Cracking nuts with Sledgehammers? SEBI’s Fit and Proper Criteria for Intermediaries

The 2021 Amendment, although, well-intentioned by SEBI, fails to achieve a balance between the interests of the general public and the constitutional rights of the Intermediaries.

I. Introduction

In the recent times, the Securities Exchange Board of India (“SEBI”) has taken a slew of measures to catalyse investor confidence and to protect integrity of the securities market. One such stringent regulation is the amendment introduced in November 2021 to the “fit and proper criteria” under the SEBI (Intermediaries) Regulations, 2008 (“Intermediaries Regulation”).¹ The November 2021 amendment (“2021 Amendment”) significantly expands the grounds for disqualification of stock market intermediaries, its directors, promoters, partners, trustees, principal officers, key managerial persons, etc.²

This fit and proper criteria provides for automatic disqualification, upon inter alia, (i) mere filing and pendency of criminal complaint or information under Section 154 of the Code of Criminal Procedure, 1973 by SEBI against such persons³; (ii) mere filing and pendency of charge sheet by any enforcement agency in matters concerning economic offences⁴ and (iii) initiation of recovery proceeding by SEBI or initiation of winding up proceedings,⁵ without there being any adjudication of the same by a competent judicial/ quasi-judicial authority. Such automatic disqualification shall apply without issue of any show cause notice or an opportunity of hearing being afforded to the concerned person.

Since its introduction, the amended fit and proper criteria has been marred by controversy and is currently subject matter of constitutional challenge before the Bombay High Court.⁶

The new fit and proper criteria covers a wide range of stockholders in the securities markets. It is applicable to all intermediaries⁷ of the securities market and also those entities who associate themselves with the market.⁸

Compliance with the fit and proper requirements must be ensured not only at the time of registration but also during the continuity of the registration⁹. Therefore, fit, and proper status has to be maintained at all times. The purpose of this test is (i) to maintain purity and integrity of securities market; and (ii)to keep the market place safe for the investors to invest.

II. Criteria for Determining Fit and Proper person

The criteria to determine a fit and proper person post the 2021 Amendment is principle based or/and rule based. The Regulations only provide for an illustrative list. SEBI has wide and unguided discretion to determine fit and proper status of the applicant or intermediary seeking registration and “can take into account any criteria as it deems fit” for that purpose¹⁰. Apart from absence of guidelines in the amended Intermediaries Regulations, there is no procedural safeguard against misuse, if any, of this unbridled power and room for arbitrariness on part of SEBI.

The applicant or intermediary firstly needs to meet the rule-based criteria which examines the competence, capability in terms of infrastructure, manpower requirements, financial soundness including the ability to meet the net worth requirements, as provided in the regulations applicable to the applicant or the intermediary¹¹. In addition thereto, there also exists a principle-based criterion which requires SEBI to consider the integrity, honesty, ethical behaviour, reputation, fairness, and character of the person¹². The rule based criteria will determine the fit and proper status of the person based on the disqualifications as prescribed by SEBI in Clause 3(b) of Schedule II of the Intermediaries Regulation.

There is a stark contrast in the fit and proper criteria applicable before the 2021 Amendment.

The pre-2021 Amendment criteria was purely principal based. It required SEBI to sufficiently examine the character of the person and apply its mind and conduct a thorough determination of their ability to hold a position. SEBI was expected to make a decision depending on the conviction or the seriousness of the charge. Now this responsibility has been done away with by providing for automatic disqualification without application of mind and without providing an opportunity of hearing.

The 2021 Amendment significantly enlarged the scope of disqualifications. The stage of pendency of criminal complaint or FIR or the stage of framing of charge sheet should not be an appropriate stage warranting disqualification. As a criminal complaint/ FIR/ chargesheet is not a conclusive determination of guilt of the accused by a court of law. Courts have repeatedly held that a charge-sheet does not constitute a substantive piece of evidence as it not yet tested on the anvil of cross-examination¹⁵. No rights of hearing are granted to the accused at this stage. Disqualifying a person therefore, simply on the basis of something which he has had no opportunity to look into, or no knowledge of, would be against the principles of natural justice¹⁶.

The said Regulations further provides that criteria for “fit and proper” is required to be met not just by the applicant or intermediary but also by their principal officer, KMP, director or managing partner, compliance officer, promoters or persons holding controlling interests or exercising control over the applicant or intermediary directly or indirectly¹⁷. In the event of disqualification of such person, the intermediary must ensure that such person does not exercise voting rights and divests their holding within six months from the date of disqualification, failing, which the intermediary itself shall entail disqualification¹⁸. Moreover, it mandates replacement of the concerned KMP within 30 days from the date of such disqualification¹⁹. These are extremely onerous obligations placed on the Intermediaries. As per the Companies Act, 2013 for variation in shareholders’ rights, written consent is required of the holders of not less than three-fourths of the issued shares of the class or there is a need for passing of a special resolution²⁰. Therefore, ensuring compliance with this within 6 months is burdensome for the intermediaries. Additionally, as these KMPs are engaged in managing the critical operations of any organization, finding their replacement in 30 days further is unreasonable and extremely burdensome. Moreover, such automatic disqualification causes irreparable financial / reputational loss to the concerned individual as merely upon initiation of proceedings they are being replaced from their employment.

