Summary: Sebi has released two orders which will ask the National Securities Depository Ltd (NSDL) to conduct internal inquiries into systemic and procedural lapses that led to the IPO scam reaching such large proportions without being detected. Though the committee has clarified that its action is not punitive in nature, which might make one wonder what the fuss was all about, the issue is how individual responsibility –as asked by the committee- will be determined.
The common thread in these orders is that existing systems and procedures and due diligence were inadequate and that NSDL viewed its role in a very narrow sense. The inquiry could lead to the very top, as the people who were responsible for setting up the systems and processes will ultimately have to own up responsibility for these lapses. This case has been full of twists and turns. Now, it remains to be seen how this order is implemented and whether it will lead to further litigation. Sebi too gets a slap on the wrist.
Sebi’s board has decided to release the 2-member committee’s report on the IPO scam, ending a rather unusual event in its history. Sebi is the Securities and Exchange Board of India, India’s capital market regulator. Mohan Gopal and V Leeladhar had been asked by Sebi to submit a report examining NSDL’s failure to put in place systems that may have helped prevent the IPO scam. This was after NSDL’s chief CB Bhave moved over as Sebi chairman, and these cases were handed over to a specially constituted committee for this purpose.
When this committee submitted its report, the board took a view, based on legal opinion, that it had exceeded its brief, and held the report as not being valid as a result or as the board then said, ‘non est’ or non-existent. Sebi has released these orders now, following a Supreme Court order.
The orders make for interesting reading; there are two of them, one pertaining to NSDL and the IPO scam and the other on NSDL and DSQ Software.
NSDL and the IPO Scam
Issue: NSDL had been issued 5 interim directions. The committee had to decide whether to affirm them.
Committee: Three of them have already been implemented by NSDL, to prevent further misuse of depository accounts and inspection and action against depository participants. Two directions remain. One, unnamed promoters of NSDL and CDSL were directed to take further action, including revamp of management. CDSL is the depository promoted by the BSE. The committee has relied on a view that these are prima facie observations rather than directions that need to be affirmed. So it has not decided to enforce the interim order’s observation on change of management.
Issue: Does Sebi need to take further action against NSDL under existing laws. Ten key areas of NSDL’s operations and systems had been examined.
Committee: The committee went into each of them to see and has found NSDL wanting in some areas, and has also said that Sebi too could have been more vigilant. It talks about the supervisory role of a depository under law and that it is not merely a technology-driven facilitator. While NSDL may have followed Sebi’s instructions, it could have been more proactive in its approach to its role as a depository.
The committee decided that NSDL should conduct an independent inquiry, with the terms of reference finalised in consultation with Sebi, to establish individual responsibility for NSDL’s failure to meet its responsibilities.
The inquiry should be completed within 6 months of the date of the order and this order should be provided to the NSDL board and to Sebi. NSDL’s board would have to take further action and inform Sebi within 3 months. Now, the order was issued on 4 December 2008, but has been released now. So it is not clear if the 6-month period will start now.
NSDL should also conduct an audit of its operations in several identified areas, including selection of DPs, opening of DP accounts and KYC systems, and supervision. This report too should be submitted within 6 months and NSDL assess the findings of the audit and report to Sebi, with proposed measures necessary to remedy deficiencies within 3 months.
Sebi under fire
The committee also expressed concern that Sebi did not carry out its role as a regulator adequately, pertaining to the IPO scam. It has recommended that SEBI should issue a code of conduct for depositories and it should also ensure that ‘an assessment of the adequacy of institutional arrangements to ensure the integrity of the depository system’ is done independently. And, where merited, changes are implemented.
The committee has clarified that the order is not punitive in nature, that is it should not be treated as a punishment, but to ensure that the regulatory framework is strengthened to prevent recurrence of a scam of this kind and magnitude.
NSDL and the DSQ Software scam
Sebi had conducted an investigation into price manipulation at DSQ Software. As part of this enquiry, NSDL’s role in the dematerialisation of DSQ’s shares was examined. The charge was that it failed to exercise due diligence in the process.
NSDL had stated that the inspection order did not state the deviations from laws, rules or regulations which it was supposed to have done.
Issue: NSDL did not seek clarification on discrepancies in details given in the form, for dematerialisation of shares issued under preferential allotment to 4 entities
Committee: The committee said that NSDL did not ensure that the required information was available while the dematerialisation was done. It should have sought clarifications on the discrepancies visible in the forms.
Issue: NSDL did not apply the lock-in for 30 lakh shares issued via the employees stock option plan
Committee: NSDL’s explanation that the Esop guidelines do not mandate a lock-in of shares (but only that one year should elapse after grant of options before they vest) was accepted.
Issue: Failure to obtain information on listing applications prior to delisting
Committee: NSDL should have insisted on disclosure of the proposed dates of listing on the stock exchanges.
Issue: Failure to ensure that shares were credited after valid allotment and receipt of consideration.
Committee: NSDL’s explanation that it had acted upon instructions issued by the RTA was accepted. But the system for guarding against fraud of this nature was found to be insufficient.
Issue: NSDL’s safeguards to prevent manipulation of records were inadequate.
Committee: NSDL’s submission was accepted, that it maintained records as sent by the company and there was no reason or legal requirement to go into every issuer’s transaction to verify if they had complied with all requirements.
Issue: Failure to protect the interests of beneficial owners
Committee: NSDL’s submission that it had taken adequate measures, including insurance, to protect the interests of beneficial owners, and that it cannot be held responsible for fraud committed by the issuer company was accepted.
Issue: Issuance of fresh shares in demat form without listing.
Committee: The committee took a view that NSDL should have verified the contents of the forms submitted while dematerialising shares. It should have put systems in place to ensure that unlisted shares are not issued. While stock exchanges should ensure that shares which do not have listing approval are not traded, depositories should ensure such shares are not delivered for settlement through the depository system.
The NSDL board has been asked to conduct an internal inquiry, with the terms of reference specified in consultation with Sebi. The inquiry will pinpoint individual responsibility for NSDL’s failure in ensuring that securities not approved for listing were not delivered in settlement. It will complete the inquiry in 6 months and submit to the NSDL and Sebi boards, and NSDL’s board will take follow-up action in 3 months.