When Soft Enforcement Stings: Rethinking SEBI’s Warning Letters

Introduction

Recently, the Securities and Exchange Board of India (SEBI) issued a warning letter to Nestlé India Limited (Nestlé) for purported violations of the SEBI (Prohibition of Insider Trading) Regulations, 2015¹ (PIT Regulations) by a “designated person of the company”.² The effect?: (i) disclosure to the Bombay Stock Exchange Limited (BSE) under Regulation 30³ of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015⁴ (Listing Regulations)⁵; and consequently (ii) significant media coverage.

Notably, despite the media coverage, SEBI’s warning letter does not appear to have affected Nestlé’s share price, however one could assume (though not necessarily) that it would have triggered a comprehensive internal inquiry within Nestlé to ascertain the cause of the warning in a bid to contain future fallout/avoid penal consequences. Precisely the kind of reaction warning letters are meant to achieve.

Yet, this begs the question — if the markets did not penalise Nestlé, does it mean that other alleged defaulters might be spared the wrath of market on issuance of warning letters? After all public disclosures have a tendency to cause significant market disruptions, as was the case with Mastek.⁶ Hypothetically, if a listed Company X is on the verge of being admitted into insolvency with rumours circulating on potential misappropriation by the promoters, a warning letter by SEBI can be particularly damaging to X‘s share price and eventually affecting its value as a going concern.

Despite warning letters’ potential to cause reputational harm to an entity, the criteria that prompt their issuance lacks transparency. In absence of an established framework governing issuance of such warning letters, the alleged defaulters have no way of knowing what prompted such action, or if they have taken remedial steps pursuant to the warning letter, whether these steps have sufficiently met SEBI’s standards of compliance. Neither the Securities and Exchange Board of India Act, 1992⁷ nor the Regulations provide for a remedy against improper issuance of warning letters. Thus, breeding the scope of abuse and arbitrariness.

This piece argues that SEBI’s warning letters, though framed as soft enforcement tools, can have substantive effects, thus warranting judicial review. However, in absence of an appeal or a review mechanism, SEBI’s warning letters can only be challenged under Article 226⁸ of the Constitution of India⁹, which may not always be practical. Resultantly, tailored framework/guidelines specifically dealing with warning letters are required to ensure business transparency and protect stakeholders’ interests.

The legal basis: Can SEBI issue these warnings at all?

Warning letters are soft enforcement tools leveraged by SEBI to ensure compliance of possible violations of securities law. On receipt of these warning letters, the defaulting company or individual is put to notice about non-compliance of securities law, thus giving them a chance to investigate and rectify the purported violations that have sparked SEBI’s scrutiny, without resorting to comprehensive punitive action in the form of show-cause notices. Since 2021-2022, SEBI’s reliance on warning letters to ensure compliance of possible violations of securities law has only increased. For instance, in 2023-2024, SEBI issued a whopping 141 warnings to defaulters, which was 41% more than the warnings issued in 2021-2022, evidencing SEBI’s inclination to bring about regulatory compliance by a slap on the alleged defaulter’s wrist.

Though SEBI is using warning letters as a preferred enforcement mechanism, its power to issue warning letters lacks explicit statutory grounding. In fact, it is only Regulation 12(a)¹⁰ of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003¹¹ (PFUTP Regulations) that provides for SEBI’s power to issue such a “warning or censure” to an intermediary. Nevertheless, SEBI issues warning letters for purported non-compliances under a host of other regulations. A case in point is the warning letter issued to Housing Development Finance Corporation (HDFC) Bank Limited for alleged non-compliances under the SEBI (Merchant Bankers) Regulations, 1992¹² and SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018¹³.¹⁴

But does that mean that SEBI’s issuance of warning letter for violations (other than the PFUTP Regulations) is bad in law? That is not so much the case. Section 11(1)¹⁵ of the Securities and Exchange Board of India Act, 1992 empowers SEBI “to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit” (emphasis supplied). The phrase “by such measures as it thinks fit” has received an expansive interpretation at the hands of the Supreme Court in Sahara India Real Estate Corpn. Ltd. v. SEBI¹⁶. At para 303.1, Justice Khehar (as he then was) opined that:

303.1. … the measures to be adopted by the SEBI in carrying out its obligations are couched in open-ended terms having no prearranged limits. In other words, the extent of the nature and the manner of measures which can be adopted by SEBI for giving effect to the functions assigned to SEBI have been left to the discretion and wisdom of SEBI. (emphasis supplied)

Thus, the Supreme Court’s reading of the phrase “by such measures as it thinks fit” confers wide power on SEBI to take all steps necessary to protect investor’s interest, including the power to issue warning letters.

