Adani–Hindenburg aftermath: Decoding the expert committee’s findings on SEBI’s regulatory failure, Part 1

An exploration of the revelations made by the expert committee report, which shows discernible deficiency in regulatory oversight.

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A Supreme Court Order dated March 2, 2023 brought into play two parallel inquiries into alleged contraventions of the Adani group of companies, with separate but interrelated remits.

The Security and Exchange Board of India (SEBI) was directed to investigate:

(a) Whether there has been a violation of Rule 19A of the Securities Contracts (Regulation) Rules 1957; 

(b) Whether there has been a failure to disclose transactions with related parties and other relevant information which concerns related parties to SEBI, in accordance with law; and 

(c) Whether there was any manipulation of stock prices in contravention of existing laws.

In addition, a separate 'expert committee' (EC) was constituted to, inter alia, investigate whether there has been regulatory failure in dealing with the alleged contravention of laws by the Adani group or other companies.

On expiry of the two months deadline set for the inquiries by the Supreme Court, SEBI applied for a six month extension citing the complexity of the transactions it was investigating, volume of material that needs to be examined, multiplicity of jurisdictions from where information needs to be obtained, etc.

In its latest Order, the Supreme Court has granted SEBI extension till August 14. Meanwhile, the EC has submitted a 173-page report to the court on May 6. What has been widely reported is that the EC has found 'no regulatory failure' on the part of the SEBI.

The perusal of the EC report, however, reveals several facts as well as a sequence of events, which not only point towards regulatory failure, but regulatory capture and collapse.

In this part, we focus on the committee's findings on regulatory performance vis-à-vis two specific terms of reference set by the Supreme Court before the SEBI inquiry, contained in Chapter 4 of the report. The committee's findings on regulatory performance vis-à-vis the third specific term of reference, and the conclusions drawn, are discussed in part 2 of this piece.

Violation of Rule 19A of the Securities Contracts (Regulation) Rules 1957

Rule 19A of the Securities Contracts (Regulation) Rules 1957 (SCRR, 1957), inserted through an amendment made with effect from June 4, 2010, stipulates that every company listed in the stock market has to maintain at least 25 percent public shareholding.

"Public" is defined in the said Rules as persons other than the promoter, the promoter group (which includes the promoter's immediate relatives like any spouse or any parent, brother, sister or child of that person or that of the spouse), and subsidiaries or associates of the company.

The Rule is laid down under "Continuous Listing Requirement" in the following words:

"19A (1) Every listed company [other than public sector company] shall maintain public shareholding of at least 25 per cent:

Provided that any listed company which has public shareholding below 25 percent, on the commencement of the Securities Contracts (Regulation) (Amendment) Rules, 2010, shall increase its public shareholding to at least 25 per cent, within a period of three years from the date of such commencement, in the manner specified by the Securities and Exchange Board of India.

Explanation: For the purposes of this sub-rule, a company whose securities has been listed pursuant to an offer and allotment made to the public in terms of sub-clause (ii) of clause (b) of sub-rule (2) of Rule 19, shall maintain minimum 25 per cent public shareholding from the date on which the public shareholding in the company reaches the level of 25 percent in terms of said sub-clause.]

(2) Where the public shareholding in a listed company falls below 25 per cent at any time, such a company shall bring the public shareholding to 25 per cent within a maximum period of twelve months from the date of such fall in the manner specified by the Securities and Exchange Board of India."

Also read: Hindenburg Adani report fallout: Supreme Court grants SEBI time till August to complete its probe

The EC report states (Para 37–38, Chapter 4) that SEBI has had a "long-standing suspicion" that some of the public shareholders in the listed Adani companies are not truly "public shareholders" as defined under the laws and rules but fronts for the company promoters.

SEBI has identified 13 overseas entities (listed in Table 1 below), which together held significant shares in five of the listed Adani group companies as on March 2020, viz., Adani Enterprises Limited or AEL (15.5 percent), Adani Transmission Limited or ATL (18 percent), Adani Total Gas or ATG (17.9 percent), Adani Green Energy Limited or AGEL (20.3 percent) and Adani Power Limited or APL (14.1 percent), as per SEBI's compilation.

The promoter group shareholdings in all of the five Adani Group companies till March 2020 were between 74 percent and 75 percent, as per the disclosures made in their annual reports. 

These companies would be in clear violation of Rule 19A of the SCRR, 1957 if the 13 suspected overseas entities were or are front companies for the Adani group promoters. 

SEBI, despite its suspicion and investigation, however, is yet to gather conclusive evidence in this regard. 

The reasons behind SEBI's inability to unearth the ultimate beneficial owners of the 13 overseas entities under suspicion have also been revealed in the committee report, through a section outlining the regulatory history vis-à-vis foreign portfolio investors (Para 17 to 36, Chapter 4). 

