The Corporate & Commercial Law Society Blog, HNLU

Category: Securities Law

  • Proxy Advisors: A Look at the Growing Intermediary & Increasing Regulations

    Proxy Advisors: A Look at the Growing Intermediary & Increasing Regulations

    BY ABHIRAJ DAS, FOURTH YEAR STUDENT AT GNLU, GANDHINAGAR

    In the past few years, there have been some striking recommendations and red-flags being given by “proxy advisors” regarding corporate-governance of some of the leading incorporates of India. A few instances can be red-flagging the 35-years-long tenure of RIL’s auditors, or recommendation in the Tata-Mistry skirmishes. Very recently, in Crompton-Greeves Power, a huge value depreciation for minority shareholders owing to the issues of corporate governance & conflict of interest of independent director was highlighted.

    What are Proxy advisory firms? 

    Proxy advisory firms are independent analyst offering analysis and voting recommendations to the institutional shareholders and investors. Securities and Exchange Board of India (SEBI) defines proxy advisors as “a person who provides advice in relation to the rights of the shareholders and investors including recommendations on public offer or voting on agenda items.” The term “proxy-advisory” originates from the concept of “proxy voting” where shareholders authorizes other person to vote on his/her behalf, and offer services related to proxy-voting by aggregating-and-standardizing information.

    Roles/impact

    It is a gospel truth that shareholders do not pay much attention to the voting in the AGMs or EGMs. In large public listed companies, public shareholders have relatively small stakes and there remains a collective-action problem and “shareholder-apathy” which lead them to vote as per the vox populi, and institutional investors like mutual funds, banks, DFIs, insurance companies, etc. cannot possibly make an well informed decisions in such voting owing to the huge-number of stocks they handle. Proxy advisory firms (PAF) undertake heavy-data researches and analyse the major agendas which are subjected to voting, providing detailed reports on voting to strengthen the corporate governance within the company.

    The recommendations by these independent and expert firms have tendencies of de-stabilising (or re-stabilising) management and raise corporate governance standard as these advisories may be related to voting against re-appointment of independent directors, auditor’s appointment, M&A and corporate structuring where there seem possibilities that public shareholding might erode, and thus, have become important corporate intermediaries. While proxy advisories in India are still at nascent stage, the American ISS deal with around 44,000 meetings in 115 markets yearly to execute more than 10.2 million ballots representing 4.2 trillion shares. A recent study has shown that around 83% of ‘vote against’ recommendations include mainly “reappointment of non-executive directors” and “remuneration of statutory auditors”.

    Issues concerning the PAF

    In addition to the potentially huge impacts these firms have, there are several downsides as well. Sometimes, simultaneously these firms also offer voting advices to the shareholders of the same companies to whom they provide corporate governance recommendations which leads to conflict of interest. There are conflicts also when the key managerial persons of proxy firms hold important positions in the subject companies. Another major concern is that these advisory firms are not subjected to fiduciary duty to show that their recommendations are in the best interest of shareholders and the corporations. Independent study has shown that ratings used by these firms do not accurately foretell subject’s performance. Further, there have been diametrically opposite opinions on the same issue. Concerns are also there that they sometimes provide distorted recommendations to further their own interests. Another issue is that even when any error is highlighted they have not always been rectified.

    Recent Regulatory Developments in the US

    The Concept-Release of 2010 by the US Securities and Exchange Commission had raised concerns inter alia regarding the influence proxy advisors had over their clients “without appropriate oversight” or “an actual economic stake in the issuer”. Amendments have been adopted by SEC allows investors utilising proxy voting advice to receive “more transparent, accurate, and complete information on which to make their voting decisions.”

    In July 2020, Exchange Act Rule 14a-1(l) has been amended to include if a person (includes entity) offers proxy advises, it shall constitute as “solicitation” under s. 14a and that such persons shall be generally required to file and furnish information regarding definitive proxy statements. Further, paragraph ‘A’ is inserted to Rule 14a-1(I)(1)(iii) clarifying that the terms “solicit” and “solicitation” include any proxy voting advice.

    Addressing the issue of conflict-of-interest, amendment has been made to Rule 14a-2(b) which now obligates that proxy-voting recommendations includes the conflicts-of-interest disclosure specified in new Rule 14a2(b)(9)(i). Further facilitating informed decision-making by the clients of such advisors, a new Rule 14a-2(b)(9)(ii) has been adopted which requires that “proxy voting advice business” adopt and publicly disclose written policies and procedures. This new term provides flexibility to cover future business models which may engage in type of advice the rules aims to address, and does not merely base upon the businesses which presently provide such services. It has also been provisioned that the registrants i.e. the subject companies shall also be provided with the report of the voting-recommendations under Rule 14a-2(b)(9)(ii)(B). Para ‘E’ has been inserted to Rule 14a-9 to define the scope of ‘misleading’ which means “the failure to disclose material information regarding proxy-voting-advice, such as the business’s methodology, sources of information, or conflicts-of-interest.” Adoptions of these amendments addresses the different concerns with the proxy firms.

    Recent Regulatory Developments in India

    SEBI brought SEBI (Research Analyst) Regulations, 2014 within a few years of the advent of the industry in India. The Regulation requires such entities to register with SEBI and lays down internal policy, and also imposes a fiduciary duty to offer detailed disclosures if required. Further, firms must proffer unbiased advice based on reliable information. Under regulation 23, they are also required to disclose the reasoning to the public. An eight-point Code-of-Conduct for firms and their employees has been adduced which broadly covers honesty & good faith, diligence, conflict of interest, insider-trading or front-running, confidentiality, professional standards, compliance, and responsibility of senior management. Recently, SEBI has introduced Procedural Guidelines for Proxy Advisors and Grievance Resolution between listed entities and proxy advisors. These circulars are the result of SEBI Working Group which recommended improvements through disclosures of conflict-of-interests, voluntary best practises, setting up code-of-conduct which are to be followed by proxy advisors on “comply or explain” basis. One of the remarkable procedures required is that the firms must also share the recommendation to the subject company as well and to include company’s response thereto as addendum. This will allow subjects to clarify on any aspect which it considers have not been completely regarded while extending the proxy recommendations.

