Reconsidering SEBI disgorgement

by Renuka Sane and S. Vivek.

SEBI disgorgement is a regulatory remedy to recover wrongful gains from entities that have violated securities laws. It is justified based on the equitable principle that no one should benefit from their own wrong. This seems like a non-controversial, even obvious, ground for regulatory action that has 'compelling intuitive appeal'. However, there are basic conceptual issues that are not clearly settled, not just India but in other jurisdictions as well. For example, the U.S. Supreme Court has considered three cases on disgorgement over the last few years - in one case, it held that disgorgement was beyond the powers of the Federal Trade Commission, overruling decades worth of practice, and in another, upheld Securities and Exchange Commission's power to seek disgorgement but with important conceptual restrictions.

These are trends that the Securities and Exchanges Board in India (SEBI) should be watching carefully. Lack of conceptual clarity about the remedy can put years of regulatory action at risk, if the basis of the remedy is questioned in a case before superior Courts. Further, a study of how SEBI orders are interpreting disgorgement powers and if they are consistent with the conceptual justifications is critical. SEBI disgorgement does not have any statutory limit - the order can direct recovery of all the wrongful gain, whatever they may be. This exercise of of vast discretion by SEBI Whole-Time Members (who are executive members of the regulator and typically do not have substantial judicial training), without transparent statutory or conceptual guidance, raises regulatory governance concerns.

In a new working paper, Reconsidering SEBI disgorgement, we study disgorgement from three perspectives:

1. The theory of disgorgement: Disgorgement is a distinct remedy that must be distinguished from other remedies such as compensation, restitution, and penalties. Disgorgement is different from compensation because compensation is focussed on the loss suffered by claimants whereas disgorgement is focussed on the gains made by the wrongdoer. While disgorgement and restitution are both gain-based remedies, there is a subtle yet important difference. Restitution is focused on reversing a wrongful gain of the defendant based, for example, on a wrong or incorrect transfer from the plaintiff. Here, the (wrongful) gain made by the defendant is equal to the loss suffered by the plaintiff - the property in question (money, for example), is returned to status quo. Disgorgement, on the other hand, strips the defendant of its gains, even if such gains are not made from the plaintiff, and even if the plaintiff does not suffer any loss. Accordingly, the loss suffered by the plaintiff need not correlate to the defendant's gain that is clawed back through disgorgement. The objective for disgorgement is to have a deterrence effect, and not to merely reverse an illegal transfer. Penalties are also generally imposed for the purpose of deterrence, among others. However, while disgorgement amounts must be equal to the gains made by the wrongdoer, penalties can be imposed merely on the basis of the violation and need not correlate exactly to the gains, if any, made by the wrongdoer.

2. The evolution of disgorgement at SEBI: SEBI had even in the early years tried exercising powers to claw back illegal gains (disgorgement), or compensate victims in insider trading cases, with mixed success at appellate fora. Subsequently, parliamentary and expert committees over the years have recommended providing SEBI with clear powers to trace the illegal gains made by wrongdoers and return such gains to their victims. Before such powers could be formalised through statute, disgorgement was used by SEBI Whole-Time Members (WTMs) as a quasi-judicial innovation in their orders,and received approval from the Securities Appellate Tribunal. Since, at that time, SEBI WTMs did not have the power to impose monetary penalties, SEBI disgorgement was justified as a 'remedial' power which only returns the wrongdoer to status quo, and hence can be distinguished from a punishment. Further, as there was no express statutory provision at the time for SEBI disgorgement, it was traced back to 'equitable' powers of SEBI WTMs.

