Degree of proof to hold an intermediary liable for default under securities law

Degree of proof to hold an intermediary liable for default under securities law written by Sidharth Sabu student of National University of Advanced Legal Studies.

INTRODUCTION

The Securities and Exchange Board of India is a statutory body established under section 3 of the Securities and Exchange Board of India for the purpose of regulating the securities market so that the interests of the investors are protected. Fraudulent activities are prevalent in the securities market, so much so that SEBI has been given enormous powers with respect to the regulation of the securities market. The participants in a securities market include corporations and the government issuing securities to the public, persons and corporations buying and selling a security, the intermediaries- brokers and sub-brokers who facilitate such dealings. By assessing the regulatory provisions under the SEBI act, it can be inferred that any kind of fraudulent activity is met with very harsh punishments including a heavy fine. It is a kind of market where there are a large number of investors who are unaware of the market conditions and the risks involved. Thus to protect the interests of these investors such regulatory measures are necessary. In this paper, more focus shall be placed on the regulatory provisions of Sebi concerning the conduct of intermediaries.
Before moving to the question of degree of proof, first, it is necessary to understand the ambit of an intermediary’s permitted activities, the prohibited activities under the Act and the Regulations, and the nature of punishments therewith. Following this, this paper shall analyze the question of the degree of proof to hold an intermediary liable.

Who Is an Intermediary?

The SEBI( Intermediary) Regulation states that an intermediary is a person mentioned under section 11(2) b and ba- that is;
“..stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities markets in any manner..” and; under section 12 (1) and (1A) which comprises of
“…stock-broker, sub-broker, share transfer agent, banker to an issue, trustee of a trust deed, registrar to an issue, merchant banker, underwriter, portfolio manager, investment adviser and such other intermediary who may be associated with securities market…” and shall not include “..foreign institutional investor, foreign venture capital investor, mutual fund, collective investment scheme, and venture capital fund;”
The function of an intermediary shall be to facilitate investments by guiding investors to investors in productive investments. For carrying out this function, the intermediaries have to follow a certain standard of quality services. The Intermediary Regulation of 1995, under schedule III, lays down a code of conduct, wherein a list of obligations that intermediaries registered under the SEBI has to adhere to. The code of conduct or the intermediary regulations for that reason fails to provide the ambit of an intermediary’s functions, however, the provisions stating the obligations are quite vast and comprehensive. Thus, the nature of the act as well as the abovementioned regulations is less emancipating and more restrictive. Looking into the regulations, much focus has been applied to ensuring the protection of investor’s interests similar to the Act. The regulations imply that the major duty of an intermediary is to render information about the market and thus has made sure that no ambiguity is present with respect to that area. Both the Act as well as the 1995 regulations are clear and comprehensive provisions regarding the service of rendering information to clients or investors.

Prohibited Practices

As far as an intermediary is concerned, even though they act as well as the regulations are not very detailed as to what it may do, it is not the case with what an intermediary ought not to do. Under the act, Section 11 (2) g prohibits inside trading wherein securities which are publically traded are bought or sold by individuals having non-public material information about the stock. Intermediaries shall not perform any activity detrimental to the interests of the investors as under Section 11B(2)ii. As under Section 12A, no person shall operate in the Securities market while possessing material or non-public information and also, one shall not leak that information out to the public.
Under the Regulation of 1995, with respect to the functions of the intermediary, it lays done that no intermediary shall provide any information or advice in publically accessible media, about security unless it discloses its interests in the said security and also its long term or short term position in the said security ( Regulation 15(1)) and an intermediary shall disclose the information regarding the interest of itself, its dependent family member and an employee under it; his short term or long term position in the security (15(2)). Further, unless the intermediary is completely aware and sure of it, shall not give advice to its clients or investors (15(3).
As per Regulation 16, intermediaries are bound to follow the Code of Conduct encompassed under Schedule III of the regulations. As mentioned earlier above, the code consists of a set of standards that an intermediary shall follow at all times, the violation of which would lead to cancellation of certificate of registration. The code of conduct primarily focuses on the advice making function of the Intermediaries and fixes certain high standards to be maintained throughout its operations. One important liability that is upon an intermediary is to keep safe confidential information. Other prohibited activities include;
• creation of a false market for securities listed or proposed to be listed on any stock exchange in India;
• price rigging or manipulation of prices of securities listed or proposed to be listed on any stock exchange in India;
• passing of unpublished price sensitive information in respect of securities which are listed or proposed to be listed on any stock exchange to any person or intermediary,
• any activity for distorting market equilibrium or which may affect the smooth functioning of the market or for personal gain.
The 2003 SEBI (Prohibition of Fraudulent Activities and Unfair Trade Practices Relating to Securities Market) also lays down certain activities which are prohibited in the Securities Market, non-adherence to which will attract punishment. This is a rather comprehensive document as it clearly defines what shall constitute fraudulent activities and lists down certain specific activities such as price rigging, falsifying records, non-disclosure of pivotal information, unethical practices such as using the investor’s lack of knowledge to their own advantage, and other such malpractices that have been clearly laid down under regulation 4. A plain reading of these laws shall give a clear idea as to the activities that an intermediary is could indulge in, the majority of which deals with rendering information and advice.