    It is very much evident that the circulars issued by SEBI are similar to the US SEC issued Rule Amendment for Proxy Voting Advice 2020 in various terms such as affording subject companies a copy of the recommendation, client access to company response, conflict of interest disclosure norms, etc. However, given the fact that Indian industry for proxy advisors is still at nascent stage, and the US market is relatively aged, it was prudent only on the part of the regulator to consider the US model. The advisory firms are required to disclose the recommendations on their website and are mandated to devise policies for voting advices including the situations when voting-recommendations are not to be offered. These policies are required to be reviewed at least once a year.

    It is pertinent to note that there is no specific mention about foreign proxy-advisory-firms in either of the circulars, thus it will be interesting to observe how the code-of-conduct, as was recommended by the Working Group, are applied to them. Another interesting aspect is that compulsory disclosures of revenue models, key income-sources, clientele have not been provisioned. Since there is a possibility of conflict-of-interest in situations where the firms may retaliate against the incorporates who didn’t avail their services by way of aggressive advices to their clients, though proxy advisors are required to disclose and mitigate any “potential” conflicts, the disclosures of the clientele could have offered reassurance against such recommendations. However, in case of any grievance the listed entities are at liberty to approach SEBI which shall investigate the matter considering non-compliance with regulation 24(2), which provides for Code-of-Conduct, r/w regulation 23(1) of SEBI (Research Analyst) Regulations, 2014 or the procedural guidelines circular recently issued. If any contravention is established, it can lead to inter alia suspension/cancellation of the registration under SEBI (Intermediaries) Regulations, 2008.

    Conclusion

    Shareholder’s votes have the potential of wide consequences on corporate decisions and governance of a company which in turn affects the market and economy ultimately. Therefore, there lies a fiduciary responsibility upon the institutional investors, who represent large number of shareholders, to vote in the best interest, and attributes a huge relevance to the recommendations made by the proxy-voting advisors. The extensive impact such recommendations may have and the possible conflict-of-interest which may arise are the major reasons for regulating these proxy-advisors.

    Having higher standards of transparency and oversight will certainly enhance the quality and credibility of this intermediary. These various aspects would require that investors take the ultimate decision based on the proxy advices and the company’s responses thereto, which would lead to more-informed exercise of voting rights and at the same time ensure that proxy advisors do not ‘control’ the voting. This sector needs nurturing at the hands of regulators & this could prove to be a major step. But time will only tell how these rules perform.

  • Outsourcing Equity: The Multi-Faceted Implications of Overseas Listing

    Outsourcing Equity: The Multi-Faceted Implications of Overseas Listing

    BY VARUN PANDEY, FIFTH-YEAR STUDENT AT UPES DEHRADUN

    The Indian FDI regime has been vying for an enhanced investment environment over the last few decades. Recent measures such as codification of Insolvency and Bankruptcy Laws, taxation incentives for foreign investors and alleviating construction permits  in the infrastructure space, among other reforms had elicited a significant rise within the global ease of doing business rankings. Unfortunately, this surge was short-lived and in a bid to revive the Covid 19-ridden distressed economy, the Ministry of Finance via the 5th stimulus package permitted direct overseas listing of Indian companies. This article analyzes the impact of overseas listing on Indian companies and dwells on the various regulatory roadblocks required to be overcome in order to facilitate such measure, and finally examines the consequent pay-off for Indian Investors.

    I. What is Overseas Listing?

    Direct Overseas Listing would allow companies registered in India to list their equity shares in foreign jurisdictions and gain liquidity. Currently, Indian companies have limited access to foreign capital markets in the form of American Depository Receipts (ADR’s) and Global Depository Receipts (GDR’s). Indian companies can avail Foreign Currency Exchangeable Bonds (FCCB’s) only for issuing debt securities, whereas foreign companies can access the Indian Capital Markets by the Indian Depository Receipts (DR’s) Scheme, 2014. 

    Interestingly, the Central Government had been mulling the said listing reforms way back since 2018. A SEBI Committee Report was published which evaluated various economic, legal and taxation aspects pertinent to foreign listing. One of the primary objectives for enabling direct listing is to expand the investment opportunities for Indian companies by attracting foreign capital and encourage them to compete on a global footing, facilitating their growth will also lead to an improved environment for ease-of-doing business in India. The recent Companies (Amendment) Bill, 2020 further incorporated the provision approving overseas listing of Indian Companies.

    II. Regulatory Overhauls

    The current laws and regulations dealing with listing of companies would require significant changes to facilitate overseas market access for Indian companies.

    • Companies Act, 2013

    Section 23 of the Act deals with public offer and private placement of shares, whereas Chapter III of the Act deals with the prerequisites for allotment of securities altogether. However, neither provisions explicitly permit overseas listing and are limited to listing of companies within the Indian securities markets only, accordingly, an exception will have to be carved out for the companies listing in approved foreign securities markets by way of an amendment within Section 23 or via a MOF circular/ notification .  Furthermore, Section 88(3) of the Act mandates a company to maintain a registry of security holders in correspondence with Section 11 of Depositories Act. Thus, in the event of overseas listing of equities, a common ground is required to be attained between the inter-linked provisions with reference to Section 88(4) that permits a company to maintain the details of shareholders residing outside India.

    • Foreign Exchange Management Act, 1999 and Regulations

    Following the repeal of FEMA 20R Regulations and subsequent enactment of FEMA (Non-Debt Instruments) Regulations, 2019, changes will have to be incorporated within the provisions of Schedule II as it regulates FPI investments. These adjustments will have to be made by taking into account the various sectoral caps which persisted during the FEMA 20R era, where FDI was permitted via automatic route and government approval route. Additionally, retention of profits and other receipts of transactions will have to be regulated in a mechanism that mirrors the ADR/GDR framework currently in place.

    • SEBI Regulations

    SEBI is the sole regulatory authority that overlooks the Indian Capital Markets and the companies listed on domestic exchanges. In order to streamline the process of equity listings on foreign exchanges, it will have to construct a mechanism that is on par with the various  pre-listing obligations of the recognized foreign stock exchange, for instance, provisions in tune with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 to secure the interests of foreign investors. This obligation extends to the listing company as well who will be mandated to issue their equities in compliance with the mutual laws and regulations.

