.

 

In particular,
it elaborately discussed the issue of synchronised trading. This is trading
where buyers and sellers match their transactions very closely in terms of
timing, volume and price. Thus, the net result is generally that, though the
market is open to all, the transactions get executed between connected parties.
The Court, discussed in detail certain decisions of SAT and ruled that
synchronised trading is not ipso facto illegal or violative of
Securities Laws.

 

However, it
noted that on the facts before it, the transactions were manipulative. The
price at which purchases and sales of futures and other derivatives was carried
out was not market driven but was pre-determined and therefore artificial. The
buying and selling price of such derivatives are usually related to the
underlying price of the shares/index with which they are linked. While of
course parties can buy at prices far away from such underlying price of the
scrip/index, if their judgement of the future tells them so, the Court found
that this was not so on the facts before it. The purchases and sales were
carried out at widely different prices on the same day and between the same
parties in a synchronised manner in terms of timing and volume. The conclusion
was only that the transactions for all practical purposes were bogus.

 

Interestingly,
a curious argument was advanced. Whether trading on the derivatives markets
could affect – and hence manipulate – the trading and price in the cash market?
For example, by manipulating say, the price of futures in Scrip X, can the
price of trading of Scrip X in the spot/cash market be affected? The SAT had
held that this was generally not possible in the type of transactions involved
in the present case. This was one of the reasons why SAT overturned the order
of Securities and Exchange Board of India. However, it is submitted the Supreme
Court, rightly pointed out that this was not the issue at all. It was not
SEBI’s case that the transactions in the derivatives markets were carried out
to manipulate the price in the spot/cash markets. SEBI’s case was that the
trading in the derivatives markets itself was artificial, bogus and
manipulative and this by itself was a violation of Securities Laws.

 

The Court also
rejected the argument that in case of futures, no delivery took place and hence
the transactions did not violate the provisions which prohibit dealing without
change of beneficial interest.

 

The Court
further described the meaning of unfair trade practices in securities particularly
in the context of the case. It stated, “Contextually
and in simple words, it means a practice which does not conform to the fair and
transparent principles of trades in the stock market. In the instant case, one
party booked gains and the other party booked a loss. Nobody intentionally
trades for loss. An intentional trading for loss per se, is not a
genuine dealing in securities. The platform of the stock exchange has been used
for a non- genuine trade. Trading is always with the aim to make profits. But
if one party consistently makes loss and that too in preplanned and rapid
reverse trades, it is not genuine; it is an unfair trade practice.”. The
Court pointedly noted that, “The non-genuineness of these transactions is
evident from the fact that there was no commercial basis to suddenly, within a
matter of minutes, reverse a transaction when the underlying value had not
undergone any significant change”. Once it held this, it was not difficult to
take the argument to the logical conclusion to hold that the trades were
violative of Securities Laws and uphold the penal action by SEBI.

 

The Court also
rejected the ruling of SAT that “only if there is market impact on account of
sham transactions, could there be violation of the PFUTP Regulations”. The
court held that fraudulent and unfair trade practices have no place whatsoever
in the capital market.

 

As far as the
stock brokers were concerned, the Court held that they could not be held liable
unless their own involvement could be demonstrated or it could be shown that
they acted negligently or in connivance with such traders.

Thus, the Court
upheld the penal actions against the traders but not against the stock brokers.

 

Tax
planning/avoidance/evasion through capital markets

The Court
steered clear of giving a specific and direct ruling on whether tax planning
through transactions in capital markets was by itself violative of Securities
Laws. However, it is submitted that it has given enough guidance on what the
approach should be. As discussed above, transactions that are manipulative or
fraudulent or apparently fake will by themselves be violative of Securities
Laws.

 

Conclusion

The decision
makes it clear that SEBI can examine transactions in light of how they are
carried out and whether they are violative of Securities Laws, irrespective of
whether or not the objective was tax planning, etc. Some tests are given on
whether such transactions would be held to be violative. The penal action under
Securities Laws will be in addition to any findings and consequences under tax
law.  

Shell-shocked – SEBI’s directions against ‘Shell’ Companies

Background

In August 2017, SEBI issued
directions to Stock Exchanges to severely restrict trading in the shares of
certain companies. SEBI had received a list of 331 companies from the Ministry
of Corporate Affairs (“MCA”). It appears that the reason for this restriction
is that these companies were shell companies (i.e., having no substantive
operations) and may have been used for money laundering post demonetisation in
November 2016. The directions caused severe distress to these companies and
their shareholders, and some of the companies appealed to the Securities
Appellate Tribunal and got relief. SEBI’s directions were remarkable, have
far-reaching impact and involve issues of law, and hence, it is worth
discussing and understanding these directions.

Overview of what happened

SEBI stated that it had
received a list of companies from MCA that were allegedly shell companies
(which apparently compiled the list after taking inputs from other authorities
such as SFIO). The list included listed companies.

In the ordinary course of
business, stock exchanges do place restrictions on trading of companies. Under
stock exchange regulations, depending on what is suspected (which may include
disproportionate rise in price/trading without underlying fundamentals),
restrictions in trading are placed. These restrictions progressively increase
by levels till the most restrictive level VI is reached. At this stage, trading
is allowed only once a month, with the price being the last traded price. Thus,
increase or decrease in price is not possible.

The
buyer is also required to pay 200% margin for five months as deposit with the
stock exchange. There are other restrictions also. Needless to say, while this
is marginally better than total delisting/suspension of listing, however, for
all practical purposes, trading in shares of such companies drops to virtually
zero. In the ordinary course, it is for the stock exchange to decide the level
of restrictions.

However, in the present
case, SEBI issued a directive to stock exchanges to place all these companies
at level VI. Exchanges are bound to obey such directions. Thus, trading was
effectively stopped and it could be done only in the restricted manner
mentioned earlier. The directions also imposed restrictions on `off market
transactions.’

Curiously, SEBI did not
clarify that the authorities that had forwarded the list had required SEBI to
place restrictions on all companies. It appears that MCA wanted SEBI to
investigate and thereafter take action. It also appears that not all the companies
were listed on stock exchanges! Hence, even SEBI had to ask the exchanges to
first check the list to find out which of the companies are listed and then
take action.

Factually, many of the
companies were large profitable companies with considerable operations and
active trading. Trading in their shares on exchanges suddenly ceased. These
companies had no choice but to urgently approach the Securities Appellate
Tribunal (“SAT”). Appealing to SAT could have been difficult, because of the
manner in which the directions were given. However, SAT gave prompt relief,
staying the orders in case of companies which appealed and ordered SEBI to
investigate and give opportunity to the said companies to present their case.

The
present status is that except for the handful of companies that appealed and
got a stay, trading in the remaining listed companies stands suspended.

Directions issued against the shell
companies

The
following extract from the directions dated 7th August 2017 of SEBI
to stock exchanges make clear what was ordered:-

“Trading in all such listed securities shall be placed in Stage VI
of the Graded Surveillance Measures (GSM) with immediate effect. If any listed
company out of the said list is already identified under any stage of GSM, it
shall also be moved to GSM stage VI directly. Under the Stage VI of GSM,
trading in these identified securities shall be permitted to trade once in a
month under trade to trade category. Further, any upward price movement in
these securities shall not be permitted beyond the last traded price and
Additional Surveillance Deposit of 200% of trade value shall be collected from
the Buyer which shall be retained with Exchanges for a period of five months.

