SEBI penalises front-running again, does not follow SAT’s order

There is yet another Order of SEBI on front running and SEBI holds that transactions in the nature of front running are violative of the PFUTP Regulations. This is close after SAT’s recent ruling (“the Patel Order”) holding that front running cannot be punished, as discussed by me here, and another later ruling by SAT (“the Karkera Order”) as discussed by Mr. V. Umakanth here. By an Order dated 19^thDecember 2012, the Adjudicating Officer levied penalty of Rs. 25 lakhs on the persons who allegedly made profit of Rs. 7.16 lakhs from transactions that fit the description of what are popularly known as front running transactions.

The facts of the present case, being substantially similar as in earlier cases, need not concern us here to avoid repetition. What is interesting is that, despite the parties drawing attention to the ruling of SAT holding that front running does not amount to violations of the PFUTP Regulations, SEBI has held that it is still punishable under the said Regulations.

It may be remembered that SAT quite clearly held that transactions in nature of front running are punishable under the PFUTP Regulations only if committed by an intermediary and not by others. More specifically, it held that, in absence of any specific provision of law in securities laws, such transactions by non-intermediaries are not punishable at all. To quote the Hon’ble SAT from the Patel Order:-

“In the absence of any specific provision in the Act, rules or regulations prohibiting front running by a person other than an intermediary, we are of the view that the appellants cannot be held guilty of the charges levelled against them.”.

This ruling was followed explicitly in the later SAT ruling in the Karkera Order.

The parties accused in this case did cite the Patel Order before SEBI. However, interestingly, SEBI did not accept this ruling to give relief to the accused on the following ground:-

“The Noticees have even produced the judgment of the Hon'ble Securities Appellate Tribunal in Dipak Patel Vs. The Adjudicating Officer (SAT Appeal No. 216 of 2012 decided on 09/11/2012) in which Regulation 4(2)(q) of PFUTP Regulations, 2003 has been interpreted by the Tribunal. However, the present case does not deal with the violation of the said Regulation but Regulation 3 (a), (b), (c) & (d) and 4(1) of PFUTP Regulations, 2003. The CBI deals in shares on its own account and on behalf of its customers. CBI is a publically listed company and any loss incurred on its investments adversely would affect the interests of its own shareholders and customers. Therefore, the fraudulent and manipulative activities of the Noticees fall upon the CBI and its customers and ultimately on the investors of the securities market. In other words, the undue profits earned by the Noticees are nothing but the losses to them.”

Though not specifically made clear, it does appear that Central Bank of India (the employer of one of the noticees) is not an intermediary. If this is the case, then the SAT rulings would directly apply. The statement of SEBI that “the present case does not deal with the violation of the said Regulation” (i.e., 4(2)(q)) is not valid, in context of the SAT rulings as a whole, particularly the words reproduced earlier.

Moreover, the Patel Order did cite and discuss the provisions of Regulation 3(1) (a) to (d) of the PFUTP Regulations.

The point of SEBI that CBI is a publically listed company and so loss incurred by it would be borne by its shareholders may sound valid but this may imply that if there were no such public shareholders, front running would not be a violation. Same concern can be raised for the point that such transactions affect the interests of its customers. Also, to reiterate, this still does not deal with SAT’s ruling that in absence of specific provisions for non-intermediaries, front running cannot be punished.

An opportunity was thus lost to discuss and analyse the provisions individually and in detail relating to fraud and unfair trade practice in the PFUTP Regulations and apply the same to such cases. Instead, as in earlier case, several provisions were merely cited together and the noticees held to have violated them.

This decision also raises again a long standing concern about the non-binding nature in law of SAT decisions as precedents on SEBI. This concern particularly arises because the next appeal after SAT is straight to the Supreme Court.

The ruling of SAT in the Patel Order (and, so, the Karkera Order too) is of course dissatisfactory, and the concerns it raises have already discussed earlier here. One hopes that this issue is resolved soon by appeal to the Supreme Court and/or amendment to the law. For such Orders as the present one are satisfactory neither as practice, nor as precedents for other cases in other contexts.