III. Impact of the amended fit and proper criteria on Intermediaries

The 2021 Amendment has faced strong criticism especially from brokerage houses. Several big brokers, including Motilal Oswal Financial Services Ltd. have challenged the constitutional validity of this amendment, particularly the aspect of automatic disqualification before the Bombay High Court²¹. The Petitioners have alleged that the onerous amendments are punitive in nature and impinges upon their fundamental rights under Article 14, 19(1)(g) and Article 21 of the Constitution of India and are liable to be declared ultra vires and struck down. The Petitioners have also contended that the amended fit and proper criteria is inconsistent with the SEBI Act, 1992, particularly, (i) Section 30(2)(d), which does not provide any power to make Regulations as regards disqualification of an intermediary²² and (ii) Section 12 which permits registration of intermediary subject to compliance with the conditions of certificate of registration obtained from SEBI in accordance with the Regulations made under the Act²³.

The genesis of this challenge was the chargesheet filed by Economic Offence Wing (EOW), Mumbai Police against the Managing Director of Motilal Oswal in an ongoing case. The filing of the chargesheet, automatically entailed his disqualification as he would fail to pass the 'fit and proper person' criterion for intermediaries.

Recently, SEBI also pulled the trigger of automatic disqualification on slew of commodity derivative brokers – who were trading and clearing members of the National Spot Exchange Limited (“NSEL”). SEBI while cancelling/suspending their registration noted that the entities do not satisfy eligibility criteria to function as intermediary due to existence of pending criminal complaint against such entities²⁴.

Considering the far-reaching impact of the amended criteria on various stakeholders, public comments on the proposal to have such a mechanism should have been solicited. Interestingly, SEBI did not deem it necessary to float a consultation paper before introducing these amendments.

IV. Comparing SEBI’s approach to the Indian and International standard for fit and proper assessment

The fit and proper person test is a determinant of good corporate governance compliance in India. Various regulatory bodies in different sectors mandate fulfilment of this criteria. However, none of the fit and proper/ disqualification criteria specified in other Indian legislations provide for such “automatic disqualification” upon such specified categories of pending proceedings/ complaints as provided for in the Intermediaries Regulations.

The Reserve Bank of India²⁵ and the Insurance Regulatory and Development Authority of India (“IRDAI”)²⁶, both provide for disqualification upon conviction for an offence involving moral turpitude. As per the requirements of IRDAI, details regarding any pending proceedings must be submitted, however they only assist in understanding the character of the applicant.

Under the Companies Act²⁷, the Chartered Accountants Act²⁸ and the Advocates Act²⁹ disqualification occurs or enrolment is denied when there is conviction in specific offences³⁰.

Additionally, The Insolvency and Bankruptcy Board of India (Insolvency Professionals) Regulations, 2016 provide that in case of conviction for an offence, the IP is not eligible to be registered³¹.

The Bombay High Court in a case involving Registered valuers, held that the IBBI’s decision to declare a person as not fit and proper based on filing of charge sheet and pendency of criminal proceedings goes against the settled position of criminal jurisprudence of innocent until proven guilty. The court opined that it is absurd that even before framing of charges, mere accusations are enough to impeach the integrity, reputation and character of a person and declare them as not fit and proper³².

Therefore, it is reasonable to conclude that SEBI has departed from the standard set for fit and proper in India particularly in the context of Intermediaries. Arguably, SEBI has stretched its regulatory powers by going above and beyond the standard set by the International Organization of Securities Commissions (“IOSCO”). The IOSCO prepared a guide on the Best Practices for fit and proper assessment (“Guide”)³³. Even though, the practices in the Guide are minimum voluntary standards and do not prohibit National Authorities from adopting supplementary measures, they are still a representation of the universally applicable framework for fit and proper test.

The Guide states that financial regulators may take into consideration conviction for offences such as financial crime, fraud, dishonesty etc³⁴. It recommends that every person’s application must be judged on the seriousness of the offence and the circumstances surrounding it³⁵. The authorities are expected to consider how the civil/criminal proceedings affected the person’s competence, judgment, honest or integrity and then declare him not fit and proper.³⁶

A comprehensive and thorough approach in line with the Guide, which takes into consideration several factors to determine the suitability of the candidate is prevalent across the globe. The European Union (“EU”)³⁷, the Monetary Authority of Singapore³⁸ and the Financial Conduct Authority of the United Kingdom (“UK”)³⁹, all consider pending civil and criminal proceedings as one of the factors reflecting negatively on the person’s reputation and character, but do not treat it as an automatic ground for disqualification.

