[By Vikram Singh Meena &Rajvi Shah]
The authors are students of Gujarat National Law Univeristy, Gandhinagar.
Introduction
Recently, the Securities Appellate Tribunal (“SAT”) set aside an order by the Securities and Exchange Board of India (SEBI) that would have compelled the National Stock Exchange (NSE) to disgorge Rs. 625 crores as a penalty for violating the SEBI (PFTUP) Regulations, 2003 in the co-location scam. In 2019, the NSE was ordered by the Whole Time Member (WTM) of SEBI to disgorge Rs. 624.89 crores (with interest at the rate of 12% p.a. from April 1, 2014) to the Investor Protection and Education Fund (IPEF), following an investigation by SEBI. SAT while setting aside this order noted that the “WTM had exonerated NSE of the charge of violating SEBI regulations”. The authors seek to analyse the approach of SAT towards SEBI in the NSE Co-location case, considering the amount of penalty involved along with the seriousness of the alleged fraud.
About the scam
In the year 2009, the NSE introduced co-location facilities, offering traders and brokers the opportunity to house their servers within the NSE data centre for a monthly fee. This allowed them to enjoy advantages such as low latency connectivity, faster access to price information, and quicker transaction execution by being in close proximity to the stock exchange servers. A whistleblower claimed in various complaints to the market regulator in the year 2015 that certain brokers involved in algorithmic trading had access to the NSE systems via hardware specifications that allowed them to gain access to the data stream of the exchange in a fraction of a second faster than other brokers. Thus, a trader who connects to the NSE server using the least load would receive updates on buy/sell orders, cancellations, and modifications and traders before those who join the exchange server later. Unlike a broadcast, where everyone receives the pricing information at once, this ‘Tick-By-Tick’ (TBT) data feeds distributed information sequentially in the order the brokers connected or signed in to the server.
SEBI’s order
SEBI issued an order in the NSE co-location case in 2020, which involved allegations of unfair access to the NSE’s trading systems by certain traders, known as “co-location” clients. SEBI’s investigation found that the NSE’s systems and processes were unfair, non-transparent, and discriminatory, thereby violative of the provisions of the SEBI (Stock Brokers and Sub-Brokers) Regulations, 1992 and the SEBI (PFUTP) Regulations, 2003.
In its order, SEBI imposed a fine of Rs. 625 crores on the NSE for failure to ensure fair access to its trading systems. The regulator also barred the exchange from launching any new products or services for six months and directed it to conduct a forensic audit of its systems and processes. The NSE was also directed to put in place proper systems and processes to ensure fair access to its trading systems. SEBI also imposed a fine of Rs. 1 crore on the former Managing Director and Chief Executive Officer of NSE, Chitra Ramkrishna, and Rs. 25 lakhs each on three former executive directors of the exchange – Ravi Narain, R. Srinivasan and C. B. Bhave for their failure to ensure fair access to the trading systems.
The SEBI order also imposed a fine of Rs. 5 crores on SUN Trading and Rs. 25 Lakhs each on three individuals, Rajendra Gupta, Ashok Kumar Jain and R. Venkattesh who were found to have availed unfair access to NSE systems. SEBI’s order also directed NSE to disgorge the amount of Rs. 62.50 crores, which has been calculated as the net profit made by the NSE due to the above-mentioned violation. This disgorgement amount was to be deposited with SEBI within 45 days from the date of the order.
SAT’s order
SAT set aside the order noting that the WTM had exonerated NSE of the charge of violating SEBI regulations. A bench of Justices Tarun Agarwala (Presiding Officer) and MT Joshi (Judicial Member) held in its order passed on January 23,
“In the instant case, the lack of due diligence is not on account of any violation of any provisions of the Act or the Regulations or circulars but is on account of human failure to comply with the circulars completely in letter and spirit…
…WTM has exonerated NSE of the charge of violation of the PFTUP Regulations holding that no fraud was committed by NSE or its employees. We, therefore, find that the activity of NSE was not in contravention of any provisions of the SEBI Act or the Regulations or circulars made therein and it is only a case of non-adherence of a circular to some extent.”
