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SAT Order on “Shell” Companies

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The issue of “shell” companies has captured the attention of the regulators over the last couple of years. There is a pervading sense of regulatory fear that, left unchecked, shell companies may be utilized for various illegal purposes, including money laundering. The Government has been taking steps at various levels to deal with what it visualizes as a menace of shell companies. One instance can be found in the recent e orts by the Ministry of Finance (MCA) to address the issue legislatively by limiting the layers of subsidiaries.

It appears that several of these shell companies are also listed on stock exchanges, and hence the MCA adopted an indirect route to target them through the market regulator, the Securities and Exchange Board of India (SEBI). On June 9, 2017, the MCA issued a letter to SEBI identifying a list of 331 suspected shell companies listed on the stock exchanges, and asking SEBI to initiate appropriate regulatory action against them. Two months later, on August 7, 2017, SEBI issued a communication to the three stock exchanges forwarding the list of 331 suspected shell companies and seeking all trading in such listed companies to be placed in Stage IV of the Graded Surveillance Measures, which places the trading in those stocks under signification limitations, thereby affecting the liquidity of the stock. The stock exchanges were in turn asked to verify the credentials and fundamentals of those companies, and then suitability determine the consequences based on the results of the investigation. As widely reported in the media, SEBI’s move was received with considerable consternation by the markets, which were taken by surprise.

Reaction on the legal front was swift. Two of the affected companies, J. Kumar Infraprojects Limited and Prakash Industries Limited approached the Securities Appellate Tribunal (SAT) on appeals for relief, which SAT in turn granted in its order passed yesterday. The threshold question before SAT was whether the appeals were maintainable in view of the Supreme Court’s decision in The National Securities Depository Limited v. Securities and Exchange Board of India on the ground that SEBI’s communication to the stock exchanges was administrative in nature. Rejecting SEBI’s preliminary objection, SAT held that SEBI’s communication in this case was not general in nature and was a specific direction given to 331 identified companies that were suspected to be shell companies. Therefore, SEBI’s action would be in nature of a quasi-judicial order, over which SAT can sit on appeal.

On the legal validity of SEBI’s action, SAT found that SEBI had taken steps to curb trading in the stock of the speci c companies even before undertaking (let alone completing) a full-scale investigation, with no opportunity being given to those companies of being heard. Similarly, the stock exchanges themselves were yet to carry out any form of investigation. All of these consequently had an adverse impact on the reputation of the 331 companies, thereby affecting their investors. In terms of the process, SAT seems to have been struck by the fact that SEBI had issued the communication to the stock exchanges two months after receiving the letter from MCA, without having conducted any form of investigation in the interim. This also persuaded SAT to conclude that there was no urgency on the part of SEBI to have passed the order that led to adverse consequences on the companies. For this reason, SAT stayed SEBI’s communication dated August 7, 2017 and also reversed the decisions taken by the stock exchanges pursuant to that.

This episode has led to a regulatory quagmire, from which SEBI will have to extricate itself. SAT’s order calls into question the actions of SEBI that were taken effectively in disregard of principles of natural justice. This may compel SEBI to revise its planned course of action not only with reference to the two companies that preferred appeals, but also in respect of the remaining companies in the list. The more important question on the substance is whether SEBI can bring out a case of the violation of appropriate regulations by these entities.

At the moment, and as Sumit Agrawal has pointed out, it is not clear which laws and regulations the suspected “shell” companies have violated.

Even if SEBI crosses the hurdle of completing a thorough investigation, its ability to successfully bring legal actions is unclear. As noted (in the above link), if international experience is anything to go by, SEBI is likely to have an arduous road ahead.