On 7th October, 2016, SEBI issued a consultation paper proposing stricter regulation of investment advisory and research activity in relation to securities. Of the 17 odd proposals in the consultation paper, two proposals directly affect the right of hitherto unregulated persons to opine on securities on public platforms. These proposals are:
- No person shall be allowed to provide trading tips, stock specific recommendations to the general public through short message services (SMSs), email, telephonic calls, etc. unless such persons obtain registration as an Investment Adviser or are specifically exempted from obtaining registration.
- No person shall be allowed to provide trading tips, stock specific recommendations to the general public through any other social networking media such as WhatsApp, ChatOn, WeChat, Twitter, Facebook, etc. unless such persons obtain registration as an Investment Adviser or are specifically exempted from obtaining registration.
This is sought to be done by modifying the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003 (FUTP Regulations), which deal with securities market abuse, to reflect these prohibitions.
In this article, we (a) critique these proposals for being excessive and not backed by empirical research; and (b) analyse how a similar proposal would be dealt with under the draft Indian Financial Code which was written by the Financial Sector Legislative Reforms Commission (FSLRC).
In the field of public economics, there are four classes of market failure: public goods, market power, asymmetric information and externalities. The field of consumer protection in finance is rooted in market power and asymmetric information. The former is the subject of competition policy. The present discussion is about the latter.
In any market, consumers obtain information from three sources (a) from the manufacturer of a product; (b) from an advertiser or distributor of the product; and (c) from third persons, such as friends, family and personal acquaintances whose advice they generally rely on in making decisions in life.
Conventional consumer protection policy has regulated the sources of information mentioned in "(a)" and "(b)" because information disseminated from these sources is likely to be biased (Shapiro (1983)). For example, the State requires that a seller of a television in a multi-brand showroom must not be vested in a specific brand of TV, and must equally advertise TVs of all brands. On the other hand, a friend or personal acquaintance who opines on a new brand of TV, on social media or on other telecommunication channels, is not regulated. If the person to whom the opinion is given knows that the opinion giver is associated with the brand of TV that she recommends, she can choose to make her own decision on whether or not to purchase the TV. Other factors such as reputation and previous experience with the opinion giver, will also factor in the decision making process of the person to whom such opinion is given.
Why do we not regulate personal acquaintances as an information source? There are four reasons: (a) such regulation deters people from speaking freely, which in turn, adversely affects decision-making by all the users of the market, (b) it burdens people with the obligation to act in a fiduciary capacity every time they express an opinion on a market, (c) it is inconsistent with a core element of enlightenment values, free speech, and (d) the State does not have the capacity to regulate communications made in ordinary conversations (notwithstanding the platform).
Similarly, in the market for financial products and services, the regulatory strategy that has always been adopted is a controlled one: Only issuers of financial products, and financial intermediaries, must be regulated with respect to the information that they disseminate on financial products, because such information is vulnerable to bias. All communications made by such persons must be regulated, whether the communication be in the form of television or radio advertisements or posts applications or on social media. However, regulating persons who are neither the issuers of financial products nor in the business of financial intermediation, is akin to regulating a relative or personal acquaintance having an opinion on a specific brand of a TV. SEBI's proposal to regulate any person who opines on the securities market, as an investment advisor, falls in this category.
2 Concerns about over-reach
Pursuant to the enactment of the SEBI (Investment Advisers) Regulations, 2013 (Investment Advisors Regulations), SEBI gave itself powers to regulate only those persons who were in the business of rendering investment advice. This is evident from the definition of "investment adviser", which is defined thus: investment adviser means any person who for consideration, is engaged in the business of providing investment advice to clients....
The proposal to regulate any person who opines on a specific security or financial product on social media or other telecommunication channels, as an investment advisor, is inconsistent with the concept of investment advisor (as defined above). Regulation as an investment advisor triggers several costs and obligations such as minimum capital adequacy requirements, fiduciary obligations, suitability and disclosure obligations. Mandating every person expressing a view on a security to take on such obligations would be a case of regulatory over-reach. Adding sanctions in the form of including similar provisions in the FUTP regulations would be stifling free speech. In any market, consumers benefit from more availability of information rather than less. Free speech by trusted persons is a great check against consumer abuse. Consumers are in a `marketplace of ideas' and will choose what experts, friends and relatives to believe.