 

Exchanges shall initiate a process of verifying the
credentials/fundamental of such companies. Exchanges shall appoint an
independent auditor to conduct audit of such listed companies and if necessary,
even conduct forensic audit of such companies to verify its credentials/
fundamentals.

 

On verification, if Exchanges do not find appropriate credentials/
fundamentals about existence of the company, Exchanges shall initiate the
proceedings for compulsory delisting against the company, and the said company
shall not be permitted to deal in any security on exchange platform and its
holding in any depository account shall be frozen till such delisting process
is completed.”

MCA had only suggested investi-gation by
SEBI, not orders

In its defense before SAT,
SEBI made a plea that it was required by the Ministry of Corporate Affairs to
pass such directions. This contention was rejected by SAT. Even otherwise, it
was held that SEBI cannot blindly follow directions of MCA. SEBI, being an
entity bound by the SEBI Act, could not issue such directions without following
due process prescribed under the SEBI Act. SAT also noted that MCA had merely
required SEBI to investigate such companies, whether they were shell companies,
etc. and to take action, if required under law.

Issue of directions as a circular which
could be non-appealable

SEBI took an interesting
mode of taking action against such companies. In the ordinary course, it would
examine the facts of each company, notify and put the facts before them, make
specific allegations and ask them to explain their side before passing an
order. In extreme cases, SEBI can even pass interim ex parte order and
could grant the company a post-order hearing. But, even such orders would
require at least basic investigation and also be a speaking order.

Instead, SEBI directly
issued directions to stock exchanges requiring them to put the companies on the
highest restriction level. The result of this was that – the companies faced
restrictions just as they would have under a direct order on them. It seems,
SEBI did that to avoid an overturning of its order by claiming protection under
a recent decision of the Supreme Court (in NSDL vs. (2017) 5 SCC 517,
discussed in an earlier article in this column) that administrative orders
cannot be the subject matter of appeal. Thus, the only course of action against
such directions would have been a writ petition to the High court.

When the companies appealed
to SAT, SEBI contended that such directions being of administrative nature,
were not appealable as held by the Supreme Court.

However, SAT rejected this
contention. The following observations of SAT are relevant in this regard:-

 

“4. We see no merit in the preliminary objection raised by SEBI.
In the case of NSDL (Supra) the Apex Court after considering the scope of the
expression ‘administrative orders’ held that in that case the administrative
circular issued by SEBI was referable to Section 11(1) of SEBI Act and hence
falls outside the appellate jurisdiction of this Tribunal.

…

 

6. Thus, the impugned communication is not a general direction
given by SEBI to the three stock exchanges in the interests of investors or
securities market as contemplated u/s. 11(1) of SEBI Act, but a specific
direction given in respect of only 331 listed companies which MCA suspected to
be shell companies. Moreover, specific direction given in the impugned
communication prejudicially affects the interests of only those companies
covered under the list of 331 companies identified by the MCA as ‘suspected to
be shell companies’. Therefore, in the facts of present case, the impugned
communication of SEBI which has serious civil consequences cannot be said to be
an administrative order. In other words, the impugned communication which
prejudicially impairs the rights and obligations of the appellants, its
promoters and directors would fall in the category of a quasi judicial order
and hence appealable before this Tribunal u/s. 15T of SEBI Act.

 

7. It is contended on behalf of SEBI that appeal u/s. 15T of SEBI
Act is maintainable only against an order passed by the Board or the
Adjudicating Officer of SEBI and therefore, the impugned communication issued
by the Chief General Manager of SEBI is not appealable u/s. 15T of SEBI Act. We
see no merit in the above contention, because, it is admitted by counsel for
SEBI during the course of arguments that the impugned action was approved by
the WTM of SEBI on 28.07.2017 and only thereafter on 07.08.2017, the Chief
General Manager has issued the impugned communication. Since the impugned
communication which is approved by the WTM of SEBI seeks to suspend the trading
in the securities of the appellants, on day to day basis the impugned
communication is in effect referable to a quasi judicial order passed u/s.
11(4) of SEBI Act and not an administrative order passed u/s. 11(1) of the SEBI
Act. Accordingly, we see no merit in the preliminary objection raised by SEBI.”

Whether matter was urgent?

SEBI often passes interim
orders before concluding investigation to ensure that status quo is
maintained. In the instant case, SAT rejected the view that there was an
urgency. SEBI received the letter from MCA dated 9th June 2017, but
issued directions after nearly two months.

Striking off of names of companies by
Registrar of Companies

A similar action against
allegedly shell companies was initiated earlier by the respective Registrar of
Companies of various states. However, due process of law was followed whereby a
notice was issued, giving reasons as to why their names were sought to be
struck off and an opportunity was given to the companies to respond.
Reportedly, such companies were more than 2.50 lakhs in number. However, SEBI,
did not issue any such notice.

What laws have such companies violated?

An interesting question
that arises is: What Securities Laws have such companies violated, even if it
was found that they were guilty of money laundering? Though SEBI does have wide
powers to issue orders, generally they are passed where Securities Laws are
violated, or to protect interests of investors, etc.

If there was any money
laundering, the company and its directors could face action under appropriate
law. However, that   may  not enable SEBI to pass orders under the
Securities Laws. In particular, if restrictive orders are passed, it is the
public shareholders of such companies who may get affected probably for no
fault of theirs as it happened in the instant case. Earlier, in cases where it was alleged that price manipulation
and other wrongs was carried out for helping parties to earn tax free long term
capital gains, there were several grounds to take action under Securities Laws.
However, in the present case, it is not evident on the face of it as to what
action SEBI could take.

Conclusion

This is an
example of arbitrary action by SEBI. The prices of the shares of the companies,
even of those who got a stay order, crashed. There was no formal investigation
as required by law and no hearing was granted before or after such directions.
While the companies who rushed to SAT got a stay, the SAT has not granted a
stay for operation of the directions on all companies. Even the route adopted
by SEBI of issuing directions to stock exchanges with a hope that it cannot be
appealed against was not justifiable. The silver lining in all this is how
SAT promptly distinguished the decision of the Supreme Court and thus created a
precedent for questioning SEBI’s orders.

 

The
concerns about abuse of corporate form for money laundering and other crimes
and even of listing remain. However, a well thought out strategy would be
needed to ensure that the action hits those entities who engage in such
activities – and them only.

Board Meetings By Video Conferencing Mandatory For Companies? – Yes, If Even One Director Desires

Background

Is a company
bound to provide facilities to directors to participate in board meetings by
video conferencing? The NCLAT has answered in the affirmative even if one
director so desires. This is what the Tribunal has held in its recent
decision in the case of Achintya Kumar Barua vs. Ranjit Barthkur ([2018] 91
taxmann.com 123 (NCL-AT)).

