Fit & Proper Test under Intermediary Regulations of Securities Exchange Laws

Introduction

The Securities and Exchange Board of India (hereinafter referred to as SEBI) is the primary regulator of the incidents relating directly or indirectly to the safety and integrity of the exchange of Securities in the Indian markets. In order to perform its functions properly and to keep a check on the actions of all the players involved in the Securities market, SEBI is empowered with some discretionary powers which enables SEBI to act as a watchdog in the market and to take appropriate actions against the malicious players of the market. These powers enable SEBI to act in a quasi-judicial manner and to apply the test of reasonability and in order to decide any incident which seems to be involving some unfair practices. SEBI is not merely having the substantive powers on which it can take actions against a party, but it is also empowered with discretionary powers which enables SEBI to go outside the ambit of the concrete law in order to decide something which is not codified if SEBI thinks it to be fit and proper as per the situation.

One such power is provided to SEBI in terms of the ‘fit and proper’ test which is mentioned in the Regulation 7(2)(e) r/w Schedule II of the SEBI (Intermediaries) Regulations, 2008. This regulation empowers SEBI to reject the application for Registration of a party as an Intermediary in the Stock or Commodities or Derivatives market if it thinks that the party does not qualify the test of a ‘fit and proper person’ in terms of Schedule II of the regulations. Schedule II of the regulations defines the test of a ‘fit and proper person’ as follows: 

SCHEDULE II – Criteria for determining a ‘fit and proper person’-

For the purpose of determining as to whether an applicant or the intermediary is a ‘fit and proper person’ the Board may take account of any consideration as it deems fit, including but not limited to the following criteria in relation to the applicant or the intermediary, the principal officer and the key management persons by whatever name called – 

  • integrity, reputation and character;
  • absence of convictions and restraint orders; 
  • competence including financial solvency and net worth.” [1]

The said test had already been applied in various cases by SEBI one of whom is discussed hereinbelow.

Case Study: Motilal Oswal Commodities Broker Private Limited[2]

Motilal Oswal Commodities Broker Private Limited (hereinafter referred to as ‘MOCBPL’) was a commodity derivative broker in the National Spot Exchange Limited (hereinafter referred to as ‘NSEL’), Multi Commodity Exchange of India Ltd (hereinafter referred to as ‘MCX’) and National Commodity & Derivatives Exchange Limited (hereinafter referred to as ‘NCDEX’). Forward Market Commission (hereinafter referred to as ‘FMC’) got merged in SEBI in 2015 which required a fresh registration of all the brokers in the market with SEBI after which MOCBPL applied for registration as a broker in SEBI. SEBI conducted a due diligence on MOCBPL and found doubtful transactions in the accounts of MOCBPL. In year 2016,  a Designated Authority was appointed by SEBI to enquire into the same for alleged violations of various provisions of the SEBI (Stock Brokers & Sub Brokers) Regulations, 1992, SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003, Forward Contracts (Regulation) Act, 1952 (hereinafter referred to as ‘FCRA’), Prevention of Money Laundering Act, 2002, Central Government Notifications and various Circulars / Code of Conduct, Guidelines, Bye Laws, Business Rules etc. by MOCBPL. The Designated Authority after conducting the enquiry, asked SEBI to reject the application for registration as a broker filed by MOCBPL and further asked SEBI to initiate prosecution against them for violations of the laws as mentioned above. In this regard, SEBI initiated proceedings against MOCBPL on the question that whether MOCBPL was a fit and proper person to be granted registration by SEBI as a commodities derivatives broker.

NSEL was incorporated in May 2005 as a Spot Exchange for trading in commodities. Central Government soon recognised the shortcomings of short selling of stocks and commodities in the market which does not contribute to the economy directly but increases the transactions in the market at the same time. Thus, the Central Government in the year 2007, exempted all forward contracts of one day duration for the sale and purchase of commodities traded on NSEL from operations of the provisions of FCRA subject to certain conditions, and further stated that “no short sale by the members of the exchange shall be allowed” and “all outstanding positions of the trades at the end of the day shall result in delivery”.[3] In October 2008, NSEL commenced its operations by providing an electronic trading platform to participants for spot trading of commodities such as bullion, agricultural produce, metals, etc.

In September 2009, NSEL introduced a new concept of ‘paired contracts’ which means buying and selling the same commodity through two different contracts at two different prices and enabled investors that they could buy a short duration settlement contract and sell a long duration settlement contract and vice versa at the same time viz. Trades for Buy (T+2 / T+3) and Sell (T+25/ T+36) used to happen on the exchange at the same time at different prices. This concept was similar to the concept of short selling which was now not allowed to be done directly.

