How SEBI Should Deal With Disgorged Money

The Primary function of Securities and Exchange Board of India under the SEBI Act, 1992 is the protection of the investors' interest and the healthy development of Indian financial markets. The question to be asked is whether the SEBI has been successful in fulfilling its primary function in the midst of so many securities and Initial Public Offering (IPO) scams taking place in the country, which is not only harmful for the healthy development of our financial markets but also harmful for the investors' interest and which eventually lowers the morale of the investors and act as a deterrence for them to invest their savings in the financial markets? No doubt, it is very difficult and herculean task for the regulators to prevent the scams in the markets considering the great difficulty in regulating and monitoring each and every segment of the financial markets and the same is true for the Indian regulator also.

But what are the responsibilities of the regulators to set the system right once the scam has taken place, especially the responsibility of redressing the grievances of the investors so that their confidence is restored? The redressal of investors' grievances, after the scam, is the most challenging task before the regulators all over the world and the Indian regulator is not an exception. One of the weapons in the hand of the regulators is the collection and distribution of disgorged money to the aggrieved investors. In this paper, the writer will critically analyze the present situation in India as regards the distribution of disgorged money to the aggrieved investors in the light of the existing position in the U.S.A

Concept of Disgorgement

The word disgorgement means to bring up and expel from the throat or stomach, to surrender (stolen goods or money or any other things) unwillingly. In the financial markets, the word 'disgorgement' is used to mean the repayment of ill-gotten gains that is imposed on the wrong-doers by the courts or the regulators. Funds that were received through illegal or unethical business transactions, such as defrauding creditors or cheating investors, are disgorged, or paid back, with interest to those harmed by the illegal and/or unethical actions of the wrong-doers.

Disgorgement is a remedial civil action rather than punitive civil action and disgorged money can be demanded from not only those entities/individuals directly involved in unethical and illegal business activities and those who violate securities regulations but also from anyone profiting from such activities. But it should be noted that the term disgorgement is not the same as imposing civil money penalties. Generally, individuals and companies violating the securities regulations are required to pay both civil money penalties and disgorgement. Civil money penalties are punitive in nature but disgorgement is not punitive and it is about paying back profits made from violating the securities regulations. The scope of the term disgorgement is wide and it is demanded not only from those who are directly involved in violations of securities regulations but from anyone who has profited from such unethical or illegal business transactions.

Whether Disgorged Money Be Distributed To Cheated Investors: Two Extreme Viewpoints

Supportive Viewpoints
The question whether the disgorged money be distributed to affected investors or not has received a lot of support from one section of the capital markets experts, functionaries and intermediaries. According to their view, not distributing the disgorged or ill gotten money to the cheated investors militate against the basic and primary function of SEBI which is the protection of investors' interest. According to them, after disgorging the illegal gains, it would be unethical on the part of the SEBI not to distribute to the affected investors. Without compensation to the affected investors, investors' protection would remain rhetoric.

They further argue that there is urgent need to amend the SEBI Act, 1992, which envisages protection of investors' interest without making a specific provision of awarding compensation. The also derive their support from the D P Wadhwa Committee which was constituted to recommend the procedure for allocation of shares to deprived investors' in the IPO Scam. Giving examples of developed countries, including U.S.A and U.K, they further argue that the objectives of disgorgement in developed countries are two fold: to disgorge illegal gains as a preventive measure and its distribution among affected investors, if identified, as a redressal measure. But in India, there is no statutory obligation on the regulator to distribute the disgorged money to the affected investors and hence, whatever money is disgorged, it is deposited in the Consolidated Fund of India.

Unlike Indian securities laws, awarding compensation to the cheated investors forms an integral part of the legal framework in the west and the investors are statutorily empowered to get them enforced. Thus, they argue that, on the line of developed countries, in India also the investors should be statutorily empowered to get compensation for the fraud committed on them. And hence SEBI Act should be suitably amended so as to make it mandatory on the part of the SEBI and government to distribute the disgorged money to the affected investors. One more argument of them is that if the money disgorged is not distributed among affected investors, it is likely to be transferred to the proposed Investor Education and protection Fund of the SEBI. This would merely augment unutilized resources available for investor education and protection.

