Earlier this year, as part of this series, we had written a detailed piece analysing the conundrum with respect to the interpretation of two special statutes – the Insolvency and Bankruptcy Code, 2016 (IBC) and the Securities and Exchange Board of India Act, 1992 (SEBI Act). In that article, we had attempted to reconcile the reading of the non-obstante clauses in the IBC and the SEBI Act. One issue which we had briefly touched upon was with respect to initiation of the corporate insolvency resolution process with respect to those entities which were under SEBI’s regulation and the challenges that this throws up for the regulator while trying to uphold investors’ interests.
This discussion (and the precedents analysed there) was limited to the instances where SEBI was trying to rein in those errant businesses which, under the garb of super-normal returns, had been found to have duped innocent investors. The entities which we had referred to (such as Pancard Clubs and HBN Dairies) were found to be operating illegal money-pooling schemes without appropriate registration and sans the safeguards which are prescribed for collective investment schemes. The ideological (and perhaps juridical) gap that was sought to be bridged was between the competing objects of the securities laws (i.e., protection of the interest of investors by a market regulator) and the insolvency law (i.e., providing a predictable and efficient insolvency resolution process).
However, at the same time, there was another pitched battle brewing in our courts – on the question as to whether stock-brokers could be subjected to the insolvency resolution process in terms of the IBC. The issue was whether an application in terms of Section 7 of the IBC could be admitted against a stock broker and the moratorium (as contemplated under Section 14) could come into effect – especially given the fact that admission into a corporate insolvency resolution process, i.e. CIRP, would negate the ability of sectoral regulators (and stock exchanges) to take the corrective measures to contain the effects of the default.
The Bye-laws of the Stock Exchanges, in conjunction with SEBI-issued circulars, establish a self-contained code for investor grievance redressal. This regulatory framework provides a well-structured process that is both detailed and effective. The framework outlines a sequential approach to addressing grievances, commencing with a client of a Trading Member filing a complaint which initiates a series of steps aimed at amicable resolution. If dissatisfied, the parties have the option to pursue their claims through arbitration. This multi-tiered approach ensures comprehensive dispute resolution. Recently, this mechanics of this system have been entirely overhauled by SEBI, but the core features remain the same – effective, conclusive and time-bound dispute resolution mechanisms with built-in features which put the interest of retail investors first.
Stock exchanges’ bye laws, combined with the SEBI’s regulations, not only provide for mechanisms to seek redressal of grievances against stock brokers but also sets out the ways and means to continually monitor whether the dues of a stock broker outstrips its assets. Whenever a potential default is triggered, the law allows for the assets of the errant broker to be commandeered and deployed to meet the dues of its creditors. While the process has many conceptual similarities with a typical liquidation or insolvency resolution process, there is one significant difference – in the defaulter mechanism, the claims of the clients are prioritised and they stand first in the line of claimants in the ‘waterfall’ mechanism. This protection is unique given SEBI’s mandate of safeguarding investors’ interest which, other than being reflected in its direct administrative and quasi-judicial actions, are reflected through these measures which are hard-coded within the market infrastructure institutions.
In July 2019, a client of the stock broker named ‘Simadhar Broking’ filed a complaint against the broker. Dissatisfied with the outcome, and instead of availing of the mechanism for escalating the matter, Section 7 IBC application was filed. The National Company Law Tribunal, Ahmedabad admitted the same in April 2021 and a moratorium was imposed according to the IBC.
Close at its heels, the NCLT New Delhi also passed an order in November 2021 admitting a Section 7 application against a stock broker called Astiva Capital. The application was filed by an erstwhile director of the broker, and as a result of its admission, the pending investor grievance redressal procedure came to a halt.
These orders came up in appeal before the NCLAT, where the core challenge was on the ground that stock brokers, being registered with and regulated by SEBI, would fall outside the definition of a ‘corporate debtor’ and therefore, no application under Section 7 of the IBC was maintainable against them.
In September this year, the NCLAT disposed of these matters by quashing the orders of the NCLT benches.
The NCLAT’s judgment examined the definition of a 'corporate debtor' as per Section 3(8) of the IBC. According to this definition, a ‘corporate debtor’ must meet two criteria: firstly, being a ‘corporate person’, and secondly, defaulting on a debt owed to any person. Crucially, it observed that, the definition of a ‘corporate person’ as per Section 3(7) expressly excludes ‘financial service providers’. This exclusion is evident from the specific wording that reads, “… shall not include any financial service provider”. Basis this, the NCLAT observed that this exclusion renders 'financial service providers,' such as stock brokers, ineligible to be categorized as ‘corporate persons’.
