Reliance v. SEBI (29 May) sets aside a Rs. 447 cr disgorgement. Reg. 2(1)(c) is so broad that, read literally, even running would qualify. The Court read it down.
A breach of limits is not a fraud. On 29 May, the Supreme Court set aside a Rs. 447 crore disgorgement against Reliance Industries and drew a line under SEBI's habit of dressing up rule-breaches as manipulation. Three points:
• Position limits are a disclosure regime. Breach attracts a penalty, not a fraud finding. • Reg. 2(1)(c) is self-contradictory — one limb dispenses with intention, the other requires inducement. The Court read inducement as controlling. • Concentration gives a trader the ability to manipulate. It is not, by itself, manipulation.
Judge Posner made the same point in Sullivan & Long v. Scattered Corp. in half a page. Our Reg. 2(1)(c) has taken twenty years and is still arguing with itself.
My piece in today's Financial Express:
The Supreme Court has told the securities regulator something it did not want to hear: that breaking a position limit is not the same as committing a fraud. The reasoning in Reliance Industries v. SEBI, decided on 29 May, matters more than the Rs. 447 crore disgorgement order it set aside.
The dispute goes back to November 2007. Reliance Industries, then holding 75 per cent of Reliance Petroleum, decided to sell five per cent of that stake, some 22.5 crore shares, into a market that analysts thought overpriced. To hedge the risk of a price fall, it took short positions of 9.92 crore shares in the November RPL futures. It did so through twelve agent entities, because the client-level position limit set by SEBI's circular of 2001 would not have allowed a single client to hold a position of that size.
SEBI's case was that the twelve entities were a device to corner the futures market, that Reliance held up to 93 per cent of the open interest, and that it depressed the settlement price by selling 1.95 crore shares in the closing minutes of 29 November. All of this, the regulator said, was fraud under the Prohibition of Fraudulent and Unfair Trade Practices Regulations. The Securities Appellate Tribunal agreed, by a majority of two to one.
The Court's first move was to separate two ideas that SEBI had run together. A position limit is a risk-containment tool. The 2001 circular did not forbid crossing it; it required a trader who crossed it to disclose the excess, and penalised the failure to disclose. Breaching the limit, even through agents, was therefore a disclosure default that attracted a monetary penalty. It was not, on that fact, a fraud. The Court upheld the penalty and set the fraud finding aside.
The second move went to the definition of fraud itself. Regulation 2(1)(c) defines fraud to include any act, omission or concealment, whether deceitful or not, that induces another to deal in securities. The Court noticed what practitioners have long known: the definition is self-contradictory. Its first limb dispenses with intention; its second limb requires inducement, which presupposes intention. Read literally, the Court said, the provision is so wide that almost any act in the market could be called a fraud. The court relied on this author’s book to state that by the current definition of fraud, even running would amount to fraud. Faced with that absurdity, the Court read the two limbs together rather than against each other, treating inducement as the controlling element and the words 'whether deceitful or not' as descriptive of the act rather than dispositive of intent.
From that the Court drew a disciplined conclusion. Inducement remains a necessary ingredient of fraud, except where manipulation is itself proved so cogently that inducement can be presumed, as the Court held earlier in Rakhi Trading, where the manipulation was patent on the tape. Where inducement is not shown, the regulator carries a higher burden: it must prove a distinct act of price manipulation, not merely a motive or an opportunity. Concentration of positions gives a trader the ability to manipulate. It is not, by itself, manipulation.
Applied to the facts, the case collapsed. The futures positions were a genuine, if imperfect, hedge against a real cash-market exposure, and the law has never required a hedge to be perfect. The closing-minute sales were made into an unexplained price spike, at prices in line with what Reliance had accepted earlier in the month, while other participants sold similar quantities in the same window. On these facts, the Court found, fraud rested on suspicion rather than proof.
The significance of the judgment lies in what it does to SEBI's enforcement methodology. For years the regulator has treated the breadth of the fraud definition as a licence to convert regulatory infractions into charges of manipulation, because the latter carry disgorgement and a stigma that a fine does not. The Court has now drawn a line. A breach of an exchange rule is to be punished as a breach of an exchange rule. It becomes fraud only when the regulator proves the ingredients of fraud.
The Court's instinct here has good company abroad. In Sullivan & Long, Inc. v. Scattered Corp., 47 F.3d 857 (7th Cir. 1995), the legendary law and economics expert, Judge Posner faced a complaint that a broker had committed manipulation on an awesome scale by short-selling more shares of a company than existed. The conduct looked extreme, and the plaintiffs urged that the scale alone proved the wrong. Posner refused to accept the equation. What Scattered had done, he held, was arbitrage, not manipulation: its sales did not push prices away from underlying value but towards it, puncturing a balloon rather than launching one. He similarly found that breach of an exchange rule, may be a violation of that rule, and doesn’t make it a fraudulent position.
There is a lesson for the rule-makers too. The Court was blunt that Regulation 2(1)(c) is a piece of inelegant drafting, and that an enactment with such consequences for the economy should leave no room for doubt. The criticism is fair. A definition that, on its own terms, could catch the innocent and the guilty alike is not really a definition. It is a discretion dressed as a rule.
The fraud definition needs rewriting so that it names what it forbids. Until it does, the regulator will keep winning at first instance and losing on appeal. Better to draft the rule clearly than to keep litigating its meaning. The Seventh Circuit took half a page to say what manipulation is and is not; our Regulation 2(1)(c) has taken twenty years and is still arguing with itself. That is a drafting problem, and drafting problems have drafting solutions.
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