   In 2014, the Securities and Exchange Board of India Act, 1992 (SEBI Act), was amended to clarify that SEBI disgorgement was part of SEBI's remedial powers. The amendment also stated that the amounts so clawed back are not to be deposited with the Consolidated Fund of India as in the case of penalties; instead, they are retained by SEBI's Investor Protection and Education Fund, to be used in terms of SEBI's own regulations. Interestingly, despite tracing its origins to Parliamentary and expert committees which discussed disgorgement powers in the context of using the proceeds to compensate victims, the amendment did not require SEBI to even attempt to distribute the amounts to victims. Since then, SEBI's power to direct disgorgement without clear statutory limits has been entrenched. Gradually, SEBI also received judicial recognition for its power to impose interest on the disgorgement amount. These rates are calculated from the date of the violation, sometimes going back 10 years or more (as opposed interest on penalties which is typically calculated from the date of non-payment after the SEBI order). Further, the initiation of proceedings for disgorgement or penalties, remains with SEBI and it is unclear how it is exercised.

   These vast powers are conferred on the regulator on the basis that SEBI disgorgement is only 'remedial' and is returning the wrongdoer to status quo. The use of the term 'disgorgement' while at the same time emphasising the return to status quo creates some confusion between the related albeit distinct remedies of disgorgement and restitution. In this context, we study whether in practice what kind of remedy SEBI disgorgement actually is, regardless of its nomenclature. Further, as a legal matter, returning the wrongdoer status quo is critical as a point of distinction from SEBI penalties; if the wrongdoer is left worse-off, it could be argued that SEBI disgorgement is a penalty by another name.

3. The practice of disgorgement at SEBI : If SEBI's case for disgorgement is based on clawing back illegal gains and returning the wrong-doer to status-quo, do they actually do so? We use all the SEBI disgorgement orders between January 1, 2018, and July 15, 2021, and find that in 9% of the cases there is no finding that the noticee has made a benefit or avoided a loss, and yet noticees have been ordered to disgorge. In none of the cases is there a finding that the direction brings the noticee back to status-quo and does not leave them worse off - a critical element in the justification for SEBI disgorgement and its characterization as a remedial power. Further, it is interesting that SEBI disgorgement is usually used for insider trading, and fraudulent trading offences, for which the SEBI Act allows penalties to be issued up to three times the profits made. Why is disgorgement, and not penalties, being used in these cases?

Our results suggest that lawmakers and the SEBI Board must review how SEBI disgorgement is conceptualised and what goals it serves. It should scrutinise how disgorgement orders are being issued under the existing framework so that they are consistent with the justifications for remedial measures (such as, allowing deductions for legitimate expenses and a transparent and careful system to determine causation of the gains from the wrong). A holistic look at remedies available for securities law violations is required so that they serve all the goals required for stakeholders - deterrence, compensation, and restitution.

S. Vivek is a researcher with the Regulatory Governance Project at the National Law School of India University, Bengaluru. Renuka Sane is a researcher at NIPFP. Author names are in alphabetical order.

Threats to legal certainty in government contracting by electricity distribution companies

by Akshay Jaitly and Ajay Shah.

A battle in Andhra Pradesh, 2018-2022

In September 2018, electricity distribution companies in Andhra Pradesh (Discoms) filed a petition before the Andhra Pradesh Electricity Regulatory Commission (APERC) to reduce the feed-in tariff for wind power projects (that had been determined under Section 62 of the Electricity Act, where the regulator sets the price). Another petition was filed requesting APERC to revise the tariff payable by Discoms under solar power PPAs (this time discovered under Section 63 of the Electricity Act, where there is a competitive bidding process). The argument made by Discoms was that the tariff discovered in other states pursuant to competitive bidding was lower than the tariffs statutorily determined in Andhra Pradesh. There are also newspaper reports about the state load dispatch centre (SLDC) curtailing output by renewables generators, ostensibly in the interests of grid safety.

These attempts at reneging on contracts, by the state, go against basic notions of sanctity of contracting and legal certainty. When X contracts with Y, both are bound by and obliged to fulfil the terms of the contract, regardless of future fluctuations of prices and technology. The Indian Contract Act, 1872, and a line of case law under it, gives no space for either X or Y, as private persons, to renege on a contract because better prices had come about somewhere else in the economy.

