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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Wed, 22 Nov 2006

SEBI Disgorgement Order

The Securities and Exchange Board of India has passed a bizarre “disgorgement” order for over rupees one billion (approximately $25 million) against both the depositories in India as well as a number of depository participants involved in the IPO scam that I blogged about last year. The most charitable explanation is that this is a penalty masquerading as a disgorgement. The less charitable explanation is that SEBI is merely behaving like class action lawyers who routinely proceed only against those with deep pockets because that increases the likelihood of recovering something if they succeed on the merits.

The IPO scam involved people submitting multiple applications in fictitious names to increase their allotment in a fixed price IPO. The disgorgement order does not target any of those who perpetrated the fraud but is directed against the depositories and the depository participants who opened the demat accounts used by the fraudsters. SEBI says in its order that “it stands to reason that the Depositories and Depository Participants who enabled the opening of numerous demat accounts (afferent accounts) in fictitious / benami names either by turning a Nelson’s eye to the compliance with KYC norms prescribed by SEBI or by actively participating in the scheme designed by the key operators and the financiers, should be held liable for the loss caused to innocent retail investors. Had each market participant played their respective roles diligently with a degree of real time sensitivity, the rampant cornering of IPO allotments, particularly on this scale would not have taken place. The failure of each intermediary in the hierarchy of intermediaries contributed cumulatively, (jointly and severally) to the market abuse.”

There are many problems with this theory. First of all, disgorgement is not about liability for loss caused to investors. In its own order, SEBI states the legal position regarding disgorgement as follows:

It is well established worldwide that the power to disgorge is an equitable remedy and is not a penal or even a quasi-penal action. Thus it differs from actions like forfeiture and impounding of assets or money. Unlike damages, it is a method of forcing a defendant to give up the amount by which he or she was unjustly enriched. Disgorgement is intended not to impose on defendants any demand not already imposed by law, but only to deprive them of the fruit of their illegal behavior. It is designed to undo what could have been prevented had the defendants not outdistanced the investors in their unlawful project. In short, disgorgement merely discontinues an illegal arrangement and restores the status quo ante (See 1986 (160) ITR 969). Disgorgement is a useful equitable remedy because it strips the perpetrator of the fruits of his unlawful activity and returns him to the position he was in before he broke the law. The order of disgorgement would not prejudice the right of the regulator to take such further administrative, civil and criminal action as the facts of the case may warrant.

Similarly a report prepared by the US Securities and Exchange Commission pursuant to the Sarbanes-Oxley Act describes the legal position regarding disgorgement:

Disgorgement is a well-established, equitable remedy applied by federal district courts and is designed to deprive defendants of “ill-gotten gains.” In contrast to actions for restitution or damages in private actions, which are brought to compensate fraud victims for losses, disgorgement orders require defendants to give up the amount by which they were unjustly enriched. Before exercising their discretion to order defendants to pay disgorgement, courts have required findings that a causal connection exists between the defendants’ wrongdoing and amounts to be disgorged. “[D]isgorgement extends only to the amount with interest by which the defendant profited from his wrongdoing.” To assist in determining the amount of disgorgement, the Commission often seeks, and courts require, that defendants provide an accounting of the funds and other assets they received in the course of their wrongdoing. In ordering disgorgement, courts have not required the Commission to determine the exact amount of the defendant’s ill-gotten gains. The Commission has the burden, though, of showing that the amount sought is a “reasonable approximation of profits causally connected to the violation.” Once the Commission has satisfied its burden, a defendant who asserts that the amount should be less has the burden of demonstrating that the amount should be reduced. As long as the measure of disgorgement is reasonable, courts have held that the wrongdoer should bear the risk of uncertainty regarding the precise amount. [footnotes omitted]

The only ill gotten gains for the depositories and their participants would be the account opening charges and transaction fees that they levied on the fraudulent demat accounts. This would be a miniscule fraction of the billion rupee disgorgement that has been ordered.

The second problem is that the deficiencies pointed out in the SEBI order against the depositories and their participants are largely in the nature of negligence or lack of diligence. The appropriate response to that is a penalty or a suit for damages.

Another problem is the joint and several liability that is imposed by this order. Joint and several liability is rooted in the principle that a wrongdoer is liable for the reasonably foreseeable acts of his fellow wrongdoers committed in furtherance of their joint undertaking. US courts have held that joint-and-several liability is appropriate in securities cases when two or more individuals or entities collaborate or have close relationships in engaging in the illegal conduct. It is difficult to see how this applies to several depository participants acting largely independently of each other.

Above all, it must be remembered that from a finance purist’s point of view, the notional gain made by even the genuine applicants in the retail quota of the IPO are in some sense “ill gotten gains” as they were given shares at less than their fair value. This gain really comes at the cost of the existing shareholders of the company and of those who bought shares under the non retail quota. Thus we should not get into the trap of believing that the IPO scamsters defrauded the genuine applicants in the retail quota. The correct way of looking at the situation is that the retail quota itself amounted to looting the company and the scamsters only changed the proportion in which this loot was shared. If the so called disgorgement were ever to be turned into a restitution, the recompense must go the company that did the IPO (and therefore to all its shareholders) and not to the genuine applicants in the retail quota.

Finally, the SEBI order raises serious questions about the capital adequacy of the depositories. If this is the kind of liability that SEBI intends to fasten on the depositories, they need to have a lot more capital than they currently have. The joint and several liability that the order imposes on the country’s largest depository, NSDL, represents 45% of its net worth as disclosed in the the 2005-06 annual report. It needs to have a lot more capital to protect against actual losses caused to investors by failures in its systems.