The SEBI has neither used nor directed the stock exchanges to utilise the Investors Services Fund, aggregating Rs 200 Crore, lying with them. This amount is different from Rs 500 Crore Investor/ Customer protection Fund of Stock Exchanges, created to repay investors in case of default by brokers. The corpus of Investor Education and Protection Fund under the Ministry of Corporate Affairs, Government of India, is over Rs 400 Crore. But the objective of none of these funds is to pay compensation to cheated investors. These funds are meaningless and useless if they are not utilised for the purpose of compensating cheated investors who are the victims of IPO and other securities scams in India.

Not-Supportive Viewpoints
Another viewpoint is that distribution of disgorged money to affected investors would set up a bad precedent. Scams would then be sanctified with the alibi that affected investors have been compensated. Further, identifying the cheated investors and quantifying the amount of compensation would be a herculeon task before the regulator. It would be extremely difficult to satisfy all the affected investors, which would further led to more litigation proceedings and allegations of favouritism and nepotism.

Further, the whole new machinery has to be set up in motion for the purpose of distribution of disgorged money and hence more personnel, infrastructure and other requirements are to be fulfilled. It will require more funds and hence more expenditure needs to be incurred for the purpose of distribution of disgorged amount which, considering the financial constrain of the regulators and reluctant attitude of the government, seems difficult to achieve. They further argue that losses suffered by the investors in the IPO scams are notional losses and not real or actual losses in the sense that they did not get the shares of the IPO because of the cornering of those shares by the market manipulators and at best their losses can be termed as opportunity or notional losses. In this regard, they further argue that recommendations by Justice D P Wadhwa Committee should not be treated as sacrosanct. They are of the opinion that it would be better to create a corpus for anti-scam education programme for the investors and SEBI should strengthen its monitoring and vigilance sections to avoid such scams in the future.

Position In U.S.A
In the United States of America, the concern for the protection of investor's interest led the Congress to pass the Sarbanes-Oxley Act of 2002 which was signed into law by President Bush on 30th July, 2002. The Sarbanes-Oxley Act of 2002 , also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly called SOX, was enacted in response to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom.

These scandals, which cost investors billions of dollars when the share prices of the affected companies collapsed, shook public confidence in the nation's securities markets and lowered the morale and the confidence of the investors in the U.S securities markets. To restore the investors' confidence in the markets, this Act was passed. The aim of the Act is to protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise.

The act is administered by the Securities and Exchange Commission (SEC), which sets deadlines for compliance and publishes rules on requirements. One of the noblest provisions of the Act is Fair Fund provision incorporated in Section 308 (a) of the Act. The passing of the Sarbanes-Oxley Act and the provision of Fair Fund inserted therein created a new era in the area of investors' protection in the U.S.A.The Securities and Exchange Commission receives payments from wrongdoers in the form of civil money penalties and disgorgement. Prior to Sarbanes-Oxley Act of 2002, the Commission was always empowered to distribute disgorged moneys to the cheated investors in the appropriate circumstances, but the civil money penalties was transmitted to the Department of Treasury because the penalty amounts could not be paid to harmed investors.

But the situation changed after the passing of the Sarbanes- Oxley Act. Now under the Fair Fund provision of the Act, the disgorged and civil money penalties collected by the wrongdoers are distributed to the harmed investors, who have lost money because of the illegal or unethical activities of individuals or companies that violate securities regulations. The provision of Fair Fund enables the SEC to compensate the cheated investors and plays a very significant role in encouraging the investors to continue to place trust in the U.S stock markets.