It is also settled law that when the state enters into a contract, it does so in a commercial capacity and not as the sovereign. If the Indian state purports to renege on contracts in this fashion, it deepens the problems of the state as an untrusted counterparty, and fewer private persons will be willing to do business with the state in the future. This would harm the prices at which the state is able to enter into contracts.

As an example, consider a Jan 2022 story by Kailash Babar in the Economic Times, about NHAI terminating a contract with IL&FS which had been established in 2013. NHAI did not just walk away: it paid IL&FS Rs.891 crore for the privilege of terminating the contract. Concessions typically have a formula for termination compensation in three scenarios – authority default, no fault and concessionaire default. These are expressed as percentages of debt due plus some equity return and some other terms.

Attempts at reneging on PPAs elsewhere in India

This experience from Andhra Pradesh is actually not unique. Discoms and regulators in Karnataka, Uttar Pradesh, Jharkhand and Tamil Nadu have subsequently attempted unilateral termination or renegotiation of renewable energy tariffs under validly executed PPAs.

Punjab took this one step further in November last year, by introducing and unanimously passing legislation to get out of its PPA obligations. A few months ago, we wrote about the Punjab Renewable Energy Security, Reform, Termination and Re-Determination of Power Tariff Bill passed in the Punjab Legislative Assembly. This law seeks to renege on PPAs that the Punjab state Discom had voluntarily entered into, on the basis that these created too heavy a financial burden on the state. This attempt by the state, to have immunity from contract performance, is under legal challenge.

A seminal skirmish took place a while ago, in Gujarat in 2013, where the Appellate Tribunal for Electricity had held with reference to the actions of a Discom in Gujarat, that a PPA could only be reopened for "giving thrust to renewable energy projects and not for curtailing the incentives". In other words, PPAs could not be reopened to reduce tariffs. In this case, Gujarat Urja Vikas Nigam Ltd (GUVNL) had filed a petition before the Gujarat Electricity Regulatory Commission (GERC) in 2013, asking for a revision in solar tariffs determined by the commission in its 2010 order on the grounds of reduced customs and excise duties, which would justify a downward revision of the tariffs. The GERC dismissed GUVNL’s petition and its decision was upheld by the Appellate Tribunal for Electricity (APTEL) on appeal. APTEL held that since GUVNL had not established that there is a legal right available to it to seek a redetermination of the tariff by reopening the PPA, the GERC would not be expected to revisit the generic tariff ‘to dis-incentivise the project developers and consequently discourage future investment in the sector’.

How the Andhra Pradesh story played out

Despite this, solar and wind power developers challenged this in the High Court of Andhra Pradesh. A single judge bench of the High Court dismissed the Discoms' petitions in September 2019, with a direction to APERC to decide the issues raised by the developers.

But the High Court directed the Discoms to pay an interim tariff (lower than the tariffs under the PPAs) until APERC adjudicated the matter. The legal foundations through which the court chose to go against contract law are not clear. This created tremendous commercial difficulties in the industry. In some instances, there are reports that even this lower interim tariff was not being paid by the Discoms, causing further distress to power generators.

The typical renewables project is a tight arrangement of capital and PPA, with little room for contracting wobbles. Once the predictability of cash flows was disrupted, some of the generating assets were classified as 'non-performing'. The generators tried to go to court to force lenders to not do so.

This problem then showed up at a Division Bench at the Andhra Pradesh High Court. The case played out over three years. The Division Bench held that:

1. The tariff under concluded PPAs cannot be re-negotiated;
2. Financial difficulty of Discoms is not a ground to permit non-performance of the PPAs or to reduce the tariff set out under the PPAs;
3. A tariff determined through competitive bidding process under Section 63 of the Electricity Act cannot be re-determined; and
4. Since renewable energy plants operate on a ‘must-run basis’, any arbitrary curtailment of power by the state load despatch centre without notice and not based on grid security or safety reasons is illegal.