In the backdrop of controversies over participatory notes issued by foreign institutional investors through which unidentified overseas investors were participating in the Indian capital market during the last decade, regulatory changes were brought in through SEBI (Foreign Portfolio Investors) Regulations, 2014, notified in January 2014.

The FPI Regulations, 2014 had specified that designated depository participants in the stock market are obligated to "ensure that foreign portfolio investors do not have opaque structure(s)". 

The term 'opaque structure' was explained as "any structure such as protected cell company, segregated cell company or equivalent, where the details of the ultimate beneficial owners are not accessible or where the beneficial owners are ring fenced from each other or where the beneficial owners are ring fenced with regard to enforcement." 

The FPI Regulations, 2014 were amended by SEBI with effect from December 2018, whereby the "ultimate beneficial owners" were redefined to have the same meaning as "beneficial owner" as defined under the Prevention of Money Laundering Act, 2002 (PMLA 2002). 

Subsequently, the FPI Regulations, 2014 were repealed and replaced with FPI Regulations, 2019 with effect from September 23, 2019, whereby the "opaque structure" clause in the FPI regulations was done away with altogether and replaced by "compliance with all the requirements under Prevention of Money Laundering Act, 2002 and rules and regulations made thereunder".

Having made these significant regulatory changes in 2018 and 2019, first diluting and then repealing the restrictions on "opaque structure" in the FPI Regulations, SEBI has tied its own hands. 

Now, in order to investigate suspicious overseas entities and identify their ultimate beneficial owners, SEBI has to first establish a prima facie case of money laundering and prosecute under PMLA. 

Such investigation and enforcement cannot be undertaken without the involvement of the Enforcement Directorate, which functions under the revenue department of the Union finance ministry.

What is also relevant to note is that Rule 9 of the Prevention of Money Laundering (Maintenance of Records) Rules, 2005, till very recently, required at least 25 percent ownership in a company to establish "controlling ownership interest" for the determination of its "beneficial owner", which was not required under the initial definition of "ultimate beneficial owners" of the FPI Regulations 2014.

Also read: Why Adani's buying spree merits a rethink in India's competition law framework

The PMLA (Maintenance of Records) Rules, 2005 has recently been amended (March 7, 2023) whereby the 25 percent ownership threshold in a company to establish "controlling ownership interest" has been brought down to 10 percent. 

In terms of FPI Regulations, 2019, the revised ownership threshold of 10 percent can be applied by SEBI to identify beneficial ownership, only with prospective effect. 

Clearly, a regulatory loophole was opened by the SEBI through significant changes made in FPI Regulations in 2018 and 2019, which has been partially plugged only with effect from March 7, 2023, i.e., after the Supreme Court ordered inquiry into alleged non-compliance with Rule 19A of SCRR, 1957 by the Adani group companies. (The Prevention of Money-laundering (Maintenance of Records) Amendment Rules, 2023 were notified by the department of revenue, ministry of finance in the official gazette on March 7, 2023.)

The EC notes that the 13 overseas entities being investigated by SEBI had declared their "beneficial owners" (provided in Table 1), in accordance with the definition of the PMLA. 

The controlling shareholders of these 13 FPIs and the Adani group promoters have asserted their independence from each other. Yet, SEBI has expressed suspicion about shareholders who have contributed capital that has been invested by these 13 entities. 

SEBI has identified 42 such contributors and shareholders, each of which are companies incorporated in tax haven jurisdictions, namely Cayman Islands, Malta, Curacao, British Virgin Islands, Bermuda, Ireland and UK. 

SEBI has been able to obtain the "beneficial owner" details of only 24 out of these 42 entities so far. The details regarding other controlling shareholders and economic interest shareholders have not been made available.

The committee expresses scepticism regarding SEBI's ability to obtain full disclosure on the ultimate beneficial owners of these entities in the following words (Para 49–50, Chapter 4):

"[T]his is where it has hit a wall. It is evident that SEBI had drawn a blank in this investigation and the publication of the Hindenburg Report has revived SEBI's efforts to attempt figuring out economic interest in the FPIs that have these investments in listed Adani stocks. It is evident that such an exercise could be a voluminous one but potentially a journey without a destination."

The EC further elaborates on SEBI's references made to the Central Board of Direct Taxes (CBDT) and Directorate of Enforcement (ED), asking them to investigate the 13 suspected overseas entities (Paras 53–61). 

CBDT has stated that it cannot take up an investigation unless the "tax evasion petition" contains specific, verifiable and actionable intelligence. 

