Sebi penalised for arbitrary conduct

WITHOUT CONTEMPT

This week's column is about regulatory accountability. In a landmark judgment, the Securities Appellate Tribunal (SAT) has imposed costs on the Securities and Exchange Board of India (Sebi) for unsustainable conduct in passing an order barring a company from accessing the capital market or dealing in securities for five years.

Dealing with an order passed by a wholetime member of Sebi in July 2004, SAT has held the Sebi order to be "as arbitrary as it could have been" and ruled that it "smacked of highhandedness."

The SAT imposed costs of Rs. 2 lakh since the Sebi order had seriously damaged the reputation of the company. The SAT ruled that since the company was listed, the Sebi order, in fact, worked to the detriment of the investors in the company.

"The damage caused is irreparable both to the company and its shareholders," the SAT order notes, and adds, "We are, therefore, of the view that this is a fit case where the Board should be burdened with heavy costs."

This is a rare occurrence. Hopefully, the conduct from the regulator that led to such an order, too, would become a rare occurrence. In an environment where worldwide, slightest suspicion about wrongdoing results in regulators getting to use wide-ranging powers to take drastic action, the SAT order is a reminder that where the law provides for checks and balances, regulatory conduct has to be in line with the law, and can never be arbitrary.

In this case, the company was issued a notice alleging manipulation, and thereby, a violation of Regulation 4 of the Sebi (Prohibition of Fraudulent and Unfair Trade Practices Relating to the Securities Market) Regulations, 1995 (FUTP Regulations). In its order dealing with the response to the notice, Sebi cleared the company of these allegations.

However, in relation to a preferential allotment made by the company in January 2000, Sebi's order found the company guilty of violating the preferential allotment norms contained in the Sebi (Disclosure and Investor Protection) Guidelines, 2000, which require any allotment of shares to be made only on a fully paid-up basis. Sebi also recorded a serious finding that the records had been falsified to show that the company received the funds before allotment.

It was found that the requirement to allot shares on a preferential basis only in the form of fully paid-up shares was not in existence when the allotment had been made. Worse, the Sebi did not give any notice of this allegation and proceeded to pass the final order.

The Sebi order mentioned that the funds received towards the preferential allotment subscription amounted to Rs 4.8 crore while the requisite amount was Rs. 5.2 crore.

However, on a review of the material on record, the tribunal found that Rs 5.2 crore had come in.

Sebi had also ruled that even the receipt of Rs 4.8 crore was fictitious because an identical amount had been paid out by the company on the same day. Using these circumstances, Sebi also accused the company of falsification of records, and thereby violating Regulation 6 of the FUTP regulations. Again, no notice of this allegation was given to the company.

The tribunal found that Sebi did not even enquire into the source of funds and where the funds went to, and blithely recorded a conclusive finding that since the funds seemed to have come in and gone out on the same day, the funds never really came in.

Therefore, this finding, too, was set aside.

The SAT order serves as a reminder that regulatory action should not be arbitrary. Often, in the zealousness to demonstrate a record number of penal and remedial actions in their annual reports, regulators make short shrift of the due diligence process required for drawing conclusions. Insistence of regulators in passing orders where none is warranted often leads to failure in defending such actions in the law courts. Such failures, in turn, harm the credibility of regulatory action.

The Sebi Act at least affords an appellate forum for such orders to be challenged. No such forum exists for decisions of the Reserve Bank of India, another core financial sector regulator, whose actions, too, need to be consistent, fair and balanced. It is time to bring about a law for an appellate forum against decisions of the central bank as well. Ultimately, appellate oversight can only improve the quality of work done by the regulators. The existence of a sound and judicious regulator lies at the core of making the market safe, simple and predictable for all participants.

(The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.)