Taking advantage of this Act and coupled with its commitment to protect the interest of the investors, the Securities and Exchange Commission has set up number of examples by distributing compensation to the cheated investors. Some case examples are-
# On June 18th, 2008, the SEC distributed more than $103 million to investors who lost money because of mutual fund market timing and late trading involving Banc of America Capital Management LLC (BACAP) and several of its affiliates.

The distribution of this amount was the first in a series that will return approximately $ 375 million to more than 1.5 million harmed and cheated investors as a part of the SEC's settlement with the BACAP. The firm had been charged with facilitating market timing and late trading in mutual funds and others. The Commission ordered the BACAP to pay $250 million in disgorgement and $125 million in civil penalties for distribution through a Fair Fund. In addition to disgorgement and civil penalties, the respondents also consented to a cease-and-desist order and a censure, and agreed to undertake certain compliance and mutual fund governance reforms. After the distribution of the amount, Dick D' Anna, Director of the SEC's new office of Collections and Distributions, said, Today's distribution demonstrates the Commission's commitment to returning money from wrong doers to investors under the Fair Fund provisions of the Sarbanes-Oxley Act of 2002.

# On August 15th, 2008, the SEC distributed more than $18 million to more than 325, 000 investors who were affected by the undisclosed market timing in certain mutual funds managed by Denver-based Janus Capital Management LLC( JCM). JCM consented to Commission order charging anti-fraud violations and requiring the respondents to pay $50 million in disgorgement and another $50 million in civil penalties for distribution through a Fair Fund. In addition to disgorgement and civil penalties, JCM also consented to a cease-and-desist order and a censure, and agreed to undertake certain compliance and mutual fund governance reforms.

# On 11th August, 2008, the SEC announced the distribution of more than 48 million dollars to more than 12,000 defrauded Vivendi Universal (VU) investors. The SEC filed a settled enforcement action in December 2003 against Vivendi, its former CEO Jean-Marie-Messier, and its former CFO, Guillaume Hannezo, alleging violations of the antifraud and other provisions of the federal securities laws. The Commission allegation against Vivendi was that they engaged in antifraud violations by making misleading statements about the Vivendi's financial condition.

The Complaint against the Vivendi was that it engaged in misconduct that disguised Vivendi's cash flow and liquidity problems improperly adjusted accounting standards to meet earning targets and failed to disclose material financial commitments. Of the total 12, 115 investors receiving checks, approximately 5, 300 are from the United States. The remaining 6,800 claimants are from 15 countries, including more than 3,300 claimants who bought shares from the Paris Stock Exchange. Mr David Nelson, Regional director of the SEC's Miami Regional Office, said in a statement, I am particularly gratified that we have been able to identify and help investors not just in this country, but overseas as well.

Position In India
In India, the position is not so well settled as compared to U.S.A and hence the picture is not clear as to how the disgorged money is to be treated. Generally, the payments received by way of penalties are deposited in Consolidated Fund of India. In its first ever disgorgement order on 21st November, 2006, in Karvy case, SEBI directed NSDL, CDSL and eight depository participants (DPs) to return Rs115.81 crore in six months. The DPs include Karvy, HDFC Bank, Khandwala Securities, IDBI Bank, Jhavei Securities, ING Vysya Bank, PR Stock Broking and Pratik Stock Vision. The Karvy case involved a scam where a handful of market operators opened multiple demat accounts in fictitious names to corner shares reserved for retail investors in a public issue. On the issue of disgorgement, in the order passed in the Karvey case, SEBI said, 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 behaviour. 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. 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. Although this order of disgorgement was challenged in the Securities Appellate Tribunal (SAT) on the ground of the violation of principles of natural justice and ultimately the matter went to the Supreme Court, the matter of importance is that SEBI for the first time recognized and realised the importance of disgorgement and its distribution to the harmed investors as one of its responsibilities.

