India ends its experiment in using consent orders to atone for capital market offences. This could increase the pressure on the already overloaded court system
The Indian stock market regulator, the Securities and Exchange Board of India (SEBI) has restricted the use of consent orders, which have been used extensively by those accused of various capital market-related offences.
In a 25 May circular SEBI amended its 2007 framework for passing consent orders and said that it has done so “on the basis of the experience gained and with the purpose of providing more clarity on its scope and applicability”.
Under the consent order scheme the alleged violator agrees to pay a fine and stay off the stock market, usually without admitting to or denying any wrongdoing.
Used more widely
Sanjay Buch, a partner at Crawford Bayley & Co in Mumbai, says that the consent order scheme adopted by SEBI is “an amnesty scheme on the basis of the United States model of plea-bargaining”.
Although it is intended for trivial or non-infectious violations “like an inadvertent failure to make mandatory disclosures”, the wording of the present regulations has meant that lawyers and companies interpret it as being applicable widely. As a result Buch points out that even insider trading offences are covered under it.
One the biggest and most serious cases settled through consent proceedings was the violation of foreign investment rules by Anil Ambani-led Reliance ADAG.
Wheels within wheels
In a January 2011 consent order, SEBI said that it had found Reliance Infrastructure and Reliance Natural Resources “prima facie responsible for misrepresenting the nature of investments” in their annual reports between 2007 and 2009. The two companies were also found to have been “misusing the framework of the SEBI (Foreign Institutional Investors) Regulations, 1995”.
Although SEBI’s four-page order did not provide any more details, the specifics of the case came to light on 15 May this year through a UK tax tribunal order. It related to a case involving an-ex UBS banker, Sachin Karpe, who as it emerged helped the Reliance ADAG companies misuse SEBI regulations.
The order by the Upper Tribunal (Tax and Chancery Chamber) Financial Services in London, found that Karpe, who was the head of a desk at UBS that provided wealth management services to customers resident in India, had “arranged the implementation of an investment structure for Reliance ADA Group [Reliance ADAG], via an investment fund incorporated in Mauritius for the purpose of breaching Indian law and in clear contravention of UBS’ guidelines”.
As the UK order explains, SEBI regulations do not allow an Indian person or company to invest in Indian securities through a foreign institutional investor vehicle. Such vehicles are designed to channel investments from non-Indians into Indian securities.
However, in 2006 and 2007 on instructions from Reliance ADAG, Karpe had arranged to invest US$250 million from a Reliance ADAG fund to a shell company for further investment in its Indian companies. The tribunal directed the Financial Services Authority to impose a penalty of £1.25 million (US$2 million) on Karpe.
The case against the Reliance ADAG companies had been settled by SEBI though the January 2011 consent order, with the two accused companies paying a settlement charge of ₹250 million (US$4.5 million) each. They were also barred from investing in the stock market until December 2012.
The new regime
As per the 15 May circular SEBI will not consider consent order applications for offences of insider trading, front-running, failure to make an open offer or redress investor grievances. Consent orders will also not be considered for offences involving fraudulent and unfair trade practices, which it considers to be very serious.
Habitual offenders – those who have committed an alleged default within two years from a previous consent order – will also be barred from using the scheme. In addition an applicant that has already obtained more than two consent orders will be barred for three years from the date of the last application.
The SEBI circular states that the minimum penalty to be imposed by SEBI is ₹200,000 for first time applicants and ₹500,000 for others. In cases of “serious fraudulent and unfair trade practices, default or violations” it could be much higher.
According to the annexure to the circular, in such cases if the amounts arrived at on the basis of the prescribed formula are “found to be low and not commensurate to the seriousness of the alleged default/violation”, SEBI may impose a penalty of US$4.5 million or three times the profit made or loss avoided, whichever is higher.
Not as easy as it looks
The new regulations may send a warning to the offenders, but they could also pose serious problems for SEBI itself, as it will have to find a way through the already clogged judicial system.
Sandeep Parekh, founder of Finsec Law Advisors in Mumbai, says that while there is a moral victory in saying that SEBI will not consent to cases of serious violations, on a practical level it will lead to more violators escaping justice.
“Given India’s criminal conviction rate of 3%, the argument that a violator should be severely punished is more theoretical than real,” says Parekh. He adds that capital market offenders often have far more resources than SEBI and can delay the payment of the penalty for a very long time if the cases go to court.