    Until now, the only Indian debt instrument which are listed on a foreign exchange are Masala Bonds. They are supervised via the SEBI (International Financial Services Centers) Guidelines, 2015 but there exists a lack of regulatory oversight with regards to equities listed by and Indian Corporation. Therefore, the definition of Permissible Securities under Section 7 of the guidelines can be amended to include such class of equities by virtue of the powers conferred to SEBI under Section 11 of the SEBI Act, 1992.

    III. Indian Entities and Investors

    There are glaring queries in the face of benefits accruing to Indian investors by this move, since neither the Companies (Amendment) Bill, 2020 nor the SEBI Report explicitly discuss the consequences in their preliminary disclosures permitting overseas listings. At first glance, it is apparent that Indian entities that will opt for direct listing on overseas platforms will get first-hand exposure to multiple sources of capital from Alternate Investment Funds (AIF’s) and foreign industry-exclusive investor classes that were initially prevented from diversifying their investments to Indian entities due to their respective investment laws and regulations. However, uncertainty regarding authorization of Indian investors subscribing to such entities listed on overseas stock exchanges is sustained, as there are neither any sectoral caps identified on class of shares, nor any clarification about whether the Indian investors will be able to subscribe to equity under the automatic route or the government approval route.

    IV. Relevant Concerns

    In order to facilitate direct overseas listing, there are multiple areas that could prove to be a challenge for the entities as well as the regulators and will need to be rectified.

    Firstly, the SEBI Report identified 12 permissible jurisdictions for overseas listing of Indian companies including the NASDAQ, London Stock Exchange, Euronext Paris etc. To ensure swift listing of equities, Indian entities will be required to coordinate with the local listing regulations under the permissible jurisdictions along with the SEBI framework that shall govern overseas listings, which could hand a double-blow for the Indian corporations due to multiplicity of norms. For instance, an Indian corporation directly listing on the LSE, in order to prohibit insider trading, will have to figure out a mutual ground between SEBI (Prohibition of Insider Trading) Regulations, 2015 and the Financial Services and Markets Act 2000 (Market Abuse) Regulations 2016  of the UK to prevent any potential conflicts which may arise in between their provisions. Similar issues extend to corporate governance norms that may not be unequivocal with the permissible jurisdiction’s regulations.

    Secondly, if a conflict does arise between the regulators, there is a need for a swift dispute resolution mechanism that is relatively quicker than traditional arbitration. Furthermore, since the primary accountability will rest with SEBI, it is imperative that its extra-territorial powers are expanded to encompass any such disputes relating to the Indian equities listed on overseas stock exchanges, also to ascertain that SEBI shall exercise exclusive authority in dealing with corporate offences that may arise on the permissible jurisdiction. Although, the current KYC norms for Indian investors form a reliable frame of reference to curb such occurrences, pairing up with countries which are members of the Financial Action Task Force (FATF) would significantly prevent any large-scale economic offences such as money laundering through these channels.

    Finally, even prior to the legislative amendments, there is an immediate need to strengthen the infrastructural capacity of the Indian Depositories framework and the concerned registrars of Indian securities. A lack of stable gridwork could potentially affect the inter-links between Indian registrars and their foreign counterparts, consequently hampering the efficient trading of equities on the foreign permissible jurisdiction.

    V. Conclusion

    It is admitted that a plethora of concerns related to overseas listing will be clarified once SEBI releases an elaborated framework, yet there are still issues that would require detailed elucidations. For instance, whether overseas listing would grant an exemption to the corporations involved within the prohibited sectors under FDI regime; or what would be the process of subscription to such equities, and which sectors would fall under the government approval route and whether there will be sectoral caps? etc. These are just a few queries that would have to be resolved prior to any Indian entity’s first IPO on foreign soil.

    It is also to be noted that just like much of the reforms announced under the stimulus, overseas listing was already in consideration and might have mitigated the strain on Indian companies had it been already enforced and was functioning. Nevertheless, the move to allow direct listing to overseas exchanges should be welcomed by cash-strapped Indian entities which would now be able to tackle the liquidity-crunch arising from Covid-19 by accessing foreign investors and capital. Furthermore, this leaves the door open for foreign entities to directly list on Indian markets as well, that may allow Indian investors to diversify their stock portfolio as well.  

  • Converting Preference Shares into Debts: Tax Evasion or Tax Planning?

    Converting Preference Shares into Debts: Tax Evasion or Tax Planning?

    BY YASH MORE AND HITOISHI SARKAR, THIRD-YEAR STUDENTS AT GNLU, GANDHINAGAR

    In December 2019, the National Company Law Appellate Tribunal (“NCLAT“) in Joint Commissioner of Income Tax v. Reliance Jio Infocomm Ltd. & Ors., while approving a demerger under s. 230-232 of the Companies Act, 2013, allowed the conversion of preference shares of a company into debt during the scheme of arrangement. However, the tribunal failed to adjudicate and determine the legal validity of such a transaction. The ramifications of such conversion include a considerable reduction in the profitability of the demerged company and a consequent estimated loss of Rs 258.16 crores to the public exchequer which would otherwise have received such payment in the form of dividend distribution tax under s. 2(22)(a) of the Income Tax Act. 

    The main thrust of the argument before the NCLAT was that by the scheme of arrangement, the transferor company sought to convert the redeemable preference shares into loans, i.e., conversion of equity into debt, which is contrary to the principles in s. 55 of the Companies Act, 2013. However, the NCLAT dismissed this contention stating such a determination is not a subject matter of the Income Tax Department. It noted that such an objection could be raised only by the competent authorities, i.e., Regional Director, North Western Region and the Registrar of Companies.

    This article aims to determine the legality of such a conversion of preference shares into debt under the scheme of the Companies Act. In doing so, the authors have first expounded on the nature of preference shares and delineated on the vanishing line of distinction between tax evasion and tax planning. The authors have concluded the discussion by highlighting the problems faced in law while such conversion transactions are carried out.

    Preference Shares under Companies Act

    As per Explanation (ii) to s. 43 of the Companies Act, 2013, preference share capital refers to those shares which carry a preferential right with respect to (a) payment of dividend, either as a fixed amount or an amount calculated at a fixed rate, and (b) repayment, in the case of a winding-up or repayment of capital, of the amount of the share capital paid-up or deemed to have been paid-up.

