Category: Securities Laws

This particular case (Order of SEBI dated 16th February 2017 in the matter of Arvind Remedies Limited) has an interesting and perhaps worrisome feature. SEBI has taken a view that the concerned auditors had been negligent in their duties as auditors and failed to maintain requisite professional standards in their work. Based on this, the auditors have been accused  of fraud, manipulation, deceit, etc. These allegations are not only more serious but can result in far stricter punishment.

FACTS OF THE CASE
A forensic audit was carried out of the listed company, Arvind Remedies Limited, by a consortium of bankers. Several findings were made by these forensic auditors and also by SEBI’s own subsequent investigation. Some of alleged frauds/manipulation, etc. were as follows:-

1.    Maintenance of multiple sets of books of accounts.
2.    Recording of bogus sales.
3.    Allegedly making fake sales/entries with several companies.
4.    Destruction of large amount of inventories which SEBI suspects to be originally non-existent.
5.    Reduction of a large amount of tangible assets in a suspicious manner.
    And so on.

The turnover of the company had reduced very substantially. The share price on stock exchange too had reduced to a small fraction of the price in preceding period. It was alleged that during the relevant period the Promoters sold a very substantial number of shares and reduced  their shareholding from 46.84% to 3.58%. The Promoter Director also had drawn a large amount as commission on sales which SEBI has alleged to be fake.

Around this time, the erstwhile auditors (“the Auditors”) of the Company resigned and a new firm was appointed. The findings by the new firm were similar to findings of SEBI/the forensic auditor.

ACTION BY SEBI AGAINST THE COMPANY AND PROMOTER DIRECTOR
SEBI alleged that the Company and its promoter director were guilty of violation of several provisions of the SEBI Act/SEBI (PFUTP) Regulations relating to manipulations, frauds, etc. It also alleged that the promoter director had drawn a large amount of commission on the basis of bogus sales. Accordingly, it issued the following interim directions:-

1.    Debarred the Company and the promoter director from accessing the securities markets, buying/selling shares, etc.

2.    Directed the promoter director to impound the commission that he had drawn on basis of allegedly bogus sales.

SEBI also directed the promoter director not to alienate any of his assets till the amount of commission was duly impounded in the manner specified by SEBI.

ACTION AGAINST THE AUDITORS
SEBI had sought a statement from the Auditors on various issues to which replies were given by them. Pursuant to such replies and investigation, SEBI made several observations against the role of the Auditors. SEBI stated: “For negligence in certification of accounts of listed company, failure to maintain professional standards in Audit, the Statutory Auditor and its proprietor were prima facie alleged to have violated – i. Section 12A(a), (b) and (c) of the SEBI Act and Regulation 3(b), (c) and (d) and Regulation 4(1) and 4(2)(a), (e), (f), (k) and (r) of the PFUTP Regulations.” (emphasis supplied).

Again, SEBI pointed out several alleged lapses of the Auditors such as not reporting on certain discrepancies in the accounts. Based on this, SEBI observed, “The irregularities perpetrated by ARL, its Director and Statutory Auditor, discussed hereinabove are prima facie in violation of Sections 12A(a), (b) and (c) of the SEBI Act; Regulations 3(b), (c) and (d) read with Regulations 4(1) and 4(2)(a), (e), (f), (k) and (r) of the PFUTP Regulations. “

Thus, SEBI has alleged that the Auditors have prima facie violated the provisions relating to fraud, manipulation, deceit, etc. as contained in the SEBI Act and the PFUTP Regulations.

These provisions provide for certain fairly serious violations. Section 12A(a) concerns with use of “any manipulative or deceptive device or contrivance” in connection with certain issue/purchase/sale of securities. Section 12A(b) deals with employment of “any device, scheme or artifice to defraud” in connection with issue or dealing of securities. Regulation 4(2)(r) of the PFUTP Regulations deal with “planting false or misleading news which may induce sale or purchase of securities.”

Thus, and to repeat, these are serious violations alleged.

The interim order also operates as a show cause notice to the Auditors asking them to show cause as to why they should to be debarred from giving various certificates for having allegedly committed violations of the provisions relating to fraud, manipulation, deceit, etc.

Whether negligence/lower professional standards in audit can be treated as fraud, deceit, etc.

In the earlier order in the case of Shashi Bhushan discussed in an earlier article in this column, the auditor concerned was specifically alleged to have committed the violations relating to fraud, etc. In other words, the allegation was that he was party to such things.

In the present case, the order, though not wholly clear/consistent, seems to be on a different footing. The Auditors are not specifically alleged to be party to such fraud, etc. The allegation against them is that they have been negligent in their audit and/or they have applied lower professional standards in their audit. However, whether such negligent work can amount to fraud, manipulation, etc.? The latter are allegations that can result in severe consequences of debarment, penalty, prosecution and perhaps more.

The Order/Show Cause notice further states that “The Statutory Auditor therefore, enabled ARL and its Director to perpetrate manipulation/fraud on genuine investors in the securities market.” Thus, it appears that the allegation is that the alleged actions/defaults of the Company/director were a consequence of such alleged negligence, etc.