PUNISHMENTS UNDER SECURITIES LAW

The Sebi Act as well as the regulations not only states the activities prohibited the securities market but also discuss various punishments that individuals who violate the provisions of these laws and regulations have to be charged with. However, before coming to the punishments, it is necessary to understand the procedures involved. The Board is bestowed upon with powers to conduct investigations under reasonable grounds, and shall delegate that powers upon a person to be known as an Investigation Authority (S11C (b). Once the wrong committed is identified, an Adjudicating Authority shall be appointed by the Board who shall not be below the rank of a Divisional Chief and will adjudicate upon the matter. There are quite a few penalties mentioned under the act corresponding to some specific violation. 15HA lays down the penalty for fraudulent and unfair trade practices in the securities market to be a fine of 25 crores Indian Rupees or thrice the sum of profits earned through such malpractice.
An important provision with respect to the question of evidence/proof is laid down under section 15J- factors to be taken into account by the adjudicating officer. Under this provision, it has been stated that the adjudicating authority shall give due regard to the disproportionate gain to the defaulter, loss to the aggrieved, and the repetitive nature of the default. These are the three things that may be instrumental in determining the quantum of punishment for the defaulter. How far the evidence adduced establishes the liability of an intermediary under the security market should be able to prove these factors clearly.
With respect to the nature of penalties, there are penalties of civil as well as criminal nature under the statutes and regulations. Under Regulation 25 of the SEBI ( Brokers and Sub- Brokers) Regulations, it is stated that brokers, who constitute a major part of intermediaries shall, in the case of a default shall be dealt with particularly three kinds of punishments, namely- Penalty of monetary nature under chapter VIA of the SEBI Act, Penalties specified under Chapter V of the SEBI intermediaries regulations and prosecution under section 24 of the Act. The first kind of penalty, for defaults mentioned under regulation 26 is for violation of the provisions of the Act such as failure to submit records, information, and such other violations. The second kind of penalties is for those who fail to comply with the conditions of the certificate and those individuals who violate any securities law in force. Punishments under this head include disciplinary measures such as cancellation of certificates. It is clear from the clear reading of these preceding provisions that they are civil in nature as they impose fines and disciplinary measures. On the other hand, section 24 of the Act seeks to impose a penalty of criminal nature; imprisonment for 10 years and a fine which may be extended to 25 crores.
Notwithstanding anything contained in the Code of Criminal Procedure, any offense punishable under the SEBI Act, not being an offense punishable with imprisonment only, or with imprisonment and also with fine, may either before or after the institution of any proceeding, be compounded by a Securities Appellate Tribunal or a court before which such proceedings are pending.