    The problem that arises when preference shares are converted into a loan is that the shareholders turn into creditors of the company. This leads to two main consequences – firstly, the shareholders who are now creditors can seek payment of the loan irrespective of whether there are accumulated profits or not and secondly, the company would be liable to pay interest on the loans to its creditors, which it otherwise would not have had to do to its shareholders.

    Tax Evasion v. Tax Planning

    S. 2(22)(a) of the Income Tax Act, 1961, taxes any distribution of accumulated profits by a company to its shareholders, if such distribution entails the release of all or any part of the assets of the company. By way of converting preference shares into loans, there is an “indirect release” of assets by the demerged company to its shareholders without appropriating funds from the accumulated profits of the company. Thus, the conversion aid companies to circumvent payment of dividend distribution tax which would have otherwise been attracted in light of s. 2(22)(a). Further, the payment of interest on such vast amounts of loans would lead to a reduction in the company’s total income in an artificial manner.

    The order of the NCLAT reminds one of the Supreme Court’s landmark verdict in Vodafone International Holdings BV v. Union of India wherein the Court had frowned upon artifice, which leads to tax avoidance. However, this has to be read in consonance with the ruling of the Gujarat High Court in Vodafone Essar Gujarat Ltd. v. Department of Income Tax, where it was held that the mere fact that a scheme may result in a reduction of tax liability does not furnish a basis for challenging the validity of the same.

    The Supreme Court in McDowell & Co. Ltd. v. CTO had acknowledged and dwelled upon the fine although significant distinction between tax planning and tax evasion and expounded that ‘tax planning may be legitimate, provided it is within the framework of the law.’ Therefore, in order for us to determine the validity of the scheme of arrangement, we must look into the legality of the conversion of equity into debt under the scheme of s. 55 of the Companies Act.

    Legal Validity of the Conversion under the Companies Act, 2013

    The pertinent question that needs to be addressed is whether such a conversion of preference shares to a loan is in contravention of s. 55 of the Companies Act, 2013. It deals with the issue and redemption of preference shares. However, it does not state anything about the conversion of preference shares. In fact, in the event where a company is not in a position to redeem any preference shares or to pay dividend, it may either (a) further issue redeemable preference shares equal to the amount due, including the dividend thereon, or (b) convert the preference shares into equity shares.

    S. 55(2)(a) of the Companies Act, 2013, necessitates the requirement that preference shares cannot be redeemed except out of the profits of the company. Likewise, s. 80(1) of the Companies Act, 1956, provided a similar requirement. Thus, when the preference shares are converted into loans, the problem lies in the fact that shareholders who would now have become the creditors of the company will have to be paid irrespective of the availability of profits, thereby presenting a prima facie conflict with provisions of the Companies Act, 2013.

    However, the courts have refused to construe such a conversion as a contravention of company law. In PSI Data Systems Ltd., the Kerala High Court while adjudicating upon a conversion held that the requirement under s. 80(1) of the Companies Act, 1956, is to protect the preference shareholders from a company’s unilateral action. However, if the preference shareholders consent to such a conversion of preference shares into loans, no contravention of s. 80(1) can be established. The same has been affirmed by the Andhra Pradesh High Court in In Re: SJK Steel Plant Ltd., where the Court refused to read a conversion of preference shares into Funded Interest Term Loan (FITL) as a contravention of the law.

    Did the NCLAT erroneously sanction the Scheme of Arrangement?

    It is beyond doubt that any scheme of arrangement needs to satisfy the requirements of s. 230-232 of the Companies Act, 2013, so as to be sanctioned by a competent court. The corresponding provisions of the erstwhile Companies Act, 1956 in this regard were s. 391-394 of the Companies Act, 1956. Thus, for a scheme of arrangement to be denied sanction, a violation of the aforementioned statutory provisions must be established.

    It is a well-settled position of law post the Supreme Court’s ruling in Miheer H. Mafatlal v. Mafatlal Industries that a scheme of compromise and arrangement which is in violation of any provision of law cannot be sanctioned and the Court has to first satisfy itself that any scheme of arrangement does not contravene any law or such compromise is not entered into in breach of any law. However, juxtaposing the legal pronouncements in PSI Data Systems Ltd. and SJK Steel Plant Ltd., it is evident that s. 55 nowhere prohibits conversion of the preference shares into a loan.

    A pertinent objection which was raised before both the NCLT and NCLAT was that the conversion of preference shares by canceling them and converting them into a loan would substantially reduce the profitability of the demerged company. The Andhra Pradesh High Court in In Re: T.C.I. Industries Ltd., laid down that while exercising powers under s. 391 and 394 of the Companies Act, 1956 the Court cannot sit in appeal over the decision arrived at by the shareholders or the secured creditors or the unsecured creditors, and minutely examine whether the proposed scheme as approved by the shareholders should be sanctioned or not. Thus, it is beyond the powers of a court under s. 230-232 of the Companies Act, 2013, to examine the implications of a particular scheme on the profitability of the company.

    Conclusion

    The authors duly acknowledge that conversion of preference shares into loans may lead to a massive loss to the public exchequer as the payment of loans to the creditors (who were formerly preference shareholders) cannot be taxed as opposed to payment of dividend under s. 2(22)(a) of the Income Tax Act. However, as detrimental as it may be to the exchequer, the courts have not found any explicit or implicit statutory provision that prohibits such transactions. The opposite, i.e., conversion of loan into shares, although, has statutory recognition under s. 62(3) of the Companies Act, 2013 by way of issuance of convertible debentures.

    Nevertheless, the NCLAT should have been careful while allowing such conversion and must not have dismissed the contention of Income Tax Authorities merely on the grounds of locus standi. The NCLAT alone is empowered and responsible for ensuring that no scheme of arrangement is carried out in contravention of any law even though shareholders or creditors agree to such terms. At the same time, there is a need to further deliberate upon the legality of such conversion and courts must not approve of such transactions merely because they have not been expressly prohibited.

