Grossly deceiving receipts: fraud found in GDR

The Securities and Exchange Board of India (SEBI) received alerts about large scale off-market transactions through its market monitoring system. On investigation, it was found that global depository receipts (GDRs) had been issued to sub-accounts of various foreign institutional investors by certain Indian listed companies. These GDRs were rapidly converted into underlying Indian equity shares of the issuing company and subsequently sold in large and synchronized deals to several buyers, including some stockbrokers registered in India.

Thus, a whole chain was formed – facilitation of the GDR issue, arranging for investors, and then providing an exit for these investors in the Indian markets through a further chain of known stockbrokers. The GDR issuance and disclosure standard was followed to effectively place the underlying securities in the hands of Indian investors without complying with the requirements for an issuance in the Indian market.

On the facts, the whole time member (WTM) of SEBI who heard the case held that all of the stages combined demonstrated “manipulation” or “fraud” on the part of each of the show cause noticees.

[ihc-hide-content ihc_mb_type=”show” ihc_mb_who=”3″ ihc_mb_template=”2″ ]

Chain of deceit

The investigations revealed that the GDR issues were devised and structured by the brokers in connivance with the issuer companies through a fraudulent arrangement. The sub-accounts converted the GDRs into shares and sold them in the Indian securities market, where the counter-parties to most of the sales were connected to brokers.

The aim of such trading was to create an impression of liquidity in the market. Investors in India were lulled into thinking that stocks of the issuing companies had been highly valued by foreign investors, and were induced to buy the shares of the issuer companies in the Indian securities market. Indian investors were therefore adversely affected by the misleading signals sent out in the market.

The noticees were connected by common telephone numbers and addresses in know your customer documents, common directorships, cross-holdings, etc. From these facts it was inferred that each noticee had a role to play in the fraudulent activity.

Analysis

The WTM rejected the affected entities’ argument that SEBI did not have jurisdiction over the issuance of GDRs since they relate to securities traded outside India. He reasoned that GDRs can be converted to shares of Indian companies in the Indian market and therefore the impact of shares so converted has a direct bearing on the securities market in India. He also noted that the GDRs are “marketable securities” under section 2(h) of the Securities Contracts (Regulation) Act, 1956.

The WTM relied on the wide ambit of section 12A(a)-(c) of the SEBI Act, 1992, read with regulations 3(a)-(d) and 4(1) and 4(2)(a) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market) Regulations, 2003, which prohibit buying, selling or dealing in securities in a fraudulent manner and employing any manipulative/deceptive device, scheme or artifice to defraud in connection with dealing in securities which has the potential to induce the sale or purchase of securities of any company and influence investment decisions.

The intent to circumvent the due diligence and regulatory processes required for raising funds in the Indian market appeared obvious. The WTM observed that it is the Indian investor who ends up getting hoodwinked when the GDRs are converted into Indian shares. The entire arrangement was in essence an issuance of Indian stock, as most GDRs were cancelled and converted into the underlying shares.

By endorsing SEBI’s jurisdiction to look into matters relating to issuance of GDRs when there is reason to believe that entities have acted fraudulently to the detriment of investors in the securities market, this order is in contrast with the decision of the Securities Appellate Tribunal (SAT) in a case involving Pan Asia Advisors and its promoter, Arun Panchariya.

In that decision (which was stayed by the Supreme Court on 13 December 2013), SAT held that SEBI’s jurisdiction does not extend to transactions executed outside India with respect to the issuance of GDRs since these are governed by the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (through Depository Receipts Mechanism) Scheme, 1993, and the Master Circular on Foreign Investment in India and since SEBI has not framed any regulations concerning GDRs.

The Sahoo Committee report suggested that if under the capital control regime, an investor is permitted to access a particular security, the investor should also be permitted to access the domestic depository receipts issued on the back of such securities. However it would be hard for SEBI to effectively implement this, especially given that it is not in a position to effectively monitor overseas trades of GDRs.

[/ihc-hide-content]

Suhail Nathani is a partner and Yogesh Chande is an associate partner at Economic Laws Practice. Malek-ul-Ashtar Shipchandler, a trainee, assisted with research. This article is intended for informational purposes and does not constitute a legal opinion or advice.