Monday, March 16, 2015

SAT Order in the DLF Case: Controlling SEBI’s Punitive Vehemence

[In an earlier post, I had offered some initial overview and commentary on the SAT Order in the DLF IPO Case.

In the following post, Vinod Kothari offers another perspective that focus on certain specific aspects of the order and analyzes their impact on SEBI’s role as an enforcer of securities regulation. The author can be contacted at]

The order of the Securities Appellate Tribunal (SAT) in the case of DLF Limited makes interesting reading, not because it is the first of its kind passing strictures against the vehement use of  punitive powers by SEBI, but it provides an important opportunity to reflect on the question whether massive penal powers in financial statutes are to be used in sync with the gravity of the matter, or can simply be deployed casually?

This post is not intended to cover the facts of the case, but on significant points on which ruling has been given by the Securities Appellate Tribunal (SAT). A brief review of facts has been given because the judgement itself has been inspired, at least in part, by the stark  facts surrounding the case.  Author needs to submit that this article is no endorsement or evaluation of the business practices followed by real estate companies, which may encompass different shades of gray, replete with cash deals, unfair practices and so on. However, that commercial dispute between a party having a land deal with an alleged affiliate of the company should have been raked up before SEBI, SEBI should have, 7  years after the closure of the issue, with absolutely no evidence of any investor damage due to the alleged non-disclosure, passed strict penal orders, is a matter of great interest. We need to understand civil disputes are civil disputes ; while a complainant may go forum shopping to find the one which is strongest and strictest, the temptation of assuming irrelevant jurisdiction has to be avoided by securities regulators.

Facts of the case in brief

The matter pertains to a red-herring prospectus (RHP) for a public offer made by DLF. The complainant’s case is that DLF had some affiliate entities, not disclosed as subsidiaries in the RHP, and that these alleged subsidiaries were engaging in dealings, whereby the complainant had allegedly been defrauded some Rs 34 crores worth cash which was promised to be paid, but was never paid.

The civil nature of the complaint apart, the securities law related issue is the non-disclosure in the offer document of some 281 subsidiaries, which were subsidiaries of a vertical chain of 3 companies. Once again, do note that formation of special purpose vehicles (SPVs) for holding land is quite a common feature in the real estate world for several reasons. Also, it is quite a common device to use a chain-breaker company in between to segregate a complete chain of de-facto subsidiaries from the parent company[1].  According to the version of the company and the merchant bankers, there is no question of these SPVs being reported as subsidiaries or affiliates as their equity capital stood transferred in the name of the wives of some of the senior employees of the company. Neither was there voting control, nor management control, with DLF.

In fact, the complainant’s issue was not so much the disclosure: his real issue lay in the financial  claim that he had against DLF promoters. He had filed a criminal case for that purpose in Delhi courts, apparently 3 days before the merchant bankers  approved the company’s prospectus.  This was March 2007. Two months later, SEBI gave its detailed observations on the offer documents, which were duly incorporated. The pubic issue was floated in mid-June 2007.

The complainant also put up a complaint with SEBI that DLF’s sister concern had duped him – this was some days after the RHP had been finalised and the public offer was just about opened. Once again, it is not unusual for litigants to try to stall something like a public offer, which is quite time sensitive and,  if blocked or delayed, may cause considerable costs and injuries to the issuer.  As usual, SEBI sends complaints to the merchant bankers and the company for appropriate response, and as usual, the company and the merchant bankers would have denied the allegations, primarily on the ground that the companies with which the complainant had an issue were not even the subsidiaries of DLF.

The complainant went to the High Court with a writ petition, to direct SEBI to investigate his complaint. This was October 2007 – almost 5 months after the public issue had already succeeded. The writ petition was favourably disposed by a single judge of the High Court in April 2010 – almost 3 years after the relevant time. The company as well as SEBI went in appeal to the Division Bench, which initially stayed the order, but later in July 2011 (that is, more than 4 years after the public issue) gave an order directing SEBI to investigate the complaint of the complainant. In October 2011, a SEBI whole-time member (WTM). In June 2013, SEBI issued a show cause notice alleging various violations of the-then applicable regulations, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 (the DIP Guidelines).[2] Hearings took place around January 2014, and the final penalty order was passed by a WTM 9 months after the conclusion of the pleadings.

Interestingly, in the meantime, the FIR filed by the complainant  was found to be false and frivolous, and  Delhi police closed the matter. That is, the root cause of all this uproar was anyway out; however, SEBI had, in the meantime, concluded that there were misstatements in the prospectus on the ground of the huge chain of subsidiaries not reflected in the prospectus. There was no finding of any investor losses by reason of the non-disclosure.

