Monday, November 7, 2016

Disgorgement Orders under Indian Securities Law

[The following guest post is contributed by Shubham Janghu, a third year student at Jindal Global Law School with inputs and minor edits by Aditya Swarup, who is an Assistant Professor at Jindal Global Law School.]


Gain-based remedies, though rarely adjudicated in India, are an important aspect of commercial law. The powers of courts to award such remedies arise from statute, for instance, the Indian Contract Act, 1872 (“Contract Act”) and common law and equity. Another instance of a statute providing for a gain-based remedy is the amended explanation to section 11B of the Securities and Exchange Board of India Act, 1992 (“SEBI Act”) that grants to SEBI the power to direct any person to disgorge an amount equivalent to the disproportionate gain or advantage made or loss averted without prejudice to any other enforcement action”. Two cases, viz. Re: Beejay Investment & Financial Consultants Private Limited and Re: Ramalinga Raju & Ors. have thrown light on the application of such a remedy.

In Beejay Investment, SEBI had passed an earlier order prohibiting the parties from “buying, selling or dealing in the securities market, directly or indirectly, till further orders.” While such directions were in force, the parties allegedly dealt in securities indirectly and earned huge profits and SEBI ordered disgorgement of these profits under section 11B of the SEBI Act. In Ramalinga Raju’s case (arising out of the Satyam scandal), Ramalinga Raju and others falsified financial reports, duped investors and engaged in insider trading. They were held to have violated various provisions of the SEBI Act and SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market) Regulations, 2003 and hence, instructed to disgorge the entire amount which they received from the sale of shares (Rs. 1,848.93 crore).

The aim of this post is to provide an introduction to gain-based remedies and analyse the application of section 11B of the SEBI Act. It is divided into three parts. The first part discusses gain-based remedies in general. The second part talks about the disgorgement remedy with reference to English law. The third part examines the origin of disgorgement in Indian securities law and analyses the current understanding of Indian Courts.

Gain-based Remedies in General

Standard remedies in commercial law aim to compensate the plaintiff for the loss occurred, i.e., award a sum of money which, so far as money can be so, is equivalent to the plaintiff’s loss. However, there also exists a niche area of gain-based remedies, i.e. remedies that focus on the gain made by the defendant rather than the loss caused to the plaintiff. Such gain-based remedies are classified into two types: (1) restitution (including for unjust enrichment), and (2) disgorgement. The basic distinction between the two is that the former operates to reverse a wrongful/unjust transfer of value (restitutionary damages) gained at the plaintiff’s expense and the latter operates to disgorge the profits which have accrued to a defendant from a wrong (disgorgement damages).[1]

Restitutionary damages for unjust enrichment are embodied in sections 64 to 72 of the Contract Act.[2] Section 64 states that in consequence of rescission of a voidable contract, the rescinding party has to ‘restore’ the benefit it has received under the contract. The word ‘restore’ implies that parties are to be restored to status quo ante.[3] Section 65 requires the parties to restore any ‘advantage’ received by a person under a void contract. ‘Advantage’ refers to the relative benefit and is narrower than ‘benefit’.[4] In accordance with section 68, where a person incompetent to contract is supplied with necessaries, then he is liable to ‘reimburse’ the supplier. Section 70 states that where a person has done any lawful non-gratuitous act for another person, then the former is entitled to ‘compensation’. The liability under this section would be in proportion to the benefit enjoyed by other party and is not the same as contractual rights.[5] As can be observed above, different words have been used in different sections of the Contract Act to provide a gain-based remedy. However, not much examination by the Courts or research has been done to elaborate on the meanings and ramifications of each of these words in the respective sections.

Disgorgement remedies on the other hand find their roots in common law and equity. In the case of such a remedy, the plaintiff seeks to claim the gain made by the defendant from the wrong committed by it. The measure of the gain ignores whether or not any transfer of value has occurred from the plaintiff and is measured by the actual profit accruing to the defendant from the wrong.[6]

English Law of Disgorgement

Justice Edelman (writing academically) in his book Gain Based Damages propounds that disgorgement damages are a measure of deterrence and concerned with stripping of the profits earned by the defendant who has committed a wrong to the plaintiff. The distinct feature of disgorgements is that it focusses on actual profit earned from the wrongdoing rather than examining whether the gain was transferred from plaintiff’s assets.[7]

Disgorgement is quite often confused with punitive damages. There are two points of difference between disgorgement damages and punitive damages. Firstly, the former requires wrongful profit to be proved and the latter does not. Secondly, while, punitive damages are granted where the defendant has engaged in “malicious and high-handed conduct”, disgorgement damages do not require such high standards.