An Instance of Accounting Fraud

The New York Times analyzes an instance of possible accounting fraud at a Chinese company, Longtop Financial Technologies that has close similarities with India’s own Satyam scandal (i.e. improper confirmation of bank balances). While the Satyam scandal came into the public domain through a confession letter of the Chairman, in this case the auditor blew the whistle. Here is an extract:

Deloitte, which had given clean audit opinions to Longtop for six consecutive years, apparently was well on its way to providing a seventh, for the fiscal year that ended March 31. But for some reason — Deloitte did not say why —the auditor went back to Longtop’s banks last week to again seek confirmation of cash balances.

It appears Deloitte sought confirmations from bank headquarters, rather than the local branches that had previously verified that Longtop’s cash really was on deposit. And that set off panic at the software firm.

 
It is reported that SEC has begun an investigation, which will also throw the spotlight generally on non-US companies listed on US stock exchanges.

Fraud and the amendment of a section 34 application

In an important fallout of the Satyam controversy, the Supreme Court, earlier this month, reiterated the law on the amendment of section 34 applications, and also clarified the kinds of fraud that would justify the setting aside of arbitral awards on grounds of public policy. After the fraud perpetrated Mr. Raju, Venture Global sought to amend its section 34 and bring the facts about the fraudulent conduct on record. Before the AP High Court, Satyam successfully contended that the amendment of the pleadings was hit by the limitation period prescribed under section 34, and could not be allowed. Venture’s appeal against this decision fell for the Supreme Court’s consideration.

Section 34 of the Act, in its relevant part, reads-

34. Application for setting aside arbitral award.

(1) xxx

(2) xxx

(a) xxx

(b) the Court finds that-

(i) the subject-matter of the dispute is not capable of settlement by arbitration under the law for the time being in force, or

(ii) the arbitral award is in conflict with the public policy of India.

Explanation.-Without prejudice to the generality of sub-clause (ii) it is hereby declared, for the avoidance of any doubt, that an award is in conflict with the public policy of India if the making of the award was induced or affected by fraud or corruption or was in violation of section 75 or section 81.

(3) An application for setting aside may not be made after three months have elapsed from the date on which the party making that application had received the arbitral award or, if a request had been made under section 33, from the date on which that request had been disposed of by the arbitral tribunal:

Provided that if the court is satisfied that the applicant was prevented by sufficient cause from making the application within the said period of three months it may entertain the application within a further period of thirty days, but not thereafter. [emphasis supplied]

Based on the language of the provision, there were two arguments available to the Satyam- (a) that the extended period of 30 days, contained in the proviso to clause (3), had expired and it was not open to the Court to allow any further extension; and (b) that the fraud in question had not induced or affected the award, and was not relevant for the purposes of section 34. The first of these arguments had been considered and rejected by the Supreme Court in State of Maharashtra v. Hindustan Construction Company. In this case, the Apex Court had been called on to consider whether the limitation period applied only to fresh applications for setting aside awards, or also to amendments to existing section 34 applications. The Court held that amendments to existing applications, if necessary in the interests of justice, and not amounting to a fresh application, would not be barred by the proviso to section 34(3). (A more detailed discussion of the decision is available here).

That then left only the question of whether the fraud perpetrated by Mr. Raju could be said to have induced or affected the impugned award. Mr. Salve contended for Satyam that the phrase ‘making of the award’ had to be read narrowly, and that events subsequent to the award had no bearing on a section 34 application. Mr. Venugopal, for Venture Global, contended that since the facts were not revealed by Mr. Raju until after the award, there was no way they could have been made part of the original section 34 application. Also, since the concealment had materially affected the passing of an award in Satyam’s favour, it was material for the purposes of setting aside the award. Accepting the Respondent’s contentions, the Supreme Court overturned the decision of High Court and allowed the amendment of the application. The Court observed that the phrase ‘making of the award’ could not be read narrowly, especially since the scope of the provision was widened by the phrase ‘induced or affected’. Further, the Court went on to elucidate on its conception of public policy in the following words-

The concept of public policy in ABC, 1996 as given in the explanation has virtually adopted the aforesaid international standard, namely if anything is found in excess of jurisdiction and depicts a lack of due process, it will be opposed to public policy of India. When an award is induced or affected by fraud or corruption, the same will fall within the aforesaid grounds of excess of jurisdiction and a lack of due process. Therefore, if we may say so, the explanation to Section 34 of ABC is like `a stable man in the saddle' on the unruly horse of public policy. [emphasis supplied]

Thus, the Court concluded that the amendment of the section 34 application could not be barred by limitation in the interests of justice, and that the fraud alleged was such as to fall within the scope of fraud which had ‘induced or affected the making of the award’. On this basis, the decision of the High Court was overturned. (Another exhaustive discussion of the decision is available here).

