[Vaishnavi Srinivasan and Philip Oommen are lawyers based in Mumbai, and graduates of the National Institute of Securities Markets]
Rule 8(3)(f) of the Securities Contracts (Regulation) Rules, 1957, (“SCRR”) is one of the lesser-known, yet crucial provisions in securities regulation. From the placing of restrictions on loans and advances to the prohibition of digital gold sales, rule 8(3)(f) is the common thread that connects various regulatory actions against stockbrokers. Rule 8(3)(f) is a crucial tool in the hands of the regulator to ensure that stockbrokers do not engage in businesses unrelated to the securities markets. In this post, we will examine the rationale, scope, and implications of rule 8(3)(f) and analyse how the Securities and Exchange Board of India (“SEBI”) has failed to adopt a consistent and coherent approach in its application.
Understanding the Rudiments
Rule 8 of the SCRR lays down the qualifications for membership in a stock exchange (i.e. to become a stockbroker). While rule 8(1) stipulates the qualifications required for election to membership, rule 8(3) contains qualifications required for continuing the said membership. One such qualification, rule 8(3)(f), is presently under scrutiny, the relevant portion of which is as under:
“Qualifications for membership of a recognised stock exchange.
8. The rules relating to admission of members of a stock exchange seeking recognition shall inter alia provide that:
(3) No person who is a member at the time of application for recognition or subsequently admitted as a member shall continue as such if—
(f) he engages either as principal or employee in any business other than that of securities [or commodity derivatives] except as a broker or agent not involving any personal financial liability…”
Madras Stock Exchange v. S. S. R. Rajkumar was one of the first instances where rule 8(3)(f) was subjected to judicial interpretation. The Madras High Court critiqued rule 8(3)(f) by stating that the “rule cannot be said to have been very well drafted”. According to the Court, rule 8(3)(f) consists of two components. Firstly, the stockbrokers are prohibited from being the principal or employee of any business other than that of securities (or commodity derivatives). The second component provides for an exception to the first: it permits the stockbroker to function as a broker or agent in a business other than securities, provided no personal financial liability is incurred.
Decoding Intent: The Journey So Far
Interpreting rule 8(3)(f) becomes a herculean task as the bare provision must be read in light of the multiple circulars issued by SEBI and the stock exchanges. Additionally, the orders passed by SEBI and the Securities Appellate Tribunal (“SAT”) are crucial in analysing the application of rule 8(3)(f). To interpret the provision, due regard must be had to the objective of the law. Since the SCRR is unclear on the same, reliance is placed on alternative sources.
In 2017, SEBI in Adjudication Order of Geojit BNP Paribas observed that the main purpose of rule 8(3)(f) is to “prohibit the brokers to invest the clients’ money in other businesses”. This implies that the primary objective is to safeguard the client’s funds, restricting the scope to the extent where the client’s funds are adversely affected and no more. Thus, stockbrokers could indulge in other businesses if the client’s funds were kept clearly demarcated and unaffected.
In 2020, the SAT in Jitendra Pukhraj Jain v. NSE observed that the objective is to prevent a negative impact on the balance sheet of a stockbroker, thereby maintaining the safety and integrity of the securities trading ecosystem. The SAT emphasized that maintaining the integrity of the balance sheet of the broker was of paramount importance. This broadened the scope of rule 8(3)(f) by reformulating its primary purpose from mere protection of client’s funds to ensuring the overall financial stability of stockbrokers. Therefore, rule 8(3)(f) would bar any activity that could adversely impact the balance sheet of the stockbrokers.
Interestingly, the scope of restriction as defined in Jitendra Jain appears to be narrower than the bare provision. While the bare provision restricts activities that involve any kind of personal financial liability, Jitendra Jain provides some leeway as engaging in other businesses involving personal financial liability might be acceptable if the integrity of the stockbroker’s balance sheet is maintained. However, the scope defined in Jitendra Jain is vague as it employs ambiguous terminology such as “negative impact” and “integrity” in relation to the balance sheet.
In 2022, rule 8(3)(f) witnessed a paradigm shift propelled by a change in the stance of SEBI. Firstly, clarificatory circulars issued by the National Stock Exchange and the Bombay Stock Exchange (in consultation with SEBI) listed 12 instances that are considered violative of rule 8(3)(f) —some of which might not be in congruence with the interpretation of objective of the said rule as envisaged in Jitendra Jain and Geojit Paribas. Secondly, SEBI’s informal guidance in VLS Finance Limited quoted the clarificatory circulars above and stated that certain activities would not comply with rule 8(3)(f). Interestingly, in doing so, SEBI did not respond to VLS Finance’s submission regarding the objective of rule 8(3)(f) as espoused in Geojit Paribas, implying a shift in the viewpoint of SEBI and the resultant affirmation of the overriding effect of clarificatory circulars. Thirdly, SEBI’s Order in Inventure Growth and Securities Ltd. made its stance regarding Geojit Paribas abundantly clear:
“I note that the said Adjudication Order was passed based on a very narrow interpretation of the purpose of Rule 8(3)(f) of SCRR by the Adjudicating Officer which as per him, was to prohibit the stock brokers from investing the clients’ money in other businesses. I do not concur with the said view of the Adjudicating Officer. As noted in the preceding paragraphs, under Rule 8(3)(f) of SCRR any kind of business activity which may incur financial liability on the trading member is prohibited, if the said business activity is not incidental to or consequential upon the securities business and not merely if the purpose of the loan is investing clients’ money in its other businesses. In any event, findings given in an order by an authority of SEBI is not binding in nature” [emphasis added]
Further, it was observed that the impact of business activity on the financial strength of a broker is irrelevant as rule 8(3)(f) does not permit carving out exceptions, even subject to any caveat. In essence, the primacy of the bare language is absolute and bars exceptions even in circumstances where the objective of the rule is not contravened. Therefore, Inventure Growth disregarded the objectives espoused in Geojit Paribas and Jitendra Jain, by imposing a blanket ban on activities contravening the bare language.