Posted at 15:08 on Wed, 22 Nov 2006     5 comments     permanent link


Seshachalam wrote on Thu, 23 Nov 2006 15:14

Re: SEBI Disgorgement Order

Sandeep has done his job, he did what he had preached in this blog earlier. His impact is visible on the order.

Disgorgement order of this magnitude without an express legeslative mandate certainly leads to serious litigation. It seems that SEBI wanted to achieve multiple goals by this order. One is to instill confidence in the investors community, secondly to disciplince the market and thirdly to generate a debate on the powers of SEBI, or lack of it, so that it will influence the legeslative process that is currently going on to amend the SEBi Act.

No doubt, SEBI has to do lot of explaining, both in and out of Tribunal, which it has already started.

Our understanding of disgorgement is to take away the illgotten gains form the fraudsters. SEBI had widened the scope of disgorgement process to contributory negligent acts also. Is vicarious liability recognised for disgorgement?

Is it that a disgorgemetn order can be passed by SEBI against registered inermediaries only? How does the restitution take place. Who will adjudicate rights and liabilities of various investors who deemed to have incurred loss? These issues are left to be decided by judiciary!!

Gaurav wrote on Fri, 24 Nov 2006 13:24

Re: SEBI Disgorgement Order

I think this piece arises from a misunderstanding of the powers of the regulator and from factual issues of what amounts to negligence v. contribution to an illegality. A regulator has two types of powers (sliced in one way). One is administrative power and the other is civil power. Administrative powers can be exercised By the regulator by virtue of its control over registered intermediaries, no reference to civil courts is required. This remedy is quick, signaling and efficacious. The alternative power is that of filing a civil suit against any person – civil courts of course have unlimited equitable and legal powers. It would be very naïve to believe that civil courts will be able to pass any order which is prompt – thus leaving only administrative power as a legitimate threat to wrong-doers.

It is not clear how the regulator is making disgorgement wear a false mask. The argument that the regulator is behaving like class action lawyers who go after deep pockets is also factually incorrect. The US market is actually moving towards ‘strict liability’ of gatekeepers – albeit with some limitations. Reference may be made to a paper by Prof. John Coffee (one of the foremost experts in securities law in the US) where he recommends strict liability with some caps. In fact the range of gatekeepers includes not just registered intermediaries but also accoundants, banks, auditors and lawyers.

Regarding the flaw in the joint and several liability argument, is it being asserted that those who actively participate in opening tens of thousands of accounts in the system have not benefited? I find that fairly difficult to believe that all they have made is account opening charges. Obviously the entire system was allowed to be broken by the intermediaries deliberately for more than a gain of Rs. 20 per account. Even taking a charitable view of the argument that the intermediary were themselves not profiting directly, it is difficult not to pin blame on them on a joint and several liability. If a gang of 5 people go to extort money from a shopkeeper, where one is only standing guard outside (assuming he works on a salary). Would there be a similar argument that the person got no money out of the extortion bid and is therefore not jointly and severally liable for the crime?

The deficiencies pointed out against the intermediaries are not ex facie that of negligence. The order is very clear about that. This is not the case of the Bombay Municipal Corporation being made liable for the extortion case above. The case is of active complicity, if not of a standard of rashness. To drive at 80 km/h in a crowded street cannot be called negligence. Unfortunately, this is not a case where eyes were shut, but a case where not only were the eyes of the gatekeepers open, but the hands were used to help the other fraudsters in breaking the lock (sorry for the excessive use of analogy).

The principle of joint and several liability in law is NOT based on reasonably foreseeable actions of fellow wrongdoers. That is the test of damages in a civil action. The defense against vicarious liability in common law arises from a defendant establishing BOTH lack of knowledge and lack of reasonable ground to believe in the existence of the facts. The test is objective and subjective. Clearly, here there was knowledge of the intermediaries in the present case. In the above example, the person who was to stand guard was not even informed of the planned extortion, of course he cannot be held liable for disgorgement, but that is a case where there is no action (in the dual requirement of intent and action which are required for liability). In the present case, the person was in fact standing over (system audits year after year by the depository showed accounts being opened without proof of address – and often by the same DPs year after year – doesn’t sound like negligence to me).

Again, the principle of several wrongdoer not knowing each other does not protect them. This has also been developed by US courts and is called the hub and spoke theory. Where the hub (of this wheel) is the person who knows several people who are wrongdoers (the spokes of this wheel), the liability will be affixed on the entire ground even though not a single spoke knows a single other spoke. This is commonly used in takeover violations in the US.

Lastly, the argument that the company suffered rather than the other investors is not correct even from the most theoretical/purist point of view. Fraud does not arise from what is legally doled out to primary market applicants, this is an extremist view even by financial purists as it presumes that there will be over-subscription in each and every allotment. I guess a sustained bull run clouds even the theory of issues. The prime reason issues are under-priced is because they represent a risk that the listing price will be below the allotment price – there is no charity by the existing shareholders. So to call all retail investors ever as scamsters runs contrary to even a purely academic view of the issue.

NSDL recorded a net profit of 30 crores this year alone (figures out just last week), so I’m not sure the figure given is even close to the figure of 45% of net worth any longer. But the point of solvency is an important point if not material in this case.

Mobis Philipose wrote on Sat, 25 Nov 2006 12:53

Re: SEBI Disgorgement Order


Can you explain your comments about the retail quota, "the notional gain made by even the genuine applicants in the retail quota of the IPO are in some sense “ill gotten gains” as they were given shares at less than their fair value. This gain really comes at the cost of the existing shareholders of the company and of those who bought shares under the non retail quota."?

As far as i remember, barring a few PSU public issues few years ago, most issues have been done at the same price to the retial as well as the non-retail (QIB and HNI) segments. How then can we say that retail investors were given shares at less than fair vale?