Soft letters, real consequences: Impact and remedies

Although a warning letter is SEBI’s soft enforcement tool, it has the potential to result in serious civil consequences being: (i) reputational damage; and (ii) adverse market impact for the entity concerned on account of public disclosures. As such, it is settled law that any action of a statutory authority resulting in civil consequences must be tested on the anvil of reasonableness and is subject to judicial review.¹⁷ Therefore, SEBI’s warning letters are no exceptions and fall within the ambit of judicial review of courts. However, in absence of any redressal mechanism, the only recourse to an entity would be to challenge the warning letter under Article 226 of the Constitution before the jurisdictional High Court.

Regarding remedial measures under Article 226, owing to the administrative nature of a warning letter and SEBI being a specialised regulator, the High Courts would be slow to interfere with it. A case in point is State of Haryana v. Ashok Khemka¹⁸, where the Supreme Court has ruled that:

25. … judiciary must exercise restraint and avoid unnecessary intervention qua administrative decision(s) of the executive involving specialised expertise in the absence of any mala fide and/or prejudice.

However, in any case, “exercise of restraint” cannot be equated to carte blanche to SEBI’s actions, and these warning letters can be made subject-matter of a challenge on the ground of patent illegality, irrationality or procedural impropriety.¹⁹

Though not reducible to a straitjacket formula, the key grounds for judicial review of warning letters can be drawn from the principles laid down by the Supreme Court in Amarendra Kumar Pandey v. Union of India²⁰, regarding judicial review over administrative decisions, which are as follows:

(a) The formation of statutory authority’s opinion should be based on evidence.

(b) The evidence on which the opinion is made should have a reasonable nexus with the purpose for which the power is to be exercised.

(c) Misapplication or misconstruction of statutory provisions.

(d) Exercise of power for improper purpose, and not to take immediate action.

(e) Irrelevancy of grounds or non-consideration of relevant grounds for exercise of powers.

Considering the above, illustrative situations which may warrant interference with SEBI’s issuance of warning letters are as follows: First, issuance of warning letters without backing of credible information. Second, reliance on unrelated evidence to level allegations in the warning letters. For example, if the warning letter alleges violation of the PFUTP Regulations, then there should at least be a prima facie satisfaction of such violations based on relevant evidence. Third, extraneous and mala fide considerations motivating issuance of the warning letters. As is evident, the Court’s focus while testing the reasonableness of warning letters under Article 226 would be on propriety of SEBI’s decision-making process and not on the decision itself.

Without a doubt, this check is extremely important. However, in a fast-paced business environment, the Court’s exercise of its powers of judicial review may sometimes prove to be too little, too late. For example, considering the high pendency of cases in High Courts, the market price for a company may drop significantly even before an interim order is secured against a warning. Thus, stakeholders need greater visibility on the framework/guidelines governing issuance of warning letters, to account for them while taking business decisions and strategy calls,²¹ instead of looking for post facto remedies.

To establish such a framework, SEBI can draw helpful assistance from the procedures adopted by UK’s Financial Conduct Authority (FCA) and the US’s Securities and Exchange Commission (SEC) which also employ soft enforcement tools to ensure compliance of securities law. Illustratively, the framework can include: (i) a pre-warning consultation mechanism (like the “minded-to” procedure adopted by the FCA before issuing a private warning²²); (ii) clear thresholds for public disclosure; (iii) post-warning feedback channels; and (iv) annual reporting of anonymised enforcement statistics. Together, these safeguards can enhance regulatory predictability without compromising SEBI’s flexibility.

Conclusion

To conclude, while SEBI’s warning letters are positioned as soft enforcement tools, their issuance can have significant consequences on entities and individuals, both in terms of market perception and reputational harm. Given their potential impact, the absence of a structured framework governing their issuance, disclosure and review creates uncertainty and scope for arbitrariness. Judicial review under Article 226, though available, may not offer timely relief. Therefore, to ensure regulatory predictability and protect stakeholder interests, SEBI must consider adopting clear guidelines around warning letters — balancing their utility as a compliance tool with the need for fairness, transparency and accountability in securities regulation.