TOPIC : REINVENTING THE REGULATORY ROLE OF THE SECURITIES AND EXCHANGE BOARD OF INDIA IN THE AFTERMATH OF NSE SAGA

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THE CONTEXT: On February 11, 2022,the Securities and Exchange Board of India (SEBI) passed an order involving the country’s largest stock exchange-The National Stock Exchange. Apart from highlighting the issue of corporate misgovernance, the whole episode has raised questions on the role of the capital market regulator. In this article, we examine the issue in detail.

ALL YOU NEED TO KNOW ABOUT THE NSE IMBROGLIO

THE SEBI FINDINGS

• The National Stock Exchange (NSE)’s former Managing Director (MD) and Chief Executive Officer (CEO) is penalized for misusing her office for:
• making appointments,
• concealing confidential information pertaining to operations of the exchange,
• and making incorrect and misleading submissions to the Securities and Exchange Board of India (SEBI).
• The regulator states that her unknown spiritual guru influenced her decision making.
• The former NSE Chief is also being examined for a case registered in May 2018 pertaining to alleged abuse of a trading software of the exchange and the SEBI order comes in this backdrop (Read Ahead).

IMPROPER PERSONNEL MANAGEMENT

• The former NSE head appointed a person as the Chief Strategic Officer (CSO) of the exchange despite the latter not having any exposure to capital markets.
• SEBI notes that the exchange had not advertised any vacancy pertaining to the appointment of CSO
• SEBI notes that his previous work experience was not relevant to his new consultancy position at NSE. With recurrent appraisals and performance ratings, his compensation rose to ₹4.21 crore within two years(1.8 crore when he joined)

DIVULGING CONFIDENTIAL INFORMATION

• The regulator found the former NSE Chief guilty of divulging confidential information pertaining to the NSE’s organizational appointments, financial results and projections, dividend pay-out ratio and board meeting consultations to her unknown spiritual guru.

FAILURE OF THE NSE BOARD

• The NSE Board was found guilty of not informing the market’s regulator and opting to keep it under wraps.

PENALTIES IMPOSED

• The former NSE Chief has been forbidden from dealing in stocks, etc. for a period of three years, alongside a penalty of ₹3 crore.
• The erstwhile CSO has been restrained from associating with any market infrastructure institution or an intermediary for three years. He would also have to pay a penalty of ₹2 crore.
• NSE has been ordered not to launch any new product for the next six months.

AN ANALYSIS OF THE NSE SCAM?

BLOW TO CAPITAL MARKETS

• The NSE is a Market Infrastructure Institution that provides facilities for trading stocks and other products in the capital market.
• The scam has sent alarm bells to the investors and trading community and even has the potential to undermine the economic security of the nation apart from hugely denting investors’ confidence.
• The government has already indicated that it will initiate measures to sustain investors’ confidence in the Indian capital market.

POOR CORPORATE GOVERNANCE

• The approach by the Board of NSE amounted to a cover-up of the entire episode so that no outsider, including the regulator, would ever come to know.
• The public interest and shareholder directors collectively decided to not document the board discussion with respect to the irregularities of the management, thereby abdicating their primary responsibilities.
• Instead of sacking her, the Board allowed her to resign with respectable compensation and buried the matter, reflecting the complete collapse of corporate governance in NSE.

REWARDING MALFEASANCE

• The entire Board’s complicity is further indicated by the fact that, despite being aware that the MD-cum-CEO was divulging confidential information of the NSE to an anonymous individual and had recruited and excessively rewarded another individual, the Board allowed her to resign on December 2, 2016.
• For good measure, the Board placed on record her “sterling contribution and approved a 44-crore severance package!

CONDUCT OF DIRECTORS OF GOVT COMPANIES/BANKS

• Senior executives of the LIC, the SBI group and the Stock Holding Corporations etc, are part of the BoD who are delegated to protect the interests of their companies. But they have not raised any alarm but went along with the questionable approach of the management.
• Their role highlights a troubling issue that when they are on the Board of prominent private sector companies, they apparently abandon their own companies.
• And it also seems they are ready to align themselves and take instructions from the executive management of the private sector companies. It raises questions for the public about how the parent companies themselves are managed.