However, like in the law of contracts, it is a central idea to the law of disgorgement that there be a causal link between the wrong committed and the profit earned.[8]

Causation Link

English Courts have developed and applied various tests to determine causation. Under the ‘but for’ test, the court considers ‘if the defendant would have made that gain irrespective of the wrong’.[9] In cases where only a part of the gain is attributed to the wrong, Justice Edelman suggests that it is important for the courts to identify such part. Where a part of the activity is non-infringing, he says, it is best to create a divide between infringing and non-infringing parts of the profit. To explain the concept, he cites Potton Ltd. v. Yorkclose Ltd,[10] where the defendant designed several houses by infringing the plaintiff’s copyright. Millet J. separated the profits which were not a result of the wrong by independently accounting for profits earned from landscaping, appreciation of the value of the houses between finishing of the building project and sale, advertising, marketing etc.[11] Similarly, in other cases on disgorgement the courts have opined that profits arising from “skill, efforts, property and resources of the [wrongdoer], the capital he has introduced and the risks he has taken so long as they are not risks to which the principal’s property has been exposed” must be separated.[12] Where the defendant has committed a deliberate wrongdoing, the courts have impliedly rejected such an “allowance” on the grounds of punitive damages.[13]

In case of breach of fiduciary duty, there are two approaches to determine causation. In the first approach, causation is satisfied ‘where the profits flowed from the breach irrespective of whether some of the profits might have been gained if there had been no breach’.[14] The second approach puts the burden on the defendant to prove that a part of the profit would have arisen even if there was no breach.[15]

Application of Disgorgement Damages in India

In addition to the power to grant disgorgement under common law and equity, SEBI has been directing disgorgement under the powers provided to it. Earlier, in the case Rakesh Agrawal v. Securities Exchange Board of India,[16] the Securities Appellant Tribunal (“SAT”) held that SEBI did not have any power to order disgorgement. It held that pecuniary burden such as disgorgement must be expressly provided in the legislation. Since at that time section 11B of the SEBI Act did not provide for disgorgement, SEBI could not order the same. It ruled that quasi-judicial bodies, such as SEBI, unlike ordinary civil courts, do not have equitable powers and hence they cannot order disgorgement under their ‘inherent powers’.

Another attempt to empower SEBI to order disgorgement was made in the Roopalben Panchal Scam Case.[17] In that case, SAT upheld SEBI’s disgorgement order. It held that SEBI has wide powers under sections 11 and 11B of the SEBI Act, including the power and authority to order disgorgement. It added that the disgorgement remedy is equitable and not penal.[18] It aims at stripping the defendant of ill-gotten gains and restoring status quo ante. Hence, an order of disgorgement does “not prejudice the right of the regulator to take such further administrative, civil and criminal action as the facts of the case may warrant”. This ruling was upheld in Karvy Stock Broking Ltd.v. SEBI.[19] In that case, SAT further added that this power can only be exercised only against those violators who have made a profit out of their illegal acts.[20] The amount cannot exceed the total profits earned out of the illegal acts. The burden of proof is on SEBI to prove the causation link between illegal act and profits earned therefrom.

In 2009, SEBI, in order to avoid inconsistency in its decisions, proposed an amendment to provide an express power to itself to direct any person to disgorge amount equivalent to disproportionate gain or advantage made or loss averted without prejudice to any other enforcement action.[21] The proposed amendment was incorporated by adding an explanation to section 11B of the SEBI Act through the Securities Laws (Amendment) Act, 2014.[22]

Karvy and Roopalben seem to be in consonance with the principle of disgorgement discussed above. However, recently, in the case of Beejay Investment & Financial Consultants Private Limited[23] and Satyam Scam Scandal case,[24] SEBI and SAT have wrongly applied the concept of disgorgement.

In the former case, SEBI ordered disgorgement of profits to tune of Rs. 27.44 crores made from transactions made by persons who were barred from participating in securities market. The concerned persons were barred by SEBI for alleged violations of regulations 3, 4(1), 4(2)(a) and (g) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations. It is respectfully submitted that SEBI has misunderstood the traditional concept of disgorgement damages. As discussed above, the disgorgement damages arise from a “wrong”. However, in the present case, the transactions entered into (although in violation of the order of prohibition) were carried out in normal ordinary course of business. Hence, the “profits” do not arise from the violations of the aforesaid regulations but violation of a prohibitory order. The power to order such disgorgement under section 11B is suspect.

In fact, it is submitted that rather than ordering disgorgement under section 11B, the SEBI/SAT could have considered ordering the same amount to be disgorged under its equitable powers for violation of the injunction/prohibitory order. In law, injunctions act in personam and if a person violates an injunction order, then he or she is liable for contempt. However, the equity courts, in addition to the power to punish for contempt, also have the power to order disgorgement of any gains made in violation of the injunction order.[25] The same is the position in India.[26] In Cheruvannoor Nallalam Grama Panchayath v. Kathalatt Ravi,[27] the Court stated:

"The court is entitled under its inherent power to direct a party who has gained an undue advantage by flouting the order of the court, to restore status quo ante or to disgorge the ill-gotten advantage obtained through breach of the court order (vide paragraph 7 of the decision of the Full Bench in Kanakku Kumara Pillai Thanu Pillai v. Mathevan 1962 KLT 688)."