It will be interesting to read the final order of SEBI on the matter and how it bridges what I see as a gap between alleging negligence/low professional standards in audit and an active fraud/manipulation/deceit. Negligence/low professional standards in audit is surely a default that ought to be acted upon but allegation of fraud, manipulation, etc. are different and serious defaults. Negligence, it is submitted, does not amount to committing fraud which requires mens rea and a conscious and active participation to commit such an act.

WHETHER SEBI HAS POWERS TO ACT AGAINST AUDITORS
To consider whether SEBI has powers to act against auditors of a listed company, the decision of the Bombay High Court in Price Waterhouse & Co. vs. SEBI (2010) 103 SCL 96) is relevant. The Court had observed therein:-

“25. ….The powers available to the SEBI under the Act are to be exercised in the interest of investors and interest of securities market. In order to safeguard the interest of investors or interest of securities market, SEBI is entitled to take all ancillary steps and measures to see that the interest of the investors is protected. Looking to the provisions of the SEBI Act and the Regulations framed thereunder, in our view, it cannot be said that in a given case if there is material against any Chartered Accountant to the effect that he was instrumental in preparing false and fabricated accounts, the SEBI has absolutely no power to take any remedial or preventive measures in such a case. It cannot be said that the SEBI cannot give appropriate directions in safeguarding the interest of the investors of a listed Company. Whether such directions and orders are required to be issued or not is a matter of inquiry. In our view, the jurisdiction of SEBI would also depend upon the evidence which is available during such inquiry. It is true, as argued by the learned counsel for the petitioners, that the SEBI cannot regulate the profession of Chartered Accountants. This proposition cannot be disputed in any manner. It is required to be noted that by taking remedial and preventive measures in the interest of investors and for regulating the securities market, if any steps are taken by the SEBI, it can never be said that it is regulating the profession of the Chartered Accountants.
….
With a view to safeguard the interests of such investors, in our view, it is the duty of the SEBI to see that maximum care is required to be taken to protect the interest of such investors so that they may not be subjected to any fraud or cheating in the matter of their investments in the securities market. In our view, the SEBI has got inherent powers to take all ancillary steps to safeguard the interest of investors and securities market.”

The Court thus has held that where a Chartered Accountant is “instrumental in preparing false and fabricated accounts”, SEBI does have jurisdiction to act in interests of investors/markets. The Court further observed:-

“If it is unearthed during inquiry before SEBI that a particular Chartered Accountant in connivance and in collusion with the Officers/Directors of the Company has concocted false accounts, in our view, there is no reason as to why to protect the interests of investors and regulate the securities market, such a person cannot be prevented from dealing with the auditing of such a public listed Company.”

It is clear thus that SEBI does have power/jurisdiction to take action against a Chartered Accountant who connives/colludes with the management of the company to concoct false accounts.

However, the questions that this particular case presents are two. Whether negligence/applying lower professional standards in auditing by itself amount to fraud. Secondly, whether such negligence, etc. itself are actionable
by SEBI. 

IMPLICATIONS ON OTHER PROFESSIONALS AND GENERALLY THROUGH OTHER LAWS
Action by SEBI against the Chartered Accountant does not rule out action by the Institute of Chartered Accountants of India for defaults of professional negligence, misconduct, etc. Further, action is also conceivable under other laws such as the Companies Act, 2013, etc.

Adverse action is also possible in appropriate cases against other professionals such as Company Secretaries, lawyers, etc.

It will be of interest whether and to what extent the defence of double jeopardy (under Article 20(2) of the Constitution of India) of double punishment for the same offence would be available.

CONCLUSION
The liability of auditors of entities to which Securities Laws apply have only increased over the years. Apart from increasingly complex laws and wider requirements/scope of audit and other work, there are multiple regulators who end up regulating the same work. The auditors would have thus to be prepared to defend their work against action by different regulators/forums and also be subject to multiple forms of adverse action for the same work.

The order of SEBI (“the Order”) is in the case of Shri Shashi Bhushan, Proprietor of M/s. Bhushan Aggarwal & Co., in the matter of Ritesh Properties and Industries Limited (Order No. WTM/RKA/EFD/23/2016 dated 17th February 2016).

Summary of THE Order
The matter concerned a listed company (“the Company”) that was alleged to have carried out several accounting irregularities such as inflated revenues/profits, incorrect classification of assets, etc. The report of the Auditors did not point out these irregularities. In a subsequent year, the Company actually reversed by way of restatement the whole of such inflated revenues of the two years under consideration. The price of the shares of the Company had moved from Rs. 3.52 to Rs. 123.50 during the period that the order covered. An earlier order of the SEBI on the Company gives more details of other alleged violations by the Company.

The Company, as per the order, was engaged in real estate/ land related activities. The Company had recognized substantial revenues that were shown to have resulted in significant profits. SEBI appointed an independent Chartered Accountant to conduct special examination of the accounts of the Company. SEBI recorded a finding that there were serious accounting irregularities that had resulted in overstatement of revenues/profits. SEBI considered this not only to be a fraud by the Company but also alleged that the auditors abetted the company in doing so. Consequently, SEBI passed prohibitory directions to such Chartered Accountant.