MOCBPL questioned the jurisdiction of SEBI in the matters relating to NSEL as NSEL itself was not a recognised organisation. MOCBPL further filed a withdrawal for the application for becoming a broker registered with SEBI after the initiation of enquiry against it which was rejected by SEBI on the grounds that MOCBPL cannot evade the enquiry by merely withdrawing its application. The rejection of withdrawal application of MOCBPL was unsuccessfully challenged by it before the High Court of Bombay. MOCBPL further contended that the scope of enquiry is beyond the ambit of powers conferred by SEBI under FCRA and alleged that SEBI was taking a predetermined action against them. MOCBPL argued that the proceedings initiated against them were being misconceived. SEBI rejected all the aforesaid contentions and arguments raised by MOCBPL while giving reasonable justification on basis of facts of the case. 

SEBI further took into consideration various precedents of Mukesh Babu Securities Limited vs. SEBI & others decided by the Securities Appellate Tribunal, as well as the precedent of Jermyn Capital LLC vs. SEBI in which Securities Appellate Tribunal held:

“A reading of the aforesaid provisions of the Regulations makes it abundantly clear that the concept of a fit and proper person has a very wide amplitude as the name fit and proper person itself suggests. The Board can take into account any consideration as it deems fit for the purpose of determining whether an applicant or an intermediary seeking registration is a fit and proper person or not. The framers of the Regulations have consciously given such wide powers because of their concern to keep the market clean and free from undesirable elements. It can take into account the financial integrity of the applicant and its competence. Absence of convictions or civil liabilities would be another relevant consideration which could weigh with the Board. Good reputation and character of the applicant is a very material consideration which must necessarily weigh in the mind of the Board in this regard. Reputation is what others perceive of you. In other words, it is the subjective opinion or impression of others about a person and that, according to the Regulations, has to be good.”

The SEBI observed that NSEL and Paired Contracts are criticised by various Courts and Authorities as the transactions are violative of FCRA and various provisions of Maharashtra Protection of Interest of Depositors Act, 1999, even if there is no concrete law present against the same. SEBI held that the reputation of the party can be considered as a reasonable ground to accept or reject the application for becoming a broker in the market as it would come under the ambit of ‘Fit and Proper Person’ test. If someone is having a doubtful reputation in the market due to reasonable causes, then such applicant must not be given registration as a broker for the sake of protection of the investors in the market. SEBI found that MOCBPL facilitated certain transactions in paired contracts with its clients in NSEL. Thereby the existence of paired contracts in NSEL can be directly linked to MOCBPL which is not considered to be an ethical way of trading as a broker in the market. Furthermore, MOCBPL was involved in promoting such paired contracts in the market. Therefore, on this ground SEBI observed as follow:

“98.3. The Noticee, by virtue of being a broker, and by its own admission, has facilitated transactions in the said paired contracts for its clients on the NSEL platform. This in itself establishes a close association between the Noticee on the one hand and paired contracts and NSEL on the other. Over and above this, the Noticee, by its own admission allowed himself to become a channel and instrument for NSEL to promote paired contracts amongst its clients.

98.4. Given the close association of the Noticee to NSEL and the paired contracts, and the relatability of the same to the Noticee, the serious adverse observations of the various Courts and Authorities have, in turn, seriously eroded the reputation and belief in competence, fairness, honesty, integrity and character of the Noticee. The SAT order laying down this position of law as to reputation being linked to close associations in the matter of Jermyn vs Sebi was confirmed by the Honorable Supreme Court in second appeal.

98.5. Reputation is an important factor for consideration of Fit and Proper Critera and the reputation of the Noitcee has been seriously eroded. Thus, I find that the Noticee is not a fit and proper person to be granted registration/ to operate as a commodity derivatives broker.”[4]

Thus, SEBI rejected the application filed by MOCBPL to become a broker as MOCBPL did not cleared the ‘Fit and Proper person’ test. On 22.02.2019, SEBI held that MOCBPL is not entitled to hold registration under the SEBI (Intermediaries) Regulations as it does not qualifies the ‘fit and proper person’ test for the same. Thus, SEBI held that MOCBPL would cease to be a broker in the commodities and derivatives market and would transfer all its operations to other qualified brokers who are not directly or indirectly related to it.

Conclusive remarks

SEBI is empowered to use the test of ‘fit and proper person’ in a very large ambit using its discretionary power as the test is inclusive of a three criteria but is not limited to those in order to be fulfilled. Thus it also imposes a responsibility on SEBI not to misuse the powers given to it and to use it in a bona fide manner with utmost caution. SEBI is entrusted with a great responsibility to maintain the integrity of the Securities market in all manners possible but the same powers if misused can defy the whole purpose as well. Thus, it is extremely important to use such powers in a just and proper manner.


[1] Schedule II, SEBI (Intermediaries) Regulations, 2008.

[2] See Motilal Oswal Commodities Broker Private Limited, Order by SEBIhttps://www.sebi.gov.in/sebi_data/attachdocs/feb-2019/1551087705719.pdf.

[3] Central Government vide notification dated June 5, 2007.

[4] Motilal Oswal Commodities Broker Private Limited and Another, 2019 SCC OnLine SEBI 213.