SEBI Imposes Financial Penalties On Market Infrastructure Institutions For Surveillance Failures

The benchmark equity indices of Indian stock exchanges have been on the rise in recent months. A few days back, the National Stock Exchange of India Limited (NSEIL), one of India's premier stock exchanges, set a world record by processing 1,971 crore transactions in a single day. Considering the significant increase in trading activity during the past few years, increased participation by retail individual investors, increased trading activity in the derivatives segment and deployment of new trading techniques and strategies by market participants, the Securities and Exchange Board of India (SEBI) has issued a Circular to address Surveillance Related Lapses (SRL) by Market Infrastructure Institutions (MIIs).

What are Market Infrastructure Institutions (MIIs)?

Stock exchanges, Clearing Corporations and Depositories together constitute MIIs. The securities market cannot function without these MIIs. SEBI regards MIIs as primary regulators and expects them to possess a deep understanding of the practical dynamics of the securities market and its stakeholders. Moreover, as a regulatory authority, SEBI emphasises that MIIs be well-prepared to detect market abuse, including emerging schemes employed by unscrupulous actors. It is imperative that they promptly enact effective and preventative measures against such activities.

MII’s surveillance obligations

The Securities and Exchange Board of India Act, 1992 (SEBI Act) mandates SEBI to safeguard investors' interests in securities and regulate the market. This includes provisions to oversee the operations of stock exchanges, as well as the functioning of depositories and clearing corporations.

Presently, the MIIs, supervise their members i.e. stockbrokers, depository participants and clearing members in terms of the respective byelaws framed under the Securities Contracts (Regulation) Act, 1956 (SCRA) or Depositories Act, 1996. Additionally, SEBI has the authority to act against stock exchanges or clearing corporations for any violations under the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2018 (SECC Regulations), and against depositories for any contraventions under the Securities and Exchange Board of India (Depositories and Participants) Regulations, 2018 (DP Regulations).

According to the SECC Regulations and DP Regulations, surveillance is deemed a fundamental function of both stock exchanges and depositories. Any lapse in monitoring - that fails to identify and prevent manipulative or abusive trading practices - suggests inadequate surveillance by MIIs. Such shortcomings could undermine investor trust and confidence in the securities market.
Learnings from Past Instances
In the past, there have been multiple instances where members regulated by MIIs were involved in market wide misconduct leading to a substantial loss for investors.

A few years ago, a SEBI-registered stockbroker was implicated in the unauthorised pledging of client securities and misuse of client funds, leading to significant financial losses and eroding investor trust. While the pledges made by the broker were technically valid, the broker failed to adhere to SEBI's guidelines. SEBI had issued several circulars calling for stricter oversight by Stock Exchanges, Clearing Corporations, and Depositories. Pledging securities, not in alignment with these circulars therefore places direct responsibility on the MIIs.SEBI had initiated adjudication proceedings and imposed penalties on stock exchanges and clearing corporations for the failure of adequate surveillance mechanisms. However, by the time these actions were taken, the damage had already occurred, leading to concerns raised by various retail investors and foreign portfolio investors regarding SEBI's apparent failure to promptly monitor the MIIs.

In another instance, a stockbroker defrauded its clients’ of INR 1400 crores by providing false account statements and misappropriating clients’ securities for personal trades. The scheme was uncovered when investors began cross-referencing the depositories' websites, revealing discrepancies between the securities listed in their account statements and the contents of their demat accounts.

New Framework

With the aim of enhancing surveillance mechanisms implemented by MIIs, SEBI has issued a Circular on June 06, 2024[1], introducing a framework for Financial Disincentives for Surveillance Related Lapses (“FDSRL”),.According to the Circular, effective July 1, 2024, "SRL" shall encompass the following:

a.    Lapses observed in the implementation of decisions taken during the Surveillance Meetings.

b.    Lapses observed in discharge of surveillance activities deviating from the agreed scope and timelines.

c.    Inadequate reporting or non-reporting of surveillance related activity as per agreed timelines.

SEBI shall identify SRLs, initiate proceedings against MIIs where necessary, and provide MIIs with an opportunity to make submissions with regards to the alleged SRL.

•    Financial Disincentives: The Circular mandates "financial disincentives" in the form of monetary penalties for any occurrences of the aforementioned Surveillance Related Lapses (SRLs). These penalties are calculated based on the total revenue of the Market Infrastructure Institutions (MIIs) during the financial year in which the SRL occurred.The financial disincentives would range from INR 1 Lakh to 1 Crore, depending on the total revenue of the MII and number of instances. The penalties imposed on the MII will be credited to the Investor Protection and Education Fund (“SEBI–IPEF”) within 15 working days.

•    Disclosure requirements: The MIIs are also mandated to disclose the details pertaining to the “financial disincentives” levied on them, on their websites and in their annual reports.  The listed MIIs will further have to make disclosures as applicable to them under the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR Regulations), regarding any financial disincentives imposed by SEBI under this circular.

•    Exemptions: As a relief to the MIIs, the Circular also lists out the matters/instances wherein the FDSRL will not be applicable to matters that are procedural in nature like minor delays in providing relevant information, minor errors in filings and disclosure, extensions sought for making submissions, etc. Further, it is clarified that the Circular will not extend to instances which have a market wide impact or cause losses to large number of investors. Due investigation and action therefore shall be taken in case of major market fraud or lapses.

The Circular is issued with the primary objective to motivate the MIIs to strengthen their approach towards surveillance of the market. The Circular refrains from using the word “penalty” and instead used ‘financial disincentives”, which further shows that the intent of the Circular is precautionary and not penal in nature. It will be interesting to see whether this Circular proves instrumental in enabling SEBI to effectively safeguard the interests of investors. A positive result will shed light on the Circular's efficacy in enhancing surveillance, and SEBI’s prime objective of investor protection within the securities markets.

Authors: Jitendra Motwani, Partner; KC Jacob, Counsel; Shourya Tanay, Senior Associate at Economic Laws Practice

[1] (Available at: https://www.sebi.gov.in/legal/circulars/jun-2024/framework-of-financial-disincentives-for-surveillance-related-lapses-at-market-infrastructure-institutions_83984.html)