Supreme Court Rules That The Company Cannot Ratify The Illegal Fund Diversions

Supreme Court heard an appeal against the Securities Appellate Tribunal (SAT) and restores penalties imposed by SEBI in Terrascope Ventures Case; ruling that the illegal fund diversion cannot be ratified by shareholders and set aside a SAT order.

The Apex Court observed that the "fraud" under PFUTP Regulations does not require deceit, and It emphasized that fair disclosure of objects is a mandatory safeguard for the integrity of the securities market.

Background: Terrascope Ventures Limited (then Moryo Industries Limited) in the year 2012 raised approximately ₹15.87 crores bu issuing a notice for the Extraordinary General Meeting (EoGM), and represented to its shareholders and the public that the proceeds would be utilized for capital expenditure, acquisitions, working capital, and setting up offices abroad. However, the amount so raised was invested and loaned to others, and investigations by the Securities and Exchange Board of India (SEBI) revealed that almost immediately after receiving the funds, the company diverted them to grant undocumented loans and purchase shares in other entities.

Following the finding of diversion of funds, the SEBI’s Adjudicating Officer (AO) imposed significant monetary penalties on the company and its directors for violating the PFUTP Regulations and the Securities Contracts (Regulation) Act (SCRA) The Securities Appellate Tribunal (SAT) set aside these penalties in 2022, accepting the respondents' argument that a 2017 shareholder resolution had "ratified" the diversion of funds.

The Supreme Court, in this appeal by SEBI, allowed the appeal and restored the Adjudicating Officer (AO)'s penalty orders, holding that an act that is "plainly illegal" and impacts public interest cannot be validated through private ratification.

The bench comprising of Justice J.B. Pardiwala and Justice K.V. Viswanathan, held that 'Illegality Cannot Be Ratified', and that while a company may regularize an "irregularity" but it cannot ratify an "illegality".

Furthermore, the Apex Court observed that as the diversion of funds violated mandatory SEBI Regulations and disclosure norms designed to protect multiple stakeholders, a private resolution by shareholders could not wipe off the crystallized liability.

The Apex Court reitrated that the PFUTP Regulations, "fraud" is defined broadly and is not confined to common law deceit, The Court observed that making a promise (disclosing specific objects for an issue) without the intention of performing it constitutes fraud under Regulation 2(1)(c)(4).

On the significance of disclosure, the Apex Court held that the investors and stakeholders adjust their affairs—whether to buy, sell, or hold—based on the "fair disclosure and transparency" mandated by Regulation 73 of the ICDR Regulations Casually compromising these objects through post-facto diversions jeopardizes public interest

Supreme Court also rejected the respondent's reliance on Section 27, noting it applies to variations of objects in a prospectus for public issues, not to the fraudulent diversion of funds in a private placement . Thus, the Apex Court clarified that proceedings by the Whole Time Member (WTM) for market restraint and the Adjudicating Officer (AO) for monetary penalties operate in "separate fields"

Coram: Justice J.B. Pardiwala and Justice K.V. Viswanathan.