  • SEBI in the Shoes of CCI: the Jurisdictional Tussle Continues

    SEBI in the Shoes of CCI: the Jurisdictional Tussle Continues

    By Deepanshu Agarwal, a fourth-year student at UPES, Dehradun

    Introduction

    The Securities & Exchange Board of India (‘SEBI’) and the Competition Commission of India (‘CCI’) are separate independent regulatory bodies which often jurisdictionally overlap with each other. This happens due to the commonality in their objectives of ensuring the protection of consumers and promoting a healthy market.

    In the case of Advocate Jitesh Maheshwari v. National Stock Exchange of India Ltd. (2019) (‘NSE Case’), CCI refused to deal with the matterregarding abuse of dominance by National Stock Exchange (‘NSE’) and allowed SEBI to continue with their practice. This was a drastic turn taken by CCI to allow a sectoral regulator to deal with the abuse of dominance, which is an issue majorly dealt with by CCI under section 4 of the Competition Act, 2002.

    In the instant case, the informant alleged that for almost four years (i.e. 2010-2014), NSE had been giving preferential treatment and unfair access to some of the traders by communicating to them price feed and other data. According to the informant, this was a discriminatory practice followed by NSE towards other traders on the same footing & thus resulted in ‘denial of market access’. Moreover, the informant proposed the relevant market as the ‘market for providing services of trading in securities’ and contended that NSE is a dominant player in the market as it holds a huge market share, consumer dependency and entry barriers for the new stock exchanges.

    Though CCI noted that such discriminatory practices exist in its jurisdiction, the case was dismissed without going into its merits. The reasoning of CCI was that: (i) the allegations against NSE were not final and are yet to be established in appropriate proceedings; and that (ii) there was a lack of evidence to form a prima facie opinion about the role of NSE. However, CCI mentioned that it could examine the discriminatory and abusive conduct independently, based on cogent facts and evidence after the completion of investigation by SEBI. But the question that remains unanswered here is that if SEBI does not reach an adverse finding on the question of NSE’s role, can CCI then still examine NSE’s conduct? To answer this question, it becomes imperative to analyse this order in the light of the Supreme Court’s judgment in the case of CCI v. Bharti Airtel Ltd. & Ors. (2019) (‘Bharti Airtel’).

    The jurisdictional tussle in Bharti Airtel

    Though this case revolves around the jurisdictional fight between Telecom Regulatory Authority of India (‘TRAI’) and CCI, yet it is a landmark judgment when it comes to the jurisdictional overlap between CCI and other sectoral regulators, apart from TRAI.

    Reliance Jio Infocomm Ltd., a new entrant in the telecom market, approached CCI against the Incumbent Dominant Operators (or ‘IDOs’ namely Bharti Airtel, Idea Cellular and Vodafone) for forming a cartel to deny market entry and thereby causing an adverse effect on competition in the telecom market. While the case was already under investigation by TRAI, CCI found out a prima facie violation against the IDOs. The Bombay High Court, in the appeal made by the IDOs, set aside the order of CCI on the grounds of lack of jurisdiction as the matter was already under investigation by TRAI.

    The Supreme Court while confirming the findings of the Bombay High Court did not deny the jurisdiction of CCI altogether but made its investigation subject to the findings of TRAI. It did so by giving CCI a secondary jurisdiction over the matter. In this regard, the court held that “Once that investigation is done and there are findings returned by the TRAI which lead to the prima facie conclusion that IDOs have indulged in anti-competitive practices, the CCI can be activated to investigate the matter going by the criteria laid down in the relevant provisions of the Competition Act and take it to its logical conclusion”.

    Applying the reading of Bharti Airtel to the NSE case, it can be concluded that the jurisdiction of the CCI begins only when there are adverse findings returned by SEBI. Similar to TRAI, SEBI is also a sectoral regulator and will have primary jurisdiction in dealing with the abuse of dominance/adverse competition in the capital markets. Therefore, it can be concluded in the instant order that the CCI was justified in not going into the merits, by accepting itself as a regulator having a secondary jurisdiction in such cases.

    Since the instant order passed by CCI is in line with Bharti Airtel, it also suffers from similar criticisms.

    Criticism of the NSE Case

    Since both SEBI and CCI have a common objective to ensure consumer protection and fair market competition, it is clear that there may be jurisdictional overlaps. Both the Securities and Exchange Board of India Act, 1992 and the Competition Act, 2002 provide for jurisdiction in addition to and not in derogation to other laws. However, neither of the two acts provide the remedy in case of a jurisdictional overlap. This ambiguity paves the way for concurrent jurisdiction of both the regulators which further leads to conflicting decisions and legal uncertainty.

    In such a scenario, putting CCI at a lower pedestal by giving it secondary jurisdiction (as evidenced in Bharti Airtel and the NSE case) may not be the optimal solution for jurisdictional issues. Rather, the CCI being an independent competition watchdog should be allowed to deal with the competition matters freely and irrespective of the findings of the sectoral regulators. It has to be noted that CCI is a specialized body created solely with the purpose to prevent abuse of dominance and adverse effect of competition. Therefore, subjecting CCI’s jurisdiction to the findings of any other sectoral regulator would only hamper the object for which it was created, thereby weakening its authority.

    The Way Forward

    The best way through which the jurisdictional tussle can be resolved is following the mandatory consultation approach. This means that if a situation of jurisdictional intersect arises, then both the regulators should consult with each other as to who can deal with the matter more effectively and efficiently. This can be a credible solution to remove all defects from such jurisdictional matters and ensure some technical input is also given by the sectoral regulator.

    Under the current regulatory framework, India follows a non-mandatory consultation approach. Section 21 & 21A of the Competition Act incorporates a mechanism for consultation between the statutory authorities and the commission. However, consultation under these sections is neither mandatory nor binding.

    Lessons should be drawn from other countries which are successfully following the mandatory consultation approach. For example, in Turkey, under the Electronic Communications Law No. 5809, the Competition Board has the statutory duty to receive and take account of the opinion of the relevant regulatory authority (the Information Technologies and Communications Authority) when enforcing the competition law in the telecommunications sector. Moreover, Turkey’s competition authority also sends its opinion to the Information Technologies and Communications Authority regarding draft regulations in the consultation process.