On a concluding note, one issue discussed earlier seems to be interesting in the context of the discussion above. In Moore Stephens, the House of Lords had held that fraud by the ‘directing mind and will’ of a company will be attributable to the company is all cases, except when the company itself is a victim (as opposed to a vehicle) of the fraud. In the case of Satyam, whether the company was a vehicle or a victim of the fraud is open to argument. Hence, in a case like this, it may be possible to argue that the fraud perpetrated by Mr. Raju is not attributable to Satyam. However, on the text of section 34, there is no requirement that the fraud which ‘induced or affected the making of the award’ be attributable to a party to the arbitration proceedings. It is probably for this reason that the question of attribution was not argued before or considered by the Court. It is instructive to contrast the Indian language with that of the English Arbitration Act, 1996, which talks of an award ‘being obtained by fraud’. The use of the word obtained (as opposed to influenced or affected) can be taken to signify that under English law, the fraud in question should be attributable to a party.

On this reading of the provision, it seems that the question of attributability of the fraud is not relevant for the purposes of section 34(3). However, on a closer examination of the decision of the Supreme Court, there are a couple of observations which can be taken to be assumptions by the Court that fraud under section 34 is fraud attributable to a party. First, the Court cites and approves the provision in the English Arbitration Act, which, as seen above, can be interpreted as containing the requirement of attribution. Secondly, there is the observation of the Court that “If the argument advanced by the learned counsel for the respondents is accepted, then a party, who has suffered an award against another party who has concealed facts and obtained an award, cannot rely on facts which have surfaced subsequently even if those facts have a bearing on the facts constituting the award ... Such a construction would defeat the principle of due process and would be opposed to the concept of public policy incorporated in the explanation” [emphasis supplied]. Admittedly, neither of these instances are authority for the proposition that attribution of the fraud to a party has been read into section 34 by the Court. This is especially so given broad observations like “if the concealed facts, disclosed after the passing of the award, have a causative link with the facts constituting or inducing the award, such facts are relevant in a setting aside proceeding and award may be set aside as affected or induced by fraud”. However, since the Court only decided that the application may be amended to make fraud a ground, and did not dispose of the question of whether the award may be set aside on grounds of fraud (which being a question on merits, is still to be decided by the lower courts), there is always the possibility that this question comes up for consideration in future.

SEBI’s Domain Over Auditors of Listed Companies

Earlier this month, the Bombay High Court issued its judgment in the case of Price Waterhouse & Co. v. Securities and Exchange Board of India. The court ruled that SEBI possesses necessary powers to initiate investigations against an auditor of a listed company for alleged wrongdoing.

Facts: A writ petition was filed before the Bombay High Court by Price Waterhouse & Co. (PWC) and some of its partners and affiliates challenging a show cause notice issued to them by SEBI. This pertains to PWC’s audit of Satyam Computers and their alleged failure to detect financial wrongdoing within the company of significant magnitude that in turn resulted in severe losses to Satyam shareholders. The financial wrongdoing included overstatement of cash and bank balances, non-existent accrued interest, overstated debtor position and the like. SEBI’s show cause notice sought to initiate action against PWC under Sections 11, 11B and 11(4) of the SEBI Act and Regulation 11 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003. Although PWC raise objections regarding jurisdiction of SEBI before its member, no order was passed on jurisdiction, which then prompted PWC to file the writ petition before the Bombay High Court for quashing the pending proceedings before SEBI.

