[By Anushka Aggarwal]
The author is a student of National Law School of India University (NLSIU).
Introduction
Recently, the Securities and Exchange Board of India (SEBI) sent a 31-point advisory to investment bankers via the Association of Investment Bankers of India, the investment banking industry’s representative to SEBI (IPO advisories), which increases the Initial Public Offering (IPO) disclosure requirements and due diligence requirements. This was a part of regulatory advisories that SEBI frequently issues to intermediaries like the AIBI. These advisories operate along with the existing legal framework including the Companies Act, 2013 and Part A of Schedule VI of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. I argue that SEBI’s authority to issue such advisories without a well-defined legal framework opens the door to potential regulatory substitution, i.e., using advisories to perform functions that would typically require a more formal legal framework, such as an amendment. This is concerning given the judiciary’s usual deferential stance toward SEBI which can fail to keep a check on SEBI’s advisory powers, and the implications of this on the securities market: First, the article describes the absence of a clear legal framework governing advisories, and second, addresses the broader implications of this, including how it fails to keep a check on regulatory substitution and contributes to increased transaction costs and inefficiencies within the securities’ market.
The Issue: (Lack of) Legal Framework
The Securities and Exchange Board of India Act, 1992 (SEBI Act) which establishes SEBI and lays down its powers and functions does not use the term ‘advisory.’ Under S. 11A and 11B, SEBI has the power to issue ‘regulations,’ ‘orders’ and ‘directions’ to the securities market. I argue that none of these can encompass advisories. All rules and regulations made by the SEBI have to be tabled before the Parliament under S. 31. The Parliament can modify such regulations or invalidate these. However, none of the advisories issued have been tabled before the Parliament, or their validity subject to such tabling. Under S. 11B, a direction by a statutory authority is like an order requiring positive compliance. However, advisories are typically supposed to be clarificatory, offering guidance to help interpret existing law and align market practices. Whether advisories require positive compliance is unclear. Additionally, ‘directions’ is synonymous with ‘orders.’ Since ‘advisories’ cannot be considered ‘directions,’ they cannot be considered ‘orders’ either.
Thus, the SEBI Act not only lacks a clear framework authorizing the issuance of ‘advisories,’ but also the aforementioned ways of regulation cannot encompass ‘advisories.’ Arguendo, the SEBI Act gives SEBI overarching powers to protect the interests of investors and regulate the securities market, and advisories fall under this general regulatory function. However, the lack of a structured legal framework governing advisories leads to concerns about potential regulatory substitution: The content of the IPO advisories is not limited to guidance but effectively amends a regulation as elaborated upon subsequently, but due to its status as an ‘advisory,’ the SEBI circumvented the need for parliamentary tabling. Further, these advisories may blur the line between informal guidance and enforceable regulation, creating uncertainty. For example, the IPO advisories necessitate that the offer document not in conformity with the advisories shall be returned to the company.
The Relevance: Why is This An Issue?
This section first examines how issuing advisories bypasses the formal processes required for making regulatory changes, such as passing amendments or issuing new regulations, thereby amounting to regulatory substitution. Instead of following the more rigorous procedures that ensure accountability and transparency, advisories are used to introduce changes informally. This may remain unchecked due to the judiciary’s deferential. Second, it analyzes how the advisories increase transaction costs and lead to inefficiencies in the securities market.
1. Regulatory Substitution
Under the IPO advisories, SEBI notified that “any entity or person having any special right under articles of association or shareholders’ agreement should be cancelled before filing the updated draft red herring prospectus.” Before these advisories, such rights were cancelled after the listing of a company as per Regulation 31B of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. These special rights, like veto powers, Right of First Offer/Right of First Refusal, etc., are important for private equity (PE) investors. Retention of special rights, during the critical phase of the company’s transition to a public entity, provides them with a safety net and the ability to influence major decision that could impact their rights vis-à-vis the company. PE investors usually have limited day-to-day control over the company. Their special rights compensate for this by providing mechanisms to protect their investment. Thus, the SEBI effectively amended a Regulation that secures important rights for PE investors through the use of advisories, which are part of an informal framework. This constitutes regulatory substitution because by issuing advisories, SEBI was able to introduce a significant change without going through the formal process that would normally require parliamentary approval. This not only undermines the transparency and accountability checks required for rule-making but also impacts the regulatory landscape. Although SEBI later withdrew the advisory, this action did not fully resolve the issues created by the initial substitution. The next section will explore how these negative impacts cannot be undone by the withdrawal.