    The mandatory consultation process is also followed in other countries like Argentina and France. This process was also suggested in India by the National Committee on National Competition Policy and Allied Matters in 2011. Therefore, it is the need of the hour that this change be implemented.

    Considering the existing legislative framework, substituting the word ‘may’ with ‘shall’ in Sections 21 and 21A of the Competition Act and making the opinion of CCI or the sectoral regulators binding upon the other will leverage the expertise of both the entities and will enable the initiation of a cooperative regime.

    Conclusion

    Abuse of dominance/adverse effect on market is specifically the area that CCI deals with, it is erroneous for SEBI to encroach upon the same. Both the technical aspects and the competition matters in a case have to be viewed separately. SEBI being a sectoral regulator and a lex specialis in the capital markets can deal with the technical matters more effectively than CCI. Whereas, on the other hand, CCI being a lex specialis in competition matters can deal with the same with more proficiency. Therefore, in cases involving jurisdictional conflict, it is fallacious to place CCI at a secondary stage. Rather, the mandatory consultation approach should be followed by the regulators in such cases to solve the conflict in a more harmonious and effectual manner.

  • Rationalizing the Need for Inclusion of Mens Rea in Insider Trading Regulations

    Rationalizing the Need for Inclusion of Mens Rea in Insider Trading Regulations

    By Sezal Mishra, fourth-year student at NLIU, Bhopal

    Introduction

    Securities Regulations in India prohibit the offence of Insider Trading under the SEBI (Prohibition of Insider Trading Regulations), 2015. (‘PIT Regulations’) Insider Trading is the offence of dealing in the securities of a company on the basis of unpublished price sensitive information (‘UPSI’) in order to gain an unfair advantage over the general public. UPSI refers to any information relating to a company or its securities, directly or indirectly, that is not generally available and which upon becoming generally available is likely to materially affect the price of the securities. In simple words, information which relates to internal matters of a company and is not disclosed by it in the regular course of business can be considered as UPSI. Communication of UPSI by an insider without any legitimate reason is prohibited under Regulation 3 of the PIT Regulations.

    Recently, through a series of orders, SEBI penalized several individuals in the ‘WhatsApp Leak Case’ for the unlawful communication of UPSI relating to several companies like Asian Paints, Wipro, and Mindtree through the popular messaging app. An exorbitant penalty of Rs 45 Lakh was levied upon these individuals who were found to be in violation of Regulation 3. These orders interpret some of the most important aspects of Regulation 3 of the PIT Regulations and have severe implications in deciding the liability of insiders in communication of UPSI. Through this article the author advocates the need of taking cognizance of mens rea while adjudicating liability in insider trading cases to ensure just penalization of offences.

    Communication of UPSI and the Need for Mens Rea

    The PIT Regulations have been enacted in accordance with Section 12A of the Securities and Exchange Board of India Act, 1992 with a purpose of ensuring a level playing field and to prevent undue benefit to any individual at the expense of public investors. Regulation 3(1) of the PIT Regulations prohibits an insider from communicating any UPSI, relating to a company, to any person except for legitimate purposes or in discharge of legal obligations. The aim of the legislature in enacting such regulations is to oblige all insiders to handle sensitive information with care since a leak of such information can lead to an undue advantage to both – the tipper and the tippee. The legislature, however, fails to take into consideration a scenario entailing an accidental leak of information which yields no benefit to the tipper or the tippee. Since it has already been established that the purpose of insider trading regulations is to prevent undue advantage to the tipper or the tippee over public investors, a paradox is created when regulation agencies seek to punish even the accidental communication of UPSI which entails no profit to the parties.

    In India, at present, communication of UPSI without personal benefit or even unknowingly, is a ground for liability under the insider trading regulations. Mens rea or intention of the tipper is considered irrelevant under the PIT Regulations. The only available means of solving this paradox lies in the insertion of the element of mens rea in insider trading regulations. The consideration of mens rea at the time of imposition of liability under insider trading regulations can be justified on the two grounds –

    (i.) Mens Rea is in Consonance with the Objectives of PIT Regulations

    Firstly, the purpose with which the PIT Regulations have been enacted is rendered meaningless by the non-inclusion of mens rea. The basic purpose of insider trading regulations is to prevent undue advantage to individuals engaging in trade on the basis of sensitive information. At present, however, the control of SEBI in such cases has been strengthened to a point where the mere possession or communication of UPSI can be considered as a ground for insider trading.

    The legislature has lost sight of its true purpose and engaged itself in policing information and its spread rather than regulating trading done with the intention of acquiring profits. If an insider is penalized for mere communication of information or for trade in securities with no advantage to him over the general investors, the interest of investors remains unharmed. In such a scenario, penalization of such acts becomes meaningless and is clearly beyond the scope of the purpose of the PIT Regulations.

    (ii.) Punishment without Mens Rea is Unjustified

    Secondly, the penalty levied upon an individual for a violation of the PIT Regulations is often exorbitant. Due to the diverse repercussions entailed by the offence, it is of utmost significance that the market regulations take steps towards prosecuting individuals after ascertaining proper cause. This has lead Securities Regulation Agencies in countries like the USA to consider mens rea as a vital element in imposition of liability in order to avoid imposing large penalties in cases of accidental tipping.

    In India, the opinion of the Supreme Court in SEBI v. Shriram Mutual Fund and the legislative notes to Regulation 4 have made it clear that mens rea cannot be considered as an essential element for penalization under the PIT Regulations since it is neither a criminal nor a quasi-criminal offence. Insider trading proceedings pertain to Section 15G of the SEBI Act which are essentially civil proceedings and so the question of proof of mens rea does not arise. However, the Securities Appellate Tribunal has not always subscribed to the same opinion. Previously in Rakesh Agarwal v. SEBI, SAT decided that if an insider deals in securities based on the UPSI for no advantage to him, over others, it is not against the interest of investors and hence should not constitute an offence. It can be similarly inferred that mere communication of information without any advantage to the insider must not be considered an offence. The position adopted by SAT widens the scope of PIT Regulations by correctly interpreting the purpose for which the Regulations were enacted. 