While India has double tax avoidance agreements (DTAA) with three of the overseas jurisdictions relevant to SEBI investigation and tax information exchange agreement (TIEA) with three more, the requesting jurisdiction must "clearly establish foreseeable relevance" of the information for tax purposes. CBDT has expressed unwillingness to conduct a tax investigation into the suspected entities. 

The ED has responded that it is not empowered to invoke the provisions of the PMLA unless SEBI files a case under the scheduled offences listed under PMLA 2002.

Scheduled offences under the PMLA include "false declaration, false documents, etc.", but only under the Customs Act, 1962, where they are punishable with up to two years of imprisonment. It is unclear whether false declarations of "beneficial owner(s)" by FPIs are covered in the scheduled offences under the PMLA.

The SEBI has not reported any violation of the Foreign Exchange Management Act, 1999 (FEMA Act) or the Securities and Exchange Board of India Act, 1992 (SEBI Act). 

ED has also prodded the SEBI to investigate "potentially violative and concerted selling by specific parties just ahead of the publication of the Hindenburg Report", on which it claims to have found intelligence. 

Thus SEBI, while suspecting 13 overseas entities having significant shareholding in Adani group of companies, as front companies of the group promoters, wants further investigation to obtain more evidence before presenting a prima facie case of non-compliance and violation of Rule 19A of the SCRR, 1957. 

Agencies like the CBDT and ED, on the other hand, requires the SEBI to first present a prima facie case to conduct further investigation. This, as the EC has noted, "reveals a chicken-and-egg situation" (Paras 58–59). 

The EC is apprehensive that the chicken-and-egg situation can become perpetual, given the repeal of the "opaque structure" prohibition in FPI regulations by SEBI as well as the restrictive provisions of Rule 9 of PMLA Rules, 2005, which makes it difficult to make out a prima facie case against the suspected overseas entities under PMLA. 

The EC further notes that SEBI's regulatory policies and enforcement stance have moved in the opposite directions (Para 60).

While SEBI has diluted regulations regarding foreign portfolio investors since 2018 to enable concealment of their ultimate beneficial ownership, it is now trying to establish non-compliance by 13 suspected FPIs on the basis of rules and regulations as they existed prior to their dilution. This is a clear indictment of SEBI. 

Also read : Past investigations into Adani's businesses have come to nothing – Ravi Nair

Contraventions of disclosure norms in related party transactions 

The EC notes that the Hindenburg report has questioned the appropriateness of over six thousand related party transactions and specifically alleged ten transactions to be related party transactions which were not disclosed as such (Para 76, Chapter 4). 

The Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR Regulations, 2015) had defined "related party" as having the same meaning ascribed to it under Section 2(76) of the Companies Act, 2013. The relevant section of the Companies Act, 2013 reads:

"(76) Related party, with reference to a company, means— (i) a director or his relative; (ii) a key managerial personnel or his relative; (iii) a firm, in which a director, manager or his relative is a partner; (iv) a private company in which a director or manager is a member or director; (v) a public company in which a director or manager is a director or holds along with his relatives, more than two per cent of its paid-up share capital."

This definition of "related party" in the LODR Regulations, 2015 was amended by SEBI in 2018 (with effect from April 1, 2019), adding a separate provision enabling a member or entity of the promoter group of a listed company being deemed as a "related party" only if the shareholding of that person or entity was at least 20 percent. Alongwith the added provision, the clause read as under:

"2(zb) Related party means a related party as defined under sub-Section (76) of Section 2 of the Companies Act, 2013 or under the applicable accounting standards:

Provided that any person or entity belonging to the promoter or promoter group of the listed entity and holding 20 per cent or more of shareholding in the listed entity shall be deemed to be a related party."

A series of subsequent amendments were made to the LODR Regulations in 2018, 2019, 2020, 2021 and 2022.

As per the committee's report, SEBI's investigation into possible contraventions of rules and regulations by the Adani group of companies started on October 23, 2020 after receipt of complaints in June–July 2020 (Para 104(h), Chapter 4). 

On November 21, 2021 the definition of "related party" was further amended by SEBI, with effect from April 1, 2022, as reproduced under:

"2(zb) Related party means a related party as defined under sub-Section (76) of section 2 of the Companies Act, 2013 or under the applicable accounting standards:

Provided that: (a) any person or entity forming a part of the promoter or promoter group of the listed entity; or (b) any person or any entity, holding equity shares: (i) of twenty per cent or more; or (ii) of ten per cent or more, with effect from April 1, 2023; in the listed entity either directly or on a beneficial interest basis as provided under Section 89 of the Companies Act, 2013, at any time, during the immediate preceding financial year; shall be deemed to be a related party."