The order of disgorgement by SEBI was a matter of great debate in the legal and financial circles especially the matters pertaining to the legality of the disgorgement orders, its correctness and rationale, and whether the SEBI erred in imposing it only on the intermediaries as they were violators but not the profit makers, which goes against the principal of disgorgement( By definition, the term 'disgorgement' is used to refer to an order to give up trading profits, based upon two conclusions: the first, that there has been a violation of law, and second that the violator has profited thereby) and hence the correctness of the disgorgement order against them.

The legality of the order and appeal against is not the subject matter of this paper and hence writer will not go into the detail of the case . The point of importance here is that the order was passed with the need felt to restore confidence about the market process in the minds of investors who were deprived of their entitlement to shares under the IPO as a result of illegal cornering of shares by some financiers. The Wadhwa Committee report of December 2007 recommended making good deprived investors in money terms, which, it seems, went well with the SEBI, as understood from its order of disgorgement.

Suggestions
The writer will make some suggestions to make the investors protection in India a reality in true sense of the term. These suggestions are-
# First of all, on the line of U.S.A, we urgently need a separate law on investors protection, which shall deals with the wide gamut of investors protection right from the watch on the pre- and post- launch stages of IPO to the expedite, efficient and investors friendly mechanisms for the collection of disgorged money and civil penalty and its timely distribution to the harmed investors.

It should also be noted that identification of the affected investors and the quantification of the compensation amount is a herculeon task and hence it requires specialised staffs and professional competency on the part of the regulator. Further, on the line of U.S.A, we should also have a provision for Fair Fund. The question of utilisation of the disgorgement proceeds can be considered for financing the right type of corporate governance, investor education, investor compensation for the loss suffered, and induction of independent experts of high credibility into the work of functional intermediaries like depositories, demat managers and participants, stock exchanges and even company board of directors.

# Secondly, if required, SEBI Act, 1992, need to be suitably amended to see that fines, penalties and disgorged amount collected by the SEBI do not go to Consolidated Fund of India and it remains with the SEBI for the purpose of its distribution to the harmed investors.

# Thirdly, in case the affected investors are not identified and/or quantification of compensation amount is not possible or practicable, then the amount collected should go to the Investors Education and Protection Fund (IEPF). The existing Investors Education and Protection Fund (IEPF) under the Ministry of Corporate Affairs should be abolished and it should be brought within the ambit of SEBI, since it is the latter and not the former which is primarily responsible for protection of investors' interest in India.

# Fourthly, since, after the SEBI order in Karvey case, a lot of confusion is there as to what is the legal and precise meaning of disgorgement, it is imperative that new law on investors' protection should clearly define the term. Given that the concept is new to India, there is a considerable lack of clarity about the principles that underlie this concept.

# Fifthly, given the increasing incidents of securities and IPO scams in the country and given the low level of awareness among the investors, it is very important and highly indispensable that investors' education and awareness is given a top priority in the country. An informed, aware and alert investor can play a great role in minimising the chance of such scams and market manipulations and we must always remember that prevention is better then cure. To achieve this purpose, there should be no financial constraint, as SEBI is facing right now, and there should be a team of highly qualified personnel who can make investors aware about their rights and precautions they are required to take.

The SEBI, in collaboration with Central and States Government, should open and operationalize investors protections centres in different parts of the country especially in small towns, where investors are not very much aware. If we want the Indian middle class to be a part of the financial sector of the country so that they can invest their savings in the financial market, it is very much essential to restore their confidence in the markets in the midst of so many scams. No doubt, the task of investors' education and awareness in different parts of the country is daunting but the end result will be fruitful. There should be no financial scarcity in such a crucial issue and SEBI should launch a nationwide investor awareness programme.

At present, SEBI gets no part of the fines and penalties it collects as it goes straight to a common Government of India account. SEBI does not get an annual budgetary allocation. It only earns through fees and charges that it collects from market intermediaries. The amount collected by it is used for meeting its day to day expenses. Such a dismal situation needs to be changed quickly and sufficient financial allocation should be made to SEBI for fulfilling its primary functions of investors' protection and healthy development of Indian capital markets.

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