Violations of Accounting Standard/Guidance Notes
SEBI considered the relevant requirements of Accounting Standard 9 on Revenue Recognition and the Guidance Note on Recognition of Revenue by Real Estate Developers issued by the Institute of Chartered Accountants of India. It examined the detailed facts of the case and contrasted the requirements of such Accounting Standard/ Guidance Note with the actual accounting practices followed by the Company. According to SEBI, “correct accounting procedures and practices had not been followed in preparation of financial statements of the Company”.

Allegations/findings of SEBI against the Auditors
SEBI stated that, “It was observed from the analysis of the report that the auditor had fraudulently certified the annual report, which it did not believe to be true and had fraudulently caused the annual reports of the relevant period to be published with untrue information, in spite of the presence of unusual features in the accounts of the Company”. SEBI made certain further observations such as:-

“… the Auditor had fraudulently omitted to disclose…”

“It was alleged that as a statutory auditor of the Company, the Auditor failed to notice that the Company had not followed the accounting standards for recognising revenue.”

– “The Auditor had certified the overstated revenue and profits recognised by the Company in violation of the applicable Accounting Standards for recognising revenue from real estate business.”

– “In spite of the presence of unusual features in the accounts which prima facie gave reason to believe that the revenue recognised by the Company was not in order, the Auditor had willfully/ fraudulently failed to take note of the same while certifying the accounts of the Company. The aforementioned commissions and omission by the Auditor prima facie indicated the intention to benefit the Company in disseminating the false financial position and to defraud the investors by not giving the true and fair picture of the Company’s financial position.”

– “…it was observed that knowing very well that what was being certified was not true and fair report of the Company, the Auditor had certified its Annual Reports, suppressing Related Party Transactions and showing inflated and false financial position of the Company only to defraud the general investors.”

SEBI alleged that the Auditors had contravened several provisions of the SEBI Act and PFUTP Regulations relating to fraudulent and other practices. After reviewing the submissions of the Auditors, SEBI concluded that:-

“…it has been established that correct accounting procedures and practices had not been followed in preparation of financial statements of the Company and the Noticee had falsely certified misleading Annual Accounts of the Company, containing distorted information, which he did not believe to be true but certified knowing that the same when published would be relied upon by the investors to be true and fair and such certification was intended for the benefit of the Company and its promoters/ directors in their alleged manipulation of price in the scrip of the Company. I, therefore, find that by the aforesaid acts and omissions the Noticee aided and abetted the Company in disseminating the false financial position and to defraud the investors by not giving the true and fair picture of the Company’s financial position and, thus, its acts and omissions amount to aiding and abetting in the fraudulent, unfair and manipulative acts in connection with dealing in the shares of Ritesh Properties and are covered within the definition of “fraud” and “fraudulent” under regulation 2(1)(c) of the PFUTP Regulations…” (emphasis supplied)

Direction of debarment against the Auditors
In view of this, SEBI passed prohibitory directions debarring the Auditors. The wording of the debarment are interesting (emphasis supplied):-

“… hereby prohibit Shri Shashi Bhushan, Proprietor of M/s. Bhushan Aggarwal & Co. from, directly or indirectly, issuing any certificate required under securities laws namely Securities Board of India Act, 1992 (sic), the Securities Contract (Regulations) Act, 1956, the Depositories Act, 1996, Rules, Regulations, Guidelines made thereunder, the Listing Agreement and the applicable provision of the Companies Act, 2013, the Rules, Regulations, Guidelines made thereunder which are administered by SEBI, with respect to listed companies and the intermediaries registered with SEBI for a period of one year.”

Some aspects need attention:-
– the prohibition is on issue of certificates and not reports.
– The certificate may be under any of the specified securities laws, viz., SEBI Act, SCRA and Depositories Act and the rules, regulations and guidelines issued thereunder. The laws specified, particularly the rules, regulations and guidelines are numerous.
– The certificate may be even under the the applicable provision of the Companies Act, 2013, the Rules, Regulations, Guidelines made thereunder which are administered by the Securities and Exchange Board of India.
– The certificate must be required under the said specified laws.
– The certificates may relate to listed companies as well as intermediaries registered with SEBI. The term intermediaries covers a wide range of entities active in the securities market.

Applicability to other professionals
It is not uncommon for SEBI to find such entities engaging in accounting irregularities. Clearly, while SEBI would take actions against such persons for such matters, the role of the Auditors would also now increasingly come into focus. This order may become thus one of the first of many such orders in the future.

While passing the order, SEBI stated, “This is also a fit case where SEBI needs to send a stern message to professionals who associate themselves with securities market so as to prevent them from indulging in such acts of omissions and commissions as found in this case.” (emphasis supplied). While these words do show SEBI’s desire to act strictly, the use of the word “professionals” needs attention. Other professionals such as Company Secretaries, lawyers, etc. too associate themselves with and advise entities in the securities markets. It can thus be expected that, in appropriate and similar cases, such orders may also be passed against other professionals such as Company Secretaries, lawyers, etc.