REGULATOR’S CONDUCT

• The SEBI’s order on the NSE saga and the delay of six years in concluding the probe raises troubling questions on the regulator’s role (Read Ahead)

A SERIES OF SCAMS IN NSE

• The current scam comes in the backdrop of a progressing CBI led investigation into the co-location scam and other glaring irregularities in NSEs.
• This point out that the NSE’s financial success and near-monopoly has clouded the judgement of the NSE leadership or they believe to be above the rule of law.

WHAT IS THE CO-LOCATION SCAM?

WHAT ARE CO-LOCATION FACILITIES?

• There are dedicated spaces in the exchange building, right next to the exchange servers, where high-frequency and algo traders can place their systems or programs.

BENEFITS OF THESE FACILITIES

• With the co-location facilities being extremely close to stock exchange servers, traders here have an advantage over other traders due to the improvement in latency (time taken for order execution).
• But the co-location is mainly used only by institutional investors and brokers for their proprietary trader. Retail investors have a negligible presence here.

UNFAIR ACCESS TO SERVERS

• The scam in NSE’s co-location facility took place almost a decade ago. It was alleged that one of the trading members, OPG Securities, was provided unfair access between 2012 and 2014 that enabled him to log in first to the server and get the data before others in the co-location facility.
• It was alleged that the owner and promoter of said private company abused the server architecture of NSE in conspiracy with unknown officials of NSE, SEBI etc.
• This preferential access allowed the algo trades of this member to be ahead of others in the order execution.

ROLE OF WHISTLEBLOWER AND MEDIA

• The scam came to light due to a whistle-blower’s complaint to SEBI in 2015, in which the entire modus operandi of the people gaming the system was laid out.
• When Money life(a media outlet) exposed the scam, the NSE management adopted a high-handed attitude, slapping a ₹100 crore defamation suit against Money life.
• The matter moved to Bombay High Court, which came down hard on NSE and dismissed its suit. Further, NSE was told to pay ₹50 lakh as the penalty for its arrogant attitude in responding to the media.

EXTENT OF LOSS

• The point to note is that there is no way of proving any loss to any investors or traders due to this scam. The SEBI order of 2019 directed OPG Securities and its directors to disgorge unfair gains of ₹15.7 core with the interest of 12 per cent from April 7, 2014, as a notional loss.

PENALTY ON NSE

• In 2016, SEBI asked NSE to carry out a forensic audit of its systems and deposit the entire revenue from its co-location facilities into an escrow account. Deloitte was tasked with the job of conducting a forensic audit of NSE’s systems.
• In 2019, SEBI passed its order on the issue, asking NSE to pay ₹625 crore with an interest of 12 per cent and also barred NSE from raising money from stock market for six months.

CORRECTIVE MEASURES

• NSE has changed its order execution protocol in the co-location facility to Multicast TBT from April 2014, thus plugging the loophole that allowed some to game the system.

THE SECURITIES AND EXCHANGE BOARD OF INDIA: AN OVERVIEW

CONSTITUTION OF SEBI

• The Securities and Exchange Board of India was constituted as a non-statutory body on April 12, 1988, through a resolution of the Government of India.
• The Securities and Exchange Board of India was established as a statutory body in the year 1992 and the provisions of the Securities and Exchange Board of India Act, 1992 (15 of 1992) came into force on January 30, 1992.

PROTECTIVE FUNCTION OF SEBI

• Checking price rigging
• Prevent insider trading
• Promote fair practices
• Create awareness among investors
• Prohibit fraudulent and unfair trade practices

REGULATORY FUNCTION OF SEBI

• Designing guidelines and code of conduct for the proper functioning of financial intermediaries and corporate.
• Regulation of takeover of companies
• Conducting inquiries and audits of exchanges
• Registration of brokers, sub-brokers, merchant bankers etc.
• Levying of fees
• Performing and exercising powers
• Register and regulate credit rating agency

DEVELOPMENT FUNCTION OF SEBI

• Imparting training to intermediaries
• Promotion of fair trading and reduction of malpractices
• Carry out research work
• Encouraging self-regulating organizations
• Buy-sell mutual funds directly from AMC through a broker

OBJECTIVES OF SEBI

• Protection to the investors: The primary objective of SEBI is to protect the interest of people in the stock market and provide a healthy environment for them.
• Prevention of malpractices: This was the reason why SEBI was formed. Among the main objectives, preventing malpractices is one of them.
• Fair and proper functioning: SEBI is responsible for the orderly functioning of the capital markets and keeps a close check over the activities of the financial intermediaries such as brokers, sub-brokers, etc.

