Fraudulent Diversion Of Company's Funds Can't Be Cured By Subsequent Shareholder Ratification : Supreme Court

The Supreme Court on Tuesday held that diversion of funds raised through preferential allotment for purposes other than those disclosed to investors amounts to fraud under securities law, and cannot be cured by subsequent shareholder ratification.Allowing appeals filed by the Securities and Exchange Board of India (SEBI), a Bench of Justice J.B. Pardiwala and Justice K.V. Viswanathan set aside an order of the Securities Appellate Tribunal (SAT) which had exonerated Terrascope Ventures Ltd. and its directors. The Court restored penalties imposed by SEBI's Adjudicating Officer (AO).“…objects set out in the explanatory note for the issuance of securities including preferential allotment of shares are of utmost significance and have a large say in influencing and impacting the conduct of the stakeholders concerned with the securities market.”, observed the bench, pointing out that any diversion of funds without proper disclosure to the investors, amounts to fraudulent activity under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 (“PFUTP Regulations”).“Utilizing funds for purpose different from the purpose stated in the invitation to subscribe is a fraudulent activity under the PFUTP Regulations.”, the court held. Background The case arose from a 2012 preferential allotment by Respondent-Terrascope Ventures Ltd. (then Moryo Industries Ltd.), through which the company raised approximately ₹15.87 crore. In its Extraordinary General Meeting notice, the company had specified that the funds would be used for capital expenditure, acquisitions, working capital, and expansion-related purposes. However, SEBI found that the company diverted the funds almost immediately, using them to purchase shares of other companies and extend loans and advances, contrary to the stated objectives. Following regulatory proceedings, SEBI's Adjudicating Officer imposed monetary penalties, while its Whole Time Member (WTM) had also restrained the company and its directors from accessing the securities market. The company defended its actions by relying on a 2017 shareholder resolution that purported to ratify the change in utilisation of funds. Accepting this argument, the Securities Appellate Tribunal held that once shareholders had approved the deviation, the utilisation became valid, leading to the setting aside of penalties. Against the SAT's order, the SEBI appealed to the Supreme Court. Issue The core issue was whether a company's diversion of funds raised through a preferential allotment can be legitimized by a subsequent shareholder resolution ratifying the act. Decision Setting aside the SAT's order, the judgment authored by Justice Viswanathan emphasized the importance of the disclosures made to investors while raising funds, stating that such disclosures are not mere formalities but form the foundation of trust in securities markets. Any diversion of the fund against the objective of the prospective undermines market integrity. “When a company offers private placement or goes public, the legal regime mandates fair disclosure and transparency. The investors and all other stakeholders concerned with the securities market irrespective of whether they ultimately subscribe to the shares or not, adjust their affairs based on the disclosure made.”, observed the Court, adding that “disclosure of the objects as mandated in Regulation 73 of the ICDR Regulations and as mandated by the fairness and transparency required of companies by the various regulations of SEBI have salutary purposes, which ought not to be casually compromised with.” Post-Facto Shareholder Approval Can't Legitimise Wrongful Diversion The Court held that companies cannot legitimise wrongful diversion of funds through post-facto shareholder approval. “It is very clear from the facts that the respondents had from the very inception had no intention to use the funds for the stated objects and their only object was to somehow raise the funds and divert it for the purpose they ultimately did.”, the court noted, pointing out that “the entire amount raised was utilized for a different object than the one set out in the EoGM notice and ratification was sought after committing the illegality.” “What is crucial for our purpose is that the object set out in the explanatory note appended to the notice of EoGM prior to the issuance of preferential shares. The funds were not utilized for those disclosed objects. To make the matters worse for the respondents here the diversions were made soon after the amounts were raised between 16.10.2012 and 08.11.2012. The diversion was contrary to the object set out to the explanatory note and was before any amendment was carried out to the Memorandum of Association and the purported resolution of ratification dated 29.09.2017. More importantly, the diversion was contrary to the PFUTP Regulations of SEBI, the SEBI Act and the disclosure norms under Section 173(2) of...

Fraudulent Diversion Of Company's Funds Can't Be Cured By Subsequent Shareholder Ratification : Supreme Court

Yash Mittal

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