SEBI’s Operation Shell Expel: More Questions Than Answers?
The Securities and Exchange Board of India has issued an ‘extraordinary’ direction to stock exchanges to effectively freeze trading in 331 suspected shell companies, creating panic in the market. This list of companies was apparently forwarded to SEBI by the Ministry of Corporate Affairs (MCA) almost 2 months back, which, in turn, drew the list based on inputs from the income-tax department, the Serious Fraud Investigation Office (SFIO) and other agencies.
SEBI advised the exchanges to place these suspected shell companies under a Graded Surveillance Measure (GSM) stage VI. Accordingly, the BSE, on August 8, placed 162 companies out of total 331 in the list, in stage VI of the GSM with immediate effect. Under the stage VI of the GSM framework, trading in these identified securities shall be permitted only once a month under the trade-to-trade category. Further, any upward price movement in these securities shall not be permitted beyond the last traded price and an additional surveillance deposit of 200 percent of trade value shall be collected from the buyers, which shall be retained with exchanges for a period of five months. Similar action was taken by the NSE.
Missing Pieces In SEBI’s Diktat
Interestingly, SEBI has not passed an order by itself but has, through a letter, directed stock exchanges to take various corrective measures including ‘verification of credential/fundamental by exchanges’; ‘appointing an independent auditor to conduct audit of such listed companies and if necessary, even conduct forensic audit of these companies to verify its credentials/fundamentals’; ‘initiate the proceeding for compulsory delisting against the company’.
Some of these directions may be at variance with the procedure prescribed under SEBI (Delisting of Equity Shares) Regulations, 2009.
What is more interesting is that the direction to the stock exchanges is neither backed by a legal provision which authorises SEBI to delegate such power to the exchanges, nor is there a description of the violations committed by these companies whose securities are facing restrictions from public trades. No one as on date, publicly knows the basis or parameters which SEBI has applied for considering these companies as ‘shell companies’! In the widely worded direction, very little is known on what was weighing on SEBI’s mind while passing such a drastic order. Was SEBI worried that someone could play a pump-and-dump scheme like the one played by Jordan Belfort, whose 1990s scheme was brought to life in The Wolf of Wall Street ? Is this an act for Swachh Capital Markets from tax evasion through the stock exchange mechanism?
Policing penny stocks or thinly traded securities on the stock exchanges has been a challenge for SEBI and other securities regulators globally. Shell companies have “no active business,” existing “only in name” and are commonly used for reverse mergers and pump-and-dump schemes.
U.S. SEC’s Operation Shell Expel
Empty shell companies are to stock manipulators and pump-and-dump schemers what guns are to bank robbers — the tools by which they ply their illegal trade.Robert Khuzami, Then Director Of Enforcement, U.S. SEC
Five years ago, the United States Securities and Exchange Commission put trading suspensions in the securities of 379 dormant companies. On May 14, 2012, while issuing an order, the SEC had found against each of 379 companies the lack of current and accurate information concerning the securities of (each of those) companies, and questions had arisen as to the operating status of each of such companies. The SEC had admitted on record that it was the largest such action in its history. The intent was to scrutinise micro-cap stocks in the markets nationwide and identify shell companies that were clearly dormant and ripe for potential fraud. Continuing ‘Operation Shell Expel’, the SEC suspended trading in securities of 61 companies through an order dated June 3, 2013, and of 255 companies through an order dated February 3, 2014.
Either the SEC did not receive a response to its letter, the letters were returned as undeliverable, or the registered agent responded that they had no forwarding address for the issuer.
Additionally, the staff of the SEC had independently endeavoured to determine whether any of the issuers were operational. Each of the issuers had either confirmed that they were no longer operating or were now private companies, failed to respond to the SEC’s inquiry about their operating status, did not have an operational address, or failed to provide their registered agent with an operational address.
Even after the SEC’s removal of 842 companies, hundreds of others may still be trading. Various rulings of the SEC demonstrate that the circumstances that might lead it to suspend trading include:
- A lack of current, accurate, or adequate information about the company, for example, when a company is not current in its filings of periodic reports;
- Questions about the accuracy of publicly available information, including in company press releases and reports, about the company’s current operational status, financial condition, or business transactions;
- Questions about trading in the stock, including trading by insiders, potential market manipulation, and the ability to clear and settle transactions in the stock.
While the SEC has argued its method of targeting shell companies as preventive and prudential regulation, lawyers and media have criticised such a move as a regulator’s failure to find evidence of manipulation or securities fraud against controllers of shell companies, and using a selective action to defend a too-little-too-late regulatory inaction. Till date, there is no known study on the efficacy of this move, as it is difficult to measure the extent to which Operation Shell Expel averted fraud, statistically. On the other hand, the SEC failed to prove charges and found considerable difficulties in litigations against the custodianship hijackers or Shell Kings – the brains behind such shell companies or their marketers.
For SEBI, More Questions Than Answers
SEBI’s challenges are similar. Companies are likely to litigate and ask why SEBI did not think it appropriate to seek details from them, provide them a hearing or independently verify the factual position, in effect presuming everything against them. The authorities should be mindful of the seriousness of such actions, as it may raise stern questions and cast doubts about the company in the minds of investors, failing its reinforcement plans.
The regulator may face a challenge in explaining why a settled legal principle ei incumbit probatio qui dicit, non qui negat (the burden of proof is on the one who declares, not on one who denies – is the principle that one is considered innocent unless proven guilty) was given a go-by. This action is – in the absence of an inquiry, notice and hearing – certainly going to face a challenge and could be called presumptive, vague and against the principles of natural justice. Though every company in the SEBI list has been painted with the same brush, on the face of it, there are companies who are generating profit and financial reporting about them is publicly available.
On the other hand, writ courts are likely to ask whose interest this order seeks to protect.
The order itself shows little regard for minority investors or retail investors in these companies, whose shareholding has been rendered worthless.
The surprise attack by SEBI will practically result in a freeze in trading activity in these stocks, which constitutes almost 10 percent of the market. From a policy angle, should a regulator assume the role of an investment advisor to decide in their analysis if a company might turn out to be a mischievous one eventually, in the absence of finding fraud or manipulation? Additionally, a battery of regulatory lawyers should be ready to answer what is a ‘shell company’ and what constitutes ‘credentials/fundamentals of a company’?
Needless to say, while the object behind SEBI’s order is honorable, the process is questionable.
Sumit Agrawal is a partner at Suvan Law Advisors and Ex-Assistant Legal Advisor, SEBI.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.