Locus standi of SEBI to pass such orders
It will be interesting to watch the progress of such orders and how appellate authorities/courts act in that regard. In Price Waterhouse vs. SEBI ((2010) 103 SCL 96), the Bombay High Court had observed that, “isst cannot be said that in a given case if there is material against any Chartered Accountant to the effect that he was instrumental in preparing false and fabricated accounts, the SEBI has absolutely no power to take any remedial or preventive measures in such a case. It cannot be said that SEBI cannot give appropriate directions in safeguarding the interest of the investors of a listed Company….. If it is unearthed during inquiry before SEBI that a particular Chartered Accountant in connivance and in collusion with the Officers/Directors of the Company has concocted false accounts, in our view, there is no reason as to why to protect the interests of investors and regulate the securities market, such a person cannot be prevented from dealing with the auditing of such a public listed Company.” (emphasis supplied). Thus, the Court endorsed the power of SEBI to take action against auditors who engage in such acts.

Whether SEBI has exclusive, parallel or overlapping jurisdiction over auditors?

In the present case, SEBI held the Chartered Accountant to have acted in a manner aiding and abetting in the fraudulent, unfair and manipulative acts, etc. as prohibited under the SEBI PFUTP Regulations. However, this obviously does not rule out actions by other authorities including ICAI depending on facts of each case. The auditor may also face action for non-reporting of fraud u/s. 143(12) of the Companies Act, 2013. Thus, Auditors (and other professionals) may see multiple actions under different provisions and from different authorities/ persons. And it is possible that the parties who can take action may only increase. For example, if and when the provisions relating to class actions u/s. 245 of the Companies Act, 2013, are brought into effect, there may be claims for damages/compensation too. Similarly, when brought into effect, NAFRA may also have a role. Concerns may also arise whether such actions can be exclusive or overlapping/multiple for essentially the same default.

The Bombay High Court in Price Waterhouse’s case cited earlier did make some distinction between the role of ICAI and SEBI. For example, it stated that, “It is true, as argued by the learned counsel for the petitioners, that SEBI cannot regulate the profession of Chartered Accountant. This proposition cannot be disputed in any manner”. However, it also held if SEBI takes “remedial and preventive measures in the interest of investors and for regulating the securities market, if any steps are taken by SEBI, it can never be said that it is regulating the profession of the Chartered Accountant”. Importantly, it also observed, “In a given case, if ultimately it is found that there was only some omission without any mens rea or connivance with anyone in any manner, naturally on the basis of such evidence, SEBI cannot give any further directions.”

These words do give broad guidance of what role SEBI has and where it can and cannot act. They affirm SEBI’s powers but at the same time limit them. Having said that, several concerns and issues still remain as to where the lines of demarcation, if any exist, are to be drawn, whether the role will be overlapping, whether the defense of double jeopardy for multiple punishments would be available, etc. Discussion of this would be beyond the scope of this article and competence of this author.

Conclusion
SEBI has powers to take action against a wide range of persons who are associated with the securities markets. Such persons are not merely those who are registered with SEBI as intermediaries or are listed companies whose securities are listed on stock exchange. Auditors and other professionals, independent directors, key managerial personnel, etc. are also persons who have been over the years been acted against by SEBI. The law is clearly developing and there are grey areas and concerns that hopefully will see more light on as time passes.

Background
It is interesting to see that SEBI and Securities Laws generally, relatively late-comers to financial markets, saw development in leaps and bounds. Securities Laws developed generally and specifically. Elaborate – perhaps too elaborate in places; law and systems have been put into place. These include regulations, a sophisticated intelligence gathering mechanism, a relatively transparent investigation, adjudicating and enforcement system, etc. In comparison, the law relating to commodity contracts, put into place more than six decades earlier, looked almost ancient. This is despite having huge quantity and volumes in commodity trading.

The turnover on commodity markets is huge, even with the existing relatively rudimentary regulatory structure. The turnover on national commodity exchanges was nearly Rs. 1.80 crore crore during 2013. That is nearly half the turnover on equity markets.

The objective of commodity markets may be different from equity markets. The crop grower, for example, looks up to plan and even hedge his produce, decide what he will produce, what he will sell, when he will sell, what he will store, etc. The buyer too looks at it to decide his output pricing, his product mix, what and how much he will buy and when, how much he will store, etc.

However, perhaps one another reason for the hesitation in making major changes in law was the sensitivity to commodity trading since food crops also happened to be a significant part of commodity trading volumes. Speculation, price manipulation, hoarding, etc, was feared to play havoc to livelihood of farmers and consumers. However, finally, the realisation seems to have sunk in that the answer to that is not keeping hands off, or worse, a relatively poor set of ancient regulations under an ill-equipped regulatory body. The better recourse is to modernise and update the law. Or, as the law makers have chosen, merge it with a body that already has much expertise and infrastructure in a field that is in many ways quite similar to commodity contracts.

The recent massive scam in National Spot Exchange Limited exposed this regulatory gap like never before. What was even more interesting is that many of the players here were also brokers, investors, etc. who operated in the securities markets as well. The practices followed in the spot exchange were also similar. The only difference was that the rules of the game and the regulatory bodies were different. The scam and the subsequent unfolding of facts later showed how inadequate were the law and the systems.

Existing Law
The existing law relating to commodity derivatives was mainly contained in Forward Contracts Regulation Act (FCRA) and rules made thereunder. The governing body is Forward Markets Commission (FMC). FCRA itself has not seen many changes, the last change in 1970 (contrast that with the continuous amendments over the years in SEBI Act). However, significant details are given the Rules, Circulars, Notifications, etc. issued under that Act. Major amendments were sought to be made to give FMC more powers and include several provisions in law that were similar to provisions in Securities Laws. However, the changes could not be finally put in place.

