Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

SEBI Disgorgement Order

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
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

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

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

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.


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