Relief Defendants in Recovery Proceedings: Implications of the Dave Committee’s Suggestion

[Pranav Mihir Kandada and Anuraag Bukkapatnam are 3rd year law students at NALSAR University of Law, Hyderabad]

On June 16, 2020, SEBI notified the report of the High Level Committee under the chairmanship of Justice (Retd.) Anil R. Dave on the “Measures for Strengthening the Enforcement Mechanism of the Board and Incidental Issues”. The Committee examined the present securities laws and noted certain legal concerns including the challenges in recovery of siphoned-off monies. The primary challenge was that the recovery officer would not be able to proceed against any person or entity to whom assets were transferred in order to avoid recovery. To address the same, the Committee suggested that the concept of “relief defendant”, which is available to the US Securities Exchange Commission [“SEC”] be emulated by SEBI.

The authors shall elaborate on the challenges in recovery in existing laws, which the Committee had noted. The authors shall then explain the concept of a relief defendant, and the implications of the Committee’s suggestion.

Challenges in the Recovery Process

Section 28A of the Securities and Exchange Board of India Act, 1992 [“SEBI Act”] provides that the recovery officer of SEBI may recover the amount due from a person who fails to comply with a penalty, refund, or disgorgement order issued under section 11B of the SEBI Act. The process of recovery provides for attachment and sale of property, as well as attachment of bank accounts, among other methods. Explanation 1 to section 28A allows recovery of transfers made by the person to an exhaustive list of dependent relatives (spouse, son’s wife, minor child and son’s minor wife). The person’s assets would include any assets transferred to these relatives without adequate consideration, and hence may be recovered. However, as the Committee noted, this precludes the recovery officer from dealing with any third party to whom such assets are transferred.

According to SEBI’s 2018-19 Annual Report, only Rs. 262.02 crore were recovered against the total Rs. 1,845.3 crore that were covered under the recovery certificates. Challenges in the recovery process had even prompted SEBI to contemplate a “difficult to recover” tag earlier this year for cases where recovery of penalties and other dues from defaulters proved to be virtually impossible. Hence, the Committee deemed it necessary to enable the recovery officer to proceed against any person to whom assets have been siphoned. In furtherance of the same, the Committee took into consideration the SEC’s power to name relief defendants in disgorgement proceedings.

Relief Defendant

The SEC’s enforcement mechanism of disgorgement is often frustrated by corporate defendants who transfer their ill-gotten gains to third parties. In order to overcome this, case law in securities regulation in the USA has developed the concept of “relief defendants”. Relief defendants are those third parties who, although not accused of any malpractice, are in possession of the proceeds of a securities law violation. They are added as defendants in order to facilitate the recovery of these proceeds. Such recovery is based on the theory of unjust enrichment, which prohibits any person from conscientiously retaining the benefits of an illegal act. In order to avoid disgorgement, relief defendants have to prove that they have a “legitimate claim or ownership interest” in the funds received from the primary defendants. While the concept of relief defendants significantly enhances the SEC’s ability to recover proceeds, it has been criticized to be economically inefficient due to its unpredictability and vagueness in standards.

Suggested Amendment to SEBI Act

After referring to the concept of relief defendants in the US, the Committee suggested two amendments to the SEBI Act in this context. Firstly, to insert an explanation that states that the power to issue directions under section 11B would include the power to direct any person to whom proceeds were transferred without a legitimate claim. Secondly, to substitute explanation I to section 28A of the SEBI Act to emulate the relief defendant concept in the recovery process. However, there are certain differences between the manner in which SEC makes use of relief defendants, and the suggested expansion of the powers of recovery officers under the SEBI Act.

Issuing Authority

The SEC does not have the power to directly issue disgorgement orders against a relief defendant. Relief defendants are so called because the SEC, as a plaintiff, seeks a federal court to pass a summary judgment allowing disgorgement from the third parties named as relief defendants. Section 21(d)(1) of the US Securities Exchange Act of 1934 provides that the SEC may bring an action against any person violating the regulations to a district court, and obtain a permanent or temporary injunction upon proper showing of such violation. In SEC v. Materia, the Second Circuit Court of Appeals held that 21(d) cannot be read “so as to restrict the remedies the SEC may pursue solely to injunctive relief.” The Court further held that disgorgement of illegal proceeds would be a permissible equitable remedy. Recently, the Supreme Court of the United States affirmed this position and held that a disgorgement award sought by the SEC in federal courts would be an equitable remedy permitted by the federal securities.This equitable remedy extends to relief defendants as held in SEC v. Seibald, where the Court stated that allowing disgorgement from relief defendants is an acceptable use of the power of a federal court under securities law. Hence, the SEC seeks, as a plaintiff, a federal court to pass such order against the relief defendant. Further, as held in SEC v. Unifund Sal, the “proper showing” of violation before the district court would be analogous to the standard of “likelihood of success” that is applied to private litigants.

In their report, the Committee noted instances where courts or tribunals had permitted sale of assets of third parties to whom monies were siphoned (Arrow Global, Sahara Group, etc.). The Committee stated that it was doubtful whether the recovery officer could sell off the assets of third parties without directions from a court or tribunal, and discussed the SEC’s “relief defendant” concept in contrast to the present situation. As opposed to the SEC, which seeks disgorgement as an equitable remedy, SEBI exercises statutory power for the same (according to the explanation to section 11B of the SEBI Act). Further, no preliminary check is imposed on the decision of the recovery officer whereas the SEC has to convince a federal court with a “proper showing” to obtain such relief. Hence, the difference in the powers of SEBI and SEC in issuance of directions, and the Committee’s suggestion, would expedite the recovery proceedings.

Legitimate Claim and Adequate Consideration

The Federal Courts in the US have not specified what is sufficient to constitute a legitimate claim or ownership interest for a third party to prevent disgorgement.  In FTC v. LeadClick Media, the Second Circuit Court of Appeals held that while there are no explicit guidelines, “relief defendants who have provided some form of valuable consideration in good faith in return for proceeds of fraud are beyond the reach of the district court’s disgorgement remedy.” Although courts have referred to whether the consideration was fair based on the situation, there remains ambiguity in whether it is sufficient for the consideration to be valuable or whether it should be adequate as well.

Section 28A states that the recovery officer may deal with transfers made to certain individuals without adequate consideration. “Adequate consideration” is an import from the Income Tax Act, 1961 which implies that the consideration must be equal or nearly equal to the value of the assets transferred. Under the Income Tax Act, income arising out of assets transferred without adequate consideration to certain dependent relatives are clubbed with the taxpayer to the extent that the consideration is inadequate. Although section 28A of the SEBI Act mentions this criteria and enumerates dependent relatives to facilitate attachment, it is unclear whether any such assets can be recovered in full or only to the extent of the inadequacy.

Conclusion

By relying on the concept of “relief defendant” to make its suggestions, the Committee has enabled the recovery officer to be more efficient in the recovery proceedings. The concern that monies would be siphoned off to various individuals and system concerns has been adequately dealt with by providing the recovery officer with the power to attach those assets which have been siphoned off to third parties. The criteria of adequate consideration also serves as a deterrent to any attempt at siphoning off assets to relatives. With these suggested amendments, SEBI’s enforcement mechanism would be better equipped to recover assets from third parties than that of the SEC. However, whether the extent of inadequacy in consideration would be relevant during recovery proceedings needs to be clarified. Given that the original concept of relief defendant was an equitable remedy where the SEC could approach the court for suitable orders, it remains to be seen whether allowing it under a statutory power would compromise the fairness of the procedure.

Pranav Mihir Kandada & Anuraag Bukkapatnam

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