The definition of "related party transactions" in 2(zc) was also amended with a similar deferred prospective effect, i.e April 1, 2022, to expand its scope to include transactions between: 

1. A listed entity and its subsidiaries on one hand and a related party of the listed entity or any of its subsidiaries on the other hand; or 
2. A listed entity or any of its subsidiaries on one hand, and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiaries, with effect from April 1, 2023.

The committee notes that such amendments were "necessitated" to address the mischief or contrivance of effecting a related party transaction without having to comply with the regulations and disclosure norms governing related party transactions (Para 72). 

Such contrivances occur through complex structures of entities and transactions. The amendments to the definitions of "related party" and "related party transactions" in LODR Regulations were ostensibly amended to bring such complex structures and transactions within their sweep (explained in Paras 77–80).

It is evident that the 2018 amendment to the LODR, 2015 by SEBI had facilitated the mischief or contrivances with regard to related party transactions. 

The committee further notes in Para 81 that Section 12A of the Securities and Exchange Board of India Act, 1992 (SEBI Act, 1992) explicitly prohibits contrivances and devices that are structured to bypass the law.

Para 85 of the report reproduces the relevant extracts from Section 12A of the SEBI Act, 1992, as under:

"12A. No person shall directly or indirectly: 

• use or employ, in connection with the issue, purchase or sale of any securities listed or proposed to be listed on a recognised stock exchange, any manipulative or deceptive device or contrivance in contravention of the provisions of this Act or the rules or the regulations made thereunder; 

• employ any device, scheme or artifice to defraud in connection with issue or dealing in securities which are listed or proposed to be listed on a recognised stock exchange; 

• engage in any act, practice, course of business which operates or would operate as fraud or deceit upon any person, in connection with the issue, dealing in securities which are listed or proposed to be listed on a recognised stock exchange, in contravention of the provisions of this Act or the rules or the regulations made thereunder; 

• engage in insider trading; 

• deal in securities while in possession of material or non-public information or communicate such material or non-public information to any other person, in a manner which is in contravention of the provisions of this Act or the rules or the regulations made thereunder; 

• acquire control of any company or securities more than the percentage of equity share capital of a company whose securities are listed or proposed to be listed on a recognised stock exchange in contravention of the regulations made under this Act."

Also read: Hindenburg Adani report fallout: Supreme Court forms committee to review regulatory framework

In effect, therefore, had SEBI investigated the alleged contraventions of the Adani group of companies with regard to the nondisclosure of related party transactions under Section 12A of the SEBI Act, 1992 and the LODR Regulations, 2015 as it existed prior to its successive amendments starting from 2018, the complex structures and transactions between the overseas entities and the Adani group of companies could have been unravelled by now.

However, given the series of amendments to the LODR, 2015, it has become difficult to establish the contraventions. 

The amendments initially opened a loophole by which a promoter group member of a listed company cannot be deemed as a "related party" unless the member's shareholding in the company is at least 20 percent. 

The subsequent amendments brought in 2021, which attempts to partially plug the loophole, have been brought with prospective deferred effect, which cannot be applied in retrospect.

On the whole, Section 12A of the SEBI Act, 1992 has been subverted through the legislative actions of the SEBI. 

The committee states in Paras 92–94 of the report:

"SEBI has also repeatedly submitted to the committee that the transactions may be technically compliant with the letter of the law and it may be difficult to prove a violation in a court of law but the spirit and purpose of the law may have been violated.

"SEBI's pursuit of investigations is based on the premise that it is pursuing the 'spirit of the law', which flies in the face of the prospective amendments with deferred effect that SEBI has made on the legislative side." 

Para 100 of the committee report further notes:

"Since the amendments were not only given prospective deferred effect, but were given an effective date that would start with the next financial year, it is evident that the legislative intervention was a substantial one, taking care to provide listed entities with time to re-arrange their affairs to remain compliant. 

"Therefore it would not be legally tenable to assail transactions that were evidently effected when the newly envisaged substantive law did not exist; on the premise that they violated the law."

This clearly indicates that the alleged contraventions of the Adani group of companies and the overseas entities under investigation vis-à-vis related party disclosures have been rendered compliant with the amendments brought by SEBI in the LODR Regulations, 2015 with regard to the definition of a "related party". 

In other words, Adani group of companies have benefitted from successive amendments to the LODR, 2015 brought by SEBI, and their contraventions cannot be proven unless SEBI's legislative actions are considered mala fide and therefore bad in law. 

The relevant amendments to LODR Regulations, 2015 clearly violate Section 12A of the SEBI Act, 1992 which prohibits manipulative and deceptive devices, insider trading and substantial acquisition of securities or control.

Read Part 2 here.

An abridged version of the article was published in The Hindu as 'Decoding the expert committee report on Adani' on June 19, 2023.