Arguments: The principal arguments raised by PWC are that SEBI does not have the requisite jurisdiction to initiate action against auditors who are discharging their duties as professionals. SEBI can only regulate the securities markets and that auditors can never be considered to be associated directly with the securities markets. Moreover, PWC argued that there is already an established legal regime in the form of the Chartered Accountants Act, 1949 (and the Institute of Chartered Accountants of India (ICAI) established therein) that governs the accounting profession and hence any restrictions on the practice of that profession can be imposed only by the ICAI. Only the ICAI can determine whether there has been a violation of applicable auditing norms. Failing this, SEBI would be seen as encroaching upon the powers of the ICAI.

On the other hand, SEBI argued that the investigation pertains to a corporate scam that had a cascading effect on the price of Satyam’s shares and consequently on the securities markets as a whole. Since the auditor’s role is to certify the books of accounts of the company, persons dealing in the securities markets are likely to place reliance upon those accounts while making investment decisions. Consequently, it is argued that SEBI has jurisdiction to take appropriate steps in relation to auditors of listed companies.

Issues: The key questions before the court were (i) whether the show cause notice issued by SEBI was without jurisdiction so as to require quashing of such proceedings; and (ii) whether the proceedings initiated by SEBI amount to an encroachment of the powers of the ICAI under the Chartered Accountants Act.

Decision: The court analyzed the powers of SEBI under various provisions of the SEBI Act. It found various measures were available to SEBI that could be employed in regulating the securities markets. Those powers were of wide amplitude which would “take within its sweep a chartered accountant if his activities are detrimental to the interest of the investors or the securities market”. The court found that by taking remedial measures to protect the securities markets, it cannot be said that SEBI is regulating the accounting profession. SEBI’s general domain extends to protecting investors of listed companies and the securities markets. In exercise of such powers, there is no reason why SEBI cannot prevent any person from auditing a public listed company. Even though the auditors are not directly involved in the securities markets, the court found that since investors rely heavily on the audited accounts of the company, the statutory duty of the auditors and discharge thereof “may have a direct bearing in connection with the interest of the investors and the stability of the securities markets”. The court finally ruled that the powers of SEBI are independent of those held by the ICAI and hence SEBI cannot be said to encroach upon the powers of the ICAI under the Chartered Accountants Act.

Analysis: The judgment is important as it establishes the regulatory domain of SEBI over auditors of listed companies. The court largely arrives at its conclusions based on an analysis of SEBI’s powers to regulate the securities market, which is then contrasted with ICAI’s powers to regulate the accounting profession.

A greater significance of this judgment is that it establishes the role of an auditor to be closely linked with the functioning of the securities markets. Inherent in this analysis is the fact that proper performance of audit role in listed companies is a prerequisite for investor protection which is crucial to maintain robust securities markets. If audit and investor protection are said to be interconnected, it then takes us to a fundamental legal question: do auditors owe a duty to shareholders/investors? The Bombay High Court, in this case, appears to answer in the affirmative: “The auditors in the company are functioning as statutory auditors. They have been appointed by the shareholders by majority. They owe a duty to the shareholders and are required to give a correct picture of the financial affairs of the company.” [emphasis added]. Although the court cites to Institute of Chartered Accountants of India v. P.K. Mukherjee to state that auditors owe duties to shareholders in a company, that case had largely to do with a provident fund and its beneficiaries and it is not clear whether the ruling has any direct application to the present situation.

More importantly, the fact that auditors owe duties to shareholders seems to move away from conventional wisdom. In cases involving civil liability, the general position appears to be that the duty of reasonable care in carrying out audit of the company’s accounts is owed to the company in the interests of its shareholders, and that no duty is owed directly to individual shareholders. This has been solidified ever since the House of Lords pronounced its decision in Caparo Industries Plc v. Dickman [1990] 2 A.C. 605 (H.L.). The Bombay High Court’s judgment in the PWC steers clear of any detailed discussion regarding this jurisprudence. At one level, it may be argued that this discussion is not necessary in view of SEBI’s wide powers under the SEBI Act, but since those powers are derived from the investor protection mandate of SEBI, those powers may not be available if auditors do not have duties to individual shareholders in the first place. It is not clear if the discussion of auditors’ civil liability to individual shareholders can be divorced from auditors’ subjection to powers of a securities regulator acting to protect the investor community.