Section 173(2)
of the Companies Act, 2013 provides that a director may participate in a board
meeting in person or through video conferencing or through audio-video visual
means. Clearly, then, a director has three alternative methods to attend board
meeting. The question was: whether these three options arise only if a company
provides such facility or whether a director can insist that he be provided all
the three choices the director has the option of using any one of the three.

It is clear
that, for video-conferencing to work, facilities would have to be at both ends.
Indeed, as will also be seen later herein, the company will have to arrange for
far more facilities to ensure compliance, than the director participating by
video conference. The director may need to have just a computer – or perhaps
even a mobile may be sufficient – and internet access. Apart from providing
these facilities, the process of the board meeting itself would undergo a
change in practice where meeting is held by video conference.

While one may
perceive that, particularly with internet access and high bandwith
proliferating, video conferencing would be easy. However, the formal process of
Board Meetings by video conferencing has May 2018 video conferencing article
first post board been simplified. This would not only require bearing the cost
of video conference facilities but also carrying out several other compliances
under the Companies Act and Rules made thereunder. This makes the effort
cumbersome and costly particularly for small companies. Moreover, the
proceedings would become very formal. Directors would be aware that their words
and acts are being recorded. These video recordings can be reviewed later very
closely for legal and other purposes particularly for deciding who was at fault
in case some wrongs or frauds are found in the company.

Arguments before the NCLAT

Before the
NCLAT, which was hearing an appeal against the decision of the NCLT, the
company argued that the option to attend by video conferencing to a director
arises only if the company provides such right.

It was also
argued that the relevant Secretarial Standards stated that board meeting could
be attended by video conferencing only if the company had so decided to provide
such facility.

Additional
issues raised including facts that made it difficult for the company to provide
such facility.

Relevant provisions of law

Some relevant
provisions in the Companies Act, 2013 and the Companies (Meetings of Board and
its Powers) Rules, 2014 are worth considering and are given below (emphasis supplied).

 Section 173(2)
of the Act:

173(2) The
participation of directors in a meeting of the Board may be either in person or through video conferencing or other
audio visual means, as may be prescribed, which are capable of recording and
recognising the participation of the directors and of recording and storing the
proceedings of such meetings along with date and time:

Provided
that the Central Government may, by notification, specify such matters which shall not be dealt with in a meeting through video
conferencing or other audio visual means:

Provided
further that where there is quorum in a meeting through physical presence of
directors, any other director may participate through video conferencing or
other audio visual means in such meeting on any matter specified under the
first proviso. (This second proviso is not yet brought into force)

Some relevant
provisions from the Rules:

3. A company shall comply with the
following procedure, for convening and conducting the Board meetings through
video conferencing or other audio visual means.

(1) Every
Company shall make necessary arrangements to avoid failure of video or audio
visual connection.

(2) The
Chairperson of the meeting and the company secretary, if any, shall take due
and reasonable care—

(a) to
safeguard the integrity of the meeting by
ensuring sufficient security and identification procedures;

(b) to ensure availability of proper
video conferencing or other audio visual equipment or facilities for providing
transmission of the communications for effective participation of the directors
and other authorised participants at the Board meeting;

(c) to record
proceedings and prepare the minutes of the meeting;

(d) to store for safekeeping and marking the tape
recording(s) or other electronic recording mechanism as part of the records of
the company at least before the time of completion of audit of that particular
year.

(e) to ensure that no person other than
the concerned director are attending or have access to the proceedings of the
meeting through video conferencing mode or other audio visual means; and

(f) to ensure that participants attending the meeting
through audio visual means are able to hear and see the other participants
clearly during the course of the meeting:


What the NCLAT held

The NCLAT,
however, held that the right to participate board meetings via
video-conferencing was really with the director. This is clear, it pointed out,
from the opening words of Section 173(2) that read: “The participation of
directors in a meeting of the Board may
be either in person or through video conferencing or other audio visual means“.
Thus, if the director makes the choice of attending by video-conferencing, the
company will have to conduct the meeting accordingly.

The NCLAT
analysed and observed, “We find that the word “may” which has been
used in this sub-Section (2) of Section 173 only gives an option to the
Director to choose whether he would be participating in person or the other
option which he can choose is participation through video-conferencing or other
audio-visual means. This word “may” does not give option to the
company to deny this right given to the Directors for participation through
video-conferencing or other audio-visual means, if they so desire.”.

The NCLAT
further stated, “…Section 173(2) gives right to a Director to participate
in the meting through video-conferencing or other audio-visual means and the
Central Government has notified Rules to enforce this right and it would be in
the interest of the companies to comply with the provisions in public
interest.”.

On the issue of
the relevant Secretarial Standard that stated that video conferencing was
available only if the company had provided, the NCLAT rejected this
argument saying that in view of clear words of the Act, such standards could
not override the Act and provide otherwise. In the words of the NCLAT, “We
find that such guidelines cannot override the provisions under the Rules. The
mandate of Section 173(2) read with Rules mentioned above cannot be avoided by
the companies.”.

The NCLAT
finally stressed on the positive aspects of video conferencing. It said that
vide conferencing it could actually help avoid many disputes on the proceedings
of the Board meeting as a video record would be available. To quote the NCLAT, “We
have got so many matters coming up where there are grievances regarding
non-participation, wrong recordings etc.” It also upheld the order of the
NCLT which held that providing video conferencing facility was mandatory of a
director so desired, and said, “The impugned order must be said to be
progressive in the right direction and there is no reason to interfere with the
same.”.

Implications and conclusion

It is to be
emphasised that the requirements of section 173 apply to all companies –
listed, public and private. Hence, the implications of this decision are far
reaching. Even if one director demands facility of video conferencing, all the
requirements will have to be complied with by the company.

Rule 3 and 4 of
the Companies (Meeting of Board and its Powers) Rules, 2014, some provisions of
which are highlighted earlier herein, provide for greater detail of the manner
in which the meeting through video conferencing shall be held. Directors should
be able to see each other, there should be formal roll call including related
compliance etc. There are elaborate requirements for recording decisions
and the minutes in proper digital format. 

In these days,
meetings so held can help avoid costs and time, particularly when the director
is in another city or town or in another country. However, there are attendant
costs too. Even one director could insist on attending by video conferencing
and the result is that the whole proceedings would have to be so conducted and
the costs have to be borne by the company.

Certain
resolutions such as approval of annual accounts, board report, etc.
cannot be passed at a meeting held by video-conferencing. A new proviso has
been inserted to section 173(2) by the Companies (Amendment) Act, 2017. This
proviso, which is not yet brought into force, states that if there are enough
directors physically present to constitute the quorum, then, even for such
resolutions, the remaining directors could attend and participate by video
conferencing.

Thus, in
conclusion, it is submitted that the lawmakers should review these provisions
and exclude particularly small companies – private and public – from their
applicability.  

Note: in the april 2018 issue of
the journal, in the article titled “tax planning/evasion transactions on
capital markets and securities laws – supreme court decides”, on page 110, the
relevant citation of the decision of the supreme court was inadvertently not
given. the citation of this decision is sebi vs. rakhi trading (p.) limited
(2018) 90 taxmann.com 147 (sc).