    Mens Rea as a Requirement for Insider Trading in the UK and US

    For the first time in 1984, the US Supreme Court in Dirks v. SEC established that while adjudicating liability in insider trading cases, the mens rea of the tipper must be considered. The Court arrived at its decision by devising a test to decide whether or not breach of a fiduciary duty had been committed by the insider and consequently, whether or not the tippee had committed the offence of insider trading. This was explained by the Court as,

    “The test is whether the insider personally will benefit, directly or indirectly, from his disclosures. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach by the tippee.”

    Hence, post the judgment in Dirks case, the simple test for insider trading violations was whether the insider has communicated sensitive information with the unlawful intention of earning undue personal benefit. If communication of information was done with a guilty intention, the insider had breached his fiduciary duty and would be liable under the regulations. Additionally, the tippee would be considered liable on the basis of his knowledge of the said breach by the tipper.

    The prosecution of individuals was made much more difficult by the Court in the subsequent case of US v. Newman. Here, the Court reinstated its faith in the personal benefit test by clarifying that a mere breach of an insider’s fiduciary duty to not disclose sensitive information is not sufficient to constitute an offence of insider trading, even if the information was communicated to a friend, unless some improper purpose on the part of the insider is demonstrated.

    Similarly, insider trading is illegal under Section 52 of the Criminal Justice Act, 1993 in the UK. Since the offence entails criminal liability under the Act, the requirement for mens rea is indispensible. Section 53 of the Act lays down three defences that can be used by individuals accused of insider trading. To qualify for a defence, the accused must exhibit that, (i) it was not expected at the time of dealing that the transaction would result in a profit; or, (ii) the accused was under the impression that the information is within the public domain; or, (iii) that transaction would have been undertaken even without access to the sensitive information. 

    In a situation entailing an accidental communication of sensitive information where no personal benefit is derived by the tipper, an application of the personal benefit test or the defences enlisted under Section 53 would lead us to the conclusion that there exists no ground for imposing penalty under insider trading regulations.

    Conclusion

    Over the years, the scope of SEBI’s insider trading norms has been widened in order to protect the interests of the investors and to create a healthy environment for trade in the securities. While recent orders in the WhatsApp leak case provide an impression of SEBI’s tireless efforts in curbing insider trading, upon close scrutiny it becomes evident that these orders establish a new threshold of evidence for liability under the existing PIT Regulations. The orders omit discussion on the issue of mens rea and turn a blind eye to a situation where the sharing of the information is accidental and has not resulted in any insider trading or undue benefit. Evidently, at present, the Insider Trading Regulations operating in India are much more rigid and strict than those operating in other countries of the world. It is, thus, proposed that the tipper-tippee test and other principles relating to mens rea prevalent in other jurisdictions should be incorporated in the Indian jurisprudence at the earliest.

  • U.S. Ruling on Disgorgement of Profits: A Model for Indian Securities Market

    U.S. Ruling on Disgorgement of Profits: A Model for Indian Securities Market

    By kartik singh, a second-year STUDENT OF at NLUO, CUttack

    Disgorgement refers to the repayment of unlawful profits earned by an individual arising from unlawful activities. Disgorgement of ill-gotten profits has been a potent tool for global regulatory authorities in preserving the interests of the stakeholders in the securities markets. In spite of having a provision to that effect incorporated under Section 11B of the SEBI Act, 1992, added by an amendment in 2013, the Indian market regulatory authorities have been hesitant in enforcing such powers, primarily due to the lack of clarity in the legislation itself and precedents thereof as to how the amount for disgorgement must be computed. The Indian courts and tribunals, thus, often look to foreign pronouncements on the subject.

    The Indian regulatory law for disgorgement has been inspired by the provisions of the US securities law, therefore, the developments in the US securities market are of considerable importance to the Indian regulatory regime. Recently, the US Supreme Court’s decision in Liu v. SEC has thrown light on the issue of the quantum and computation of disgorgement amount by expounding certain guiding principles for the same. Considering the absence of such a computation mechanism in the Indian securities regulations, the ruling serves as an example for India.

    The Securities and Exchange Commission (‘SEC’) charged Charles Liu and Xin Wang with defrauding Chinese investors of a project that the couple falsely claimed met the requirements of the Immigrant Investment Program, following which they diverted the investment funds to overseas marketers and by paying themselves generous salaries. Proceedings were initiated against them and the matter ultimately reached the US Supreme Court.

    Observations of the US Supreme Court: A guiding example for the Indian Framework

    Firstly, the US Supreme Court categorically observed that the power to order disgorgement must not be viewed as a “punitive remedy”, rather it must be considered as an “equitable remedy” i.e. the same must be meant to remedy the wrong and not to punish the wrongdoer. The amount ordered to be disgorged must not exceed the amount of ill-gains gained by the wrongdoer, the contrary of which would fall within the ambit of a “punitive remedy”. The Securities Appellate Tribunal (‘SAT’) in Gagan Rastogi v. SEBI and Shadilal Chopra v. SEBI had too observed the same principle. The US ruling further exemplifies the principle by providing useful direction to enable the courts and tribunals to differentiate between an equitable order and a punitive order.

    Secondly, the Supreme Court noted that the process of disgorgement must be followed by the restitution of such amount to the victims of the wrongdoing. It is often observed that the regulatory authorities disgorge the amount and then claim to have brought justice to the victims. The US Supreme Court depreciated such practice and observed that the true essence of the disgorgement provision would only prevail if the process of restitution of the disgorged amount is followed. Emphasizing the point that mere collection of the disgorged amount and depositing the same in the government treasury would amount to a penalty, the Supreme Court ordered to follow the principle of restitution. To facilitate this, the regulatory authorities must consider the number of stakeholder/victims of the wrongdoing and pass necessary order to protect their interests. A similar approach has been adopted by SAT in Ram Kishori Gupta v. SEBI, wherein it observed the exclusion of principle of restitution in the disgorgement process to be unacceptable, remarking “disgorgement without restitution does not serve any purpose”. Again, the backing of the US Supreme Court on the aforesaid principle augurs well for the Indian securities framework going forward.