The Appellate Tribunal, however, directed the NSE to deposit a sum amounting to ₹100 crores in the IPEF as a deterrent and as a penalty for lack of due diligence which resulted in -“a lapse which is not expected from a first-level regulator”.
Moreover, SAT overturned the order that prohibited NSE from entering the securities market for six months and ordered NSE to conduct system audits regularly.
Impact Analysis of the SAT order
The entire saga, which is far from over, has taken a new turn since the SAT ruling. The order stated that SEBI’s approach was sluggish and lackadaisical, taking turns based on what transpired on the floor of parliament.
The position of SAT in cases of disgorgement has been constant since the very establishment of the concept. In National Securities Depository Ltd. vs. SEBI, the SAT under the then-Presiding Officer Chief Justice N K Sodhi held that, “persons who have made illegal or unethical gains alone may be required to disgorge their ill-gotten gains.” This was in the context of the IPO scam (Roopalben Panchal Scam), in which SEBI issued a disgorgement order against depositories NSDL and CDSL for failing to conduct adequate due diligence by allowing certain key operators, financiers, and afferent account holders to create multiple demat accounts using photographs from Shaadi.com, and ultimately cornering the retail quota in as many as 21 IPOs. The SAT overturned SEBI’s disgorgement while expressing concerns, criticised SEBI, and urged the regulator to reconsider how it was handling the case. Similarly here, SEBI’s disgorgement judgement against the NSE and individuals lacked sufficient evidence or calculations of illegal or unethical earnings.
The SAT, however, discovered irregularities in the co-location case. In accordance with Rule 21 of the SAT (Procedure) Regulations of 2000, the NSE was fined Rs 100 crores for failing to fulfil the standards expected of a primary regulator. The SAT itself observed that there are no guidelines to measure the violations committed by the NSE, but that the amount is sufficient to serve as a deterrence. The SAT maintained SEBI’s findings against OPG Securities, one of the trading members accused of exploiting NSE flaws, but remanded the matter to SEBI to determine the amount of disgorgement. The SAT determined that OPG Securities continued to use the secondary server despite repeated communications from the NSE to switch to the primary server, gaining an advantage over other trading members in terms of milliseconds and microseconds. Consequently, the SAT held that OPG Securities engaged in unfair trade practices in violation of the SEBI (PFUTP) Regulations, 2003.
The SAT also ordered SEBI to investigate allegations of conspiracy and connivance between OPG and its directors and employees/officials of the NSE. The SAT also upheld the directive of a whole-time SEBI member for the NSE to investigate its employees.
Consequently, the SAT’s criticisms of SEBI from the investigative phase to the issuance of the order by the whole-time member necessitate introspection on the part of SEBI. However, it remains to be seen whether these instructions will result in a re-evaluation of SEBI’s procedures or whether SEBI would fight and prefer an appeal against the order in its entirety or at least to have these remarks removed.
In April 2014, the NSE switched to multicast TBT for order execution in the co-location facility, making a recurrence unlikely. In this context, the Securities Appellate Tribunal’s decision is debatable. The exchange’s new administration may appeal the verdict or learn from it and move on. The Supreme Court will have another chance to set disgorgement limits if the SAT order is challenged.
Conclusion
Due to the fact that they do not make use of co-location services, casual traders and investors are not susceptible to fraud. The security flaw that had been taken advantage of by manipulators has been fixed since April 2014, when the exchange moved to Multicast TBT as its order execution protocol at the co-location facility. Since then, the issue has been eliminated. Yet, taking everything into consideration, one can’t help but question the level of administration and safety at the most prominent stock exchange in the country. SEBI has, over the course of the past four years, been working to address these deficiencies by putting into effect a number of regulatory amendments. Further, it has to be seen if the order is challenged at the Supreme Court or if the issue stands settled with the SEBI learning the lesson.