In the existing FCRA, terms like forward contract, ready delivery contract, goods, options, ready delivery contract, etc, are defined. Commodity exchanges regulate the sale and purchase of “goods” and there is a system & criteria for their recognition/registration by the FMC/Central Government. There is a ban/restriction on forward contracts for which the object is to route them through the exchanges. Though drafted in a fairly broad way, there are brief clauses that prohibit making of false statements relating to forward contracts, price manipulation in forward contracts, etc. and provide for their punishment by way of forfeiture, fines and prosecution.

Broadly, the essence and scheme is similar with the Securities Laws such as SEBI Act, Securities Contracts (Regulation) Act (SCRA), and related laws. What is also apparent is the nature of commonality between commodity contracts/derivatives and contracts in securities. The system, the nature of contracts, and even the mathematical sophistication involved in their valuation are quite similar. It makes sense, therefore, that a body having such expertise governs both. The proposal in the 2008/2010 proposed amendments was to create a parallel body and law for commodities that would be quite similar to that under securities laws. Having said that, there are important differences too, warranting special treatment for commodity contracts, which will be discussed later.

Proposals under the Finance Bill, 2015
Part II and III of the Finance Bill, 2015 propose many changes. These are, as will be seen later, merely enabling and do not immediately bring about the change. The changes will come into effect from a date to be notified. The FCRA is sought to be repealed. FMC will be merged with SEBI. The SEBI Act and SCRA will be amended to include certain definitions relating to commodity contracts/ derivatives. Existing commodity markets/associations will become at par with stock exchanges. And so on.

However, it will be a full year before which they will come into effect, and maybe even longer. During this period, SEBI is expected to develop the necessary regulatory base specific to commodity contracts, adapt if needed some of existing law and systems, get the commodity markets/associations change their bye laws and systems to the extent needed similar to existing stock exchanges, etc.

Implications for the law
Clearly, the next one year (and I expect it will be more than a year considering the huge task ahead) would be very busy for SEBI and the commodity regulators/associations. SEBI may appoint one or more Committees to look into the matter and suggest appropriate regulations and/or modification in existing regulations for commodity markets. Model bye laws and similar provisions for commodity markets may be developed and existing commodity associations would be asked to change their bye laws or adapt their existing bye laws, etc. It is possible that considering some specialised aspects of commodity markets, a separate department may be formed.

There are many similarities between commodity contracts and contracts in securities. There are ready delivery contracts for commodities that are treated with less regulations just like spot delivery transactions for securities. The forward contracts and their valuation too have substantial mathematical and structural similarities. Their manipulations too have similarities.

However, there are substantial differences too. Securities are different from commodities in many ways. Commodities are mined, grown, processed, etc. they may have seasonal variation and limited or periodical supplies. they may be renewable or they may be not. they are eventually meant to be usually consumed. Commodities fall into numerous categories and their producers and consumers often fall into very distinct and non-homogenous categories. Many of these differences may eventually need to be reflected into not just the law regulating them but even in the structuring of their contracts. At the same time, considering that most commodities already have a track record of trading and existing well accepted contracts as well as their regulation, the process would not be so much from scratch. In most cases, it may be aligning to a large or small extent the existing contracts and systems into the new scheme. Still the job ahead is large.

The existing regulatory scheme for securities markets are tailor made for capital market operators/intermediaries. there are regulations for companies and listing, intermediaries like brokers/merchant bankers, etc, for mutual funds/alternate investment funds, etc. While there are some lessons to be learnt from these regulations, it is quite clear that commodity market specific regulations would have to be formulated for entities operating there.

Existing regulations for control of malpractices and/or for ensuring fairness are also substantially specific/unique to securities.  The  takeover  regulations  for  example  would have  no  relevance  for  commodity  markets.  the  insider trading regulations too may have very little commonality, if at all, with commodity markets (though curiously the earlier Bills did make provisions for insider trading). Similarly, buyback regulations, corporate governance, etc. would not have relevance. however, the regulations relating to unfair, fraudulent, manipulative practices may be quite relevant though it would need substantial adaptation for commodity markets. perhaps relatively sophisticated and directly applicable  set  of  regulations  would  be  the  regulations relating to adjudication and punishment of violations. The system for investigation, issuing show cause notices, giving a fair hearing, applying certain  well  accepted  principles for levy of penalty or other adverse actions ought to be substantially and directly applied o commodity markets too. So would the regulations relating to settlement by consent orders and compounding.

Implications for Chartered Accountants and other Professionals
This change offers both a new challenge and opportunity for Chartered accountants. Securities laws have welcomed the services offered by Chartered accountants in several ways. Be it audits, advisory, valuation, inspection and investigation, Chartered accountants have the requisite skills and expertise to provide these services. Commodity contracts and markets are likely to become more developed as well as more complex in laws. CAS will have an active role to play in their audits, in valuation, in tax and advisory, in compliance, reporting, and so on.