STANDARD OF PROOF

The nature of an intermediary’s functions, actions prohibited under the Act and the nature of punishments have all been discussed and it is understood that for the violation of the same set of laws, there are two kinds of punishments laid down- criminal prosecution and civil punishments hence there is an ambiguity with respect to how courts would adjudicate disputes with respect to the degree of proof needed to fix liability upon a defaulting intermediary. It is not only about fixing the liability but also the extent of evidence for the respective kinds of punishments to be enforced upon the defaulter. This is purely a question of how courts interpret the abovementioned provisions of the act as well as the regulations. For this, some important court decisions have to be discussed.
The Supreme Court decision in SEBI v Kishore R Ajmera deals with the question of law; the extent of the degree of proof needed to hold a broker or a sub-broker liable for default. In this case, there was an allegation that the broker wrongfully facilitated matching thereby creating artificial volumes of trading resulting in the abnormal and unnatural increase in prices. The Adjudicating Authority after inquiry and examining the documentary evidence fixed liability upon the broker and suspended his certificate of registration. The aggrieved broker filed an appeal before the Appellate Tribunal under Section 25T and the Tribunal, however, reversed the order on grounds that unless some concrete proof is presently proving the direct involvement of the defaulter, no action could be taken against him. SEBI challenges this order to the Supreme Court.
The Court analyzed all the provisions that have been discussed earlier in this paper, the act and the regulations. The court discussed the code of conduct of brokers and sub-brokers enumerated under Schedule II of the Brokers and Sub-Broker Regulations and lays that, as per the code of conduct, a broker or a sub-broker is supposed to maintain a high standard of services. The allegation that has been made under the case is that the broker committed grave negligence.
The court comments that there are ambiguity and confusion with respect to the determination of punishments under SEBI laws as there are quite a number of regulations that “contain identical and parallel provisions with regard to the imposition of a penalty resulting in myriad provisions dealing with the same situation.” It also remarked that comprehensive legislation needs to be there to bring about clarity to the matter. The Supreme Court suggested further that the SEBI Act was enacted for the protection of the interests of the investors and the confidence of the investors in a market determines its effectiveness of the protective legal mechanism and hence the Act and the subsequent regulations ought to be interpreted in that light.
It is a fundamental legal principle that proof of an allegation leveled against an individual shall be direct and substantive and in cases where such proof is absent, the court will have to infer it out of the facts and circumstances surrounding the issue. The judicial mind has to be applied in those facts and circumstances and the test to e applied shall be; how an ordinary and prudent man would adopt to come to a conclusion.
As per this case, the fact that the clients were related entities, that this was known to the broker, and the volume of scrip that was purchased and sold mutually through a sub-broker was significant, the court held that there was no conclusive and direct proof to conclude that the broker had direct involvement in the malpractice.
The court further held on what grounds the court shall arrive at a conclusion regarding the liability of the broker- the volume of the trade affected; the period of persistence in trading in the particular scrip; the particulars of the buy and sell orders, namely, the volume thereof; the proximity of time between the two and such other relevant factors. The case was heard along with other cases of similar facts and circumstances. In one of such cases, the volume of the scrip was very huge and the transaction took place in a time frame of 60 seconds which increased the doubt regarding the involvement of the broker. A reasonable prudent man would be alarmed by such a transaction and hence this shows that either there was grave negligence or it was done with malign intent.
To conclude, the court laid down the basic test that; “The test, in our considered view, is one of preponderance of probabilities so far as adjudication of civil liability arising out of violation of the Act or the provisions of the Regulations framed thereunder is concerned. Prosecution under Section 24 of the Act for violation of the provisions of any of the Regulations, of course, has to be on the basis of proof beyond reasonable doubt.”
This is a quite clear and comprehensive standard that the supreme court has laid down on the question of the degree of evidence. This is the basic difference that the law of evidence lays down to differentiate between civil liability and criminal liability because, in order to attract criminal liability, the intention of the defaulter to cause harm to the aggrieved party has to be proved which needs a considerable standard of proof.

The Supreme Court in Pooja Menghani v SEBI (2017) had a dissenting opinion with respect to the standard of proof. In this case, the Supreme Court has interpreted the SEBI act as beneficiary legislation and has devised the beneficial construction rule as it states in the 22nd paragraph that the SEBI Act was enacted for the benefit of the investors and courts shall weigh against the interpretation that will take away these protections.
Hence, in its judgment, the Supreme Court held that just because the operation of Regulation 3 and 4 of the Prohibition of Fraudulent and Unfair Trade Practices invite penalties of criminal nature, the standard of proof cannot be fixed at “beyond reasonable doubts” level and thus the degree of proof shall be preponderance of probabilities. The Supreme Court held,
“The inferential conclusion from the proved and admitted facts, so long the same are reasonable and can be legitimately arrived at on a consideration of the totality of the materials, would be permissible and legally justified.”
However, in the 2018 judgment of the Supreme Court in Sebi v Rakhi Trading Private Ltd, the court took a view that, in the quasi-judicial procedures in the SEBI, the standard of proof shall be a preponderance of probability. There necessarily be no direct and conclusive evidence beyond a reasonable limit and the default shall be inferred from the factual details.
The proof of involvement of a broker in a manipulative transaction shall be proved by patterns of trading data and the nature of transactions etc.
“Where a transaction has been executed with the intention to manipulate the market or defraud its mechanism will depend on the intention of the parties which could be inferred from the attending circumstances since direct evidence in such cases is not available.”
This case, however, deals with market manipulation, which falls within regulation 27 of the Broker and Sub-Broker Regulations and shall only attract a penalty of civil nature such as cancellation of certificate of registration. The case thus does not deal with the deal with the criminal liability part.
In Jayesh S Patel v Sebi (2017) the Securities Appellate Tribunal adhered to the part of the Kishore Ajmera case that complete evidence may not be forthcoming in every such matter and what is needed is to prove that in a factual matrix preponderance of probabilities indicate a fraud.

CONCLUSION

The vagueness in law created by the fact that the same kind of violations attract different nature of punishments is a drawback in securities law. Even between Supreme Court cases, there is a conflict as to what the standard of proof should be to determine the liability of an intermediary. Kishore Ajmera case has dealt with the case in such a way the nature of punishments laid down under the Act as well as the Regulations have been taken into consideration. Thus, the court arrived at a conclusion that two kinds of standard of proof shall be present.
However, a much more broader interpretation was given in the Pooja Menghani case wherein the purpose of the act was taken into consideration and raises a very valid point that if legal action is hindered which would affect the interest of those individuals for whose protection the act was enabled, then courts should not interpret the act in that way