Principal legal issue in the case: the meaning of “control”

One of the significant legal issues discussed in the ruling is the meaning of “control” in the DIP Guidelines, since it is based on determination of control that the alleged chain of subsidiaries could be said to be affiliated with DLF. Interestingly, there was no definition of “control” in the DIP Guidelines[3].  In absence of a definition, SEBI WTM ran for various definitions of control, including the age-old Companies Act definition, definition under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (SAST Regulations), definition under accounting standards, and so on.

The SAT order eventually settles on the classic meaning of control as combination of voting control and control over policy decisions. It deals with the meaning of “significant influence” which quite often people read as “control”. Control is control over policy-making; significant influence is merely right of participation in policy-making. The holding of 20% equity is merely a rebuttable presumption as to existence of significant influence – it is possible that there is less than 20% stake and yet significant influence, and also possible that there is more than 20% stake, and yet no significant influence.

This SAT order and lots of other orders of SAT or bodies such as the Competition Commission of India highlight the draftsmen of regulations try to rope in the myriad ways in which corporate control is held, by using expressions such as “or otherwise” or “directly or indirectly”, but it is impossible for regulators to grab all the devices that corporates may use, including layers of entities with a circuit-breaker in between.
In the present case, the directors of the three alleged subsidiaries continued to be on the board, despite the transfer of shareholding. The SAT did not regard this fact as indicating “control” on the ground that it is up to the shareholders of the companies as to who do they choose as their directors, and unless a case is made that it was DLF who dictated the appointment of directors, merely because the directors have continued cannot indicate board control. It does not seem if the age-old concept of “acting as per instructions” or absentee control was at all pressed into service in the original SEBI order. The show-cause notice seems to have brought factors like transfer of shares without any payment therefor, possibly hinting that the transfers might have been back-dated, but SAT did not regard these allegations as valid.

Non disclosure of FIR: knowledge by directors is not knowledge by the company

On the allegation as to why the FIR had not been  disclosed in the RHP, the case of SEBI was that the FIR named some person who was a close relative of DLF promoters. Therefore, there was an implicit knowledge. SAT order, in its characteristically caustic style, say we are not living in the Vedic age, where relations between relatives were so strong that knowledge by a relative can be deemed knowledge by the others. SAT also relied upon a 1981 ruling of Bombay High court in Killick Nixon[4] wherein, in a matter of transfer of shares of a deceased person, it was held that  knowledge of death of the shareholder by the directors cannot be deemed to be knowledge by the company.

Respectfully, this point in the ruling seems a little far-fetched. A company has no sensory organs – there is no basis of knowledge by the company other than its principal officers. There are rulings that wrongs by the company cannot be attributed upon the directors, but it is difficult to argue that knowledge of the executive directors cannot be attributed upon the company.

The SAT ruling  also cites several precedents to hold that filing of an FIR is by itself not a case of litigation. This is an important point, and may be of relevance for disclosures by corporates. Details of pending litigation by or against the company are also to be given as a part of corporate governance codes.

Punitive vehemence of SEBI

The ruling makes several  lashing remarks against SEBI’s vigorous exercise of its punitive powers, and more particularly, of the 9 months’ delay with which the order was passed after conclusion of pleadings.  To wit:

- Therefore, reference made to the definition of 'Control' under the Takeover Code reflects a complete non-application of mind in this regard. This act of the Respondent to shop for clauses and provisions in different statutes, in an arbitrary manner, needs to be condemned. In fact, the pari materia principle ought to be invoked to promote uniformity and predictability in law in order to supplement and not supplant a rule of law by another.

- In quest of a more befitting definition of 'Control', the Respondent has gone astray by even applying the definition of 'Control' as given in an entirely different context in the Takeover Code, 1997 or even certain Accounting Standards, primarily meant for auditors to be followed. Neither the Division Bench of the Hon'ble High Court of Delhi nor the first WTM of Respondent, who ordered investigation pursuant to the Hon'ble Delhi High Court's direction for possible violation of DIP Guidelines, gives any direction or observation which would have the consequence of entwining an element of fraud with the case of violation of DIP Guidelines in the issuance of the IPO in question. If interlacing two completely different concepts emanating from the same word, as defined in two different pieces of regulation/ legislation, were to be adopted in every matter, it would give rise to the most preposterous situation, viz., the conclusion that having different regulations/legislations for different areas of the law is pointless.

- Instead of there being different laws and statutes for different circumstances and entities, there would be one statute defining all the wrongs and their respective remedies. There is a reason that has not been done. Every Act of the Parliament, just like every set of rules framed by the Respondent, has a distinct rationale behind it. The blurring of lines between different laws and regulations cannot lead to any desirable outcome. Yet, the second WTM, who passed the Impugned Order, has applied the PFUTP Regulations in total disregard of the due procedure incorporated in the said Regulations for alleging and proving a charge of fraud against a company. The allegation of fraud against any company is an extremely serious matter and cannot be pressed into service in a casual manner, as has been done in the present case.

