*By Surya Rajkumar
On the 14th of June 2017, a Westminster Magistrate Court heard the matter concerning beleaguered Indian tycoon Vijay Mallya’s extradition[i] to India. The case concerned an alleged loan default case arising from the diversion of funds amounting to $134m extended by an Indian State owned bank.
This is not the first instance where banks in India lost money due to funds diversion. From 2010 to 2015, Indian banks lost a whopping $4.1b in cases of forgery and cheating that often involved diversion of funds by borrowers.[ii] Whilst there are penalties for diversion of funds, they are only invoked in case of wilful defaulters. Thus, diversions are only sanctioned after a default has been declared by the bank. It is true that, post the default, the borrowers involved are penalized. However, in the case of companies those are listed in the stock exchange, there are no measures to protect the investor from such unethical corporate practices.
This article seeks to explain how mandating disclosures to the stock exchange as regards end use of funds (which include proceeds from Initial Public Offers (IPOs) as well as loan funds) can monitor the use of funds and better protect investors from the effects of their diversion.
What the law mandates and the case of Vijay Mallya.
The Securities and Exchange Board of India (SEBI), the national market regulator, vide Regulation 30 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (Listing Regulations) mandates disclosure of material events to the stock exchange by listed companies.[iii] Material events have been defined in Part A of Schedule III of the same regulations. These events, however, do not mention use of funds, let alone their end use. While one may argue that clause 6, Part A of Schedule III of the said regulations mentions the disclosures of fraud/default by the listed entity, it is highly unlikely that listed entities disclose such events.
The Reserve Bank of India vide a notification dated 30th May 2002, specifies penalties for diversion of funds.[iv] However, such penalties apply only in cases of a default, thus allowing diversion in cases where there is no default. The notification also specifies due diligence that the banks need to follow in monitoring the end use of loans. Nonetheless, due diligence from the perspective of the investor or the stock exchange does not find any mention.
In this scenario, the order against Vijay Mallya sets an important precedent. With such order SEBI established that diversion of funds – irrespective of the amount diverted emanating from loans or IPO proceeds and regardless of a default – amounts to fraud.[v] Specifically, the case involved a massive diversion of funds from loans taken for the purposes of one entity to another and subsequent misstatements in the books of accounts. Thus, SEBI found Vijay Mallya guilty of fraud under the SEBI Act which pelts out penalties for fraudulent activities[vi] as well as the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003 which defines fraud.[vii] Through its order, SEBI’s authority to mandate disclosures is not confined just to IPO proceeds but also the loans taken by listed entities.
Notwithstanding its importance, SEBI’s order against Vijay Mallya only constitutes a first, yet insufficient, step to deter from diversion of funds. Better measures to periodically check diversions, such as mandating disclosures with respect to end use of funds, seem necessary. As it will be explained in the following paragraph, end use of funds is indeed material information and should therefore be included in the Listing Regulations among the information mandatorily disclosed by listed companies to the stock exchange.
Why information on end use of funds is material.
It is the materiality of the end use of funds that should require their disclosure.
Regulation 30 of the Listing Regulations corresponds to clause 36 of the erstwhile listing agreement (clause 36) that mandated the disclosure of material events.[viii] In clause 36, material events have been defined inter alia as information regarding the operation/performance of the company. Clause 36 also mandates the disclosure of price sensitive information.[ix]
A discussion paper published by SEBI on the review of clause 36 states that determination of price sensitive information is to be assisted with the reasonable investor test, whereby information becomes price sensitive when it is likely to be used by a reasonable investor as part of the basis of his investment decision.[x] Further, the Black’s Law Dictionary defines material information as that which when revealed to the public is likely to change the securities perceived value.[xi]
Perceived value is not connected to actual value.[xii] It can be argued that the perceived value of a share can be changed if the end use of loans is disclosed either positively or negatively and a change in the perceived value of a share vis-à-vis any information as already stated makes that information material thus making information pertaining to loans and end use material. Additionally, the JJ Irani Committee’s Report on Company Law, envisaging investor education and protection, recommended disclosures to enable the shareholders to monitor the end use of funds collected from the public.[xiii] The committee’s report further mentions that disclosures regarding end use of loans must be given in annual reports.[xiv] The foregoing authorities are the best examples for the emphasis on the materiality of information regarding end use of funds.
Thus, the need for the disclosure for end use of funds arises from the demand to keep the investor informed about how the borrowed funds are being employed. As mentioned earlier, Indian banks have lost staggering amounts due to fund diversions. Apart from the banks, it is the investor who suffers the ultimate consequences. Notwithstanding fund diversions, the investor is still vested with the right to know how a listed entity is using borrowed funds as it affects the operation of the entity’s business.
One may argue that mandating disclosures would not make a difference as listed entities would still make false disclosures regarding the end use of funds and the penalties remain the same. This, however, is not true. In a landmark judgment[xv], the Indian Supreme Court held “failure of corporate governance on the part of directors if they failed to exercised due care and diligence and thereby, allowing fabrication of figures and false disclosure, they would be liable for such omissions and commissions.”[xvi] Therefore, in case of a diversion of funds, the target entity will be tried for both fund diversion as well as making false disclosures.
Thus, SEBI needs to develop strategies to ensure the mandatory disclosure of end use of funds, both IPO as well as borrowed funds. Doing so will not just be in the best interests of investors but also check the diversion of funds as even in the case of misstatement or concealment regarding such information, there are harsher penalties and clearly defined laws.
[i] Amy Kazim, Helen Warrel, ‘Indian tycoon Vijay Mallya faces extradition after London arrest’ Financial Times, April 18, 2017, https://www.ft.com/content/6004f212-2434-11e7-8691-d5f7e0cd0a16
[ii] Sandeep Pai, ‘Banks no longer safe havens for your money; depositors lost Rs 27000 crore in last five years’, DNA India, April 8, 2015 http://www.dnaindia.com/money/report-banks-no-safe-havens-for-your-money-depositors-lost-rs-27000-crore-in-last-five-years-2075581
[iii]SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, http://www.sebi.gov.in/sebi_data/attachdocs/1441284401427.pdf
[iv]Reserve Bank of India Notifications, May 30, 2002, https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=701&Mode=0
[v]SEBI adjudication order in the matter of USL, http://www.sebi.gov.in/sebi_data/attachdocs/1485352293202.pdf
[vi] SEBI Act, 1992 www.sebi.gov.in/sebi_data/attachdocs/1456380272563.pdf
[viii] ‘Regulation 30 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015,An Analysis’https://www.scribd.com/document/285212217/Material-Disclosure-of-Information-Event-Regulation-30-of-SEBI-LODR-Regulations
[ix] Clause 36, Equity Listing Agreement, www.bseindia.com/downloads1/ListingAgreement_30092014.pdf
[x] Discussion Paper on review of clause 36 and related clauses of Equity Listing Agreement, http://www.sebi.gov.in/sebi_data/attachdocs/1408444809721.pdf
[xi] The Law Dictionary, Material Information http://thelawdictionary.org/material-information/
[xii] The Law Dictionary, Perceived Value http://thelawdictionary.org/perceived-value/
[xiii] Report on Company Law, http://www.primedirectors.com/pdf/JJ%20Irani%20Report-MCA.pdf
[xv] N. Narayanan v. SEBI, (2013) 12 SCC 152 judis.nic.in/supremecourt/imgs1.aspx?filename=40338