The potential for SEBI to engage in regulatory substitution through advisories could remain insufficiently addressed due to the judiciary’s deferential stance towards SEBI. In Prakash Gupta, the court defers to SEBI remarking that SEBI’s actions are guided by public interest and its role in maintaining market integrity and investor protection. The courts have avoided substituting their judgment for that of SEBI, acknowledging the latter’s extensive regulatory and adjudicatory powers, and specialized knowledge. A stronger form of deference is displayed here since the statute was clear that the offences could be compounded (only) by the SAT or a court. The court concludes that SEBI’s consent cannot be made mandatory owing to the language of the statute, but held that the views of SEBI must necessarily be considered by the SAT and the court, and be entitled to deference. The judicial deference here can be contrasted with the Chevron deference, a doctrine of judicial deference to administrative actions in the USA (recently overruled in Loper Bright Enterprises v. Raimondo). Chevron requires the presence of an ambiguity in the statute and then defers to the construction favoured by the executive agency. However, in Prakash Gupta, the court mandates deference to the SEBI’s views and partially upholds the statutory construction put forth by SEBI, in the absence of any statutory ambiguity. The subsequent section shows how the assumption behind the deferential approach, that SEBI’s expertise protects market interests, fails when it comes to advisories due to their negative economic impact.
2. Costs and Inefficiencies
To understand the economic implications, this piece relies on two frameworks: First, it relies on ‘transaction costs’ framework since it highlights how informal advisories can increase uncertainty, legal risk, and compliance burdens for market participants, affecting efficiency. Second, it utilizes the ‘Kaldor-Hicks efficiency’ to assess whether the overall benefits of using advisories outweigh the harm to specific stakeholders, such as investors whose rights are affected. Together, these frameworks help analyze the broader market implications and whether advisories create economic gains or inefficiencies.
Ronald Coase argues that irrespective of the initial allocation of resources, they would ultimately be distributed efficiently and reach a Pareto optimal outcome, provided that transaction costs are minimal or nonexistent. Transaction costs generally refer to the cost of establishing and maintaining the ability to exercise choices over a good. Advisories can make the jurisprudence ambiguous. Under the IPO advisories, the requirement to cancel special rights before filing represented a departure from the established position. SEBI’s retraction increases the ambiguity such advisories can create. During the period between the advisory’s issuance and its withdrawal, the lack of clarity resulted in increased information costs, as parties had to navigate the uncertain regulatory environment and potentially incur expenses to understand and comply with the requirements. Ambiguities regarding the legal status and the enforceability of the advisories lead to additional burdens on the litigants and the courts. Further, whether advisories are intended solely for providing clarifications and guidance (as is typically the case) or if they can impose additional requirements (as seen with the IPO advisories) is unclear. Even if the transactions are assumed to be costless, it is necessary that the rights of the parties be well-defined and the results of legal actions easy to predict to ensure efficiency.
The Kaldor-Hicks criterion questions whether the benefits generated by the IPO advisories are sufficient to hypothetically offset the costs imposed on market participants. Both the form (i.e., the legal framework of advisories) and substance (i.e., the requirements under the advisories) must be examined to determine this. The burdens on lead managers, companies, and investors, due to complex regulations and uncertainties impose significant costs. Greater scrutiny could reduce market participation, or result in delayed listings. However, the increased transparency and reduced conflict of interest due to more disclosures can increase market stability. The difference between costs and benefits could be significant due to the power asymmetry between key players in the securities market, such as IPO issuers and investors, or regulatory institutions like SEBI and IPO issuers. For example, IPO issuers, who have greater control over the information presented in the market, may impose costs in the nature of limited transparency or unfavourable conditions, on investors, who have less power to negotiate and demand changes. Similarly, regulatory bodies like SEBI, through the issuance of advisories, can shift the regulatory burden onto issuers without the latter having the leverage to challenge these informal rules. This imbalance allows the more powerful party to benefit disproportionately, while the weaker party bears higher burdens. Thus, the power imbalance increases the costs due to a lack of clarity and predictability. In such a case, the compensation required to bear these costs could become disproportionately large, with the costs outweighing the benefits, thereby failing the Kaldor-Hicks criterion.
Conclusion
SEBI’s reliance on advisories, the 31-point IPO advisory being one example, raises serious issues about regulatory substitution and its economic implications for the securities market. Instead of relying on formal law-making mechanisms for changes introduced by the advisory, SEBI bypasses the accountability and transparency built into the regulatory process. This not only undermines the regulatory framework but also creates inefficiencies and uncertainty within the securities market. The judiciary’s deferential stance toward SEBI’s actions further exacerbates these issues, allowing unchecked regulatory substitution. As a result, market participants face increased transaction costs and risks, while the benefits of these advisories remain questionable. To enhance fairness and efficiency, a well-defined legal framework should be established to clarify the purpose, scope, and procedural requirements for introducing advisories.