 


 

Supreme Court Freezes Assets Of Independent Directors – A Thankless Job Made Worse

Background

 

In a recent ruling, the Supreme Court has
directed a freeze on assets of all the directors, including independent
directors, owing to certain defaults by the Company. They have also been
required to be personally present at hearings of the Court. At this stage,
there does not appear to be any conclusive finding about the guilt of the
independent directors and the matter is still sub judice. But this order
does raise concerns about the liabilities and inconveniences that independent
directors can be subjected to. As will be discussed later herein, being an
independent director is in a sense a thankless job. Their remuneration is
subject to statutory limits while their liability is enormous. There have
already been several orders by SEBI, that has taken different types of actions
against them. The defences available in law owing to recent changes appear to
have been diluted. Let us consider this decision (Chitra Sharma vs. UOI,
dated 22nd November 2017) generally in the light some existing
provisions.

 

Needless to emphasise, Chartered
Accountants, Company Secretaries, lawyers, etc. are sought after persons
to fill in the posts of independent directors in listed companies and also
committees like Audit Committee. They too will warily see the developments in
law and court rulings.

 

Role of independent directors

 

Independent directors are a major pillar of
good corporate governance. They are meant to balance against the control of
Promoters, and directly or indirectly protect the interests of minority/public
shareholders and even other stakeholders. Committees like Audit Committee or
Nomination and Remuneration Committee are to have majority or at least half of
the number of members as independent directors.

 

The Companies Act, 2013 (“the Act”) lays
down in Schedule IV a very detailed code for independent directors. Their role
and obligations are laid down broadly and generally as well as specifically.

 

Apart from the specific code for independent
directors, there is a very detailed role under the SEBI (Listing Obligations
and Disclosure Requirements) Regulations, 2015 (“the Regulations”) for the
Board generally.

 

Powers of independent directors

 

The powers of independent directors are, in
comparison, relatively scanty. They do have powers as part of the Board generally.
They have right of information as part of the Board/Committee. However, these
are available few times a year when the Board/ Committee meets. Between these
meetings, they do not have direct substantive powers, either individually or
collectively. In meetings too, they individually do not have powers except to
participate and vote and perhaps require that their dissenting views be
recorded.

 

Remuneration

 

Independent directors are in a peculiar
position. They cannot be paid too much simply because they would lose their
independence since they would become dependent on the Company. Paying them too
less means that they do not have enough compensation and incentive to do
justice to their efforts and the risks that the position carries, of action by
regulators.

 

Typically, independent directors are paid by
way of sitting fees and, where the Company is profitable and if the Company so
decides, payment by way of commission as a percentage of profits. Sitting fees
are, however, limited to Rs. 1,00,000 per meeting (in practice, often a lesser
amount). Such level of remuneration in many cases would not be adequate for
many competent directors to accept the responsibilities and liabilities that
law imposes.

 

Kotak Committee appointed by SEBI has
recently recommended certain minimum remuneration for independent and
non-executive directors and though it still does not appear to be adequate in
proportion to liability, it is clear that attention is being given to this
area.

 

Liability of independent directors generally

 

Non-executive directors usually do not have
specific and direct liability under the Act/Regulations. Generally, executive
directors, key managerial personnel, etc. are taken to task first, for their
respective general or specific role in defaults. Non-executive directors who
are promoters may of course face action under certain circumstance. But
generally, non-executive directors can ensure that due role is formally
apportioned to competent persons so that they do not face actions on matters so
delegated. However, under the Act and even the Regulations, this has changed to
an extent. Under section 149(12) of the Act and the Regulations, some further
relief is sought to be given. Essentially, an independent director will be
liable, only if the default is with his knowledge through board proceedings.
This does help him because, unless the matter is brought before and part of
board proceedings, he may not be held liable. However, this is subject to the
condition that he should have acted diligently. This provision has not been
tested well and it will have to be seen how much it helps.

 

Orders/actions against independent directors

 

SEBI has general and special powers by which
it can pass adverse orders against independent directors. And it has passed
such orders. SEBI can, of course, take action for violation of specific
provisions of the Regulations applicable to them. However, depending on their
role, SEBI can use its general powers to pass orders against them. This may
include debarring them from acting as independent directors of listed
companies.

 

The Order in case of Zenith Infotech as
originally passed is particularly noteworthy. (Order No. WTM/RKA/ISD/11/2013
dated 25th March 2013). In this case, SEBI had alleged diversion of
funds of Zenith. SEBI ordered the whole Board, including the independent
directors, to provide personal bank guarantee to the extent of $33.93
million for the losses suffered by Zenith. The guarantee was to be provided
without use of the assets of Zenith. Needless to emphasise that, independent
directors, particularly professionals, would usually not be able to provide
such guarantees. Professional directors would then face further adverse
directions for not complying with orders which may include prosecution.

 

Order of the Supreme Court

 

The Company concerned here is facing
insolvency proceedings. Numerous persons have booked flats and it appears that
the buyers are looking at loss of advances paid for purchase of flats. The
Supreme Court had earlier required the promoters to infuse funds in the
company. However, this apparently was not done to the extent ordered. The
Supreme Court has thus ordered that, inter alia, the independent directors
and their dependents will not transfer any of their assets till further notice.
The Court ordered:-

 

(d) Neither the independent
directors nor the promoter directors shall alienate their personal properties
or assets in any manner, and if they do so, they will not only be liable for
criminal prosecution but contempt of the Court.

 

(e) That apart, we also direct
that the properties and assets of their immediate and dependent family members
should also not be transferred in any manner, whatsoever.

            …

      Matters be listed on 10.1.2018. On that day, all the independent
directors and promoter directors of Jaiprakash Associates Limited, shall remain
present.

     

Thus, the directions are (i) the assets of
the independent directors and their immediate and dependent family
members are frozen (ii) the independent directors are required to be personally
present before the Court at the hearing of the case.

 

The broad based order means that independent
directors’ business/professional and even personal activities are seriously
affected.

At this stage, there does not appear to be
any final ruling of the guilt of the independent directors. It is also not
clear whether there is any finding of complicity or even negligence of their
duties as independent directors. Even if such a direction is reversed in the
future, in the interim, the independent directors face serious difficulties.

 

As stated earlier, there are some defences
available to independent directors in case of wrong doings by the company. If
they have taken due safeguards and carried out their role with diligence, they
may not ultimately be held liable. But in the interim, such orders are
effectively a punishment.

 

Recent order of SEBI exonerating
independent directors where they exercised diligence.

 

In the case of Zylog Systems Limited (Order
dated 20th June 2017), there was a finding that the Company declared
dividends but did not pay it. The question arose as to the role of the Board
generally and also of the independent directors in particular. SEBI issued show
cause notices to, inter alia, the independent directors, alleging
violations and seeking to pass adverse directions. The independent directors
explained in detail their role as independent directors generally and as
members of the Audit Committee. They explained how they brought to notice such
non payment of dividends to the Board of Directors of the company. When the
Board of Directors did not still take steps to pay the dividends, the said directors resigned. SEBI dropped the
proceedings against them and observed.