Furthermore, as Akil Hirani, managing partner of Majmudar & Partners in Mumbai, warns, historically SEBI has not been entirely successful in prosecuting offenders for insider trading, front-running and other similar capital markets offences.
“Unless SEBI tightens its evidence gathering and prosecution machinery, the eventual result may just end up being prolonged litigation with an eventual overturning of SEBI’s orders” says Hirani.
As it stands the consent order mechanism has provided swift remedies and convincing results, as Parekh points out.
From 2007 to 2011, SEBI received 2,296 consent order applications and accepted 1,012. As a result it collected US$34 million as settlement charges.
The appeals process is also relatively hassle-free because as Parekh says, the Securities Appellate Tribunal “is probably the only tribunal in the country with close to zero backlogs”.
In addition, violations are not always deliberate. Often consent order applications are made voluntarily after an internal audit brings irregularities to light. In cases where SEBI is informed about offences through its own sources, it issues a show cause notice for an alleged violation of rules.
The procedure for applying for a consent order is clear-cut. Alleged violators or their lawyers do not need to appear before SEBI officials at any stage.
The violator applies for a consent order by submitting information on standard forms, along with a penalty that they think would be acceptable to the market regulator. The process that follows could take six months, with SEBI deciding the cases ex parte. The role of lawyers involved is restricted to completing and submitting forms.
The quantum of punishment is decided after considering the gravity of the offence and its impact on the share price or the stock market. While penalties accepted in past cases become a benchmark, most parties have been able to settle for between US$10,000 and US$20,000.
Prior to the recent tightening of the consent order scheme, the Securities Appellate Tribunal was applied to only when an application was rejected. Under the new scheme, it is likely that many more offences would go directly to the tribunal.
A scheme that is before its time?
A reason for the failure of SEBI’s experiment with consent orders could be that Indian markets are not yet ready for it.
Harinderjit Singh, a senior partner at Price Waterhouse India, argues that the consent proceedings are for mature markets and that in India people do not understand them very well. “For most people in India an accused is either guilty or not guilty.”
Despite this, he favours the use of a consent order scheme as matters can be looked at on a case by case basis.
Parekh, who spent several years inside SEBI working as an executive director (legal affairs and enforcement), is also for continuing a more liberal consent order scheme. He suggests that the way to deal with serious violations is to hand out high penalties and not by barring offenders from the consent process.
“While consent orders were experimental in the Indian context, they are the norm rather than the exception in many Western countries,” he says, pointing out that the US securities regulator currently settles in excess of 95% of all cases in this manner.
Hirani believes SEBI’s move is in keeping with “the international trend where the focus is on deterrence (through punishment) as much as on recovering ill-gotten profits”.
The problem may also lie in how the scheme was implemented. SEBI has been accused of non-transparency while deciding on consent orders and its orders have been criticised as arbitrary
Furthermore Singh says, “SEBI was under pressure to explain granting of consent orders for some serious offences”.
Even the Securities Appellate Tribunal has accused SEBI of arbitrariness and being lenient with the serious offenders.
In an order passed on 2 December 2010, in a case relating to Yashraj Containeurs, the tribunal roundly criticised SEBI for being “content with initiating only adjudication proceedings … in which only a monetary penalty could be levied”.
The case against Yashraj Containeurs had involved fudging of accounts and insider trading. And even though the Securities and Exchange Board of India Act, 1992, empowered SEBI to bar an accused from trading and also hand down a jail sentence, it had only levied a penalty of US$9,090 and US$45,400 on the company and its promoters respectively.
The two-member tribunal of Justice NK Sodhi and PK Malhotra did not mince words in making the order: “the lenient view taken by the Board does not, in our opinion, protect the integrity of the market … and would send a wrong signal that the delinquents could continue with their nefarious activities by paying a monetary penalty.”
Given its track record SEBI will either have to perfect its consent rules so that the scope for protracted litigation is minimized, or resign itself to getting involved in lengthy court battles.
Either way SEBI’s about-turn on consent orders will increase the volume of litigation, because as Buch points out, “no company is going to easily accept an allegation of insider trading”.
The upside is that dispute resolution teams at law firms can expect more work. Hirani says his firm, Majmudar & Partners, and others such as J Sagar Associates, Wadia Ghandy, and AZB & Partners, that have strong financial services dispute resolution practices, will benefit from the increase in litigation.
However, they will need to ensure that their disputes lawyers are brought up to speed on SEBI regulations.