This was a salutory reaffirmation of the foundations of commercial law: Contracts must be honoured, statutory processes cannot be unilaterally set aside, power validly contracted under a PPA can only be curtailed for technical reasons. At the same time, in a well functioning market economy, these events from 2018 to 2022 -- and the associated commercial consequences for private persons -- should have never taken place. Every investor looks at this fracas and chooses a somewhat higher risk premium for doing business in India.

Implications for the Indian legal system

It is important to analyse what shapes these attempts at state immunity from contract law. In what ways can laws be amended, or principles be evolved, so that such attempts are eliminated or at least minimised?

Perhaps the Andhra Pradesh Discoms will appeal to the Supreme Court of India in this matter; perhaps the challenge to the Punjab PPA law will find its way to the Supreme Court. It is then interesting to envision: What is the Supreme Court order that can usefully underline the foundations of the extant contract law, and thus reduce the incentives to embark on such manoeuvres?

While a Supreme Court order in this regard might act as a deterrent in the future, the problem lies in the culture of government institutions, who are conditioned to exhaust all available means of reducing costs, irrespective of the merits of their position and the chances of success, out of fear of vigilance authorities. A solution would be for the government to develop guidelines and instructions setting out the bases on which appeals should be pursued or not.

In developing such guidelines, some of the questions for the state to consider would be as follows: Suppose the probability of success of such attempts at renegotiating are 0. Is it still efficient for a state government to initiate it? As Karan Gulati and Shubho Roy emphasise in a forthcoming paper, could it be that the time value of money that is used in Indian court orders make it efficient for the state government to embark on litigation that it has no possibility of winning? We need to also analyse the Indian justice system from this point of view, and identify the reforms through which the incentive of a state government is reshaped.

Implications for electricity policy

As we have argued before, the Indian electricity sector has suffered from difficulties for a long time, but the recent years represent an escalation of stress to a different level. This comes from the combination of low price renewables, volatility in fuel costs, the impact of ESG investors abroad upon electricity purchase by large Indian firms, and the accelerating exit of commercial and industrial buyers from discoms.

It is sometimes comforting to think that discoms in India have always had problems. But the problems seen today are worse. Faced with extreme stress, there is an appetite for extreme measures. When the policy process is weak, there is a greater likelihood of poorly designed policy measures being adopted, such as attempts at reneging on contracts. When even a few discoms engage in such behaviour, this reduces the investability of the Indian electricity sector in areas that have connections with the Indian state.

We should see each of these eruptions as illustrations of the underlying stress, and reorient ourselves towards the required fundamental electricity reform.

We thank Charmi Mehta for research assistance on this article.

How "Orderly" is the Evolution of the Indian Yield Curve?

by Harsh Vardhan.

"Financial market stability and the orderly evolution of the yield curve are public goods and both market participants and the RBI have a shared responsibility in this regard."

Shaktikanta Das, Governor, RBI, October 2020

"Right from October 2020, we have given explicit guidance to the bond market. We expect an orderly evolution of the yield curve, it cannot be otherwise,"

Shaktikanta Das, Governor, RBI, February 2021

As the Covid pandemic has ebbed, central banks across the world are withdrawing the extra-ordinary easy monetary policy that was followed by them since the onset of the pandemic. Reserve Bank in India (RBI) is no exception. A week ago, it took the extra ordinary step of convening an ad-hoc meeting of the monetary policy committee (MOC) to hike the policy interest rates by 40 basis points and also increase the cash reserve ratio (CRR) for banks to take out liquidity from the banking system.

As this “normalisation” of the monetary policy unfolds, its impact on the financial stability has become a matter of concern. The statements of the RBI Governor quoted above, reflect the concern RBI has on financial stability and the evolution of the yield curve. While financial stability is a broad, all encompassing term, evolution of the yield curve is a much more specific idea that can potentially be objectively assessed. In this article I try to assess the orderliness of the evolution of the yield curve over the last four years.