Conclusion
One might be tempted to argue that SEBI has not wholly removed malpractices in securities markets, even though it has over the years become very powerful. Insider trading  is said to be rampant, price manipulation and scams keep occurring, Satyam happened despite some of the best legal and corporate governance practices in place, etc. So question is while the most recent move will put a very large new market under SEBI it will inevitably make the law very complex. However, clearly, there have been substantial changes  in securities laws whose benefits, tangible or intangible, are  being  seen.  The  number  of  cases  where  violations have been detected and penalties levied is increasing. as perhaps a mark of the sturdiness of the investigation and adjudication process, as all of the law, the decisions of SeBi that are overturned on appeal are also lesser. Thus, in the short term as well as the long term, it would be fair to expect a similar improvement in commodity markets. Eventually, we ought to also see a developed law relating to commodity contracts/markets.

Brief facts
In this case, to summarise the facts as reported, a merchant banker managed a public issue. As the readers would know, the manager to a public issue (“IPO”) has the highest and broadest of responsibilities, not only in managing the issue generally but coordinating with other intermediaries. In particular, it is his prime responsibility as regards the quantity and quality of information of disclosures made in the prospectus. It was found that in an issue managed by it, certain material disclosures were not made. The Company had, immediately before the IPO, borrowed monies from certain entities and used the same for advances for capital assets and other matters. The genuineness of such outgoing/ expenditure was not accepted by Securities and Exchange Board of India. The Company, after the IPO, repaid such loans from the IPO proceeds. The SEBI alleged that this amounted to siphoning off of funds. Further, it seems that the SEBI believed that the fact that the IPO proceeds were really meant to pay off such existing liabilities would have been a material consideration for the investors. Thus, disclosure of such facts would have affected their decision in investing.

The basic facts that the amounts were borrowed, then used for certain purposes and then the IPO proceeds were utilised for repayment of such borrowings do not seem to be in dispute. Also, nondisclosure of such pre-existing borrowings was also not in dispute. The issue in question was whether the merchant banker had carried out his duty with diligence that was expected of him.

Decision and principles laid down

The SAT laid down the law relating to the duties of the merchant banker as regards due diligence. Clause 64 of the SEBI (ICDR) Regulations 2009, reads as under:

“Due diligence.

64. (1) The lead merchant bankers shall exercise due diligence and satisfy himself about all the aspects of the issue including the veracity and adequacy of disclosure in the offer documents…..”

The SAT relied on the decision of the Supreme Court in the matter of Chander Kanta Bansal vs. Rajinder Singh Anand [(2008) 5 SCC 117] where due diligence was explained in the following words:

“The words “due diligence” have not been defined in the Code of Civil Procedure, 1908. According to Oxford Dictionary (Edn. 2006), the word “diligence” means careful and persistent application or effort. “Diligent” means careful and steady in application to one’s work and duties, showing care and effort.”

The SAT then reviewed the Memorandum of Understanding between the merchant banker and the Company and the rights of the merchant banker stated in the following clause was highlighted:

“The BRLM shall have the right to call for any reports, documents or information necessary from the Company to enable them to verify that the statements made in the Draft Red Herring Prospectus or the final Prospectus are true and correct and not misleading, and do not contain any omissions required to make them true and correct and not misleading.”

The statement in the prospectus that was found to be incorrect read as under:

“Bridge Loan: We have not entered into any bridge loan facility that will be repaid from the Net Proceeds.”

The merchant banker raised several pleas in its defence, all of which (except one, which is not relevant for this discussion) were rejected.

Firstly, the merchant banker stated that it was not informed by the company about the borrowings and that such information was indeed withheld from them. The SAT did not accept this as a valid defense. It said that the merchant banker could not expect the company to provide its information on its own with the merchant banker not taking any initiative. The SAT observed, :-

“Appellant’s plea that the information regarding ICDs was withheld from Appellant by ESL cannot be accepted. BRLM, in carrying out its functions is generally expected to act in an independent and professional manner and should not rely only on issuer company to provide them with updates, if any. Due diligence on part of Merchant Banker does not mean passively reporting whatever is reported to it but to find out everything that is worth finding out.”

The merchant banker said that it had obtained undertakings from the directors of the Company that the statements made in the prospectus are true. This too was rejected as being an insufficient defense. The SAT stated that accepting statements from the Company was no substitute for proper due diligence.

Then the merchant banker explained the manner in which he carried out his duties. He said that “when he handles IPO, he carries out random checks to verify authenticity of entities mentioned in the prospectus and has submitted documents in support of same”. In particular, the verification is “with reference to objects of issue and quotations, and in respect of IPO of ESL such checks were made in respect of major quotations submitted by ESL and, in support, Appellant submitted copies of few quotations along with nothings from concerned executive at its end, confirming veracity of offer document.”.

However, the SAT did not accept this and found that the manner in which such checks were carried out was insufficient. The Investigation had revealed that a sum of Rs. 4.75 crore from the IPO proceeds was allegedly siphoned off.

The SAT also explained the manner in which an intermediary such as a merchant banker in the present case should act while carrying out its duties with due diligence:-

“It is about making an active effort to find out material developments that would affect interest of investors. It is on faith that intermediary has conducted due diligence with utmost sincerity that investing public goes forward and decides to invest in a particular company. In present case Appellant had failed to exercise due diligence in carrying out its duties as BRLM in IPO of ESL.”