Proportionality of penalties with the gravity of offence: a shunned issue

The otherwise bold ruling of SAT shuns the issue of proportionality of punishment to the gravity of the cause. Penalties are deterrent  in nature: they are not compensatory, they are punitive. Therefore, the extent of penalty is necessarily connected with the gravity of the offence, mindset of the offender, and the damage caused thereby.  For example, if the traffic rules were to say, if you jump a signal, you pay a fine of Rs 5 lacs, it is disproportionate. Lately, SEBI has been imposing penalties running into lakhs for purely mundane and innocent failures to file, for example, the particulars of trades in securities by the employees of a company.

The SAT, however, shunned the issue in the following words: “For the same reason[5], we do not propose to consider the true import of Hon'ble Supreme Court's judgment in the case of ( i) SEBI Vs. Shriram Mutual Fund reported in 2006 (5) SCC 361 and (ii) Bharjatiya Steel Industries Vs. Commissioner, Sales Tax, Uttar Pradesh reported in 2008 (1) SCC 617, regarding the scope of Sebi's power to impose punishment whenever any violation of Securities Laws is committed by a Company. We leave this question also open to be considered in future if any eventuality arises in a given case so also the question of proportionality.”


Needless to say, the ruling makes a very interesting reading. Particularly the extracts from the recommendations of the Dhanuka Committee, based on which massive powers were given to SEBI, that SAT should counterbalance the slant that may most likely be caused by an ambitious drive for penalties by SEBI adjudicating officers. Hopefully, the ruling will give SEBI a reason to offer lessons in reasonableness to its prosecuting officers.

- Vinod Kothari

[1] One of the commonest device is to use a small equity size, and much large size of preference capital, which, being non-voting, non-convertible, does not make the holder a holding company. The equity may remain dispersed so that no  single holder has a controlling or significant block. This is precisely the device apparently used in this case. In Companies Act 2013, MCA did bring convertible preference shares into the fold for capturing holding status, but it is easy to structure preference shares as non-convertible and thereby avoid this change of law. It is strongly recommended that India should put a thin-capitalisation rule where preference stock cannot exceed a certain proportion of equity.

[2] Precursor the now-applicable ICDR Regulations.

[3] The ICDR Regulations imbibe the meaning of “control” from the SAST Regulations. There have been several rulings on the meaning of “control” under the SAST Regulations. “Control” is defined in the SAST Regulations 2011, with primarily two indicia, such as right to appoint majority directors, or control policy decisions, though the words “directly or indirectly” and sources from which control flows such as management rights, shareholders’ agreements, etc. seek to make the ambit wide.  

[4] MANU/MH/003/1981;

[5] That is, since the order is being quashed on merits.


vswami said...

“ reflect on the question whether massive penal powers in financial statutes are to be used in sync with the gravity of the matter, or can simply be deployed casually?”
No gainsaying, the proverbial ‘moment of truth’ doth have arrived, to so reflect; and to the end of conceiving of, ushering in, and effectively enforcing, statutory checks and balances, to take to the logical conclusion. For that matter, such an endeavour, in one’s conviction, ought to be extended to and cover, in clear terms, -besides ‘massive penal powers’ and ‘in financial matters’- equally all others of ‘public interest’- the litmus test to apply being as to its direct or indirect influence and thereby impacting moral or social behaviour in the most comprehensive sense. As to ‘gravity’, it is, just as any other, a consideration, mostly ‘personal’ (in its inclusive meaning); hence, in the nature of it, is inherently amenable to varied mutually contradicting views, and never pass muster as ‘objective’ – in contrast to ‘subjective’.
In short, the most concern is centred on the concept of ‘bureaucracy’, and attendant vested powers having inevitable pitfalls and unbridled exercise by the empowered men.

(May have more to share)

vswami said...

To quickly add (for the nonce): Related view points are seen to have been covered in some detail, in the Blog, -

vswami said...

To quickly add (for the nonce): Related view points are seen to have been covered in some detail, in the Blog, -
In recent times there have been quite few such instances; and, expectantly, would have provoked radically changed thoughts in legal circles. Mainly, that is as to the manner in which, apart from bureaucrats/ any other governmental authority, have seemingly acted ‘vehemently’, -nay, with a vengeance. Further, tragically, such an impulsive and emotional behaviour is noted to have slowly and steadily crept into the judicial system / matters of administration of justice as well; overwhelmingly, though not necessarily in sync with ‘gravity’ of given situation.
If care to, anyone may look through the swamilook Blogs devoted to the two most vital sectors of all, being realty and banking , having a tremendous impact on the national economy in general, the societal wellbeing in particular.
For required motivation in proper and ideal direction, recommended to seek inspirational help in , - 19 AWESOME Inspirational Quotes for New Year’s 2015