SEBI investigation order under Section 11-C quashed for lacking reasonable grounds and proper application of mind

Karnataka HC held that SEBI's investigation order under Section 11-C was unsustainable due to lack of reasonable grounds. The court found that SEBI merely reiterated allegations from a withdrawn complaint without considering the entity's replies or compelling circumstances warranting suo motu investigation. The decision was flawed as internal notings remained unapproved by the competent authority and failed to demonstrate necessary reasons and belief for investigation. The court emphasized that state action must be reasonable and non-arbitrary, quashing the investigation order for want of proper application of mind.

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1. ISSUES PRESENTED and CONSIDERED

The core legal questions considered by the Court in this matter are:

(i) Whether the Executive Director of SEBI (respondent No.1) had the statutory authority to appoint the Deputy General Manager (respondent No.3) as the Investigating Authority under Section 11-C of the Securities and Exchange Board of India Act, 1992 (hereinafter 'the Act, 1992'), or whether such power exclusively vests with the SEBI Board;

(ii) Whether there existed reasonable grounds to believe that the petitioner company acted in a manner detrimental to the interest of its shareholders so as to justify the appointment of an Investigating Authority and consequent investigation under Section 11-C of the Act, 1992;

(iii) Whether the Executive Director's order appointing the Investigating Authority was passed after due application of mind, considering the petitioner's replies to the show cause notices and the withdrawal of the complaint by the shareholders;

(iv) Whether the impugned investigation order violated principles of natural justice and was arbitrary or without jurisdiction.

2. ISSUE-WISE DETAILED ANALYSIS

Issue (i): Authority of Executive Director to appoint Investigating Authority under Section 11-C of the Act, 1992

The relevant statutory provisions considered include Section 4(3), Section 11-C, and Section 19 of the SEBI Act, 1992, along with Regulation 5 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003.

Section 11-C empowers the Board to order investigations where it has reasonable grounds to believe that securities transactions are detrimental to investors or the securities market, or where any intermediary or person associated with the securities market has violated the Act or regulations. Section 19 permits the Board to delegate its powers, except those under Section 29, to any member or officer. Section 4(3) vests the Chairperson of the Board with powers of general superintendence and direction over the Board's affairs, including exercising all powers exercisable by the Board.

The Court examined a general delegation order dated 31.07.2019 issued by the Chairperson under Section 4(3), which delegated the power to order investigations and appoint investigating authorities under Section 11-C to the Executive Director (ED) of SEBI. Regulation 5 of the SEBI (PFUTP) Regulations, 2003, similarly empowers the Board, Chairman, members, or Executive Director to order investigations on reasonable grounds.

The Court reasoned that the Executive Director's appointment of the Deputy General Manager as Investigating Authority was lawful and within the delegated powers of the Board. The Chairperson's delegation order and the regulatory framework collectively authorize the ED to initiate investigations under Section 11-C, thus negating the petitioner's contention that only the Board can make such appointments.

Issue (ii): Existence of reasonable grounds to believe detrimental conduct warranting investigation

The petitioner challenged the investigation on the ground that no reasonable grounds existed to believe that it acted detrimentally to shareholders' interests. The complaint filed by certain shareholders (respondents No.5 to 11) alleged financial irregularities including impairment loss provisions of Rs. 118.66 crores, diversion of funds through subsidiaries and associates, dubious related party transactions, mismanagement, and erosion of shareholder value. However, these complainants later withdrew their allegations.

SEBI's Assistant General Manager issued notices to the petitioner seeking clarifications on the impairment loss, loans and advances to related parties, and corporate governance issues. The petitioner responded with detailed explanations, including reference to compliance with accounting standards (Ind AS 36), approval of impairment provisions by shareholders under Section 188 of the Companies Act, 2013, and disclosure in audited financial statements.

Despite these replies, the Executive Director ordered an investigation appointing the Deputy General Manager as Investigating Authority. The Court scrutinized the internal notings and found that they did not record any application of mind or reference to the petitioner's replies, nor did they reflect any reasonable grounds or belief that the petitioner's conduct was detrimental to shareholders. The internal notes were unsigned by the competent authority and merely reiterated the complaint's allegations.