Although the judgment is confined to auditors, it remains to be seen whether third parties such as other advisors involved in securities markets activity (generally referred to as “gatekeepers”) could be drawn into the ambit of SEBI’s powers. Even here, courts in other jurisdictions have been slow to impose civil liability on such third parties. E.g. the U.S. Supreme Court decision in Stoneridge v. Scientific Atlanta. As far as certain gatekeepers such as investment/bankers and credit rating agencies are concerned, they are subject to SEBI's domain by virtue of registration under relevant SEBI regulations that apply to them.

The last word is yet to be spoken in the matter, since the judgment itself indicates that PWC has sought to file a special leave petition before the Supreme Court.

Bits of Interest

1. SEBI and Auditors: It was reported a few days ago that the Bombay High Court has allowed SEBI to proceed with its enquiry against the auditors in connection with the Satyam scam. The judgment is now available on the Bombay High Court website.

2. Satyam Saga: With all the accused persons now having been released on bail, questions are being raised regarding the investigative and prosecutorial processes in India. On the other hand, the current state of affairs may be viewed as resulting from the undue complexity of the case. See Shyamal Majumdar in the Business Standard and this discussion on CNBC.

3. Foreign Investment in Pharma: The Department of Industrial Policy and Promotion has released a discussion paper titled “Compulsory Licensing” that seeks to ensure the “availability and affordability of pharmaceutical products” to Indian consumers. Noting the several recent instances of takeovers of Indian pharma companies by multinationals, it seeks to restrict the foreign investment regime in the pharma industry. One of the options proposed is as follows:

Presently, investment up to 100% in the pharmaceutical sector is on the automatic route. This could be shifted to the government route so that proposals for mergers and acquisitions in this important sector could be scrutinized by the FIPB. This could be a way of monitoring whether new technology is being brought in by a foreign company while taking over an Indian company.

4. CSR: Mandatory or Voluntary: We had earlier discussed the merits and demerits of imposing mandatory CSR requirements among companies. In this Wall Street Journal column, Aneel Karnani is agnostic about managers’ ability and their motivation to pursue CSR. He notes:

Very simply, in cases where private profits and public interests are aligned, the idea of corporate social responsibility is irrelevant: Companies that simply do everything they can to boost profits will end up increasing social welfare. In circumstances in which profits and social welfare are in direct opposition, an appeal to corporate social responsibility will almost always be ineffective, because executives are unlikely to act voluntarily in the public interest and against shareholder interests.
…

Executives are hired to maximize profits; that is their responsibility to their company's shareholders. Even if executives wanted to forgo some profit to benefit society, they could expect to lose their jobs if they tried—and be replaced by managers who would restore profit as the top priority. The movement for corporate social responsibility is in direct opposition, in such cases, to the movement for better corporate governance, which demands that managers fulfill their fiduciary duty to act in the shareholders' interest or be relieved of their responsibilities. That's one reason so many companies talk a great deal about social responsibility but do nothing—a tactic known as greenwashing.

Managers who sacrifice profit for the common good also are in effect imposing a tax on their shareholders and arbitrarily deciding how that money should be spent. In that sense they are usurping the role of elected government officials, if only on a small scale.

Karnani then discusses the role of various players such as the government/regulators and civil society as well as of self-regulation by companies, and then concludes:

In the end, social responsibility is a financial calculation for executives, just like any other aspect of their business. The only sure way to influence corporate decision making is to impose an unacceptable cost—regulatory mandates, taxes, punitive fines, public embarrassment—on socially unacceptable behavior.

Pleas for corporate social responsibility will be truly embraced only by those executives who are smart enough to see that doing the right thing is a byproduct of their pursuit of profit. And that renders such pleas pointless.

Such arguments, often adopted by opponents of the social responsibility movement, tend to take a pure economic approach. That approach does not call for voluntary CSR, let alone mandatory CSR. Such an extreme stance may not be beyond question, because both regulation and practice are beginning to recognize the existence of interests other than shareholders that corporate managers must cater to. In India, the Corporate Social Responsibility Voluntary Guidelines 2009 exhort companies to act in a socially responsible manner, while there are plenty of instances where reputable Indian companies have already embarked on serious CSR initiatives.