Monday, April 29, 2013

Supreme Court on “Market Abuse”

In a judgment delivered last Friday, the Supreme Court came down heavily on “market abuse” not just on the case at hand but more generally on the practice to the extent prevalent in India.

The case, N. Narayanan v. Adjudicating Officer, SEBI, arose in the form of an appeal from the Securities Appellate Tribunal (SAT) in relation to the appellant who was the whole time director of Pyramid Saimara Theatre Limited (PSTL). The SAT had confirmed an order of the Securities and Exchange Board of India (SEBI) restraining the appellant from dealing in securities for a period of 2 years and also an order of the adjudicating officer of SEBI imposing a monetary penalty of Rs. 50 lacs  on the appellant. These orders were in connection with the violation of section 12A of the SEBI Act as well as relevant provisions of the SEBI (Prohibition of Fraudulent and Unfair Trade Practice Relating to Securities Market) Regulations, 2003. It was found that the financial results of the company as disclosed to the stock exchanges were inflated and that they did not represent the true and fair state of affairs of the company. This maintained the stock price of the company high and enabled certain shareholders to raise financing by pledging of shares.

In an unequivocal decision, the Supreme Court upheld the orders of  SEBI and the adjudicating officer and found the appellant guilty of violating the SEBI Act as well as the 2003 Regulations. The court found the existence of the required facts that support the holding that the appellant was guilty of violating the requisite provisions of the law.

While the judgment does not appear to lay down any new principles of law, it does place tremendous emphasis on the importance of efficient capital markets that require a strict disclosure regime. The judgment also seems to lament about the current state of affairs regarding regulation of the capital markets through a proper disclosure regime.

Three points emerging from the Supreme Court’s decision are noteworthy:

1.  The first is the need for efficient capital markets with a strict disclosure regime. The court noted that where shares of a company are quoted on the stock exchange, it is crucial to have proper disclosure of information for accurate pricing of the companies securities and for the efficient operation of the capital markets. It also noted the prevalence of market abuse in India:

10. … “market abuse” has now become a common practice in the India’ security market and, if not properly curbed, the same would result in defeating the very object and purpose of SEBI Act which is intended to protect the interests of investors in securities and to promote the development of securities market. …

This must also be read with the information requirements under the Companies Act, wherein the books of accounts of the company must be maintained so as to provide a true and fair view of the state of affairs of the company and also to explain significant transactions. This is also consistent with the corporate governance requirements under the listing agreement.

2. Given the court’s view of the prevalence of market abuse in India, it has called for strict measures to be applied and for more stringent enforcement by the regulator. The court’s “word of caution” or one might say a stern warning can be witnessed in the court’s own words:

43. SEBI, the market regulator, has to deal sternly with companies and their Directors indulging in manipulative and deceptive devices, insider trading etc. or else they will be failing in their duty to promote orderly and healthy growth of the Securities market. Economic offence, people of this country should know, is a serious crime which, if not properly dealt with, as it should be, will affect not only country’s economic growth, but also slow the inflow of foreign investment by genuine investors and also casts a slur on India’s securities market. Message should go that our country will not tolerate “market abuse” and that we are governed by the “Rule of Law”. Fraud, deceit, artificiality, SEBI should ensure, have no place in the securities market of this country and ‘market security’ is our motto. People with power and money and in management of the companies, unfortunately often command more respect in our society than the subscribers and investors in their companies. Companies are thriving with investors’ contributions but they are a divided lot. SEBI has, therefore, a duty to protect investors, individual and collective, against opportunistic behavior of Directors and Insiders of the listed companies so as to safeguard market’s integrity.

3. The court has re-emphasised the principles applicable towards directors’ liability.  In this particular case, the appellant raised an argument that although he was a whole-time director of the company, he was only in charge of the human resources department, and was therefore not responsible for the other affairs of the company, including financial matters which were under the overall control of the managing director. The Supreme Court rejected this argument outright. All directors carry the responsibility to ensure that the books of accounts of the company represent a true and fair view of the financial state of the company. That responsibility cannot be passed on either to other directors or even to the auditors of the company. The level of onus laid down by the Supreme Court is as follows:

33. … a Director may be shown to be placed and to have been so closely and so long associated personally with the management of the company that he will be deemed to be not merely cognizant of but liable for fraud in the conduct of business of the company even though no specific act of dishonesty is provide against him personally. He cannot shut his eyes to what must be obvious to everyone who examines the affairs of the company even superficially.

34. The facts in this case clearly reveal that the Directors of the company in question had failed in their duty to exercise due care and diligence and allowed the company to fabricate the figures and making false disclosures. Facts indicate that they have overlooked the numerous red flags in the revenues, profits, receivables, deposits etc. which should not have escaped the attention of a prudent person.

This clearly suggests that directors cannot simply turn a blind eye to the goings on in the company. That apart, the directors appear to have a positive obligation to seek further information and raise further questions once a red flag becomes visible. While this high burden seems to be applicable to an executive director, as was the case on the present facts, it is unlikely that a non-executive director’s burden would be substantially lower than this especially in the presence of a red flag situation. Of course, the present case must be read in the context of executive directors only, but it certainly suggests the attitude of the courts towards duties and liabilities of directors of public listed company.

In all, while the Supreme Court’s decision is based on the facts and circumstances of the specific case and does not lay down any new principle of law, there is overwhelming evidence of the intention of the court to stringently apply securities laws such that the efficiency of the capital markets be maintained. While the Supreme Court does send a message to SEBI, a lot would depend not only on the availability of resources to enable the regulator to carry on a more enhanced role, but it would also depend on the robustness of various laws, particularly the procedural laws, that would equip it to carry on its mandate in an effective manner. One example of this is the high burden of proof that SEBI is expected to discharge in insider trading cases, which it has only been partially successful in discharging on average.    


Prof Bala said...

Very interesting post. Glad to note the penal provisions in the Bill, as well as their mandatory nature highlighted. The more we get rid of discretionary power in as many walks of life as we can, the better it is for the dispensation of justice at various stages. Puzzled a bit about the concerns expressed on the severity of provisions. Reminds me of the human rights sympathies for the criminal killers for getting the rights of the victims. Just as an example, consider the alleged frauds in the recent Saradha case and similar others; let's spare a thought for the victims who lost their all, and those who killed themselves. If proved, I think even the most severe punishment will be inadequate for the perpetrators. It need not be Hamurabi's eye for an eye but some thing close enough is perhaps required to deter potential fraudsters.
Prof Bala

CA Jayant Thakur said...

Thank you Prof Bala...

I believe your comment relates to my post titled "Mandatory imprisonment under Companies Bill 2012" dated 29th April 2013 which has been made inadvertently here. Accordingly, I have reproduced your comment under that post and also given my reply there.

- Jayant Thakur