Home >Opinion >The ‘fit and proper’ conundrum

Jignesh Shah and Joseph Massey may have resigned from the board of Multi Commodity Exchange of India Ltd (MCX); but it will be foolhardy to presume that they will give up without a fight when it comes to the show cause notice by Forward Markets Commission (FMC). The regulator has questioned their ‘fit and proper’ status to be a director on a national multi-commodity exchange.

Notices were sent to three erstwhile directors, including Shreekant Javalgekar, who, until recently, were also on the board of the crisis-hit National Spot Exchange Ltd (NSEL). In addition it served a notice to Financial Technologies (India) Ltd or FTIL, which holds a 26% stake in MCX. FTIL’s reply to the notice, parts of which are available with certain newspapers, suggests a long-drawn legal battle is in the offing. According to reports in The Times of India and The Financial Express, the company has said that the notice is without any legal basis. The argument is that FMC issued its ‘fit and proper’ guidelines under an ordinance that was aimed to empower the regulator, but that the ordinance has since lapsed.

According to a source at FMC, however, this is legal argle-bargle, pointing to the fact that MCX has been complying with these very same guidelines on other occasions in the past. For instance, when MCX made an initial public offering of equity shares last year, through which FTIL brought down its stake from over 31% to 26%, the company wrote to FMC stating that it is complying with the equity structure guidelines for national multi-commodity exchanges. According to the commodities futures market regulator’s guidelines, the original promoter of an exchange has to bring down ownership to 26% within a specified period. Similarly, earlier this year, when private equity firm Blackstone Group bought a stake in the exchange, prior permission was taken from FMC, in line with the very same guidelines. Investors who purchase 2% or more are required to take prior permission from FMC. According to the regulator, therefore, FTIL’s charge that FMC has no jurisdiction or power to initiate any action as suggested in show cause notice, is blunted by its own willing compliance to the very same powers until the recent past.

Of course, all this is not to say that this is an open and shut case. Not too long ago, Securities and Exchange Board of India (Sebi) had said that MCX Stock Exchange, another exchange promoted by the group, will not be allowed to introduce new segments because it had not adhered to fair and reasonable standards of honesty that should be expected of a recognized stock exchange. But the exchange challenged this in the Bombay high court and won.

What regulators consider argle-bargle may well hold in a court of law. This seems like a tragedy, because a judgment on the ‘fit and proper’ status of an applicant to run an exchange isn’t a legal judgment to start with, but the concerned regulator’s assessment. As one former Sebi chairman puts it, if the ‘fit and proper’ test were to be relegated to a mere checklist to ensure applicants don’t have legal cases against them, then a regulator’s assessment, based on its sectoral expertise, will not be needed at all. Needless to say, FMC may soon come to this view as well. Even though its guidelines expressly state that its judgment on the ‘fit and proper’ status of an applicant will be treated as the final decision, the courts may not agree.

Having said this, on the other hand, if regulators are given arbitrary powers, they could very well misuse them as well. For all one knows, an application may get rejected based on the whims of a particular regulator, instead of a sound judgment. Therefore, legal recourse for those whose applications are rejected /cancelled can not be denied. This leaves us with the disconcerting truth that the ‘fit and proper’ assessment is a messy affair.

What is the way out? In assessing the fit and proper status of new bank licence applicants, Reserve Bank of India has appointed a committee to look into the new applications. In such a model, one can argue that the concern about arbitrary use of powers is tackled. But clearly, this isn’t a fool-proof mechanism either. While there may not be enough evidence to declare someone unfit and improper at the time of the application, it’s still very much possible that a bank/exchange runs into trouble at a later stage. In fact, who’s to say that officers at the trusted National Stock Exchange will never engage in activities that will pose risks to the market?

Given this reality, regulators have little alternative but to increase monitoring of market infrastructure institutions such as stock exchanges. This column has argued in the past that an increasing number of regulatory roles should move either to an independent organization of the likes of US’s Financial Industry Regulatory Authority (Finra), or to Sebi itself. This will result in lower risks to the market. Of course, there are other benefits of an integration of regulatory roles such as surveillance— for instance, each exchange can only monitor positions taken by traders in their own segments; but an integrated approach will bring to light dangers, if any, of cumulative positions across various platforms. Unfortunately, even though these issues came to light more than three years ago, there is no movement on this front. Regulators should not fool themselves into believing that the 5,500 crore NSEL payment crisis occurred in a non-regulated exchange and that there are no risks associated with the exchanges they regulate.

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