 

I have considered the charges alleged in
the SCN and replies filed by the noticees. I note that the Independent
Directors do have an important role to play in guiding the management so that
the interest of the Company and the minority shareholders are protected.
Further, the Independent directors will also have to ensure that the
functioning of the Company is in full compliance with the applicable laws. In
this case, I have noted that noticees after noticing the violation of non-payment
of dividend have taken strong stands to convince the Company’s Board about the
necessity of ensuring that the statutory dues and the dividends are paid
without any delay, in the Board meeting held on November 14, 2012. As the
company failed to comply, the two noticees resigned from the Company ’s Board.

 

Considering the above facts and
circumstances of the case, I am of the view that since both the noticees did
not have any role in the day-to-day management of the company and have
discharged their responsibility as Independent Directors putting in their best
efforts, I do not deem it fit to pass any directions under section 11 and 11B
of the SEBI Act, 1992 against Mr. S. Rajagopal and Mr. V. K. Ramani. The SCN is
disposed of accordingly.

 

Conclusion

 

Many of the cases till now where independent
directors have faced adverse actions are fairly glaring cases of serious
alleged violations causing losses to shareholders/others. Clearly, if
independent directors are complicit with such violations, adverse action
against them is expected and inevitable. However, adverse directions before
such allegations are proved can cause losses. Even otherwise, proving their
innocence or that they exercised diligence in their duties can itself be an
expensive affair. It is submitted that specific and general guidelines should
be framed both by Ministry of Corporate Affairs and SEBI. There should be
guidance as to the specific steps an independent director should take to
discharge his duties with diligence on one hand and clear examples where they
can be held liable. Else, there will be increasing disillusionment amongst
existing and potential independent directors. In the absence of clarity, the
intention of the lawmakers to have good corporate governance may fall flat. _

Report On Corporate Governance – SEBI Committee Recommends Significant Changes In Norms

Background

The norms relating to corporate governance in India see periodical revisions and thus have come a long way. From being recommendatory at one time, to forming part of the Listing Agreement, some provisions relating to corporate governance now form part of the Companies Act, 2013. To review the requirements, particularly in the light of several recent developments, a Committee was set up. The Committee has made several recommendations which, whilst mostly being largely incremental, have already become contentious. Considering the past, where after considering, the recommendations are fast tracked and finally implemented, and hence the proposed changes need to be highlighted. The Report itself, however, recommends a phased adoption with extra time being given in appropriate cases. The recommendations are numerous. However, considering paucity of space, only some of the important ones are highlighted.

Requirements relating to accounts/auditors

Several recommendations have been made in the area of accounts/audit. The Committee is of the view that there is a need to improve disclosures in financial statements and also enhance the quality of financial statements and audit. Important recommendations are summarised below :

Presently, a company is required to quantify the impact of audit qualifications on various financial parameters such as profits, net worth, etc. The Report recommends that the management shall mandatorily make an estimate of impact of qualifications, where the impact on financial parameters of qualifications is not quantifiable. However, such estimate need not be made on matters like going concern or sub-judice matters. But in such cases, the management shall give reasons and the auditor shall review them and report thereon.

The Report then recommends that where the auditor is not satisfied with the opinion of an expert (lawyer, valuer, etc.) appointed by the company on an issue, he is entitled to obtain, at the cost of the listed company, opinion of another expert appointed by him.

The Committee noted that, presently, the auditor of the holding company may place reliance on audit performed by respective auditors of subsidiaries while reporting on the consolidated financial statements. He may, however, decide that supplemental tests on the financial statements of the subsidiary are necessary and he may send a questionnaire seeking information to the auditor of the subsidiary. Whether this was enough or whether the auditor should have more active role was the question. In line with global standards, the Committee recommended that the auditor should be made responsible for the audit opinion of all material unlisted subsidiaries. Thus, the auditor of the holding company would have more control over how the audit of the subsidiary is conducted.

The Committee has recommended that both quarterly consolidated and standalone statements, should be published. Further, half-yearly cash flow statement should also be published. The quarterly limited review should now include review also of the subsidiaries in such a manner that at least 80% of the consolidated revenue/assets/profits are covered in such review. In the last quarter, regulations currently require that the last quarter figures would be the balancing figures of the whole year’s figures minus those of the preceding three quarters. For this purpose, the Committee recommends that material adjustments made in the last quarter but relating to preceding quarters shall be disclosed.

The Committee recommends that the detailed reasons given by the auditor for his resignation before the end of his term shall be disclosed.

A recommendation that could have far reaching effect relates to power of SEBI to take action against auditors. Presently, a decision of the Bombay High Court (Price Waterhouse & Co. vs. SEBI (2010) 103 SCL 96) affirms the power of SEBI to take action against the auditors in case of fraud/connivance. The Committee recommends that this power be taken one step ahead and SEBI should be allowed to take action also in case of gross negligence. However, the ICAI has opposed this recommendation stating that “the regulation of chartered accountants is covered under the Chartered Accountants Act, 1949” and also “to avoid jurisdictional conflict and other issues.”

The Committee has made recommendations regarding the Quality Review Board (“QRB”) in relation to review of audits including strengthening this Board, enhancing its independence, etc. The ICAI has dissented with this recommendation stating that it was outside the scope of reference of the Committee. Further, it has stated that QRB has already applied for membership of International Forum of Independent Audit Regulators (IFIAR).

Changes regarding board/independent directors/women directors/Chairman

One of the pillars of good governance is sufficient number of independent directors. The principle is to balance the promoter/management dominated board with independent directors who have no connection or relationship with the promoters or the Company. Hence, the present law requires a significant number of independent directors on the board and at least one woman director on the board.

The Report now recommends certain changes. Firstly, it recommends that the minimum board size be increased from the current three to six. The intention clearly is to have a larger board having diverse expertise, which would help in better governance. While boards having only the bare minimum 3 directors may be rare, several companies have boards in the range of 3-6 directors. Companies will now need to find more directors. Importantly, since the number of independent directors is calculated as a fraction (one-third or half) of the Board size, more independent directors would also have to be appointed. Liability of independent directors (and even directors generally) under the Companies Act, 2013, as well as the SEBI Regulations is already very high.

Remuneration of independent directors

Remuneration, particularly of independent directors, remains low and limited. The Committee has recommended increase in remuneration. The irony is that a higher remuneration to independent directors may supposedly result in dilution of independence. It would thus be tough to find directors who are really independent directors.

Remuneration of independent directors is a tricky area. Give too less they lose incentive to put in the efforts required. Give too much, they become dependent on the company for getting substantial remuneration and compromise their independence. At same time, the increased remuneration will also be a burden on the Company, even if for a valid purpose.

Presently, the law requires that at least one-third of the Board should consist of independent directors, but if the Chairman is from the promoter group or an executive director, the said proportion is one-half. The Report recommends that :

–  the Chairman should not be an executive director.

–  the number of independent directors should at least be 50% of the Board size.

–   Woman director should be an independent director to comply wih the spirit of the law.

The objective is to strengthen further this pillar of corporate governance. Needless to emphasise that the demand for independent directors will increase.