The SAT observed that the merchant banker had merely relied on certain statements provided by the Company and others. Moreover, even some of such statements were misleading or not in context of the issue before it. In any case, the SAT observed that this approach did not amount to carrying out its duties with due diligence. The SAT observed, :-

“Reliance of such documents, which in effect do not convey anything material or are misleading, infact, strengthens the case of Respondent that Appellant has done nothing to carry out due diligence and has been a passive actor, waiting for documents/information to come to him, whereas he should have been active in looking into various aspects of functioning of ESL, scrutiny of functioning of ESL, scrutiny of all relevant documents- including bank statements and order book position etc., before certifying correctnes of various statements in prospectus and issue of due diligence certificate at various stages of IPO”.

“All the directors of the company (including independent directors) shall exercise their duties with due and reasonable care, skill and diligence;”. The implications of this decision thus is wide and the principles laid down by the SAT will be useful for intermediaries including merchant bankers, chartered accountants and others associated with listed companies.

The requirements of corporate governance has resulted in tens of thousands of persons — most of them highly educated and experienced — being appointed as independent directors of listed companies. By definition, they are generally nonexecutive, since being a paid executive director would mean loss of independence. However, while such an army of independent directors has been created under this requirement, the law governing them remains age-old. Only the nomenclature of Independent Director is new. The role, powers and duties of independent directors are not provided for in the requirements relating to corporate governance framed by the SEBI and placed in the listing agreement as Clause 49. No extra powers or authority is given to the independent directors (though some functions and authority are given to the Audit Committee). Thus, for understanding the powers and duties of an individual independent directors, one has to look at the pre-existing law as contained in the Companies Act, 1956. While this law too does not lay down a specific and detailed framework for non-executive directors, the settled law is that individual non-executive directors are required to be diligent and exercise a level of care than a prudent person may ordinarily exhibit. Further, even these requirements relating to corporate governance have been, curiously, placed not in the SEBI Act or even in any notified regulations or rules, but in the listing agreement between the Company and the stock exchange. This gives these requirements, at best, a semi-statutory cognizance. The violation of these requirements generally results in action against the Company and not against the independent directors.

Expectedly, the other peculiar result is that there are no specific provisions providing for punitive or other adverse consequences for violating the requirements relating to corporate governance. As we will see later, this is perhaps the reason that the SEBI has used its omnibus powers to take action against the independent directors who were allegedly negligent and who even allegedly abetted the fraud.

The preceding paragraphs are not intended to provide for any excuse or leeway for the negligence of any independent directors, particularly a person who is a member of the Audit Committee. It is only to highlight the fairly inadequate manner in which the law has been framed. When a situation has arisen when such law was tested, the SEBI, instead of accepting this inadequate framework and taking corrective action in this regard, resorted to omnibus provisions to take punitive action which most Independent Directors could not even have visualised. Of course, it has to be noted that the facts of the case, if one goes by the SEBI Order, are fairly serious. Let us now consider the details of this case as provided in the SEBI Order.

It has been alleged by the SEBI that Pyramid, the listed company of which the specified persons were independent directors and members of its Audit Committee, overstated its revenues and thus its profits by manipulation of its accounts. The company which is engaged in the business of managing theatres and exhibition of films claimed to have entered into agreements with more than 800 theatres from which revenues flowed into the company. The SEBI recorded a finding that in reality barely about 250 such agreements could be proved and the rest of the agreements did not exist. Hence, it was alleged that the revenues based on such sham agreements were non-existent and through false book entries such revenues were recorded. The accounts based on such overstated revenues and profits were published for the benefit of the public.

SEBI made a finding that the accounts were thus misstated and the question then was, what role did the independent directors play and whether they did not perform their duties as expected of them. This was particularly so, since such Directors were also members of the Audit Committee.

It is worth noting the relevant extracts what SEBI says in its dealing with what it believes to be the role of the Board in general, of independent directors and of members of the Audit Committee :

“5. A company acts through its board of directors. It is the duty and responsibility of the directors to ensure that proper systems and controls are in place for financial reporting and to monitor the efficacy of such systems and controls. While the extent of responsibility of an independent director may differ from that of an executive director, an independent director has the duty of care. This duty calls for exercise of independent judgment with reasonable care, diligence and skill which should be reasonably exercised by a prudent person with the knowledge, skill and experience which may reasonably be expected of a director in his position and any additional knowledge, skill and experience which he has. The audit committee exercises oversight of the company’s financial reporting process and the disclosure of its financial information to ensure that the financial statement is correct, sufficient and credible. It reviews the adequacy of internal control system and management discussion and analysis of financial condition and result of operations. The institutions of independent directors and audit committee have been established to promote corporate governance and enhance the protection of interests of investors. These have a critical role to play in the regulation and development of the securities markets and protection of interests of investors in securities.

6. I note that Mr. K. S. Kasiraman and Mr. K. Natarahjan were independent directors and members of the audit committee at the relevant time. It has been submitted that Mr. G. Ramakrishnan was not an independent director and a member of the audit committee for the entire period. I find that he was an independent director and also a member of the audit committee when quarterly reports of the last two quarters of the year were considered by the Board as well as the audit committee. Further, the quarterly reports of succeeding quarters, when he continued as an independent director and as a member of the audit committee, have indication about the unreliability of the financial statements of the previous quarters.