3 What is sound homework by a regulator?
Identifying any market failure requires research. Even after a market failure has been identified, every market failure does not warrant regulation. A regulator with limited State capacity must establish priorities. These priorities must be driven by what regulation is the most effective (in terms of generating benefits) and least costly (for both the regulator and the regulated). Only where the benefits of regulation outweigh the costs, should the regulator expend its energies and resources on trying to resolve it. Hence, FSLRC recommended that all regulation making must do a formal cost-benefit analysis.
In the present context, what kind of research ought to have taken place before a proposal to make a specific policy directed to communications by financial intermediaries on social media plaforms? It would need to be backed by research on inter alia the following questions:
- How many financial intermediaries use or allow the use of social media and public platforms (not covered by the usual Advertisement Code) for dissemination of scrip-specific information?
- To what extent do consumers rely on advice disseminated on public platforms and make investment decisions on the basis of such information?
- Are these retail or sophisticated consumers? To what extent do they need to be protected?
- What has been the experience of consumers who have relied on financial advice disseminated on public platforms? Would they be entitled to challenge the advice rendered by their financial advisors, had it not been disseminated on social media?
- What kind of internal policies or quality controls do financial intermediaries who use social media platforms, put in place for their authorised employees and representatives?
- What kind of records do financial intermediaries who use the social media for advising and advertising, maintain, to allow regulatory surveillance?
- What is the cost that SEBI has expended in enforcing the Investment Advisors Regulations and Research Analyst Regulations over a given span of time? How many enforcement orders have been passed? How many were challenged and overturned? The assumption would be that the cost of enforcement would multiply as more people would require registration as investment advisors.
IOSCO has conducted research on similar lines for financial intermediaries spanning across 22 countries (including India). While the research exercise was done in 2014 and involved a relatively small survey sample set of 100 financial firms, some of the findings from the cross-country research are revealing:
- About 25% of the surveyed firms did not allow the use of social media for business purposes. Of those that did, general usage by sales staff is not allowed.
- Amongst the firms that did allow usage of social media, none of them allowed the staff to use social media to deliver product recommendations or investment advice. The usage was limited to seeking potential clients by disseminating business profiles.
- Of the 75 intermediaries that permitted the use of social media on behalf of the firm, all of them implemented some type of registration within the firm to track users, postings, training for users of social media, pre-approval and monitoring mechanisms.
- An overwhelming majority of survey respondents treated social media communications like all other business communications and in this regard, false or misleading statements and unjustified promises were prohibited.
- Majority of the firms required social media communications to be supervised by trained individuals within the firm. Most of these utilised staff from compliance, legal or branch managers to conduct this supervision.
The IOSCO survey is not perfect. However, the report, in itself, contains useful hints for a research agenda that must feed into an exercise for making a regulation that proposes to intervene so extensively with the rights of persons to express opinions on public media.
SEBI's document should have approached the question in this fashion. In a sound regulatory organisation, regulation-making should be primarily driven by research into the working of the economy, understanding the anatomy of market failure, identifying the lowest use of coercive power in addressing them, and analysing past experiences of the introduction of interventions.
4 How would these proposals be treated under the framework proposed by FSLRC?
Prof. J. R. Varma of IIM-A has rightly criticised these proposals as cases of regulatory over-reach. He correctly says that if everybody needs a license from SEBI to post any stock specific thing on any social media, SEBI would quickly become one of the richest regulators in the world with a market capitalisation rivalling that of Facebook. He also conjectures that these proposals would have gone through even within the regulatory framework proposed by the FSLRC in 2013. We now enumerate elements of the Indian Financial Code (the law that was drafted by FSLRC) which, we feel, would have correctly blocked such proposals.
Business of rendering financial service v. opining on financial markets
On a plain reading of the provisions of IFC version 1.1, we find that the scheme of the said law does not allow a regulator to mandate registration or authorisation for a person who voices her opinion on the value of a security on a public platform (including on social media), unless such person is in the business of providing investment advisory services:
- IFC requires only those persons who are engaged in the business of rendering advice on financial products, for a consideration, to be registered with the regulator. Section 154 of IFC1.1 states: No person may carry on the business (emphasis supplied) of providing a financial service or purport to do so, without an authorisation from the Regulator to provide that financial service. The expression `financial service' has been defined in section 2(76) to include: rendering or agreeing, for consideration, to render advice on or soliciting for the purposes of (i) buying, selling, or subscribing to, a financial product; (ii) availing a financial service; or (iii) exercising any right associated with a financial product or financial service;...
