SEBI Order in the USL Case: Lessons on Tunneling

In countries that are replete with corporate group structures (as in India), it is common to find transactions between a company on the one hand and a counterparty that has some relationship with it on the other. Referred to as a related party transaction (RPT), this could generate benefits if carried out on an arm’s length basis. At the same time, RPTs can be used to divert wealth from listed companies to other entities controlled by the promoters of the listed companies that causes value destruction to minority shareholders through a phenomenon popularly referred to as “tunneling”. An ideal regulatory apparatus governing RPTs must operate as a filter to allow value-enhancing RPTs to go through and to prevent value-destroying tunneling from occurring. In India, RPT regulation was hitherto considered poor. However, with the enactment of the Companies Act, 2013 (the “Act”) and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the “LODR Regulations”), the legal regime pertaining to RPTs has been considerably strengthened.

In this background, it is useful to consider a recent order of the Securities and Exchange Board of India (“SEBI”) in the case involving United Spirits Limited (“USL”) and its former promoter Vijay Mallya. In January 2017, SEBI passed an ad-interim ex parte order against the erstwhile management of USL, including Mallya, for carrying out transactions that involved diversion of funds from USL to other companies within the United Breweries (“UB”) group, in particular Kingfisher Airlines (“KFA”). An appeal by the management against SEBI’s order failed before the Securities Appellate Tribunal (“SAT”), thereby sending the matter back to SEBI. After further investigation and considering the various parties’ submissions, SEBI passed the latest order last week finding Mallya and two other members of USL’s erstwhile senior management, Ashok Capoor and P.A. Murali, guilty of the Securities and Exchange Board of India Act, 1992 (the “SEBI Act”) and the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003 (the “PFUTP Regulations”). SEBI prohibited them from accessing the securities market, from buying, selling or otherwise dealing with securities and from holding positions as director or key managerial personnel of a listed company, in each case for varying terms in respect of the three individuals. SEBI dropped actions against the other management personnel of USL.

While the facts and the legal issues have been broadly discussed in our previous posts (here and here), it would be useful to consider the broader impact of the recent SEBI order on the direction in which the law pertaining to RPTs has transitioned, and a couple of other issues of wider purport.

SEBI Investigation

SEBI had to deal with a threshold issue regarding the admissibility of a report issued by Pricerwaterhouse Coopers, United Kingdom (“PWC-UK”) that constituted the basis on which SEBI conducted the investigations. The noticees argued that the PWC-UK report was commissioned by Diageo plc after it took over control of USL, and that too for the purpose of determining appropriate action against the erstwhile USL management. They contended that SEBI’s reliance on the PWC-UK report was therefore misplaced. However, SEBI’s order states that it did not rely solely on the PWC-UK report and that it was corroborated through other correspondence and results of SEBI’s investigation. SEBI noted:

In a case where the findings of such third party investigations give specific inputs to the regulator which upon verification from other sources also stands factually confirmed, then the question of such reliance becomes merely academic. There is no mandate that every action of the regulator needs to originate from its own investigation or examination. On the other hand, as a regulator, it becomes imperative to initiate action against the perpetrators of a wrong doing, even if the same has been brought out through any other source or agency, if such regulator finds merit therein. Further, the Noticees were provided with copies of the PwC Report and they were given sufficient opportunities through personal hearings and written submissions to defend their case effectively, thus ensuring full play of principles of natural justice.

This suggests that SEBI actions need not always be based upon the findings of their own investigation and that it is entitled to rely upon the benefits of other agencies’ labour, whether governmental or private in nature. It did not matter that the PWC-UK report was commissioned by the acquirer (and subsequent promoter) of USL for its own purposes.

Levels of Managerial Responsibility

SEBI had initiated action against seven members of the erstwhile management of USL charging them with responsibility for diversion of funds from USL to other group companies. In the end, it decided to continue with action only against Mallya, Capoor and Murali and to drop the action against four other individuals. SEBI found that those four individuals did not possess sufficient knowledge regarding the consequences of their actions and that they were only acting at the behest of the senior management. However, when it came to Capoor and Murali, SEBI imposed higher standards of governance and responsibilities, as they were the managing director and chief financial officer respectively of USL at the relevant time. SEBI observed:

Having concluded as above regarding Shri PA Murali and Shri Ashok Capoor, I am of the view that officials occupying key positions, such as that of the CFO and MD etc. of a listed company are obligated to take care of the interest of the company and the shareholders’ interest. Professionals holding such positions in such companies are accountable for all their acts of omissions and commissions, which adversely impact shareholders’ impact. It is not the case of these two Noticees that they were not aware of the onward transfer of funds to other UB group companies by the TMUs and or the distributors. On the contrary, the resistance raised by them itself proves that they had knowledge of the end use of such funds being transferred to the intermittent entities.

These findings carry some implications for companies that are promoter-controlled but professionally managed. In this case, the fact that the professional managers raised concerns regarding the instructions of the promoter to enter into transactions with group companies was insufficient to exonerate them. Merely raising objections is not enough: it is necessary to pursue their conscience further without relenting to pressure from the promoters.

Moreover, SEBI’s approach suggests that the higher the rank and responsibilities of the managerial personnel, the greater the duties and liabilities in law. In other words, upper management may find it difficult to ward off their liabilities as compared to middle management. This is bound to raise some issues. Where does one draw the line between managers who carry greater responsibility and others that don’t? Is it merely based on the title of the relevant manager, her functions, or the actual act or omission in the given circumstances? In the end, the test must be more functional and purposive in the given context rather than mere labels that can easily be circumvented.

Scope of Regulations Governing RPTs

Prior to the Companies Act, 2013 and the LODR Regulations, the regulation of RPTs was considerably light as it relied largely on disclosures. There was no requirement or prior approvals either by the board (or a committee) of the company or by the shareholders, whether independent or otherwise. Hence, in this case, SEBI was compelled to rely on other general regulations to ensnare a case of diversion of funds constituting wealth tunneling from a listed company. SEBI’s main prong is that by way of fund diversions, the promoter and senior management of USL misled the investors as to the true nature of these transactions. Hence, charges were brought under the PFUTP Regulations. Relying on the SAT decision in N. Narayanan v. SEBI (2012), SEBI found that the scope of the PFUTP Regulations were broad in nature and that they could be invoked even in the absence of “dealing in securities”. In this case, SEBI has had to rely on the broader mandate of the PFUTP Regulations due to the absence of specific regulations on RPTs.

In the future, though, SEBI’s approach is likely to be vastly different due to the presence of a targeted framework for regulating RPTs in the form of section 188 of the Companies Act, 2013 and regulation 23 and other relevant provisions of the LODR Regulations. Such a framework establishes stringent procedures for carrying out RPTs. Violations would be more easily demonstrable and would obviate the need for SEBI to rely on the more abstruse nature of the PFUTP Regulations where questions of fraud, deception, misstatement and the like may have to be considered.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

Add comment


Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Top Posts & Pages


Recent Comments


web analytics

Social Media