The Court emphasized the settled legal principle that "reason to believe" must be based on an objective view drawn from tangible material and must have a proximate link to the formation of belief, not merely a subjective or arbitrary opinion. It relied on precedents clarifying that a change of opinion or mere reiteration of withdrawn allegations does not constitute reasonable grounds for investigation.

Given that the complainants had withdrawn the allegations and the petitioner had satisfactorily explained the matters raised, the Court concluded that no reasonable grounds existed to warrant investigation under Section 11-C.

Issue (iii): Application of mind and compliance with principles of natural justice

The petitioner contended that the Executive Director failed to consider its replies to the show cause notices before ordering investigation, thereby violating the principles of natural justice. The Court examined relevant precedents underscoring that administrative decisions affecting rights must be preceded by notice and an opportunity to be heard, and the reasons for such decisions must be recorded and based on relevant material.

The Court found that although the petitioner was given opportunity to respond to the notices, the Executive Director's order did not reflect consideration of these replies or any independent assessment of the allegations. The internal notings lacked countersignature by the Executive Director and did not disclose any reasoned belief justifying investigation. This amounted to failure to apply mind and rendered the order arbitrary and without jurisdiction.

Issue (iv): Legality and sustainability of the impugned investigation order

The Court analyzed the scope of judicial review over SEBI's regulatory actions. While recognizing SEBI's expertise and the limited scope of judicial interference, the Court held that such deference does not extend to permitting arbitrary or non-reasoned orders lacking statutory foundation. The Court distinguished between reviewing the adequacy of reasons (which is limited) and the existence of any reason or jurisdictional basis (which is mandatory).

Applying these principles, the Court held that the impugned order lacked the requisite "reason to believe" and was based on withdrawn allegations without any fresh or tangible material. The absence of application of mind and failure to consider the petitioner's responses rendered the order legally unsustainable.

3. SIGNIFICANT HOLDINGS

"A cumulative reading of the aforesaid provisions indicates that if the Board... has reasonable grounds to believe that transactions in securities are being dealt with in a manner detrimental to the interest of shareholders, the Board is empowered under Section 11-C of the Act to appoint any person as the investigating authority to investigate into affairs of persons associated with the securities market."

"Section 19 of the Act, 1992 empowers the Board to delegate to any member, officer of the Board, or any other person all such powers except the power to make Rules as stipulated under Section 29 of the Act, including the power conferred on the Board under Section 11-C of the Act, to order investigation into market securities."

"Where the complainants have withdrawn the allegations made on 8.5.2020, and therefore, in the absence of any material to substantiate that the petitioner's company had acted in a manner detrimental to the interest of its shareholders, the conducting of investigation against the petitioner under Section 11-C of the Act, 1992 is not legally sustainable."

"The existence of reasonable grounds is sine qua non for directing an investigation under Section 11-C of the Act. Where the competent appointing authority has merely reiterated the allegations made in a subsequently withdrawn complaint and contains no reference to notices and replies of the petitioner entity or compelling circumstances warranting an investigation suo motu, the order directing investigation cannot be said to have been passed upon due application of mind."

"All state action must be reasonable and free from arbitrariness. Where it appears from the perusal of the material on record that the Executive Director did not possess any relevant reasons to believe, the passing of an order directing investigation under Section 11-C of the Act read with Regulation 5 of the SEBI (PFUTP) Regulations, 2003, cannot be sustainable."

"The rule of audi alteram partem has two facets - 'notice of the case to be met' and 'opportunity to explain'. Any administrative decision which infringes upon the rights without apprising the affected and appraising the representations cannot be considered to be fair."

"Reason to believe is to be construed as an objective view based on disclosed information and firm and concrete facts. It cannot be arbitrary, irrational, vague, distant or irrelevant."

Accordingly, the Court quashed the impugned order appointing the Investigating Authority and directed that the investigation under Section 11-C of the Act, 1992 be set aside for want of jurisdiction and absence of reasonable grounds.

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