POWERS OF SEBI

SEBI is a quasi-legislative, quasi-judicial and quasi-executive body.

• SEBI has the power to regulate and approve any laws related to functions in the stock exchanges.
• It has the powers to access the books of records and accounts for all the stock exchanges and it can arrange for periodical checks and returns into the workings of the stock exchanges.
• It can also conduct hearings and pass judgments if there are any malpractices detected on the stock exchanges.
• When it comes to the treatment of companies, it has the power to get companies listed and de-listed from any stock exchange in the country.
• It has the power to completely regulate all aspects of insider trading and announce penalties and expulsions if a company is caught doing something unethical.

GOVERNANCE OF SEBI

The SEBI Board consist of nine members-

• One Chairman appointed by the Government of India
• Two members who are officers from Union Finance Ministry
• One member from the Reserve Bank of India
• Five members appointed by the Union Government of India

ENFORCEMENT OF LAWS

• SEBI enforces provisions of the SEBI Act, the Depositories Act 1996, the Securities Contracts (Regulation) Act, 1956, among others.
• A Securities Appellate Tribunal established under section 15-K of the Securities and Exchange Board of India Act hears appeal from the orders of SEBI which can be challenged in the SC only.

A QUESTION MARK ON SEBI’S REGULATORY ROLE

INEXPLICABLE DELAY

• Though SEBI began investigations in 2016, it has taken six years to arrive at this order. However, SEBI’s order raises more questions than it answers as it has not taken the issue into a logical conclusion.

DILUTION OF OFFENCE

• The order passed by SEBI’s whole-time member contains no provision for conducting any investigation into the possible criminal aspects of the then NSE Chief’s conduct.
   It appears that SEBI sees her criminal offence of sharing NSE’s internal confidential information with an unknown person as indiscretion.
   But converting a grave criminal offence into a regulatory indiscretion may set a dangerous precedent for the entire capital market ecosystem.

POOR CAPACITY OF SEBI

• Multiple complaints were lodged in SEBI against the then NSE MD & CEO, which led SEBI to investigate her case.
   If SEBI lacked the capability or capacity to take the investigation further, it should have sought the assistance of other investigating agencies.
• The NSE Board chairman, upon discovering that Chitra was sharing information regarding NSE with her Himalayan Yogi, apprised the NSE Board members in a closed-door meeting. And that information was too sensitive to be even recorded in minutes of the board meeting.

NO FEAR FOR REGULATOR

• NSE had knowledge that she shared sensitive information with the alleged yogi and NSE Board had concealed this information from SEBI Long after she had resigned, and only when SEBI probed, NSE directed Ernst & Young to figure out the identity the alleged Yogi.
   The whole episode reflects poorly on the status and respect the SEBI commands or put in other words; the regulated seems to have scant regard for the regulator and seems to believe that the system can be gamed and they will never get caught.

LOST OPPORTUNITY FOR REFORMS

• SEBI missed an opportunity to make an example of the CMD’s case as a warning to rogue managers. However, the meagre penalty meted out by SEBI indicates the regulator is as keen as NSE to close the case rather than address the ethical and legal cracks within the system. Penalty imposed on her is ₹3 crore – less than 7% of her severance package of ₹44 crore.

SEBI’S FAILURE TO UPHOLD NATIONAL INTEREST

• By relegating this case to a mere issue of breach of compliance, SEBI has effectively turned a possible criminal offence into a civil case. This case will embolden more who may now find it easier to abuse their official positions to compromise their own company’s integrity or hurt national interest.

ABDICATION OF AUTHORITY

• Despite being armed with exceptional powers among financial regulators to summon market participants and to search and seize evidence, SEBI failed to show the intent to get to the bottom of the scam while the trail was still hot.

REVITALIZING THE REGULATOR AND REFORMING THE NSE: THE WAY FORWARD

SCALE UP THE RESOURCE BASE

• SEBI as a regulator has to scrutinize millions of transactions done almost every minute in the stock market and that by itself makes its task herculean. The problem is compounded by the need to act swiftly, and naturally, there are limitations.
   Hence, the resource base of SEBI, especially human infrastructure, needs to be scaled up so also its technological capability through AI, etc.

