Upholding disgorgement principles

 I have a piece on SEBI’s power of disgorgement in today’s Financial Express with Rashmi Birmole and Anirudh Sood linked here. The full piece is as below:

Capital markets operate under a constant threat of malpractices which benefit a select few, at the cost of public investors and market integrity. Wrongful conduct, such as insider trading, front-running, fraudulent schemes, siphoning of money, etc., often results in an unlawful gain or avoidance of loss for the wrongdoer, which, would not have ordinarily been possible, but for the wrongdoing. Over the years, disgorgement has evolved as a remedial measure to deprive a wrongdoer of gains arising out of wrongful conduct, termed ‘unjust enrichment’ in legal parlance, and restore status quo ante, in legal jargon, in the securities market. 

Disgorgement is a gain-based, equitable remedy which seeks to reverse the unjust enrichment of the wrongdoer by stripping them off the fruits of their illegal conduct and placing them in the same position as if no wrongdoing had happened. Under the Securities and Exchange Board of India Act, 1992 (SEBI Act), SEBI is empowered to direct disgorgement of an amount equal to the profit made or loss averted by indulging in any activity in contravention of the SEBI Act or regulations. While determining the amount of disgorgement, factors such as the amount of unfair gain made by the person, liability of connected persons as joint tortfeasors, the amount of interest payable on the disgorgement amount, etc. are considered. 

The Securities Appellate Tribunal (SAT), in its recent orders in the matters of National Stock Exchange (NSE) v. SEBI and SRSR Holdings Pvt. Ltd. v. SEBI, reaffirmed key principles governing SEBI’s power to direct disgorgement of illegitimate gains. 

The NSE co-location order

The SAT, by way of an order, set aside the massive disgorgement order of Rs. 624 crores passed by SEBI against NSE for granting brokers preferential access to its co-location facilities. The matter dates back to an order passed by SEBI in 2019, directing NSE to disgorge the sum, arrived at, based on NSE’s revenue from operations, along with 12% interest from April 1, 2014. Further, the senior management of NSE in charge at the relevant time, i.e., Ravi Narain and Chitra Ramkrishna, were also directed to disgorge 25% of their salary, during their respective tenures. 

On appeal, SAT held that disgorgement can only be directed in cases where a person has made profit through illegal or unethical means and observed that NSE’s failure to comply with any provision of the SEBI Act or any regulations formed therein, cannot be the basis of an order of disgorgement, and could lead to the imposition of a penalty, at best. However, considering NSE’s failure to fulfil its obligations as a first-level regulator, a direction to deposit a sum of Rs. 100 crore in SEBI’s Investor Protection and Education Fund was passed against NSE.  

Further, NSE’s senior management were not found to have made any illicit gains. SAT noted that the order for disgorgement of 25% of their salary was incorrect, by virtue of the salary having been received for services offered in a professional capacity, as opposed to a profit or a gain. In SAT’s view, such direction, if passed, would be tantamount to penal action rather than the equitable remedy that disgorgement is envisaged to be. 

On consideration of the above, SEBI’s order against NSE and its senior management, to the limited extent of disgorgement, was set aside. While arriving at its findings, SAT stated that the direction to disgorge must be in relation to an activity which contravenes the provisions of the SEBI Act or regulations and results in illegitimate profits and cannot be imposed for mere non-compliance of  a circular. The direction must also be preceded by a finding of ill-gotten gains made by a person, by virtue of engaging in unethical acts, and establish a causal nexus between the wrongful conduct and gains. In terms of quantum, SAT observed that the disgorgement amount shall not exceed the wrongful gain in question. 

The Satyam order 

In 2018, SEBI directed Mr. B. Ramalinga Raju along with his two brothers, and SRSR Holding Pvt. Ltd. (SRSR) to disgorge INR 813.40 crore, along with a 12% interest per annum from January 14, 2009, i.e., the date when the Satyam scam was unearthed. The matter related to the transfer of shareholding in Satyam Computer Services Ltd., by the Raju brothers to SRSR, which in turn, pledged shares and raised funds from third-party borrowers, using shares with artificially inflated prices.

Aggrieved by the calculation of the disgorgement amount by SEBI, the Raju brothers and SRSR filed appeals against a SEBI order before SAT. While adjudicating on the appeal, SAT analysed pertinent questions such as joint and several liability of different appellants for disgorgement, the relevance of intrinsic value of shares for calculation of disgorgement and the calculation of interest payable on the disgorgement amount.

In terms of the appellants’ liability for the purpose of disgorgement, SAT stated that the disgorgement of unlawful gains does not have to happen jointly and severally by different appellants. Disgorgement depends on whether the persons are acting in concert and if the damage caused by each wrong-doer (tort-feasor) is divisible or not. SAT further held that even if the persons were acting in concert and the damage caused by the joint tort-feasors is divisible, then each of them is liable only for damage attributable to them, individually. In the facts of the matter, SAT found that the appellants made a series of acts at different point of time, the liability attributable to each appellant is divisible and thus, the appellants would only be liable to pay the unlawful gains attributable to their own act. 

SEBI, while computing the unlawful gains had adopted the “net profits” method, i.e., amount realised by the sale of shares on deduction of the acquisition cost and taxes payable. In the absence of information pertaining to acquisition costs, SEBI had considered the acquisition cost as ‘nil’ for the purpose of calculating illicit gains. On appeal, SAT clarified that the same is not permissible and SEBI is required to arrive at some costing of the value of shares. SEBI further held that the underlying and intrinsic value of the shares cannot be considered a component of unlawful gains and must be deducted while quantifying the unlawful gains and cannot be assumed to be ‘nil’. 

With respect to interest, SAT held that interest becomes payable after computation of the disgorgement is made. When the disgorgement amount is set aside, the imposition of interest is also set aside. Thus, in light of the low interest charged in other orders passed by SEBI e.g. 4% p.a., the SAT remanded back the matter to SEBI to reconsider charging an interest rate of 12% p.a.

Based on the above findings, the matter was remanded back to SEBI to pass a fresh order, with a direction to consider the intrinsic value of shares while calculating unlawful gains, which must be calculated individually.

Through these orders, SAT has consolidated and reaffirmed key principles to guide SEBI’s power to order disgorgement, while also restricting the scope of disgorgement to contraventions that result in illicit gains, as opposed to all instances of non-compliance. The SAT has provided clarity on key concepts like calculation of disgorgement amount, imposition of joint and several liability on accused persons, and the interest to be levied on the amount liable for disgorgement. These principles would define and channelise SEBI’s powers of disgorgement.