This artcle first apeared in Bar & Bench. Ms. Vaneesa Agrawal founder of Thinking Legal, discusses about the unprecedented orders by SEBI against NSE in Co-location Matter with Ms. Shereen Bhan of CNBC - TV18. The clip can be accessed by clicking on the image below.

Background

On April 30, 2019, SEBI passed five orders against National Stock Exchange (“NSE”) and others. While one order has directed NSE to disgorge an amount of Rs.624.89 crores(along with interest), another order has directed NSE to disgorge an amount of 62.58 Crores (along with interest). Other directions against NSE include a ban on NSE from accessing the securities markets and ban on launching new derivative products for six months.

These orders emanate from an investigation based on a whistleblowercomplaint alleging various irregularities in respect of Co-location (“Colo”) facility provided by National Stock Exchange of India Ltd. The complaint alleged that NSE was allowing preferential access to some members, which helped them in front-running in collaboration with NSE employees. In 2016, SEBI directed NSE to conduct a forensic audit. Deloitte’s report concluded that the tick-by-tick (“TBT”) mechanism of NSE was prone to manipulation in that it provided quicker order dissemination to those who managed to login early. TBT is an information dissemination system where market data is sent out one by one in a sequential manner. Another forensic audit by E&Y also supported the findings of Deloitte. SEBI issued the first Show Cause Notice (“SCN”) in 2017 and the second SCN in 2018 to NSE and others.

First Order: NSE Failed to Provide Equal Access

The first 104-page order passed by SEBI deals with the allegation that NSE violated regulation 41 (2) of the Securities Contracts (Regulation) (Stock Exchange and Clearing Corporations) Regulations, 2012 (“SECC Regulations”), which casts a duty on every stock exchange to provide equal, fair and transparent access. SEBI had also alleged that providing such inequitable access was in violation of the SEBI (Fraudulent and Unfair Trade Practices) Regulations, 2003 (“FUTP Regulations”).

NSE failed to provide a level playing field

While dealing with the issue of unfair access, the Whole Time Member (“WTM”) of SEBI held that NSE failed to ensure a level playing field for trading members subscribing to the TBT data feed system of NSE. The Order also emphasizes that, “The stock exchange, as a first level regulator, has a fiduciary duty to the entire ecosystem. Market participants' confidence in the trading system is based on the presumption that the rules of trading are completely uniform and transparent.”

SEBI found that it had been established beyond doubt that NSE has not exercised the requisite due diligence while putting in place the TBT architecture. The same created a trading environment in which the information dissemination was asymmetric, which cannot be considered fair and equitable. It was held that this failure of NSE to ensure equal and fair access resulted in violation of Regulation 41(2) of SECC Regulations, 2012.

No fraud in allowing unfair access

However, SEBI held that violation of the requirement to provide equal, fair and transparent access “cannot automatically attract the rigors of the SEBI (PFUTP) regulations, without there being any proof to indicate fraud. In the absence of any evidence leading to the culpability of any specific employee of NSE or the collusion or connivance from the side of NSE with any specific TM, I am compelled to rule against the possibility of existence of a “fraud”.”

Former MDs failed in discharging their overall responsibility

SEBI held that the Former MDs had violated the SECC Regulations and observed that: “as a fundamental principle of corporate law, the obligation to comply with the abovementioned principle of equality and fair access percolates down to the directors and KMPs of stock exchanges.” SEBI also noted that there was an obligation on the directors under the Code of Conduct specified under the SECC Regulations to endeavour to analyze and administer the stock exchange issues with professional competence, fairness, impartiality, efficiency and effectiveness.

SEBI did not accept the arguments of Mr. Ravi Narain and Ms. Chitra Ramakrishna (who served as former Managing Directors of NSE) that they were not familiar with technology and as an institutional head they had gone with the aid and advice of the functional heads and the decisions were collective decisions of the NSE Board. SEBI held that, “Having held the senior most management position in the NSE and being in charge of the affairs of the conduct of the stock exchange business, they cannot limit their roles to the non-technology issues of the exchange. The MD and CEO of a stock exchange cannot abdicate his/ her responsibility by citing limited knowledge in certain spheres of the business activities. Undisputedly, they were vested with the general and overall responsibility of ensuring the implementation of the principle of equal, fair and transparent access, as mandated under Regulation 41 of The SECC Regulations.”

SEBI’s Directions

SEBI has passed several directions in this matter including:

• SEBI has directed NSE to disgorge the net profit from the colocation operation from 2010-11 to 2013-14, which amounts to Rs.624.89 crores, along with interest.
• SEBI has also directed that NSE will be prohibited from accessing the securities market, directly or indirectly, for a period of six months.
• The Former MDs have been asked to disgorge 25% of the salary drawn by them during the relevant period and have also been prohibited from associating with a listed company, market infrastructure institution or any other market intermediary for a period of five years.

Second Order: NSE Dark Fiber Order

In a separate order,SEBI held that NSE had violated the FUTP Regulations by giving preferential treatment granted to certain brokers by permitting them to establish Point to Point (“P2P”) dark fiber connectivity through an unauthorized service provider and harbouring discriminatory approach towards some other stock brokers. It was, inter alia, held that:

“After having examined the various acts, omissions, expressions through email correspondences and the overall conduct of NSE in the entire matter which helped an unauthorized service provider to access to their Colo facility to lay dark fibre connectivity on behalf of two trading members so as to provide them with higher speed and lower latency that would have helped them in trading in securities in a more efficient and profitable manner, it leaves no doubt that the Noticee has actively supported and helped W2W and GKN to gain faster access to the market data feeds by means of a irregular connectivity which was certainly a major inducement for the two trading members to engage Sampark and to circumvent all policies and guidelines so as to achieve their goals.”

In the Second Order, SEBI has directed NSE to disgorge an additional amount of Rs. 62.58 Crores (along with interest), which is a portion of the net profit margin from Colo facility in the year 2015-16. NSE has also been directed not to introduce any new derivative product for next six months.

A significant finding of the Second Order is the expansive interpretation given to the phrase “dealing in securities”. SEBI has held that, “Thus, as can be noted from the plain language of the definition and as observed by the Hon’ble Supreme Court, the definition of “dealing in securities” is inclusive definition and is not confined only to the acts of buying, selling or subscribing to securities.”

A third order imposes a penalty on a member of NSE, who was found to have benefitted from the irregularities at NSE. The fourth and fifth orders deals with governance issues at NSE, including misuse of market related confidential information and sensitive data by Mr. Ajay Shah and others.

Conclusion

Considering that NSE is a first level regulator for companies listed with it, the orders by SEBI are very significant. The SEBI Orders have led to anunusual situation where NSE is regulating listed companies, but it is not allowed to itself access the securities market.

Although NSE had filed for settlement with SEBI earlier, it is likely that at least some aspects of the SEBI Orders will be challenged before the Securities Appellate Tribunal.The fact that the certain actions of NSE have been found to be fraudulent is likely to be contested if an appeal is filed. If such an appeal is filed, we could see further guidance on the interpretation given to the term “dealing in securities”, which will have implications on future cases of fraud as well as insider trading.

(Vaneesa Agrawal is the Founder, Thinking Legal and a Former SEBI Official)

[ DISCLAIMER:  This article is for academic purpose and is solely to provide readers with general information regarding developments in Indian law. The information contained herein does not constitute legal or a professional advice. ]