Yield curve describes the basis interest structure in the economy. As the central bank takes policy actions bonds markets reprice the yields and the shape of the yield curve changes. As a fundamental input to pricing of a wide array of assets, predictable and orderly evolution of the yield curve is indeed desirable. High volatility and unpredictability in the evolution of the yield curve, especially when the policy actions taken to normalise monetary policy and regain the GDP growth trajectory post the pandemic, could result in mispricing of financial assets. RBIs concerns and expectation of such orderly evolution are understandable.

In this article, I try to assess the orderliness of evolution of the yield curve. I use data on the yield curve for the 4-year period of 1 April 2018 to 10 May 2022 to empirically assess how the yield curve has changed during this period. To be clear, this article does not evaluate the merits of the RBI’s intent or efforts at managing the yield curve; it only attempts to empirically assess how the yield curve has behaved over this period.

Assessing the evolution of the yield curve:

While it is easy to understand why policy makers would want the yield to evolve in an “orderly” manner in response to policy actions, it is not very easy to define what exactly an orderly evolution means. Trading in government securities takes place every day where all types of financial institutions participate. Even the RBI, through its treasury operations and open market operations participates in the government bond market. The collective actions of all these players determine the prices of government bonds and hence the yield on them.

We could hypothesise orderly evolution to mean that the daily changes in the yields across the curve are smooth and stable. There are two parameters we can look at the describe such smooth and orderly evolution – the volatility of daily yield change and the correlation of changes in yields across varying maturities. If the volatility of daily change in yields remains low and the correlation of yield changes across maturities is high, then it would mean that the yield curve is moving with the policy rates, in a non-disruptive and predictable manner. Such a yield curve can be considered as evolving orderly. On the other hand, increased volatility of daily change and reduced correlation would signal increase in the “disorder” in the evolution of the yield curve.

Data and analysis:

The data for this analysis is the daily yields data on the 3 month treasury bills (T Bills), 1 year, 3, year, 5 year, and 10 year maturity government securities (GoI securities) from 01 April 2018 to 10 May 2022, a total of 993 trading days of data obtained from Bloomberg. Of these maturities the 10-year securities are the most liquid and provide data for every trading day. For the other securities there are days where there would be no trading and hence no data would be available. We consider the previous days yield to continue for such non trading days which means that the change in yields for such days is considered to be zero.

For the purpose of my analysis, I divide the data into 4 time periods as follows:

The first period is from 1 April 2018 to 11 February 2019 which can be called the "pre low interest rate" period. RBI started cutting policy rates from February 19 up until May of 2020. Hence this is the period of stable policy rates. This period has data for 215 trading days.

The second period is from 19 February 2019 to 31 October 2020 is the "downward policy rates and pandemic period" when policy rates were reduced regularly to hit the lowest rate of 4% of repo by May 2020. I extend the period to Oct 31,2020 as RBI clearly started focusing on orderly evolution from October onwards. This period gives us data on 411 trading days.

The third period is from 01 November 2020 to 31 December 2021 which starts with the date of RBI publicly announced its focus on orderly evolution of the yield curve and ends with roughly the end of the pandemic and the reopening of the economy. While the end date is admittedly somewhat arbitrary it coincides with global trend towards rising rates that started in January 2022. This period gives us data on 282 trading days.

The fourth and the shorted period is from 01 January 2022 to 10 May 2022 is the last period where Indian interest rates started inching up (along with interest rates across the world). It includes a few days of data post the surprise, out of turn policy rate hike in May 2022. This period has data on 85 trading days.

For each of these four periods, I compute the following:

• Daily change in the yields of each of the four maturity GoI securities.
• Average daily yield change and the standard deviation of the change in the daily yield which I use as the measure of volatility of the daily change.
• Correlation between yield changes of these 4 GoI securities.

Results:

Figure 1 below presents a chart of the daily yield change in these 4 securities over this entire period of little over 4 years and 993 trading days.

Figure 1: Daily Change in Yields on GoI Securities in Basis Points

Source: Bloomberg, author’s analysis

Overall, the chart shows that the volatility of the daily change seems to go up with the onset of Covid in March 2020 with larger and more frequent spikes. This is especially true for the lower maturity; the 3 year and the 1 year maturity securities.