The NCLAT held that stock brokers are ‘financial service providers’ on a comprehensive reading of the provisions of Section 3(17) in conjunction with Sections 3(15) and 3(16) of the IBC. These sections encompass entities engaged in various financial services, including buying, selling, and dealing in securities and derivative products. It also observed that stock brokers operate under the regulatory oversight of the SEBI, which is recognized as a ‘financial sector regulator’ under Section 3(18) of the IBC, reinforcing their finding regarding the classification of stock brokers as ‘financial service providers’.
It also placed authoritative reliance on several leading judgments which, in the context of other financial service providers, had upheld their exclusion of 'financial service providers' from the IBC. The Bench also noted with affirmation the Report of the Sub-Committee of the Insolvency Law Committee for Notification of Financial Service Providers under Section 227 of the IBC, dated 4 October 2019 which clarified that stock brokers are ‘financial service providers’ under the IBC and also recommended that the IBC, in its present form, ought not apply to stock brokers.
This judgment also clarifies that the only way a ‘financial service provider’ can be covered under the IBC is by way of a notification under Section 227 of the IBC by the Central Government (in consultation with the appropriate financial sector regulators). Only one such notification has been issued till date, but that too is limited and extends the applicability of the IBC only to a specific class of ‘financial service providers’ i.e., “Non-banking finance companies (which include housing finance companies) with asset size of Rs.500 crore or more, as per last audited balance sheet.”.
The judgment also affirmatively acknowledges the locus of stock exchanges as a market regulator. It notes that, in accordance with the applicable Bye Laws and the relevant SEBI circulars, a clear process unfolds when a member of a stock exchange is declared a defaulter and subsequently expelled. In such cases, the assets of the defaulting member automatically transfer to the exchange, which, in turn, calls for claims from all parties involved and utilizes these assets to settle outstanding claims. The procedures outlined within the stock exchanges’ Bye Laws, coupled with the relevant SEBI circulars, provide a comprehensive framework for addressing grievances and facilitating the resolution of disputes. This framework effectively serves as a self-contained mechanism for handling claims and disputes that may arise between a client and a trading member, while also upholding the stock exchange’s bounden duty to protect the interest of investors. It was argued that allowing the initiation of IBC proceedings against stock brokers, who are explicitly excluded from its purview, would have a detrimental impact and undermine the established mechanism. The judgment is an affirmation that with the admission of stock brokers into CIRP and the coming into force of the moratorium, the interest of investors may be prejudiced rendering them incapable of realizing their rightful claims against a trading member who has been declared a defaulter.
By looking at the manner in which stock brokers are registered and regulated as well as the the nature of their business, the NCLAT came to the unequivocal conclusion that stock brokers “clearly fall within the definition of ‘Financial Service Provider’”. It observed that “Legislature was well aware of the intricate nature of the financial services and have purposely kept Financial Service Providers out of the procedure prescribed under the Code with exception of Notification on Financial Service Provider under Section 227 by the Central Government.” It finally held and ordered that:
“…we are of the considered opinion that both the Corporate Debtors, i.e. Simandhar Broking Ltd. and M/s. Astitva Capital Market Private Limited being registered Broker with SEBI and Trading Member of the NSE are providing services, which are ‘financial services’ within the meaning of definition of Section 3(16) of the Code and by virtue of Section 3(7) read with Section 3(8) and Section 227 of the Code, Section 7 Application filed by Corporate Debtors were not maintainable. The orders passed by Adjudicating Authority in both the Appeal(s) deserve to be set-aside.”
This judgment of the NCLAT serves as a caution against misuse of the IBC mechanism. It recognises the uniqueness of the manner in which the securities market and its intermediaries operate and are regulated, and how cases of their potential default are addressed via sector-specific, bespoke regulations. Most importantly, it gives further impetus to SEBI and the stock exchanges’ endeavours to protect investor interests through efficient and determinate mechanisms.
Shruti Rajan is a Partner and Anubhav Ghosh is a Counsel at Trilegal.
This is the seventh article in the Securities Law series by Trilegal.