The same principle could have been applied in the present case.

In Satyam Scandal case, Ramalinga Raju and other were held liable for falsifying financial reports, duping investors, and insider trading. The judge held the accused in breach of their fiduciary duty owed by them to act in the interest of the shareholders. However, issues arise with respect to the amount ordered to be disgorged , the causal link between the wrong and the gain (some of the payments were not wholly attributable to the wrong itself) and the manner in which the amount was calculated.

To conclude, SEBI and SAT have deviated from the traditional concept of disgorgement damages. The concept of disgorgement, its application, and the apparent relaxation of rule of causation by SEBI and SAT needs a deeper analysis.

- Shubham Janghu

[1] James Edelman, ‘Gain Based Damages: Contract, Tort, Equity and Intellectual Property’, (Oxford: Hart, 2002), p. 65.

[2] Nallaya Goundar v. Ramaswami Gounder, (1958) 2 Mad LJ 86; Muppudathi Pillai v. Krishnaswami Pillai, AIR 1960 Mad 1.

[3] Muralidhar Chatterjee v. International Film Co. Ltd., (1943) 70 IA 35 at 49. See also Bechu v. Bhabuti Prasad, (1930) 52 ER 831.

[4] Oxford Advanced Learner’s Dictionary of Current English, pp. 100, 118.

[5] Food Corpn of India v. Allepy Municipality, AIR 1996 Ker 241 at 255.

[6] James Edelman,  at p. 72.

[7] Ibid.

[8]Andrew Burrows,The Law of Restitution’ (Oxford University Press, 2011), p. 625; James Edelman, ‘Gain Based Damages: Contract, Tort, Equity and Intellectual Property’ (Oxford: Hart, 2002), p. 103.

[9] Andrew Burrows, at p. 625.

[10] [1990] FSR 11.

[11] Id at p. 16, 18.

[12] James Edelman, at p. 105, quoting Warman International Ltd v. Dwyer (1995) 182 CLR 544 (HCA) 561.

[13] James Edelman, at p. 105, citing D Friedmann “Restitution for Wrongs: The Measure of Recovery” [2001] Texas Law Rev 1879, 1889 and Sheldon v. Metro-Goldwyn Pictures Corp 309 US 390 (1940 SCUS) 397).

[14] Andrew Burrows, at p. 684.

[15] Andrew Burrows, at p. 684.

[16] (2004) 49 SCL 351. 

[17] In The Matter Of Investigation Into Initial Public Offerings WTM/GA/101/ISD/11/06 dated November 21, 2006.

[18] See also Shadilal Chopra v. SEBI, Appeal No. 201 of 2009 dated June 10, 2009.

[19] (2008) 84 SCL 208.

[20] See also National Securities Depositories Limited v. SEBI, Appeal No. 147 of 2006 dated November 22, 2007.

[21] Paragraph 2.3.14 of agenda note for Item No. 13, in Respect of 124th Meeting of SEBI Board dated 18 June 2009 .

[23] WTM/PS/57/IVD/JUN/2016.

[24] In the matter of Satyam Computer Services Ltd., WTM/RKA/SRO/64 - 68 /2014.

[25] British Motor Trade Association v. Gilbert, [1951] 2 All ER 641 ; Attorney General v. Guardian Newspapers (No.2) (“Spycatcher”), [1990] 1 AC 149 (HL).

[26] See Cheruvannoor Nallalam Grama Panchayath v. Kathalatt Ravi, AIR 2006 Ker 132; Paruthikkattuparambil Ayisha v. Permbra Abdul Nassar and Ors., ILR2015 (3) Kerala 934; Kanakku Kumara Pillai Thanu Pillai v. Mathevan Mathevan of Aravamkadu Karakkattu Madathu Veedu and Anr.,  AIR1963Ker179; State of Bihar v. Usha Devi, AIR 1956 Pat 455.

[27] Cheruvannoor Nallalam Grama Panchayath v. Kathalatt Ravi, AIR 2006 Ker 132.


vswami said...

"......To conclude, SEBI and SAT have deviated from the traditional concept of disgorgement damages. The concept of disgorgement, its application, and the apparent relaxation of rule of causation by SEBI and SAT needs a deeper analysis."

A good attempt made to analyze, prima facie to better serve an academic purpose.

In one 's perspective, suggested deeper analysis could be purposeful, having in focus the contents of the earlier Post-; and the comment thereon.

More so, it would, ideally speaking, be so purposeful provided,- as far as feasible, instead of being bogged down by what views courts have handed down in the past, on a case to case basis, some old hence outdated - the common law on equity and principles of natural justice are principally borne in mind as the essential guiding or influencing factors.

Rahul Sibal said...

I really don't get how SEBI can exercise 'inherent power' in response to violation of its prohibitory orders, the concept of inherent power is alien to tribunals and cannot be exercised by tribunals unless specifically exercised mandated in the statute creating the tribunal