In order to understand the trends in the pattern of the daily change in yield, I plot the 30-day moving average of the daily change in yield as presented in Figure 2 below.

Figure 2: 30 Day Moving Average of Daily Change in Yields on GoI Securities in Basis Points

Source: Bloomberg, author’s analysis

Figure 2 clearly shows a pattern in the changes in the yield curve. The first period has much smaller change daily change in the curve and the changes across maturities are fairly highly correlated. The second period shows much more volatility in the daily change and a significant reduction in the correlation between yield change across maturity. This volatility comes down in the third period and the correlation improves, probably as an outcome of RBIs repeated exhortations and possibly actions in the bond market. The last period shows further reduction in volatility but the correlation is still lower than in the first period indicating that RBIs notices to the bond market and actions have had some success.

In order to more concretely understand the volatility and correlations across these periods, next two charts present the mean daily change in yields and the volatility of the daily change measured as the standard deviation of the daily change in yield.

Figure 3: Mean Daily Change in Yields on GoI Securities

Source: Bloomberg, author’s analysis

This chart clearly describes the interest rate trends in these four periods. The first period had, by and large, stable yield curve with very small changes in yields. The second period shows a secular decline in interest rates across all maturities in response to policy rate changes. The third period shows a reversal of trends and modest rise of interest rates ie the upward movement of the yield curve which becomes much more pronounced and sharper in the fourth period.

Figure 4: Volatility of Daily Change in Yields on GoI Securities

Source: Bloomberg, author’s analysis

This chart shows that the volatility of yield changes has indeed gone up noticeably in the third period when the overall rates showed an increase. The volatility increased especially for the shorter maturity papers – 1 year and 3-year maturity. This probably is the basis of the RBIs focus on ‘orderly’ evolution and hints to the bond market of its discomfort with high volatility. The fourth period shows that the elevated volatility has persisted which means that the bond market has responded only modestly to the RBI’s exhortations. Another important feature to note is that the volatility of the 10 year and the 5 year maturity securities has been contained in the third and the fourth period while that of the shorter maturity securities has continued to remain high. This possibly could also be due to RBI’s targeted interventionsh in the bond market to contain the rise and volatility of yields on long term securities.

Finally, I look at the correlations of yield changes across these maturities. Table below presents the correlation matrix of the four periods.

Table: Correlation Matrix for Yield Change in GoI Securities of Varying Maturities

Source: Bloomberg, author’s analysis

The correlation matrix shows high correlations between yield changes in the first period that start going down in the second period and decline precipitously in the third period. While they improve in the fourth period, they are still below the high levels of the first period. Clearly, the yield curve moved more haphazardly in the third period with high volatility and low correlation between yield changes across maturities. The fourth period shows improvement in correlations probably due to RBIs constant notices to the bond market (and its possible interventions in the market), they do not reach the levels of the first halcyon period.

Conclusion:

This data shows that RBI concern on orderly evolution of yield curve is well placed. The data clearly shows that in period 2, as the policy rates came down, the yield curve volatility shot up. It may well be that the RBI’s focus during this time was on keeping the long-term interest rates low to facilitate economic recovery during the pandemic. The bond market, on the other hand, was concerned about the economic impact of the pandemic and resulting tussle between the RBI and bond market participants actions resulted in increased volatility and break down of correlations in yield movements across maturity. RBI became aware of this volatility towards the third quarter of fiscal 2022 and realised that low rates will not be enough for economic recovery and the excess volatility must be curbed. As it started expressing its desire of an orderly evolution (accompanied possibly by market interventions) there was a modest decline in volatility and improvement in correlations. However, the markets are still not anywhere close to the halcyon pre-pandemic period.

Harsh Vardhan is an independent management consultant and researcher based in Mumbai. The author thanks Surbhi Bhatia for research assistance, and Josh Felman and anonymous referees for very useful comments