Bombay high court ruling raises questions on Sebi's power to freeze demat accounts of promoters for non-compliance

“Sebi may consider revisiting its regulations regarding the freezing of demat accounts for alleged violations to ensure that such actions are taken based on clear and substantiated grounds, balancing effective enforcement with procedural fairness," said Sangeeta Jhunjhunwala, a partner at Khaitan Legal Associates.

The court imposed a penalty of ₹80 lakh on Sebi, the National Stock Exchange of India (NSE), and the BSE on August 26 for illegally freezing the demat accounts of two people erroneously classified as promoters. The powers of the exchanges stem from Sebi circulars dated 30 November 2015 and 26 October 2016, which prescribe the standard operating procedures for how to deal with non-compliance of norms by listed companies.

Legal experts said the promoters of a company might not necessarily be the people making decisions. Amarpal Singh Dua, an independent advocate, said the Bombay high court’s judgement highlighted the need to shift from the concept of promoters to people in control while fixing responsibility for compliance.

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The case pertains to a Mumbai resident who was made the promoter of a company without his knowledge and consent. In July 2018, the National Securities Depository Ltd (NSDL) froze the demat accounts of Pradeep Mehta and his non-resident Indian son. Mehta told the court that the action against him was taken because he was one of the promoters of a company called Shrenuj & Co. Ltd, floated by his father-in-law in 1989.

Mehta claimed to have discovered himself as the promoter of the company only after his demat account was frozen. He held shares of other companies including ITC Ltd in the account. Shrenuj was delisted in 2018 over non-payment of penalties for failing to comply with Sebi’s Listing Obligations and Disclosure Requirements. When the company was delisted, all connected demat accounts were frozen, including Mehta’s.

Principle of fairness

“The judgement is likely to rescue the litigants whose cases are still pending before the Securities Appellate Tribunal challenging the freezing of demat accounts solely on the ground of their status as promoters. Although Sebi approved this shift in its board meeting of 2021, the framework is yet to be implemented," Dua said.

Dua said he is aware of two cases pending before the SAT, filed in 2022, dealing with the freezing of demat accounts and a case in which SAT had ordered the de-freezing of the demat account of a promoter company. He also mentioned an appeal pending before the Supreme Court challenging the SAT decision ordering the de-freezing.

Other experts said the high court’s ruling highlighted the need for regulatory action to be aligned with the principles of natural justice and fairness.

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While the court said the action against Mehta was “reckless," it also reviewed Sebi regulations to assess the extent to which a promoter can be held liable. The court was concerned whether a promoter, who played a role during the company's formation, should be liable for various regulatory compliances or if this issue should be shifted to the board of directors.

“If there is no consideration and examination of such essential attributes before taking any action against the promoters, it would certainly lead to a serious prejudice and/or even a gross absurdity, rendering any action of penalty or freezing of any demat account of a promoter, as in the present case, to be grossly arbitrary and illegal," the court observed.

In Mehta’s case, the high court said it did not find any specific power conferred on Sebi to freeze the demat account of the promoter that held shares of a company other than the defaulting company of which he was a promoter. The court’s observations made experts believe that Sebi needs to comprehensively review its regulations concerning the freezing of demat accounts of promoters.

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Kunal Sharma, a partner at Singhania & Co., said Sebi should evaluate a promoter's liability by checking whether a promoter has an active role in the day-to-day affairs of the company and if their role post-incorporation of the company is supported by robust evidence.

“Regulatory actions such as freezing demat accounts should be proportionate and specifically targeted at the violations related to the listed company," Sharma said. Asked about the implications of the judgement, Sharma said that promoters who have been unjustly penalised now possess stronger grounds to contest such actions.

However, Rohini Nair, a partner at ANB Legal, termed the incident a simple administrative mistake by the market regulator.

“Re-visiting the regulation may mean curbing the regulator’s power to take actions to protect investors. It may not be prudent to amend the regulations due to such errors," she said.