But perhaps the most curious of requirements relates to who should be Chairman. Presently, there are already some restrictions on appointing a promoter/executive director as Chairman. However, now, the Report goes much further, noting the already existing similar requirement under the Companies Act, 2013, and proposes a blanket prohibition and recommends that the Chairman shall not be an executive director. The rationale provided is that this would avoid in excessive concentration of powers in the hands of one person. I submit that this is a western concept where promoter holding is scattered and hence the CEO has vast powers without any counter balance. In India, companies are largely promoter dominated who typically hold controlling interest. The CEO, even if professional, is easily balanced by the promoter group along with the independent directors. Further, the post of Chairman, at least in India, is largely ceremonial unless executive power is specifically granted. The Chairman conducts the meetings as per law and not arbitrarily. It is reiterated that he does not have ipso facto any executive or overriding powers. On the other hand, he does represent the face and image of the Company. Shareholders do know that a promoter driven company has usually the senior family member of the promoter family in the forefront. In such a case, seeking to replace him with a non-executive person does not make sense. It may only result in a member of the promoter group being appointed as Chairman but without being an executive director. But it will not change the position that the promoters control the company. The Report does clarify that initially the requirement be made only for companies with at least 40% public shareholding. But even that is too low since this may require even a company with 51% promoter holding to have such a non-executive Chairman.

The Report now suggests that it would be fair to provide at least a certain level of minimum compensation to independent directors. This is suggested to be worked out as a mix of their actual role in terms of work done and also in terms of performance of the company in terms of profits. The Report recommends at least Rs. 5 lakh (if profits permit) should be provided as minimum remuneration (including sitting fees) to independent directors for the top 500 listed companies. The minimum sitting fees should be Rs. 50,000 for board meetings, Rs. 40,000 as sitting fees for Audit Committee meetings and Rs. 20,000 for other Committee meetings, for top 100 companies (with half of that for next 400 top companies).

This will clearly incentivise the directors. However, considering that this increase is also together with overall increase in number of independent directors, the burden on companies in terms of costs will also increase.

Sharing of information with Promoters, etc.

Finally, the Report deals with an issue having special relevance to India. And that is sharing of unpublished price sensitive information in listed companies in India with its promoters and generally also with significant shareholders who have rights under an agreement of access to such information.

The issue is detailed and complex and would require a full length article to even cover the main points. But suffice here to say that the Report makes certain recommendations to ensure that the information that the promoters and others get is not misused. In particular, they face restrictions on their use/distribution, etc. similar to insiders under the Regulations relating to insider trading.

Conclusion

There are other recommendations too. However, the Report has faced controversy on some issues, not just from outside but within the Committee itself with certain members/representatives openly and strongly expressing their dissent. It will be beyond the scope of this article to analyse the merits of such objections.

But one can conclude that some of the important recommendations may either get dropped or substantially modified and perhaps get delayed in implementation till a broader debate is conducted and a consensus  arrived at. Nevertheless, the path of future corporate governance leads is visible and it is a tough call for independent directors.

New Section 90 In Companies Amendment Act 2017 – Aims At Benami Shareholders, Shoots Everyone Else But Them

Background

‘Shell companies’ have been in the news
recently. On how money is laundered, laws are avoided/evaded, benami properties
are held, etc. through such companies. This is more so
post-demonetisation when it has been alleged that a large sum of money has been
laundered through such companies. A series of actions have been taken. Several
listed companies have got their trading on stock exchanges restricted. Though
many got relief thereafter, it is also seen that investigations have been
initiated into activities of many such companies. Directors of such companies
have also been debarred.

 

It has been perceived that shares of such
companies may be held benami, thus making it difficult to catch the real
culprits. There are of course laws to deal with benami holdings including the
most prominent Prohibition of Benami Property Transactions Act, 1988, which too
was substantially amended in 2016.

 

A further step has now been taken to,
inter alia, tackle such benami holdings through an amendment to section 89
and through introduction of a new section 90 by the Companies Amendment Act
2017, which has received the assent of the President on 3rd January
2018. However, the provisions, as this article is being written, await
notification.

 

Essentially, the said section 90, in very
wide terms, requires disclosure by individuals who, singly or jointly with
others, hold/control substantial interests in companies. This supplements and
indeed widely extends section 89 which requires disclosure of beneficial
interests in shares. This effectively appears to be intended to require
disclosure not just of benami holdings but also holding by eventual individual
owners.

 

However, the provisions are very widely and
even loosely/ambiguously worded. They will apply not just to listed companies
but also to unlisted/private companies. Further, disclosure, at least one time,
will be required by almost all companies, who then will have to make onward
disclosures to the Registrar.

 

Existing Section 89

Section 89 of the Companies Act 2013 deals
with disclosure of beneficial interests. A person who holds shares in his name
but who does not hold the beneficial interest therein is required to make a
declaration in the prescribed manner. This section corresponds to section 187-C
of the Companies Act, 1956. Now it has been amended by introduction of the
following definition which will be relevant also for section 90 discussed
below:

 

“(10) For
the purposes of this section and section 90, beneficial interest in a share
includes, directly or indirectly, through any contract, arrangement or
otherwise, the right or entitlement of a person alone or together with any
other person to—

 

(i) exercise or
cause to be exercised any or all of the rights attached to such share; or

 

(ii) receive or
participate in any dividend or other distribution in respect of such
share.”.

 

As can be seen, the scope of section 89 is
thus widened.

 

New Section 90

Section 90 goes much further beyond the
provisions of section 89. It requires that individuals who hold or control significant
holding in a company should disclose such fact to the Company. The Company will
record this declaration in a specified register and also make disclosures to
the Registrar. Some relevant extracts from the said section are given below
(emphasis supplied):-

 

90. (1) Every individual, who acting alone or together, or through one or more persons
or trust, including a trust and persons resident outside India, holds beneficial interests, of not less than
twenty-five per cent. or such
other percentage as may be prescribed, in
shares of a company
or the right to exercise, or
the actual exercising of significant
influence or control as defined in clause (27) of section 2,
over the company (herein referred to as “significant beneficial
owner”), shall make a declaration to the company, specifying the nature of
his interest and other particulars, in such manner and within such period of acquisition
of the beneficial interest or rights and any change thereof, as may be
prescribed:

 

Provided that the Central Government may
prescribe a class or classes of persons who shall not be required to make
declaration under this sub-section.

…

 

(4) Every company shall file a return of
significant beneficial owners of the company and changes therein with the
Registrar containing names, addresses and other details as may be prescribed
within such time, in such form and manner as may be prescribed.

 

(5) A company shall give notice, in the
prescribed manner, to any person (whether or not a member of the company) whom
the company knows or has reasonable cause?to believe—

 

(a) to be a significant beneficial owner
of the company;

 

(b) to be having knowledge of the
identity of a significant beneficial owner or another person likely to have
such knowledge; or

 

(c) to have been a significant beneficial
owner of the company at any time during the three years immediately preceding
the date on which the notice is issued, and who is not registered as a
significant beneficial owner with the company as required under this section.

…..

