11 August 2017

Shell Shocked - courtesy SEBI

I have a piece in the Business Standard in the all too familiar case of the 331 'shell' companies - passed by SEBI. I argue why the order should not have been passed. The article is linked here (paywalled) and the full text is as below.

We know from the Securities and Exchange Board of India (Sebi) circular that the Ministry of Corporate Affairs (MCA) forwarded a list of 331 companies (presumably listed ones from a larger list) to the market regulator on June 9, 2017 to take necessary action. On August 7, Sebi forwarded this list to the exchanges. We know that Sebi has not reviewed this list because the two numbers are identical — 331. Sebi has asked the exchanges to take the following action: To halt trading in the companies except once a month. Price traded can only go down and not up. People will need to pay 200 per cent of the agreed price and the extra amount to remain blocked for five months. The directors and promoters of these companies can buy shares only after exchange permission and cannot sell shares. The exchange to appoint auditors and forensic auditors to assess these companies. If found not to have proper “credentials”, exchanges should initiate delisting those companies.
Now this looks like harsh but swift and just action against presumable money launderers without giving them time to scoot. Only it’s not. So why is the order wrong?

First, it is clear from the Sebi circular that the MCA itself “suspects” these to be shell companies and in bureaucratese, the ministry had asked the market regulator to take “necessary action”. That really is code for, “we don’t know if being a shell company is a problem, but if it violates securities laws, you know best what action, if any, to take”, and also “we aren’t even sure these are shell companies”. Sebi has misread that routine letter to mean let’s behead these companies immediately.

Second, there appears no law in India which says being a “shell company” is an offence or violation of any law, leave alone the securities law. The Companies Act prescribes striking off a company where it has not been in operation for over two years after giving notice to the company and an exception to that provision is in fact listed companies. Besides striking the name of a company is not a penal provision, but more of a clean-up of defunct companies.

Third, many companies indeed shut their operations because their business is no longer viable. Anyone who has visited mid-town Mumbai has seen first hand, the hundreds of acres of textile land, which remained idle from the 1980s till they discovered value in the 2000s as commercial office plots. In other words, there are many listed companies which are no longer operating, but may have valuable assets which are owned by it. These companies are neither criminal in nature nor are they presumptively violating any laws, so long as they comply with their disclosure and listing norms among other laws.

Fourth, the outsourcing of regulatory work is also somewhat troubling. The MCA had some information, which we now know is not even fully accurate, of companies which suffered from the crime of being “shelly”. Its letter to Sebi with the names has been converted into a final order of the market regulator to be executed by the outsourced agency of exchanges. They in turn have been asked to outsource investigation to private auditors and forensic auditors. This is not only problematic because of privatisation of core regulatory function of investigation, but also because they have provided a provision for further enhancement of penalty if they cannot “verif[y]..the credentials/fundamentals” without reference to the regulator. Note again that the enhanced penalty is supposed to be imposed not for any violation of the law but for the high crime of not having credentials/fundamentals.

Fifth, Sebi has found a way to penalise companies, but has not provided for an exit from the harsh provisions. Say for some reason, the so called shell companies can immediately prove that they are not shell companies, or the shell companies can show that they are not operating companies but not committing any illegalities, the exchanges cannot give those companies a free pass out of the penalty provisions described. There is similarly, no provision or hearing provided before Sebi for any of the 331 companies. Principles of natural justice even at the most rudimentary level require a post decisional hearing.

Sixth, the whole concept of harsh enforcement action, not by quasi judicial action, but by a circular is an unacceptable mode of action. Sebi is trying to interpret a recent Supreme Court ruling which holds that non-quasi judicial circulars cannot be challenged in SAT, but only by way of writ in a high court. In fact, Sebi presented this argument before SAT. Labeling an enforcement order, with a virtual economic death penalty for the company and its million plus investors, with the word “circular” on top cannot make it immune to an appeal.

Seventh, as we discovered after this circular was unraveled on exchange websites on the morning of August 8, several of the companies were not only not shell companies but were active, highly profitable, fully compliant with laws and listing regulations with marquee investors and even working on prestigious government awarded projects like the Mumbai Metro.

Finally, Sebi has completely ignored the interests of millions of investors who have been impoverished overnight because of its shotgun actions.

Sebi has a fabulous top team, including intelligentsia from the industry, at the helm. It is time Sebi realises that processes are important and cannot be short-changed in its attempt to obtain rough and ready mass enforcement action against what it believes are companies choking up regulatory bandwidth. Indeed, India does suffer from hundreds maybe thousands of dubious listed companies which may frequently commit one mischief after another. But there has to be a better way to achieve its objective. This way is just too unjust and hurts many people who have failed and even more, people who invested in such companies.


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