    Thirdly, the US Supreme Court noted that the disgorgement of money must be computed based on the net profits earned by the wrongdoer and not from the money earned from the wrongdoing. It must be taken into account that the wrongdoer may have incurred certain legitimate expenses during the course of wrongdoing. It would be unfair to account and extract such legitimate expenses through the process of disgorgement. Depreciating such practice of the regulatory authorities, the court remarked that there have been instances where they have used disgorgement as a tool to shirk their responsibility of applying their mind in order to compute the “actual” amount for disgorgement i.e. by deducting the legitimate expenses incurred by the wrongdoer.

    In the Indian framework too, it is often seen that the authorities order to disgorge the entire amount in question instead of acknowledging the legitimate expenses of the wrongdoer. The US Supreme Court acknowledging such facet said the same can be done by analysing the facts and circumstances of each case, following which the remedy would be truly equitable in nature.

    Lastly, the court also raised concerns about the repeated use of the “jointly and severally liable” principle by the regulatory authorities. Generally, fraudulent activities are committed by several individuals in connivance of each other. Consequently, authorities punish or impose a penalty on one of the wrongdoers for the acts of others using the ‘jointly and severally liable’ principle. The court was of the opinion that although the use of such principle is justified and may be reasonable in circumstances peculiar to a case, however, in cases of disgorgement authorities must be mindful of the person being asked to disgorge the amount unlawfully gained by the wrongdoers as such person may not actually be in possession of the unlawful gains, thereby impeding his ability to disgorge the amount to the regulatory authorities.

    Conclusion

    The US ruling has certainly paved the way for developing a mechanism to ascertain the disgorgement amount from the wrongdoer. While it may be argued that the securities market of the US is different than that of the Indian market, the principles enunciated by the court form the basic structure and the essence as to the computation for disgorgement. Disgorgement differs from a claim of damages, the former being a right in rem and the latter being a right in personam, thus, the method developed by the courts over the years in computing claims for damages must not be applied for the purpose of disgorgement.

    Further, disgorgement, especially in the Indian context, allows the regulators to be more liberal in deciding the quantum since they are themselves the court of first instance. The concept of disgorgement is still at a nascent stage and it is expected that the US ruling would guide the development of the subject in India.

  • SEBI’s Approved Framework for Regulatory Sandboxes: Going the Right Direction?

    SEBI’s Approved Framework for Regulatory Sandboxes: Going the Right Direction?

    by aabha dixit, a fourth-year student at hnlu, raipur

    On June 5, 2020, the Securities Exchange Board of India (“SEBI”) rolled out the final framework enabling regulatory sandboxes for FinTech companies, after introducing draft mechanisms earlier last year – ‘Framework for Innovation Sandbox’ issued on 20 May, 2019 and the ‘Discussion Paper on Framework for Regulatory Sandbox’ issued on 28 May, 2019 (“Discussion Paper”). The framework is expected to provide a time-bound structure to mitigate regulatory uncertainty around new FinTech products.

    The concept of a regulatory sandbox

    The concept of a regulatory sandbox is a close-ended idea that allows FinTech companies to test disruptive technological products in a closed and controlled environment with limited regulatory relaxations. The need for such experimentation seems to arise from two evident challenges – firstly, the lack of regulations or inapplicability of existing regulations to the innovation and secondly, the trust deficit in the market to depend upon experimental FinTech products. The creation of a regulatory sandbox allows testing on innovative FinTech products in a strictly controlled environment.  Globally, over 20 other jurisdictions have successfully introduced sandboxes as a way of gradually integrating new financial innovations into the mainstream market, including the UK, Australia, Singapore etc. In the Indian scenario, the Reserve Bank of India (“RBI”) and the Insurance Regulatory and Development Authority of India (“IRDAI”) have both released guidelines for enabling regulatory sandboxes.

    SEBI’s framework for Regulatory Sandboxes

    SEBI’s framework for Regulatory Sandboxes (“Framework”) has strict eligibility criteria requiring genuineness of innovation, the need for live testing on real customers and relaxation of existing regulations. It also requires the participants to outline benefits for investors and/or the securities market and provide for a risk management system to control any potential threats to users. Further, the Framework mandates data privacy and disclosure of all possible risks to participating consumers along with setting up of a complaint redressal mechanism.

    Changes in the final Framework on Regulatory Sandboxes vis-à-vis the Discussion Paper

    The Framework extends eligibility for testing in the regulatory sandbox to all entities registered under Section 12 of the SEBI Act, 1992 either on its own or through a FinTech firm. While the Discussion Paper included the scope for SEBI to consider admitting FinTech start-ups, firms and other entities not regulated by it to the sandbox process independently, the same has not been adopted in the Framework. While this limits participation to regulatory sandboxes, the SEBI may reconsider the same based on testing results and market response.

    Further, registration granted under Section 12 is based on the nature of the specific activity undertaken by an applicant entity. To widen the ambit of products that can be tested by a participant beyond its registered category, SEBI has incorporated a cross-domain approach in the Framework. This is facilitated by a limited registration certificate issued to the entity which will allow it to operate in a regulatory sandbox without being subjected to the entire set of regulatory requirements to carry out that activity. Cross-domain testing adds to the flexibility of process and will encourage participants to venture into new product categories without excessive regulatory hindrances. 

    The chink in the armour

    Post publication of the Discussion Paper, SEBI has addressed and made necessary provisions for complaint redressal for consumers in the Framework by mandating participants to set up grievance redressal mechanisms. However, no mechanism for grievance redressal of participants has been provided by SEBI. Further, while the RBI Regulatory Framework includes clear safeguards for exercising intellectual property rights, the same are missing in SEBI’s Framework. 

    Since FinTech products may be governed by both the RBI and SEBI (and the IRDAI for products involving insurance-related solutions), the Framework needs to provide for coordination between the regulators to avoid replication of the processes and wastage of resources. For products that provide multiple solutions on the same technological platform, providing a unified channel for different regulators will simplify the compliance process. Additionally, post-testing, it is important that SEBI gives weightage to consumer feedback and complaints while drafting regulations for the new product. An inclusive and transparent approach by SEBI in this regard will benefit all stakeholders in the long run.   

    In conclusion, while the Framework seems structurally sound, it is imperative that SEBI conducts frequent evaluations of the actual outcomes as well as market responses and amends the regulations flexibly to uplift the FinTech sector through regulatory sandboxes.