 

(7) The company shall,—?(a) where that person fails to give the company the information
required by the notice within the time specified therein; or?(b) where the information given is not satisfactory, apply to the
Tribunal within a period of fifteen days of the expiry of the period specified
in the notice, for an order directing that the shares in question be subject to
restrictions with regard to transfer of interest, suspension of all rights
attached to the shares and such other matters as may be prescribed.

 

(8) On any application made under
sub-section (7), the Tribunal may, after giving an opportunity of being heard
to the parties concerned, make such order restricting the rights attached with
the shares within a period of sixty days of receipt of application or such
other period as may be prescribed.

 

(9) The company or the person aggrieved
by the order of the Tribunal may make an application to the Tribunal for
relaxation or lifting of the restrictions placed under sub-section (8).

 

(10) If any person fails to make a
declaration as required under sub-section (1),?he shall be punishable with fine which shall not be less than one
lakh rupees but which may extend to ten lakh rupees and where the failure is a
continuing one, with a further fine which may extend to one thousand rupees for
every day after the first during which the failure continues.

 

(11) If a company, required to maintain
register under sub-section (2) and file the information under sub-section (4),
fails to do so or denies inspection as provided therein, the company and every
officer of the company who is in default shall be punishable with fine which
shall not be less than ten lakh rupees but which may extend to fifty lakh
rupees and where the failure is a continuing one, with a further fine which may
extend to one thousand rupees for every day after the first during which the
failure continues.

 

(12) If any person wilfully furnishes any
false or incorrect information or suppresses any material information of which
he is aware in the declaration made under this section, he shall be liable to
action under section 447.

 

To which categories of companies does this
section apply?

Section 90 applies to all types of
companies, whether public or private, whether listed or unlisted. All persons
who hold such significant beneficial ownership are required to make such
declaration, except where the Central Government has exempted them.

What type of holdings are required to be
disclosed?

The following types of holdings/control are
required to be disclosed:

 

1.  Beneficial interest of at
least 25% (or such other prescribed percentage) in shares of a company

2.  Right to exercise
significant influence or control.

3.  Actual exercising of
significant influence or control.

 

Such holding, etc. would be by an
individual either by himself or together or through other persons including
even persons outside India. The holding/control may be in a private, public or
even a listed company.

 

Implications

The implications of the new provisions are
wide. Almost every company will see such disclosures, unless the holding is so
widely held that no individual or group hold a significant holding/control. It
applies to all companies – private, public or listed. These disclosures will
then have to be recorded and then filed to Registrar. There will be massive
paperwork, even if one-time. A husband-wife company where each holds such 50%
will require disclosure by both persons. Private equity firms will have to make
such disclosures if they hold such significant holdings. Listed companies will
also see such disclosures. Even if none of these are benami holdings. Even
foreign shareholders are covered.

 

The wording is wide and, at some places,
ambiguous. Certain definitions are not given and hence may result in further
ambiguity. Take some examples.

 

If an individual holds/controls ‘together’
with another person, disclosure is required. However, it is not clear what
‘together’ means. Does it have a meaning similar to ‘persons acting in concert’
as defined in detail under the SEBI SAST Regulations?

 

Often directors, trustees, etc. may
exercise voting rights for companies, trusts, etc. Will they too have to
make disclosures? The Central Government may notify persons who are exempted
from making disclosures.

 

Shareholding particularly in groups and
listed companies may be held in complex structures. Is the law sufficient to
unravel such structures to find out who, if any, are ultimate persons who hold
shares or have or exercise control? SEBI and RBI have given guidance under
certain circumstances how to find who are real ultimate owners. But the Act
does not give any guidance.

 

Apparently, the provision will apply to
existing holdings as well as fresh acquisitions. Hence, a one-time declaration
would have to be made.

 

In any case, will the objective of detecting
benami holdings be achieved? The Prohibition of Benami Property Transactions
Act provides for confiscation of the properties and prosecution of persons
involved. Thus, making such a disclosure could be invitation for such serious
actions. The penalties for not making such disclosures, though significant in amount,
are not very large and does not result in any prosecution under the Act.

 

The Company has an obligation to notify
persons who hold shares or control to such extent if it has reason to believe.
If they do not take action, they too may face action.

 

Action by Company which believes a person who
is a significant beneficial owner

 

If the Company has reason to believe that
there is a person who has such holding/control, it needs to notify such person
to make a disclosure. If such person does not make a disclosure, the Company
has to approach the Tribunal to investigate. If it is found by the Tribunal
that there exists such holding, etc., then it may direct that the
transfer of such shares shall be restricted and all rights relating to such
shares shall be suspended.

 

Penalties

There are penalties if such individuals do
not make such disclosure. A penalty of Rs. 1 to 10 lakh plus upto Rs. 1000 for
every day of delay can be levied. False disclosures can result in prosecution.
The Company too faces penalties.

 

Conclusion

Clearly, these provisions need
reconsideration. It is submitted that it should not be notified and brought
into effect. Ideally, a revised and well drafted provision should be introduced
or, second best, through circulars and rules, the implications need to be
diluted and restricted. _

Supreme Court Widens Powers of SEBI – Penalties Now Even More Easier to Levy

Background

The Supreme Court in SEBI vs. Kanaiyalal B
Patel (2017) 85 taxmann.com 267 has held that `front running’ by any person
(and not merely intermediaries as provided by a specific provision) is in
violation of the SEBI Regulations relating to fraud and unfair trade practices.
By holding that SEBI is right in taking penal action against a person who is
`front running’, the Supreme Court has increased the penal powers of SEBI even
where the letter of the law is found wanting. However, the reasons given by the
Court have created a precedent that will have far reaching implications. It extends
the scope of `front running’ to almost every case of tipping. It makes it easy
to levy penalties with a lesser level of proof. It also broadens the definition
of ‘fraud’ to include even cases where there is no deceit. It would allow SEBI
to act even when there is a private
wrong between two parties and even if public/securities markets are not
affected. Finally, the Supreme Court holds that proving mens rea is
not required for levy of penalty in case of fraud.

Some parts of this ruling make it easier for
SEBI to take action against persons who indulge in fraudulent acts which are
not covered by the strict letter of the law. The decision makes the law
dynamic. Some parts of the judgement cover acts that shouldn’t at all be the
business of SEBI even if the actions were wrong. Finally, some parts of the
ruling overly broaden the scope of the law to convert some actions which are
neither wrong nor irregular into an offence. Instead of actually reading down
certain overly broad wordings of the Regulations, the ruling takes them
literally, it is respectfully submitted, that this creates absurd results.
Hence, this decision has far reaching effect beyond the specific offence of
`front running.’

What is front running?

`Front running’ is recently being found to be
a common practice in the securities market, considering that several cases have
been detected. Essentially, it is abusing of trust/confidence placed usually in
a market intermediary by a client, but it can happen in another context too.
`Front running’ is not only not defined – but the term is not even used in the
Regulations/Act. The Supreme Court has cited several definitions. Taking the
example of a stock broker, the gist of the definition is :

 

–   A client may place an order for a large
quantity of shares with a stock broker. The stock broker knows that as soon as
he places this large order, the market price will move up. To profit from this,
at the cost of his client and hence unethically, he would place the order of an
identical or lesser quantity of shares for himself (or he may tip some
friend/relative to do so). The price of the share would rise. He then would
place the order in the name of his client and simultaneously offer for sale at
the higher price the shares he had earlier bought. The result would be that he
would make a profit from the difference and his client would end up paying a
higher price. He may act similarly in case of a large order of sale.

