29 May 2012

Consent orders - a new regime

I have a piece in today's Economic Times on Consent Orders

Here is the full piece:
Consent orders were introduced in 2007 by Sebi to settle cases of securities violations. I was a part of the team which discussed this in fair detail while at Sebi. While the new norms were experimental in the Indian context, consent orders are the norm rather than the exception in many western countries. The US securities regulator settles in excess of 95% of all cases; as do many other regulators. 

In brief, consent orders are passed where prima facie violations are detected and the alleged violator agrees to pay a fine, pay disgorgement amounts, or stay off the market, usually without admitting or denying guilt. This has the benefit of quicker remedies, decades long litigation being avoided, judicial systems getting unclogged and the violator coughing up sums (which can be tens or hundreds of times the amount collected after a court battle) or self-agreed debarment from the market amongst other penalties and remedies. The power to consent has its roots in the Sebi Act itself which seems to recognise such orders, as such orders cannot be appealed. 

The five-year learning has been substantial. So the recent changes in the consent scheme were in good order. The changes can be divided into four parts. 

First, certain serious violations can no longer be consented. This was a result of many people disagreeing with the fundamental principle that any violation of a serious kind should be allowed to be settled. The previous stand had its logic in terms of serious violations being permitted to be consented to, subject to imposition of extreme penalties. 

But this invited voluminous criticism on moral grounds. How can a serious and often intentional violation be consented to, so went the argument. Clearly, the critics won this argument, though I am still not fully convinced. My view continues to be that serious violations should invite extreme penalties rather than persons being barred from the consent process. Given India's criminal conviction rate of 3%, the argument that a violator should be severely punished is more theoretical than real. 

Add to that several decades of civil litigation and the fact that victims of the early 1990s financial fraud are yet to see any money. Contrast that with hundreds of crores of penalties and disgorgement that Sebi has collected in the past five years in settlements and many debarment orders agreed upon in consent. 

Einstein said that everything should be kept as simple as possible, but no simpler. One can say the same thing about discretion in government. Everything should be kept as discretion-free as possible, but not more discretion-free. In any case, the statistics show that Sebi was denying consent in over half the cases. However, the new norms do permit consent even in those cases which are barred, leaving the door of settlement a little ajar. However, the prohibition of cases like insider trading cases which are usually barred from being settled is likely to be the rule. Few will exercise discretion where the broad rule is to not allow it. I would be surprised if this discretion is used more than once or twice a year. 

Second, repeat offenders will not be able to use the consent mechanism. There is a cooling off period for both serious and all violations so the mechanism is not misused. This is welcome as it prevents recidivist violators from getting away again and again without admitting guilt.
Third, interim orders can be passed despite the consent process being initiated. This new explicit power enables Sebi to protect the market with an interim order even though it suspends passing of a final order. This is a good and wise amendment as it enables Sebi to protect the market actively, rather than just sit on the sidelines while victims suffer in the meantime.

For instance, where bogus shares seem to have been issued, to wait for the final consent order to appear if and when it does, would mean that the entire market would be flooded with fraudulent shares in the meantime. Innocent investors would have bought such shares for consideration. Potential investors who cannot be made whole by a final order as harm would have been caused, which could be prevented by an interim order.
Fourth and perhaps the most important change is the higher level of disclosure imposed upon Sebi itself in its orders. Many have rightly criticised at least some orders of Sebi which are rather sketchy about the facts, the allegations and the regulations involved. Now, the new rules impose an obligation on Sebi in its order to spell out the alleged misconduct, legal provisions alleged to have been violated, facts and circumstances of the case and the consent terms. In fact, Sebi should go a step further and open these proceedings to RTI enquiry, say after a gap of six months. Nothing beats sunshine as a policeman.

Note: the calculation of penalty is now contained in a complex formula, which was probably unnecessary. A friend who understand securities law and went through it mistook it for the formula for creating an atomic bomb. I kid thee not.


Anonymous said...

A very lucid yet simple description of the major implications in the proposed changes to the Consent Order rule... The focus needs to be on swift and punitive punishment to deter misuse of the system...

Moreover, it is important for the industry to understand the larger objective behind the same and get its act together...


Anonymous said...

Agreed, the formula was not needed. May be some guy with an MBA background must have done this, I am sure.

Anonymous said...

The annexure mentions that directions may be issued debarring certain individuals
from acting as officer or director of a company that has a class of securities
regulated by SEBI. It seems to me that there are two issues with this. First, the phrase “a company that has a class of securities regulated by SEBI” seems to be imported from SEC language with `registered’ being replaced with `regulated’. In India, the universe of companies SEBI has (part) jurisdiction over is `listed and intending to list’ companies. I think it would be more appropriate to use this language.

A more fundamental issue is the nature of `director and officer’ bar itself. In the US, the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 expressly authorizes the SEC to seek D&O bar, but the Courts seem to be cautious in granting one, as it has severe consequences (as one Court put it, this may worse than imprisonment). In the absence of a specific provision, SEBI’s authority to do so could be under doubt. It also needs to be tested on the touchstone of Art. 19(1)(g) of the Constitution.

As for the formula, maybe SEBI wanted to lay down some basis to work out the settlement amount. The settlement practice has come under fire even in the US, so this formula may inject some objectivity in the amount to be worked out. Alongside, it would be nice if SEBI explains in plain English the rationale and methodology behind the formula. As the Supreme Court observed in the Dai Ichi Sankyo case, securities regulations are often technical, and it would help if a statement of objects and reasons is provided to explain what these mean.

Mangesh Patwardhan