 7.   I find that the noticees overlooked numerous red flags in the trend in revenues, profits, receivables, advances, etc. which could not escape the attention of an independent director, who is also a member of the audit committee. For example, profits tripled in the quarter ending June 2007 over the preceding quarter. It doubled in the quarter ending December 2007 over the preceding quarter. The quarter ending March 2008 reported a loss of Rs.3.11 crore compared to a profit of Rs. 29.87 crore in the preceding quarter. Similarly, though the number of screens in theatres increased from 487 as on September 30, 2007 to 655 as on December 31, 2007, security deposits with theatres during the same period increased disproportionately from Rs.36.05 crore to Rs.170.38 crore. Such aberrations in financial figures would alert any person of ordinary prudence. The appropriate questions at the right time from the noticees would have unravelled the fraud being played by the company on the innocent investors. By failing to ask the right questions at the right point of time, I find that the noticees have failed in their duty of care as an independent director. They failed to review, as members of the audit committee, the internal control systems, which generated misleading financial statements. I find that the noticees were either too negligent to notice the aberrations in performance of the company and the fraud behind such aberrations or acted as shadow directors of the board/ members of the audit committee. In either case, they facilitated the company to make false and misleading disclosures and thereby created artificial prices and volumes in the securities of PSTL in the market, to the detriment of innocent investors. I, therefore, conclude that the charge of disclosure of false and misleading statements, as alleged in the SCN against the noticees, is established. Thus, the noticees are guilty of violating Section 12A of SEBI Act, 1992 and Regulation 3(b), 3(c), 3(d), 4(1), 4(2)(e), 4(2)(f), 4(2)(k), 4(2)(r) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.

  8.  Such conduct on the part of the noticees is disgrace to the institutions of independent directors and the audit committee of a listed company. This cannot be viewed lightly and warrants regulatory intervention. Therefore, in exercise of the powers conferred upon me u/s. 19 read with Sections 11, 11B and 11(4) of the Securities and Exchange Board of India Act, 1992 and Regulation 11 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003, I hereby restrain Mr. K. S. Kasiraman (Permanent Account Number: AFPPK3572B), Mr. K. Natarahjan (Permanent Account Number: ACJPN0418I), and Mr. G. Ramakrishnan (Permanent Account Number: AAEPR2014F) from being an independent director or a member of audit committee of any listed company for a period of two years from the date of this Order.”

This case is obviously an extreme one where, in a sense, like the Satyam case, serious allegations and findings of fraud were made and expectedly, the question would be how could such serious alleged frauds have escaped the attention of such directors. Or, worse, whether they actively abetted such frauds. This is more so, when they were also on the Audit Committee. However, such an extreme case cannot make and define the law for other cases particularly if there are lesser violations or for areas the facts are less clear.

It is also seen that the SEBI does not have any direct and specific powers to deal with non-performance of duties by the independent directors or for their being negligent. In fact, the SEBI has used its omnibus and comprehensive powers u/s. 11, 11B, etc. to take action against such Independent Directors. The issue is whether it is appropriate to use such powers in this manner creating an impression that the SEBI can act against anyone for anything that it perceives to be wrong or irregular without either defining what is right and wrong conduct and specifying clearly the consequences therefor.

Curiously, the SEBI has held that the Independent Directors are guilty of several provisions of the SEBI FUTP Regulations relating to fraud, price manipulation, etc. The Order, however, does not deal with each such clause separately and establish how it was violated. It is one thing to hold Independent Directors responsible for being negligent or passively not performing their duties and it is totally another thing that they were active participators or abettors of the fraud, etc.

It may be recollected that in an earlier case of an alleged massive fraud, the SEBI had made a similar order debarring the independent directors in that case. However, the Securities Appellate Tribunal (Appeal No. 347/2004, dated 8th December 2005) reduced the period of debarment and found that the SEBI had neither alleged nor established any aiding/abetting by the independent directors to the alleged fraud. It also noted that the independent directors were passive and had no active role in perpetrating the alleged fraud.

Of course, this is not to question the power of SEBI to take such action. As discussed in an earlier article in this column (December 2010 issue of BCAJ), the Bombay High Court in Price Waterhouse & Co. v. SEBI, [(2010) 103 SCL 96 (Bom.)] upheld the power of SEBI to take similar action against auditors and the ratio of that decision should apply directly in facts of the present case. Having said that, recently, questions have been raised (a subject that merits a separate discussion) whether the SEBI indeed has power to ‘punish’ persons under such general and omnibus powers.

To reiterate, a precedent against errant independent directors was needed and this Order does provide one. Having said so, one cannot help observing that the system is skewed against the independent directors. On one hand, by misplacing the requirements of corporate governance in the listing agreement and by not giving any specific right to individual independent director or even to them as a whole, the SEBI has not given them any teeth to really do their jobs well. On the other hand, their obligations, formal and otherwise, are significant. It could thus create difficulties for conscientious Independent Directors in their functions. And since independent directors are really the essential core of good corporate governance, the absence of a proper legal framework for their role, powers and duties is a serious vacuum that, if not filled, will make the requirements of corporate governance ineffective.