Watchdog has powers to issue directions to bar person involved in financial statement fraud: Committee.
New Delhi: The fair market committee report submitted to securities market regulator Sebi has many more unpleasant surprises for various market-connected entities. For instance, it opens a pandora's box on whether Sebi has jurisdiction over errant chartered accountants or not.
The committee wants to empower it to crack down on them in case they are subverting the law. In fact, it goes on to allow Sebi to randomly inspect books of accounts of listed companies which are in contravention of laws. On the sensitive issue of high frequency and algo trading, the committee lays down the law. This and many more incendiary issues form a part of the report on which public comments were to come in by August 27.
At the very core of the report of the committee, headed by former law secretary T K Viswanathan, is that interests of Indian investors in securities and the security market need to be protected as the entire system of fraud, manipulation and insider trading surveillance and tracking is overhauled.
The question whether Sebi has jurisdiction to issue show cause notices to chartered accountants in connection with the work they had undertaken for a listed company in the matter of maintaining accounts and balance sheets was also considered by the Bombay High Court in Price Waterhouse & Co v Sebi. In that case, it was held that Sebi, under Section 11 of the Sebi Act, had power to prohibit fraudulent and unfair trade practices and was empowered to pass appropriate orders to safeguard the interest of investors or the securities market. Sebi was held to have had the power to take remedial or preventive measures against a CA if there was material against him to the effect that he was instrumental in preparing false and fabricated accounts.
The Sebi Act is to be read in harmony with the provisions of the Companies Act, 1956. Both Acts are to work in tandem, in the interest of investors. Sebi had power to administer select provisions of the Companies Act as was set out in Section 55A of the Companies Act, 1956, whi-ch has since been replaced by Section 24 of the Companies Act, 2013. Though the corporate affairs ministry (MCA) has powers and duty to take action for financial statement frauds under the Companies Act, Sebi shall concurrently take action against persons who engage in fraud by manipulating boo-ks of accounts/ financial stateme-nts to manipulate the price of listed securities and hide siphoning / diversion / misutilisation of funds.
The committee noted that Sebi has powers under section 11B of the Sebi Act, 1992 to issue various directions, including direction to bar person involved in financial statement fraud from associating with listed companies as promoter/director/ auditor of any listed company, impounding and disgorgement of any illegal gain made by such person etc.
The committee noted that such powers are generally not available with MCA under the Companies Act, 2013. In view of above, the committee felt that there is a need for Sebi to take direct action against perpetrators of financial fraud as such fraud has an adverse impact on not only the shareholders of the company but also impacts the confidence of investors in the securities markets. While the primary responsibility of monitoring/supervision of books of accounts of companies is with MCA under the Companies Act, in respect of listed companies Sebi should also take action for fraud committed by manipulating books of accounts and/or financial statements to directly or indirectly manipulate the share price of a listed company or hide diversion, misutilisation or siphoning off public issue proceeds/assets/earnings of a listed company. The committee also examined the power of Sebi to inspect books of accounts and records of a listed company. Section 11(2A) of the Sebi Act lays down the specific power of Sebi to conduct inspection of books of account of a listed company in case it has reasonable grounds to believe that the company has been indulging in insider trading or fraudulent and unfair trade practices. The committee noted that the listed companies have to comply with various regulations framed under Sebi Act such as ICDR regulation, LODR regulations, etc. The committee was of the view that Sebi should have power to conduct inspections of books of accounts of a listed company for contravention of any securities laws without limiting it to insider trading or fraudulent or unfair trade practices.
