Prachi Manekar, Advocate, Bombay High Court and author of ‘Insights into the new Company Law’ talks to Cafemutual about the implications of mis-selling under the new law.
What does the new company law say about mis-selling?
The old law covered only mis-selling of shares and debentures’. The new Company Law covers the entire spectrum of securities. If a financial advisor makes a promise, statement or forecast which is false or misleading then there will be consequences under the Companies Law Act. This is in addition to any consequence that the advisor would face under the SEBI Law.
How does the new company law affect mutual fund distributors?
The new company law says that mis-selling is fraud. A distributor can be liable to imprisonment which can start from a minimum of six months and maximum of ten years. If the financial advice affects the general public interest then the minimum quantum of imprisonment is three years. If distributor mis-sells higher yielding products and the distributor has made wrongful gains he’ll also have to pay a fine which shall be not less than the amount involved in the fraud but which may extend to three times the amount involved in the fraud. It is also pertinent to note that this offence is cognizable offence. If somebody makes a complaint against an advisor, he/she is liable to be arrested without a warrant.
SEBI has recently defined mis-selling as a fraudulent trade practice (FTP). How does it affect mutual fund distributors?
SEBI has included mis-selling as a FTP to prevent rampant malpractices noticed in the past. Under the revised norms, instances where mutual funds are sold by making false or misleading statements like promise of assured returns where there are none, are considered as a FTP. It also includes instances where material facts are concealed or associated risks are not specified. The mutual fund distributor is also entrusted with the responsibility of taking reasonable care to ensure suitability of the scheme to the buyer.
Mis-selling is very subjective in nature. How can investors prove that they have been mis-sold a product if the mutual fund does not perform well due to bad market conditions?
Judgment errors are not considered as mis-selling. For instance, if a mutual fund does not perform as it was expected to be based in the judgment of the distributor then it is not considered as mis-selling. The fund may not perform due to macro-economic scenario. Mis-selling occurs when a distributor has willfully advised a wrong product which doesn’t suit the risk profile of the investor. For instance, if an investor approaches a distributor to invest in tax saving product and the distributor recommends a product which doesn’t qualify for tax exemption then that is deemed as mis-selling. Also, if an old person having less risk appetite is looking for a cash flow and the distributor recommends a high risk product knowingly then that is also deemed as mis-selling. Mis-selling has nothing to do with the losses faced by investors. Even if the investor doesn’t face any financial loss after being mis-sold a product, even then distributor can be charged for mis-selling. However, all these things have to be proved by the investor.
If a distributor complies with all the criteria laid down by SEBI while recommending funds then he/she is not at fault.
Can distributors be dragged to court in case of judgment errors?
Distributors can be dragged to court for cases of judgment errors but distributors have a sound legal defense. If they can show that the product was suitable but did not perform due to some unforeseen circumstances, then there is great likelihood of succeeding in the case on merits. However, in Company Law, a complaint itself triggers a serious consequence and the distributor has to go through a tedious court procedure.
How can mutual fund distributors protect themselves with the new company law?
Distributors have to disclose all the risk factors and material facts to investors and take their signature on a piece of paper stating that the investor has understood the product. If a product is sold as per the risk appetite of the investor after disclosing all the facts and if the fund doesn’t perform then investor can’t drag the distributor to court.
Can distributors record the conversation?
They can record the conversation but record keeping comes with its own costs. Further, it would be difficult to prove that the voice of investor is the same who was given advice. The recording has to be proved in court. Taking a written undertaking is a better safeguard.
If a mutual fund distributor is proven guilty by a court what kind of penalty the judiciary can impose? Can they make their company limited liability partnership (LLP) to protect themselves?
In the Company Act there is no upper limit on the quantum of penalty that can be levied against a person. If it is a proprietorship, an unlimited company or a partnership then the individual or entity may have to cough up to three times the wrongful loss incurred by the investor from their personal assets. On the contrary if it is a LLP, then it is the LLP which has to pay. The assets of LLP will be taken into consideration to pay off the fines. In LLP, personal assets of distributors are not taken into consideration. If there are numerous financial advisors working as partners then the wrongful act of one partner does not affect other partners.
SEBI Act has separate set of penalties. Under fraudulent practices, a distributor’s registration can be cancelled or suspended. SEBI also has powers to investigate and disgorge. Disgorgement means paying back whatever wrongful gains distributor has made from a transaction.
Can a distributor be charged both by SEBI and the Company Law provisions?
You can’t be doubly prejudiced for any wrongful act. For instance, if you have murdered a person you can only be charged once. You can’t be charged twice. That’s unconstitutional. As of now it is unclear as to whether SEBI or Company Law or both will be applicable in case of mis-selling. SEBI cannot interfere in certain areas which are governed by Company Law.
What legal recourse distributors have?
If you feel that your registration is cancelled wrongfully then you can approach Securities Appellate Tribunal (SAT) challenging SEBI’s decision. If SAT also decides against you then you can approach the Supreme Court.
Are ULIPs covered under this law?
Insurance products are not covered under the definition of ‘Securities’. ULIPs and insurance products don’t fall under the purview of company law. ULIPs fall under the purview of IRDA.
If a banks relationship manager mis-sells a product and changes his/her job can an investor drag the bank to court?
There have been many instances where banks try to shed their responsibility for the wrongs done by their employees. However, the bank is vicariously liable for the actions/omissions of its employees. A bank’s employee is an agent of the bank and the bank cannot wriggle out of its responsibility. It is liable for their actions and can be dragged to court.
