'Inelegantly Drafted': Supreme Court Lays Down Two-Part Framework For Establishing Fraud Under PFUTP Regulations

The Supreme Court on Friday held that the definition of fraud under Regulation 2(1)(c) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003, suffers from "inelegant legislative drafting." Adopting a purposive interpretation of the provision, laid down a two-part framework for establishing fraud.

Observing that the definition of fraud under Regulation 2(1)(c) appears to treat both deceitful intention and proof of wrongful gain or avoidance of loss as non-essential ingredients, the top held that a literal reading of the provision could result in virtually any market conduct that induces trading being characterised as fraud.

To address this anomaly, the court adopted a purposive interpretation of the provision and held that regulators need not prove deceitful intention where inducement causes injury and enables the accused to secure unlawful gains or avoid ordinary losses. However, where injury cannot be established, proof of wrongful intention becomes necessary.

The observations came while allowing Reliance Industries Ltd's appeal against findings of fraud and market manipulation recorded by SEBI and the Securities Appellate Tribunal in relation to trading in Reliance Petroleum Ltd shares and futures contracts in November 2007.

At the centre of the dispute was the interpretation of Regulation 2(1)(c), the provision that defines fraud under the PFUTP Regulations. The Court set aside the fraud findings and quashed a disgorgement order of ₹447.27 crore with interest. However, it upheld findings relating to violation of position-limit requirements under the 2001 SEBI Circular.

A bench of Justices J.B. Pardiwala and R. Mahadevan held that both mens rea and actus reus remain relevant considerations while determining fraud under the PFUTP Regulations. The Court said a literal reading of Regulation 2(1)(c) would create uncertainty about what conduct amounts to fraud in the securities market.

The bench noted that the provision, inter alia, defines fraud to include "any act, expression, omission or concealment committed whether in a deceitful manner or not by a person or by any other person with his connivance or by his agent while dealing in securities in order to induce another person or his agent to deal in securities, whether or not there is any wrongful gain or avoidance of any loss".

The court noted that the definition appears to make both deceitful intention and proof of wrongful gain or avoidance of loss non-essential for establishing fraud.

The bench observed that any imputation of wrongdoing is ordinarily founded on either an unlawful mindset, unlawful action, or both. However, Regulation 2(1)(c), if read literally, appears to deprive courts and regulators of both benchmarks by making them irrelevant for establishing fraudulent conduct.

Describing Regulation 2(1)(c) as an example of "inelegant legislative drafting," the Court observed:

"Regulation 2(1)(c) in our opinion, is an illustration of inelegant legislative drafting. We say so because any imputation of wrong doing is founded either on unlawful mindset or unlawful action or both. Unfortunately, Regulation 2(1)(c) deprives us of both by making them irrelevant for the purposes of establishing fraudulent conduct."

The Court said the plain language of the provision ought not to be read in a strict sense. It observed that the requirement of a "deceitful intention" had been made non-essential. It also noted that the provision does not require proof of wrongful gain or avoidance of loss.

"In our considered opinion, the plain language of the Regulation 2(1)(c) ought not to be read in a strict sense. We say so because the requirement of 'deceitful intention' being non-essential to the definition runs counter to the third element of the first part of the definition of fraud. As discussed hereinabove, the language of Regulation 2(1)(c) places no requirement to prove wrongful gain or avoidance of loss. Rather, it only requires the proof of inducement by which a third party is misled to deal in securities," the bench observed.

"Reading these two 'non-essentials' together shows that minimal weightage has been given to both 'deceitful mens rea' as well as 'injurious actus reus'," it added.

The court said a literal interpretation could produce unintended consequences.

"We have no choice but to ask ourselves the question– what exactly is the basis for someone to fall under the definition of fraud because at the moment, anything and everything in the stock market that may induce someone to deal in securities, could very well be termed as fraud by the respondent."

Referring to its earlier decision in SEBI v. Kanhaiyalal Baldevbhai Patel, the Court held that the difficulty in defining fraud cannot justify an interpretation broad enough to cover virtually every market act capable of inducing trading.

To resolve the issue, the Court adopted a purposive interpretation of Regulation 2(1)(c). It held that both mens rea and actus reus continue to be relevant considerations while determining whether fraudulent conduct has been established.

Summarising its conclusions, the Bench held that both mens rea and actus reus cannot be treated as irrelevant while determining fraud under Regulation 2(1)(c).

"In our considered view, both mens rea and actus reus cannot be made into irrelevant factors for deciding fraud. Therefore, we may outline the following scenarios for a more purposive approach to Regulation 2(1)(c):"

The Court then laid down a two-part framework for applying the provision:

"i) In situations where injury due to wrongful act is established, i.e, inducement to deal in securities has caused the other person to be adversely affected and allowed the party accused of fraud to gain unlawful profits or avert ordinary losses at the former's expense, there would be no requirement on the respondent authority to prove deceitful intention. In other words, where injury is impossible to be proved, the requirement of wrongful intention becomes mandatory.

ii) Secondly, similarly, in situations where deceitful or mala fide intention to defraud and manipulate the securities market is clear from the blatant misconduct or attending circumstances that cogently establish wrongful intention, then proving the injury would not be required."

Applying these principles to the facts before it, the Court held that the Securities Appellate Tribunal had committed an "egregious error" in sustaining findings of fraud under the PFUTP Regulations.

It consequently set aside the findings of fraud and market manipulation under Section 12A of the SEBI Act and Regulations 3 and 4 of the PFUTP Regulations.

The court also quashed the disgorgement order of ₹447.27 crore with interest. It directed the refund of ₹250 crore deposited by Reliance Industries pursuant to earlier orders. However, it upheld findings relating to the company's violation of position-limit requirements under the 2001 SEBI Circular.