As mentioned earlier, investigation of insider trading is a challenging task and it is not easily possible to establish the link between the insiders who had access to UPSI (unpublished price sensitive information) and the persons who traded making use of such UPSI. The links may be tenuous as the persons who benefit from inside information may be school/college friends, relatives, ex-colleagues, professional contacts, or social contacts. At times, insider trading may also be done in the name of a front entity who may have no obvious link to the insider. Hence, mechanisms need to be built to enable establishment of such connections in case there is suspicion of insider trading. These mechanisms will not only help in investigating insider trading but may also prove to be a deterrent to insider trading. These mechanisms are primarily based on building a database of information within the listed company/ intermediary of persons who are connected to the “designated persons” as defined in the PIT Regulations so that, if required, a chain of connections can be traced quickly. In fact, in a recent Sebi order, it has given this opinion in response to queries by the country’s second largest private sector lender HDFC Bank with respect to trading that can be done by its employees. HDFC Bank had sought an informal guidance on whether its employees – who are in possession of unpublished price sensitive information (UPSI) related to it or other listed companies dealing with the bank – can carry out trades on the stocks concerned under discretionary portfolio management scheme. Under the scheme, day-to-day investment decisions are taken by portfolio manager without involvement of investor. Giving its views, Sebi said dealing in securities, whether it is direct or indirect, is not relevant, “but that any insider when in possession of UPSI should not deal in securities of the company to which the UPSI pertains”. “Even while dealing in such securities through a discretionary portfolio management scheme, the trades of insider shall be assumed to be motivated by the knowledge and awareness of UPSI,” Sebi said in a recent communication to HDFC Bank. This opinion is with regard to whether the bank’s employee or his relative – who have no control over investment decision under discretionary portfolio management scheme but are in possession of UPSI – can do trades on the stocks concerned. According to the regulator, the lender had also sought an interpretative letter on the issue as well as on another matter in terms of compliance with Sebi (prohibition of insider trading) or PIT Regulations.
Stringent New Recommendations
The committee recommends that a new regulation may be added in the Sebi (PIT) regulations to include the following requirements:
1. Designated persons should disclose to the listed company/ market intermediaries / other entities as applicable, the following information on an annual basis:
Names of immediate relatives, including spouse of designated person, parents, siblings, or children of such designated person or of the spouse, irrespective of whether they are dependent financially on such designated person or not.
Names of persons with whom such designated person(s) share a material financial relationship
Names of persons residing at the same address at which designated persons reside for more than one year
Phone / mobile /cell numbers which are accessible by them or whose billing address is residence address of the designated person.
2. For this purpose, the term “material financial relationship” shall mean a relationship in which one person is a recipient of any kind of payment such as by way of a loan, or gift, during the immediately preceding twelve months, equivalent to at least 25 per cent or such percentage as notified by Sebi from time to time of such payer’s annual income. However “material financial relationship” shall exclude relationships in which the payment is based on arm’s length transactions. This kind of relationship is being included to cover those cases where the insider may have funded otherwise unconnected persons to trade on his behalf in order to evade detection.
The designated person should disclose the following information on a one-time basis: In another important recommendation, since one of the terms of reference of the committee was to suggest short-term and medium-term measures for improved surveillance of the markets as well as issues relating to high frequency trades, harnessing of technology and analytics in surveillance, the committee noted that having appropriate laws/ regulations is one aspect of ensuring market integrity, fair market conduct and protection of interest of investors. However, to ensure that the laws and regulations are followed is equally important. For this purpose, mechanisms are necessary for detection of violations through effective surveillance and investigation and punishment thereof by strong enforcement action. The Committee reviewed the current processes followed by Sebi for surveillance, investigation and enforcement, and the hurdles faced by Sebi for effective enforcement of securities laws from the perspective of whether any improvements could be suggested such as more efficient use of technology, need for additional powers to augment investigation capacity and measures to enhance surveillance and enforcement.
High frequency trading/algorithmic (algo) trading
In the light of the NSE algo fiasco where there is now an overarching investigation by CBI and top echelons of NSE management named, HFT or algo trading is perceived as a new risk in securities markets because of various reasons, such as the use of opaque algorithms for trading, high speed of trading due to use of powerful technology and the growing percentage of such orders and trades generated by HFT/ algo trading systems as a percentage of total trading volumes. In order to examine the scope for improvement and risk-containment, the committee (through one of the sub-committees – investigation and enforcement sub-committee) sought presentations by NSE and BSE on the systems used by them for surveillance of HFT/algo trading. The following concerns with respect to HFT/algo trading were noted by the committee -
a) High orders to trade ratio – the number of orders placed as a proportion to trades taking place is very high due to the high speed with which orders can be placed and cancelled;
b) High cancellation of orders – Orders are placed fleetingly, either to gauge order book (to get an idea of the market for the scrip at that point of time) or create an impression of order flow, and then are quickly cancelled;
c) Possible unusual price behaviors – Algo trading could possibly cause unusual price movements due to nature of high speed order flow;
d) Possible choking of the exchange system resulting in Trading Halt – The capacity to throw large numbers of orders at the trading system could potentially choke the trading system;
e) Effect on level playing field for retail investor – retail investors are unable to invest in such technology and hence lose out on price-time priority when placing orders.