- During the deliberations among the members of the FSLRC, the language of section 154 of IFC1.1 (corresponding to section 141 of IFC1.0) was specifically debated. Two possibilities were considered:
- Possibility 1: No person may provide a financial service or purport to do so, without an authorisation from the Regulator to provide that financial service.
- Possibility 2: No person may carry on the business (emphasis supplied) of providing a financial service or purport to do so, without an authorisation from the Regulator to provide that financial service. This option was consciously chosen to ensure that an activity relating to a financial product or a financial service triggers the authorisation requirement, only if one engages in it as a business.Some test cases for this proposition are explained below: (a) A professor and some researchers are debating on the current valuation of a company. Each of them opines on it, and the notes of the class are published on a public platform. This would not trigger the mandate of registration or authorisation, as the opinions were not voiced in the course of carrying on a business of providing a financial service or a financial product. (b) At a seminar, an economist voices her opinion on oil prices. A member from the audience tweets about it, along with a note of endorsement. This would not trigger the mandate of registration or authorisation as the opinions were not voiced in the course of business of providing investment advice on oil futures.
IFC defines the scope of regulatory jurisdiction in the primary law
To avoid instances of regulatory overreach of the kind attempted by SEBI in the consultation paper, FSLRC incorporated the registration requirement in the primary law itself. Mandating registration or authorisation from a regulator is the single most important entry barrier. It is the point at which regulation begins, and the point of commencement of the jurisdiction of the regulator. Allowing this point of commencement of regulation to be defined in delegated legislation creates perverse incentives, as it gives a regulator the power to define its own jurisdiction.
Contrast this position with that in the SEBI Act. The jurisdiction of SEBI under section 11(1) of the Act has been defined thus:
Subject to the provisions of this Act, it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and regulate the securities market, by such measures as it thinks fit.
This leaves both the scope of who can be regulated and in what manner, open to interpretation by the regulator. Using public choice reasoning, we would predict that SEBI would use this provision to grow its own turf.
Section 11(2) of the SEBI Act goes on to say: Without prejudice to the generality of the foregoing provisions, the measures referred to therein may provide for --
(ba) registering and regulating the working of ....such other intermediaries as the Board may, by notification, specify in this behalf;
The SEBI Act does not define the term 'intermediaries'. This leaves it open to SEBI to define the scope of its own jurisdiction.
IFC 1.1, on the other hand, instilled checks and balances against such discretion, in the primary law itself:
- As explained above, it defines the starting point of regulation in the primary law itself. Only persons engaged in the business of rendering a financial service can be mandated to obtain regulatory authorisation.
- While the expression financial service has been defined expansively, only the Central Government has been empowered to expand this definition. At the same time, the regulator has been empowered to exclude products and services from the definition of financial services. Thus, checks and balances have been built in the primary law by allowing the Central Government to expand the jurisdiction of the regulator, and allowing the regulator to limit its own jurisdiction. The grounds on which the Central Government can expand the jurisdiction of the regulator are also specifically set out in section 161 of IFC1.1.
The world over, communications between financial intermediaries and consumers are regulated through codes of conduct and disclosure requirements. Such regulation would apply, notwithstanding the channel of communication. Monitoring and supervising compliance with such regulations is hard work. However, a regulation that is sensibly crafted to address the difficulties of surveillance, such as requiring financial advisors to maintain records of social media postings and internal approval policies within the firm, may resolve the problem. Regulations that hamper the working of the marketplace of ideas are best avoided.
SEBI's mistakes are grounded in the faulty drafting of the SEBI Act and would not arise under IFC 1.1.
Carl Shapiro, Consumer Protection Policy in the United States, Journal of Institutional and Theoretical Economics, Bd. 139, H. 3., Regulation: Analysis and Experience in West Germany and the U.S.A.: A Symposium (October 1983), pp. 527-544.
The authors thank Smriti Parsheera for useful discussions and Gausia Sheikh for research assistance.
Ajay Shah is a researcher at NIPFP and Bhargavi Zaveri is a researcher at IGIDR.