FAST TRACK REFORMS IN NSE

• A leading stock exchange like NSE is a systemically important institution as it serves an economic function and is the symbol of the free market. Any disruption in the NSE has a repercussion on the economy and the country.
   The NSE leadership needs to put their house in order by upholding the laws of the land and also by holding accountability of the management to the Board, which also need to be accountable to the public.
   Processes and practices currently in place at NSE need to be revisited so that such an event doesn’t re-occur at such an important market infrastructure institution.

ACTIONS BY SEBI

• SEBI has also instituted various changes in the governance of market infrastructure institutions (MIIs), including board committee structures and oversights, the tenor of management, accountability for lapses at MIIs etc., which can strengthen the control environment.

FULFILLING SEBI’S MANDATE

• SEBI has been tasked with preserving the integrity of the capital market and institutionalizing good governance in the stock market ecosystem.
   For the sake of millions who trust SEBI to preserve the integrity of the Indian capital market, the regulator must fix the systemic deficiencies in Indian exchange.
   It must not be seen as favouring or taking a soft approach to matters of regulatory violation, especially by powerful players.

EXPECTATION FROM THE NEW SEBI CHIEF

• Regulating the stock exchanges in an independent and efficient manner, especially when doubts have risen regarding the functioning of the NSE, should be high on the list of tasks for the newly appointed chairperson of SEBI.

ROLE OF PMO AND OTHERS

• The SEBI order itself seems incomplete and there seems to be something more than what meets the eye. This could require further investigation by other agencies, and the Finance Ministry and the Prime Minister’s Office needs to act expeditiously.
   The CBI investigation into this scam also need to be fast-tracked and should be done in a professional manner to unearth the truth and to prosecute and punish the guilty.

REGULATING THE REGULATOR

• The SEBI order has done more damage to its own credibility and many questions have remained unanswered. Thus, a thorough inquiry into the investigation conducted by SEBI by independent agencies needs to be undertaken to find out if any extraneous considerations were involved in the manner of investigation or its findings.
   This does not in anyway will deem to be an encroachment into the regulator’s autonomy but will be a step towards improving regulatory quality.
   Additionally, a Regulatory Impact Assessment need to be conducted to assess the functioning of SEBI and the Parliament’s control over it need to be strengthened through standing committee oversight, periodic reports, etc.

RESTRUCTURING THE BOARD OF NSE

• Persons occupying key management positions at important institutions, even if professionals, should be rotated at reasonable intervals.
• Allowing an individual to turn into a permanent fixture as CEO or MD is a bad idea. It is improper for an outgoing CEO/MD to continue on the Board.
• And it is worse if this happens when the ex-CEO’s deputy assumes charge as the new CEO. Not only can this create situations of nexus, but it can also tie down the successor from initiating a clean-up of legacy structures.

WHISTLEBLOWER PROTECTION

• As it was a whistle-blower letter that alerted SEBI to the irregularities at NSE, MIIs must be asked to put in place well-defined employee whistleblower mechanisms, where complaints can be lodged directly with the concerned.

1. The identity of the whistle-blower must be strictly protected to prevent vindictive action.

PROFESSIONAL CONDUCT OF THE GOVT COMPANY/BANK REPRESENTATIVES

• The LIC is coming to the market for its initial public offering, and prospective shareholders and policyholders have a right to demand an explanation from LIC on the unprofessional conduct of its representatives on NSE in this period.
• Similarly, shareholders of SBI also should demand an explanation from SBI on the conduct of its officers when deputed as directors in other companies.
• The govt should take note of the negligence/irresponsibility of these members and stringent actions need to be taken against them if found to be complicit.

THE CONCLUSION: Despite the capture of power by a few individuals and the governance infractions they indulged in, few can dispute that the National Stock Exchange (NSE) has served Indian financial markets extremely well in the three decades of its existence. Its state-of-the-art electronic platform and reliable trading and settlement systems have ensured that there were no systemic failures through the worst of upheavals. It is therefore critical for the government and the regulator to get to work on fixing the loopholes in the governance structures at the NSE so that such infractions don’t recur. Clearly, the regulator needs to introspect on its actions both in the co-location and ‘yogi’ scams and learn from the mistakes.