Delineating the Scope and Nature of Disgorgement Under Securities Law

Introduction

Section 11-B¹ of the Securities and Exchange Board of India (SEBI) Act, 1992, empowers SEBI to issue certain directions in order to protect the interests of market participants, and regulate the markets.² In 2014, the provision concerned had been amended to clarify that SEBI is empowered to direct any person to disgorge a sum of money equivalent to the amount that that person may have gained wrongfully. “Disgorgement” refers to the act of surrendering something, including illegal profits, because of legal compulsion or demands. Moreover, the Securities Laws (Amendment) Act, 2014³ was introduced to amend Section 12-A⁴ of the Securities Contracts (Regulation) Act, 1956 (SCRA) as well as Section 19⁵ of the Depositories Act, 1996, to include the sanction of disgorgement. Therefore, SEBI can force any person to give up any profits that the individual concerned may have gained through wrongful conduct, such as fraud or insider trading. The concept of disgorgement is premised on the idea that no individual should be allowed to benefit from their own wrongful acts.

However, the exact nature of disgorgement has largely remained elusive and its interpretation and implementation have been fraught with contradictory opinions. It must also be noted that there is a very fine line of distinction between disgorgement and other remedies such as compensation or restitution. This article will attempt to analyse the character of disgorgement as well as examine its effectiveness in achieving its intended objectives.

Remedy or penalty?

Prior to the 2014 Amendment, an attempt was made to enforce disgorgement of wrongfully gained money in Rakesh Agrawal v. SEBI⁶. However, the Securities Appellate Tribunal (SAT) had held that disgorgement was penal in nature and hence, SEBI could not pass a direction of disgorgement under Section 11-B, which only allowed for remedial directions. Following this, SEBI attempted to recharacterise disgorgement as a compensatory remedy in several cases. In Karvy Stock Broking Ltd. v. SEBI⁷ and the Roopalben Nareshbhai Panchal, In re⁸, SEBI asserted that disgorgement is an “equitable remedy” as it deprives the perpetrator of the gains made by their unlawful acts and makes them revert to their original position. Further, the Securities Appellate Tribunal (SAT) also added that since the concept of disgorgement attempts to return the perpetrator to their original position, therefore, the disgorged amount cannot exceed the cumulative gains made from the illegal act. Further, in Shailesh S. Jhaveri v. SEBI, the SAT had recognised that the order of disgorgement must be limited to the offenders who make unlawful gains from their acts.⁹

Consequently, in India, the concept of disgorgement is neither punitive nor is it meant to make whole the losses suffered by the victims of the illegal acts, as the disgorged money is credited to the investor protection and education fund. However, it is still retributive to the extent that it punishes the perpetrator by forcing them to surrender their profits.

In comparison, in US the concept of disgorgement evolved as an injunctive relief in the early 1970s.¹⁰ In Securities and Exchange Commission v. Texas Gulf Sulphur, the SEC argued that disgorgement would serve as an effective deterrent to potential violators and was termed as an equitable remedy.¹¹ Following this, the Securities and Exchange Commission (SEC) enthusiastically issued disgorgement orders. For instance, in Securities and Exchange Commission v. Contorinis¹², the Court upheld an order demanding disgorgement of profits earned by a fund that was managed by the defendant. Thus, the court went beyond the defendant’s personal profits. Such an approach led the SEC to recover huge amount of money. In 2016, the SEC was able to recover approximately $3 billion through disgorgement payments alone.¹³

It is also important to note that there is a distinction between civil penalties and disgorgement. In Kokesh v. Securities and Exchange Commission, a landmark judgment on the matter, the SEC had submitted that civil penalties are not flexible enough to fulfil the needs of the SEC.¹⁴ For example, when the profits exceed the statutory limits on the penalties, it is more effective to order disgorgement. It is in this case that the US Supreme Court held that disgorgement is a penalty in the context of Section 2462¹⁵ of the Securities Exchange Act, 1934. However, it must be kept in mind that this decision was rendered due to certain facts peculiar to the case at hand and in the subsequent case of Charles C. Liu v. Securities and Exchange Commission, the US Supreme Court maintained the position that disgorgement is an equitable relief.¹⁶

The Kokesh case¹⁷ was cited in Gagan Rastogi v. SEBI to argue that disgorgement is a penalty, however, the SAT rejected this argument and upheld the nature of the measure as an equitable remedy.¹⁸ In Dhaval Mehta v. SEBI¹⁹, it was held that non-compliance of disgorgement order would attract penalty under Section 15-HB²⁰ of the SEBI Act.

Another recent case in which the SAT upheld that disgorgement is an equitable remedy is the NSE co-location case.²¹ SEBI ordered NSE to disgorge Rs 624 crores for granting brokers access to its co-location facilities on a preferential basis. This sum was calculated on the basis of revenue generated from NSE’s operations at the relevant time period and interest calculated at the rate of 12%. Further, Ravi Narain and Chitra Ramakrishna were ordered to pay 25% of their salary as disgorgement as they were in charge of NSE during the relevant time period. The basis of such a huge disgorgement order was that NSE failed to fulfil its obligations as a first-level regulator and failed to comply with a circular issued under the SEBI Act. The SAT set aside this disgorgement order and held that the actions of NSE in not complying with a SEBI Circular would invite a penalty and not a disgorgement order. The SAT held that disgorgement should be ordered only in cases where a person has made profit through unethical or unlawful means. The salaries of both Ravi Narain and Chitra Ramakrishna were held to be received as payment for the services they rendered and were not “unlawful gains” and any order to disgorge 25% of their salary was a penal order and not in the nature of an equitable remedy. Thus, in this case the SAT clearly laid down that mere non-compliance of a circular would not make a party liable for disgorgement. There should be a causal nexus between contraventions of SEBI Act or Regulations and gaining of illegitimate profits by a person and only then can an order of disgorgement be passed against that person.²²

Taxation implications

The determination of the nature of disgorgement as an equitable remedy or penalty becomes an important question from taxation perspective as well.²³ Explanation 1 to Section 37(1)²⁴ of the Income Tax Act states that: For the removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure. Thus, if disgorgement is looked at as a penalty, then the person disgorging the sum would not be able to claim tax deductions. However, SAT’s interpretations as well as the SEBI Act indicates it to be an equitable remedy and not a penalty. In such a scenario, it is possible for assessees to argue that it is deductible and the Explanation to Section 37(1) does not apply to disgorged sums. There has been no clarification by the Income Tax Department as to how these sums must be treated for tax purposes and thus, this remains speculative.

Conclusion

From the above discussion, it is clear that disgorgement is seen more as a compensatory and equitable remedy than as a penalty in India. The SEBI Act also points to the same direction, with Section 28-A²⁵ of the Act stating penalty and disgorged sums as different and separate orders by the Board. The tax implications of treating disgorgement as a remedy however, are yet to be conclusively decided.