In a judgement delivered on Monday, the top court in the country distilled a legal principle that sets a premium on compliance with regulations and contractual commitments and cuts no slack for overstepping them even if there was commercial wisdom in doing it.
Though rendered in the context of the ‘funds’ industry, there is wider relevance to it. Managers entrusted with public funds shall strictly operate within the scope of the relevant mandate and the regulations governing the construct.
This decision arose in the context of the action initiated by SEBI (the Securities and Exchange Board of India) against Kotak AMC (Asset Management Company) and some of its senior officers for failure to comply with the terms of some of the fixed maturity plans (FMP) schemes.
FMP have set dates for returning the money to its investors who invest on the faith of the mandate that promises liquidity on a specified date.
Some Kotak FMP schemes invested a portion of their corpus in bonds issued by a few companies in the ESSEL group of which Zee TV is a part. These companies, with little financial strength to borrow, offered the shares of Zee Entertainment Enterprises Ltd as collateral.
When the issuers defaulted and the collateral itself declined in value, Kotak chose to negotiate an extension of repayment instead of immediately enforcing the security. Thus, a portion of the investors’ funds was not returned as committed.
Kotak was not the only fund house caught in this crisis. Franklin Templeton was another AMC involved and that story has been covered before in this column.
The violation of the schemes’ mandate triggered penal action by the SEBI against the AMC and some of its officers.
The defence offered was that the AMC’s action of negotiating a deal with the issuers and not resorting to the fire sale of the collateral helped secure better returns to the investors.
Seized of the issue, the SCI (Supreme Court of India), in a crisp but categorical decision, left no room for debate when compliance with regulations and adherence to the investor mandate are concerned.
Substitution of managerial discretion even to benefit the investors was frowned upon if the letter of the regulations or the mandate of the investor was not respected.
The AMC was obliged to liquidate all the investments and return the proceeds to the unit holders and it enjoyed no leeway to look for optimising the return to the investors.
Pithily put in the words of the judges: “Any breach committed to avert loss in the given circumstances does not find favour in law. Compliance with the regulatory mechanism being mandatory and non-negotiable, it is no valid defence that compliance with law would have resulted in loss.”
The court also rejected the defence that other AMCs too had invested in Essel entities and delayed redemption. In the Court’s voice “Illegality is not cured by numbers; a collective wrong remains illegal, regardless of majority.”
Kotak also attempted to justify its actions by drawing an analogy with SEBI’s side-pocketing (segregated portfolio) framework. The court rejected the comparison because Kotak had neither complied with the statutory requirements for invoking that framework nor even adopted that position before the lower authorities.
The judgement also highlights the Court’s concern that the regulator had not been kept fully and promptly informed, underlining that procedural transparency is not an optional regulatory courtesy but an integral compliance obligation.
More than the confirmation of the monetary penalty levied on the AMC and the officers, the Court’s observation with regard to two aspects in the manner of conduct of the case should concern the board of the AMC and its IDs:
The first, not all papers submitted before the previous levels were produced before them. The judges said that “they were not impressed by the selective non-disclosure.”
The second, possibly more disquieting; the senior counsel had provided extracts of the regulations for ease of reference of the bench but the same were not complete.
The Court’s take - “The omission could be deliberate; it could also be a mistake. We say no more than is necessary. Such omission, at times, could be viewed with suspicion by the court. We caution the appellants to be more vigilant in future and thereby avert reoccurrence of such mistake.”
A lot gets written about artificial intelligence (AI)-generated hallucinations finding their way into court filings. This case raises an altogether different concern—not fabricated precedents, but edited presentation of authentic material by human hands!
The larger significance of the judgement lies beyond the funds industry of mutual funds, REITs, InvITs, etc, that strictly need to adhere to the investor mandate.
It is a reminder to directors, trustees, compliance officers and advisers alike that regulatory obligations are not merely technical frills capable of being bargained against commercial expediency.
Good intentions cannot legitimise non-compliance and commercial success cannot retrospectively validate a regulatory breach.
The judgement ends with a poetic flourish uncommon to such a forum. If the SEBI is looking for a tagline, what better than this!
“MANDATE FIRST, GAINS LATER;
SEBI COMPLIANCE, NEVER FALTER.”
(Ranganathan V is a CA and CS. He has over 45 years of experience in the corporate sector and in consultancy. For 17 years, he worked as Director and Partner in Ernst & Young LLP and three years as a senior advisor post-retirement, handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies.)