 

–    There can be variants as was seen in the
cases in appeal before the Supreme Court. There may be a mutual fund
intermediary who seeks to buy a large quantity of shares and the employee who
is authorised to place such an order, tips off a friend/relative. A portfolio
manager may seek to buy and the manager/employee may do the same. Indeed, even
an employee of the client who is planning to buy such number of shares may do a
similar act.

In each of such cases, it is seen that the
person goes in front of such order and places his orders first. Hence the term
?front running.’


It is easy to see that such acts done by
registered market intermediaries result in the investing public losing trust in
the securities markets. SEBI obviously would be right in acting against such
intermediaries. However, should SEBI act even in cases where such acts are
committed by persons not registered with it? For example, should SEBI take
action against the employee of a private investor   who  
uses  the  information 
about  a  large 
planned order by his employer and commits `front
running’? Such a matter does not affect the securities markets. Is it similar
to any other fraud/breach of trust committed by an employee against his
employer! The issue becomes relevant because the Regulations relating to
frauds/unfair trade practices of SEBI provide specifically for front running by
intermediaries.

Background of the decision – front
running – law, SEBI and SAT decisions and amendments

The decision of the Supreme Court is in
appeal against five decisions of the Hon’ble Securities Appellate Tribunal (“SAT”)
in relation to `front running.’ In each of these cases, certain persons got
tipped off of large orders in shares. They thus bought ahead of such orders
(hence the term ‘front running’) and sold when these large orders actually
materialised, making a handsome profit. In each of these cases, SEBI had taken
penal action against persons found guilty of `front running.’ In the earlier
two of these cases, SAT held the SEBI Regulations applied only when an
intermediary did such front running ahead of its client’s large orders, not
when a person tipped off by an intermediary’s employee and did front running
ahead of the intermediary & its client’s large orders. The reasoning
offered was that the relevant regulation – 4(2)(q) of the SEBI (Prohibition of
Fraudulent and Unfair Trade Practices relating to Securities Market)
Regulations, 2003 (“the Regulations”) – applied only to intermediaries and not
to others. The principle applied was “expressio unius est exclusio
alterius”, i.e., when something specific is expressly mentioned, others in
the same class are excluded.

In later decisions, however, the SAT took a
different view. It held that the general provisions in the Regulations relating
to fraud were wide enough to cover front running even by non-intermediaries.

In the meantime, SEBI amended Regulation 4.
As noted earlier, Regulation 4(2)(q) treated front running by intermediaries as
a specific case of fraud prohibited by the Regulations. Some other clauses in
this Regulation too applied only to intermediaries. Apparently, to overcome
this, an explanation was introduced in 2013 to this Regulation which was stated
to be clarificatory and which, for this context, effectively said that the
clauses were not restricted to acts of intermediaries. The intention of the
amendment also appears to give it a retrospective effect and thus would apply
even to past cases including the ones decided by SAT.

Apart from the technical issue of whether the
specific provision that prohibits `front running’ only by intermediaries, there
was another issue involved.  The tipping
by an unregistered intermediary (and other parties) or its employee to an
outsider which results in front running does not necessarily mean that the
capital markets or the public are thereby harmed. The harm is caused to the
intermediary privately and/or its clients. To take an example, say a closely
held company seeks to place a large order of purchase  of 
shares  in  a particular company. An employee of the
buyer company tips a friend who then buys the shares and then sells the shares
to the buyer company at a higher price. Now in this case, the company ends up
paying a higher price, but the public who sells shares to the friend do not
lose since they would have otherwise sold the shares directly to the company at
the same price. Hence the loss is caused only to the company, by paying a
higher price, then it is arguable that the interests of the public/capital
markets are not affected. Indeed, it is also arguable that even if the orders
were placed on behalf of a client, the harm is caused by the intermediary to
the client and thus, the intermediary may need to compensate the client and
also otherwise face action for allowing such things to happen. The question
thus is whether wrongs that are private between parties and not affecting the
public/capital markets should be dealt with by SEBI?

Decision of the Supreme Court

The Supreme Court thus essentially had to
face certain basic questions. First question is, whether the specific
provisions relating to front running by intermediaries meant that front running
by others were not prohibited by the Regulations? Or were the general
provisions relating to fraud were wide enough to cover all types of front
running. The Court held that the rule that specific excludes the general does
not apply here. Several other issues were raised which were answered and also
certain reasoning and ruling of law/interpretation were provided which need
consideration.

The Court (reading together the separate
judgement of each of the two Hon’ble Judges) effectively held as follows:-

 

1. The definition of fraud is very wide. It includes every act
that induces another person to deal in shares.
Importantly, it is not necessary that such inducement should be with a
malafide intention of deceit or the like.

 

2. The act whereby the
tippee engages in front running is in breach of the understanding and law
relating to confidentiality of information and thus is an act that is violative
of the Regulations.

 

3. The general provisions of
Regulation 3 are wide enough to cover front running. Effectively, it is thus
not necessary to refer to Regulation 4 that refers to front running by
intermediaries.

 

Note: In
the author’s view, taking the ruling to its logical end, the specific
provisions relating to front running by intermediaries become redundant!

 

4. The Court held that
proving mens rea – guilty mind – is not necessary. It is sufficient if
the violation is proved by preponderance of probabilities and not beyond
reasonable doubt.

Note: This observation
lowers the bar of proof required to find a person guilty and subject to penal
action.

 

5. Any tipping by a
person to another is in violation of the Regulations. Effectively, this would
thus include
insider trading where insiders share unpublished price sensitive information
with third parties. `Front running’ thus is one of the types of such irregular
tipping.

 

Note:
This again may result in many provisions of the SEBI Regulations relating to
Insider Trading being redundant. This would extend the provisions of the
Regulations beyond what is expressly provided in the regulations.

 

Implications

As stated earlier,  we 
now  have a  broad and 
widely interpreted definition of fraud by the Supreme Court that gives
SEBI wider powers to catch and punish persons who directly or indirectly take
advantage of the securities markets. However, we have an earlier decision of
the Supreme Court in Shriram Mutual Fund ((2006) 131 Comp Cas 591 (SC)) that
has resulted in SEBI taking a view that penalty has to automatically follow
every violation. This decision goes many steps ahead and even effectively
endorses poorly drafted law, albeit mentioning in passing that current law
needs an overhaul. While one can hope that SEBI will not apply in practice the
definition of fraud which says deceit is not required. One also hopes that SEBI
exercises restraint whilst despite the wider powers provided by the Court.
However, it still remains an area of concern since parties will find it
difficult to meet allegations, which are not serious and will suffer larger
amounts of penalty, etc. whether before SEBI or even in appeal before
SAT. It is humbly submitted that this decision needs reconsideration. _