The Securities and Exchange Board of India has passed a bizarre “disgorgement” order for over rupees one billion (approximately $25 million) against both the depositories in India as well as a number of depository participants involved in the IPO scam that I blogged about last year. The most charitable explanation is that this is a penalty masquerading as a disgorgement. The less charitable explanation is that SEBI is merely behaving like class action lawyers who routinely proceed only against those with deep pockets because that increases the likelihood of recovering something if they succeed on the merits.
The IPO scam involved people submitting multiple applications in fictitious names to increase their allotment in a fixed price IPO. The disgorgement order does not target any of those who perpetrated the fraud but is directed against the depositories and the depository participants who opened the demat accounts used by the fraudsters. SEBI says in its order that “it stands to reason that the Depositories and Depository Participants who enabled the opening of numerous demat accounts (afferent accounts) in fictitious / benami names either by turning a Nelson’s eye to the compliance with KYC norms prescribed by SEBI or by actively participating in the scheme designed by the key operators and the financiers, should be held liable for the loss caused to innocent retail investors. Had each market participant played their respective roles diligently with a degree of real time sensitivity, the rampant cornering of IPO allotments, particularly on this scale would not have taken place. The failure of each intermediary in the hierarchy of intermediaries contributed cumulatively, (jointly and severally) to the market abuse.”
There are many problems with this theory. First of all, disgorgement is not about liability for loss caused to investors. In its own order, SEBI states the legal position regarding disgorgement as follows:
It is well established worldwide that the power to disgorge is an equitable remedy and is not a penal or even a quasi-penal action. Thus it differs from actions like forfeiture and impounding of assets or money. Unlike damages, it is a method of forcing a defendant to give up the amount by which he or she was unjustly enriched. Disgorgement is intended not to impose on defendants any demand not already imposed by law, but only to deprive them of the fruit of their illegal behavior. It is designed to undo what could have been prevented had the defendants not outdistanced the investors in their unlawful project. In short, disgorgement merely discontinues an illegal arrangement and restores the status quo ante (See 1986 (160) ITR 969). Disgorgement is a useful equitable remedy because it strips the perpetrator of the fruits of his unlawful activity and returns him to the position he was in before he broke the law. The order of disgorgement would not prejudice the right of the regulator to take such further administrative, civil and criminal action as the facts of the case may warrant.
Similarly a report prepared by the US Securities and Exchange Commission pursuant to the Sarbanes-Oxley Act describes the legal position regarding disgorgement:
Disgorgement is a well-established, equitable remedy applied by federal district courts and is designed to deprive defendants of “ill-gotten gains.” In contrast to actions for restitution or damages in private actions, which are brought to compensate fraud victims for losses, disgorgement orders require defendants to give up the amount by which they were unjustly enriched. Before exercising their discretion to order defendants to pay disgorgement, courts have required findings that a causal connection exists between the defendants’ wrongdoing and amounts to be disgorged. “[D]isgorgement extends only to the amount with interest by which the defendant profited from his wrongdoing.” To assist in determining the amount of disgorgement, the Commission often seeks, and courts require, that defendants provide an accounting of the funds and other assets they received in the course of their wrongdoing. In ordering disgorgement, courts have not required the Commission to determine the exact amount of the defendant’s ill-gotten gains. The Commission has the burden, though, of showing that the amount sought is a “reasonable approximation of profits causally connected to the violation.” Once the Commission has satisfied its burden, a defendant who asserts that the amount should be less has the burden of demonstrating that the amount should be reduced. As long as the measure of disgorgement is reasonable, courts have held that the wrongdoer should bear the risk of uncertainty regarding the precise amount. [footnotes omitted]
The only ill gotten gains for the depositories and their participants would be the account opening charges and transaction fees that they levied on the fraudulent demat accounts. This would be a miniscule fraction of the billion rupee disgorgement that has been ordered.
The second problem is that the deficiencies pointed out in the SEBI order against the depositories and their participants are largely in the nature of negligence or lack of diligence. The appropriate response to that is a penalty or a suit for damages.
Another problem is the joint and several liability that is imposed by this order. Joint and several liability is rooted in the principle that a wrongdoer is liable for the reasonably foreseeable acts of his fellow wrongdoers committed in furtherance of their joint undertaking. US courts have held that joint-and-several liability is appropriate in securities cases when two or more individuals or entities collaborate or have close relationships in engaging in the illegal conduct. It is difficult to see how this applies to several depository participants acting largely independently of each other.
Above all, it must be remembered that from a finance purist’s point of view, the notional gain made by even the genuine applicants in the retail quota of the IPO are in some sense “ill gotten gains” as they were given shares at less than their fair value. This gain really comes at the cost of the existing shareholders of the company and of those who bought shares under the non retail quota. Thus we should not get into the trap of believing that the IPO scamsters defrauded the genuine applicants in the retail quota. The correct way of looking at the situation is that the retail quota itself amounted to looting the company and the scamsters only changed the proportion in which this loot was shared. If the so called disgorgement were ever to be turned into a restitution, the recompense must go the company that did the IPO (and therefore to all its shareholders) and not to the genuine applicants in the retail quota.
Finally, the SEBI order raises serious questions about the capital adequacy of the depositories. If this is the kind of liability that SEBI intends to fasten on the depositories, they need to have a lot more capital than they currently have. The joint and several liability that the order imposes on the country’s largest depository, NSDL, represents 45% of its net worth as disclosed in the the 2005-06 annual report. It needs to have a lot more capital to protect against actual losses caused to investors by failures in its systems.