The Dichotomy of Purpose: To Rely or Not?
While the reliance on objective is barred for carving out exceptions, SEBI relied upon the very same “objective” on more than one occasion for broadening the scope of rule 8(3)(f). In Inventure Growth, the ambit of “business” in rule 8(3)(f) was widened to prohibit:
“…any activity/affairs of a trading member which may result in creating personal financial liability for the trading member that may cause prejudice to the interests of its investor clients.” (emphasis added)
Here SEBI appears to have relied on the objective, i.e. protection of interests of clients, to broaden the scope of restriction under rule 8(3)(f). Further, the sale of digital gold by stockbrokers was barred by the clarificatory circulars citing violation of rule 8(3)(f) as digital gold is not ‘securities’ under the Securities Contracts (Regulation) Act, 1956 and would, therefore, amount to business other than securities. However, it must be noted that the stockbrokers merely acted as agents for the vendors and not as principal sellers, thereby falling within the exception of rule 8(3)(f) namely, acting as agents without incurring personal financial liability. While the primary intent of SEBI in prohibiting the sale of digital gold is unclear, it may have been to safeguard the interests of the investor clients, owing to the lack of regulatory oversight on companies that sell and store physical gold. This once again leads to the dichotomy wherein SEBI is utilizing the objective to widen rule 8(3)(f). Furthermore, the clarificatory circulars restrict investments in associate companies by stockbrokers, which is evidently outside the scope of the bare language, since the act of “investing” cannot be equated with engaging in a “business” as a “principal” or “employee” (as also observed in Geojit Paribas).
SEBI has notably placed reliance on the bare language and blocked adverse claims based on intent, yet paradoxically doing the opposite, i.e. going beyond the scope of bare language by relying on intent to validate regulatory actions that fall outside the purview of rule 8(3)(f). However, in VLS Finance, a stockbroker engaged in proprietary business without any client enrolment (thereby having no impact on client interests) was advised by SEBI to ensure strict adherence to the clarificatory circulars. Similarly, in Inventure Growth, though the net worth of the stockbroker was far in excess and in no way affected the financial strength, SEBI observed that the same was irrelevant owing to the blanket prohibition under rule 8(3)(f). Therefore, it appears that SEBI cherry-picks instances where it is convenient to place reliance on the purpose while outright rejecting adverse claims relying on the same. Therefore, it appears that SEBI arbitrarily decides which is to prevail, amongst intent and bare language, on a case-to-case basis.
The reluctance of SEBI to adopt a uniform approach and abide by a consistent Interpretation of objectives concerning rule 8(3)(f) has resulted in much uncertainty and arbitrariness. Moreover, the clarificatory circulars state that the 12 activities mentioned therein are merely illustrative and that the determination of whether an activity constitutes a violation shall be done on a case-to-case basis, leaving scope for further inconsistency. This indiscriminate and vague application has made rule 8(3)(f) an umbrella provision which can be utilized for justifying arbitrary regulatory actions against the stockbrokers. Thus, rule 8(3)(f) has become a fallback provision that can be resorted to when a certain activity by a stockbroker is not specifically dealt with under any other regulatory provision.
Treading the Tightrope: Ensuring Market Integrity With Fairness
While undefined concepts like “basic structure doctrine” and “constitutional morality” seem justified considering the larger public interest involved, the same cannot be said for rule 8(3)(f). No doubt, it might be difficult for the regulators to come up with appropriate regulations to match the requirements of rapidly evolving securities markets. Nevertheless, such a catch-all provision creates an environment of regulatory uncertainty, which is undesirable.
Stockbrokers are essential for the smooth functioning of the securities market ecosystem, thereby, warranting an equitable regulatory regime. The fast-evolving securities market ecosystem requires SEBI to always be equipped with adequate regulatory measures to protect investors. Therefore, restricting the scope of rule 8(3)(f) to strictly defined contours may not be desirable. However, the essential constituents could be determined and applied uniformly since legal stability and predictability constitute fundamental elements of the rule of law.
At the outset, a regulatory consensus must be formed on the intent and application of rule 8(3)(f) to sufficiently enable the stockbrokers to foresee violations on their part when undertaking business decisions. Conflicting interpretations coupled with arbitrary application of the primary objective have exacerbated the situation. Most importantly, a blanket ban is imposed arbitrarily by a provision with no decipherable objective prohibiting stockbrokers from investing surplus funds (i.e., in excess of prescribed net worth requirements) in other businesses even when client interests remain unaffected. This hinders the growth prospects of stockbrokers and might even be violative of the fundamental rights enshrined under Articles 19 and 21 of the Indian Constitution. Therefore, SEBI must strike a balance by protecting market integrity while ensuring regulatory fairness and uniformity.
– Vaishnavi Srinivasan & Philip Oommen