M J Antony: Big stick for errant mutual funds

OUT OF COURT

Violation of regulations would automatically invite penalty, rules the Supreme Court.

While the share market was experiencing inexplicable convulsions last month, the Supreme Court delivered a judgement which emphasised the need for enhancing investor confidence in the context of mutual funds. "Investors' confidence in the capital market can be sustained largely by ensuring investors' protection," the court stressed while justifying the imposition of monetary penalties in addition to other penal steps against mutual funds.

The court was examining the obligations of financial institutions towards its clients in The Chairman, Sebi vs Shriram Mutual Fund. Unfortunately in this case, the Securities Appellate Tribunal had passed an order which set "a serious wrong precedent" by curtailing the power of Sebi in hauling up the erring mutual fund companies. The Supreme Court set it aside and gave full statutory powers to Sebi to take action against such companies.

In this case, the mutual fund company had violated several regulations passed by Sebi from time to time. One of the main charges was that it had conducted business through brokers associated with its sponsor in excess of the permissible limits prescribed under Regulation 25(7)(a) on 12 occasions. It had also failed to comply with the terms attached to the certificate of registration which are statutory in nature, as prescribed by Regulation 15(D)(b) of the Sebi Act. Therefore, Sebi held an enquiry by the adjudicating officer who imposed a hefty fine on the company for the infringement of the regulations. The company moved the appellate tribunal, which set aside the penalty. Thus, Sebi came up before the Supreme Court. The mutual fund did not appear in the court.

The main ground on which the tribunal set aside the penalty was that the mutual fund had no guilty mind and it had not acted with deliberate mala fide intention while transgressing the regulations. The Supreme Court rejected this, citing several of its own judgements on economic laws.

A guilty mind or culpable intention is required only in criminal cases. In dealing with civil obligations, this test would not apply. The appellate tribunal confused the legal requirements while applying principles of criminal law to civil obligations. The rule is well settled by the Supreme Court. For instance, in a case of Foreign Exchange Regulations Act (Directorate of Enforcement vs MCTM Corporation Ltd, 1996), the Supreme Court explained that it was not necessary for the directorate to prove the guilty intention on the part of the company. It can impose penalty if the "blameworthy conduct" of the company is established and there was "wilful contravention" of the provisions of the Act.

This rule applies in other areas of economic life such as labour laws, sales tax, income tax and acquisition and merger of companies. In JK Industries Ltd vs Chief Inspector of Factories (1996), the Supreme Court said that the "omission or commission of the statutory breach itself is an offence. Similar type of offences based on the principle of strict liability exist in many statutes relating to economic crimes as well as in laws concerning the industry, food adulteration, prevention of pollution and the like in India and abroad." The same point was emphasised in a sales tax case in R S Joshi vs Ajit Mills Ltd (1977) and in an income tax case in Gujarat Travancore Agency vs Commissioner of Income Tax (1989).

In a recent case of acquisition, Swedish Match AB vs Sebi (2004), the Supreme Court pointed out that according to Section 15-H, it is mandatory to impose a penalty of Rs 25 crore for the breach of the rule. The board has no discretion and the adjudication proceeding is a mere formality. Therefore there was no need for proving a guilty mind in such cases.

In the Shriram Mutual Fund case, the Supreme Court stated that the tribunal's order "set the stage for various market players to violate statutory regulations with impunity and subsequently plead ignorance of law or lack of guilty mind to escape the imposition of penalty." The rule was meant to give teeth to Sebi to secure strict compliance of the rules.

Even with the present investor protection laws, the small investor has a sorry tale to tell. Recently, a housewife wrote several letters to Sebi, the Association of Mutual Funds in India and the ombudsman to get back the money she had paid to a Pune-based mutual fund. The company did not send the documents nor return the investment for many months, ignoring several legal notices. Sebi merely gave computer-generated numbers for her complaints without any action being taken. The Association of Mutual Funds did not even acknowledge her complaint. The ombudsman can only settle claims once they have arisen. In such a state of apathy to the helpless investors, provisions like 15C (failure to redress investors' grievances) and 15D (default in case of mutual funds) of the Sebi Act appear to be mere soporific to deceive investors. The Shriram judgement should act as a wake-up call to such errant firms.