Diversion Of Preferential Issue Funds For Undisclosed Purpose Amounts To Fraud Under PFUTP Regulations: Supreme Court

The Supreme Court on Tuesday held that diversion of funds raised through a preferential issue for purposes not disclosed in the notice of the Extraordinary General Meeting (EoGM) convened to approve the allotment amounts to a violation of securities law and constitutes fraudulent conduct under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations (PFUTP).

A bench of Justices J.B. Pardiwala and K.V. Viswanathan made the ruling while allowing appeals filed by the Securities and Exchange Board of India (SEBI) against a June 2, 2022 order of the Securities Appellate Tribunal (SAT), which had set aside penalties imposed on Terrascope Ventures Ltd and its directors for misuse of funds raised through a preferential allotment.

“Applying this principle, we have no semblance of doubt in our mind that the diversion of the funds raised for an object not set out in the notice of EoGM was clearly in breach of Regulation 3 as well as Regulations 4(2)(f), 4(2)(k) and 4(2)(r) of the PFUTP Regulations,” the Court observed.

The Court further held that such violations cannot be cured by subsequent shareholder approval, observing that “being a plainly illegal act impacting a vast array of stakeholders other than the shareholders of the company, the question of ratification cannot arise at all.”

SEBI's Adjudicating Officer had earlier imposed penalties of Rs 70 lakh on the company for violation of the PFUTP Regulations, Rs 30 lakh under the Securities Contracts (Regulation) Act, and Rs 25 lakh each on its directors after finding that the proceeds of the preferential issue were not utilised for the objects disclosed in the EoGM notice.

The case arose from a preferential allotment made between October 16, 2012 and November 8, 2012, through which the company raised about ₹15.87 crore. The explanatory statement to the EoGM stated that the funds would be used for capital expenditure, long-term working capital requirements, marketing, setting up of offices abroad, and other corporate purposes, but the amounts were immediately diverted towards investment in shares of other companies and loans and advances to connected entities.

Rejecting the defence that the diversion was due to market conditions and later ratified by shareholders, the Court held that the funds were diverted almost immediately after receipt, indicating that the company never intended to utilise the proceeds for the disclosed objects.

The bench emphasised that disclosure of objects in a preferential issue is mandatory under the SEBI regulatory framework and that investors and market participants act on the basis of such disclosures, and any misleading statement affecting investment decisions would attract liability under the PFUTP Regulations.

“SEBI's Regulations including the PFUTP is to protect the rights of several stakeholders and as such has public law dimensions. The Regulations are framed keeping in mind the rights and interests of multiple stakeholders involved in the securities market,” the Court said.

Setting aside the SAT's order, the Supreme Court restored SEBI's action and upheld the finding that diversion of funds contrary to the disclosed objects of a preferential issue amounts to a fraudulent and unfair trade practice under the PFUTP framework.

For Appellant: Senior Advocate Naveen Pahwa for SEBI;

Advocate Mahfooz A. Nazki, Amicus Curiae.