V. Testing the amendment on the touchstone of the Indian Constitution

Automatic disqualification simply on initiation of certain specified categories of proceedings that are yet to be adjudicated upon by judicial/ quasi-judicial authority goes against the basic tenets of Constitution of India. Article 19(1)(g) guarantees the freedom to practice any profession or carry any occupation, trade or business⁴⁰. This right can only be curtailed by Article 19(6) of the Constitution, under which reasonable restrictions can be imposed in the interest of the general public⁴¹. Article 19(6) even allows the States to introduce professional or technical qualification which are necessary for certain professions. However, the only requirement is that any restriction has to be reasonable. In the case of Bennett Coleman & Co. v. Union of India⁴², the Supreme Court held that permissible restrictions on fundamental rights must not be excessive and not go beyond what is necessary to achieve the objective of the enactment. The fit and proper criteria have been incorporated by SEBI to ensure that intermediaries involved in the securities market, function ethically and with honesty and integrity. This is justified to maintain the public trust in the markets. However, automatically disqualifying a person on the basis of initiation of certain specified categories of proceedings is highly unreasonable. It is excessive as SEBI’s standard is not in line with the assessment provided in other Indian legislations and the International standard set by the IOSCO board.

A comparison of the grounds for disqualification under the amended criteria, clearly brings out a distinction dividing them into two categories. The first category is where a person is disqualified on mere filing of complaint, chargesheet or initiation or recovery/winding up proceedings- without any judicial or quasi-judicial adjudication. The second category includes proceedings which have been adjudicated upon inter alia grounds like order of conviction, declaration of insolvency or categorization as wilful defaulter. This classification is not based on any intelligible differentia and appears to be violative of Article 14.

Further, the regulations state that once a person is declared not “fit and proper person” by an order of the Board, such a person is not eligible to apply for registration for the period provided in the order or for a period of five years from date of such order, if no period is specified⁴³. The disqualification extending to five years comes across as a punitive measure which is arbitrary and disproportionate causing irreparable harm once registration is cancelled. Such a strict ban is not provided even when a person’s application is rejected for providing false or misleading information under Regulation 7 of the Intermediaries Regulation⁴⁴.

The automatic disqualification also falls foul of test of proportionality. It is hit by the vice of Article 14 and suffers from the vice of disproportionate restrictions and does not provide adequate safeguard against possible misuse of power. Article 14 guarantees the fundamental right to equality and equality before law. The scope of principle of proportionality was set forth in the case of KS Puttuswamy⁴⁵, wherein the Court held that

(i) Measures that interfere with or limit the exercise of fundamental rights are justified if there exists a rational connection between those measures, the situation in fact and the object sought to be achieved;

(ii) Additionally, the right-infringing measure must be necessary to achieve the objective of the act and should not interfere or infringe the fundamental right to a greater extent than necessary.

Therefore, considering the strict thresholds set by the doctrine of proportionality, it is reasonable to conclude that Regulation 3(a)(i) of Schedule II of the Intermediaries guidelines would not survive the test of constitutionality. SEBI’s act to automatically disqualify intermediaries interferes with the rights under Article 19(1)(g) to a greater extent than necessary. Filing of Charge sheet or complaint or initiation or recovery/winding up proceedings is not determination of guilt of the individual and goes against the basic principle of “innocent until proven guilty”. At this stage, there is not even a prima facie determination of guilt as the judge has not applied its mind. It lacks a rational connection to SEBI’s objective of protecting the integrity of securities market as such a severe punishment of disqualifying the person from their position in the intermediary till the time the complaint is disposed off is wrongful denial of their fundamental rights. Considering the pendency of cases in the Indian judiciary and the time taken to conclude proceedings, it is manifestly arbitrary to disqualify a person on these grounds.

Moreover, the person who fails to meet the criteria, is not even provided with an opportunity of hearing prior to triggering of automatic disqualification. This is in clear violation of principles of natural justice provided under Article 21 of the Indian Constitution⁴⁶. Regulation 7 of the Intermediaries Regulations, states that before rejection of an application on any of the grounds stated, the applicant must be given an opportunity in writing to make good the deficiencies⁴⁷. However, no such provision is available in case a person already holding a registration is disqualified, thereby clearing depriving them of their fundamental right to fair and just procedure.

Conclusion

SEBI is using a sledgehammer to crack a nut where a paring knife would suffice. The 2021 Amendment, although, well-intentioned by SEBI, fails to achieve a balance between the interests of the general public and the constitutional rights of the Intermediaries. Even though, the creation of a distinction between the individual and the entity with respect to the fit and proper status of one not affecting the other is appreciable, the provision on automatic disqualification on mere filing of criminal complaint or charge sheet or initiation of winding up proceeding or recovery proceeding is excessive and unreasonable. SEBI being a part of the IOSCO board must strongly consider adopting a thorough assessment approach as prescribed in the Guide. This approach does away with automatic disqualification and instead considers multiple factors such as previous conduct, gravity of offence charged, repeated misconduct etc. Therefore, SEBI in order to achieve the larger objective of maintaining integrity of the markets, cannot ignore its obligations to abide by the principles of natural justice and due process. SEBI must aim to harmonize its approach with international standards and ensure that unwarranted disqualifications do not hamper the investment climate in India.