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Regulation by circulars?
March 25, 2021

Opinion: K P Krishnan


The recent semi-public exchanges between Sebi and DFS raise several questions about the legislative function of regulators that need careful consideration

In March 2020, a private bank wrote off Additional Tier 1 (AT-1) bonds worth Rs 8,415 crore, based on a scheme of reconstruction approved by the Reserve Bank of India (RBI). This created a mini-crisis in the bond market. While some bondholders challenged this write-off in court, the Madras High Court upheld it. On March 11, 2021, the Securities and Exchange Board of India (Sebi) issued a circular instructing mutual funds to value perpetual bonds assuming their maturity was 100 years on the issue date. It also required that no mutual fund can own over 10 per cent of such securities from a given issuer. This led to a mini regulatory crisis.

The Sebi circular influences the pricing of these bonds, and thus the corporate financial plans of banks. This would create new demands for fiscal resources for achieving the required equity capital in public sector banks (PSBs), which impinges on fiscal planning at the Ministry of Finance (MoF) and the planning process at the MoF’s Department of Financial Services (DFS), which owns PSBs. According to some newspaper reports, the DFS wrote to Sebi asking them to withdraw or modify this circular.

There are many aspects of this story that need to be understood, and feed back into better institutional design. In this article, we address one element of this: The notion that regulators can regulate by “circulars”.

The dictionary definition of “circular” is “a paper such as a leaflet intended for wide circulation. Its synonyms are “booklet, brochure, flier, folder, leaflet or pamphlet”. As against the dictionary definition of “regulation” is “a rule or order issued by an executive authority or regulatory agency of a government and having the force of law”.

Bodies like the RBI and Sebi are “regulators”, which are fundamentally different from departments and ministries of the Government of India. A regulator is a legal person and is created by Parliamentary law. Most regulators created in recent decades in India are remarkable in fusing the three branches of the state: They combine legislative, executive and judicial functions.

The legislative function in an agency established by Parliament is, in itself, noteworthy. For example, the Sebi Act empowers Sebi to issue “regulations”. This creates a novel situation in liberal democracy, where unelected officials in a regulator are authorised by Parliament to write law. For entities in the securities markets, the bulk of the law that they face is not the law written by Parliament but the law that is written by Sebi.

Let us contrast this with something that we are more familiar with. The Indian Penal Code (IPC) specifies in detail what elements are required before a particular action is classified as “theft” or “conspiracy”. The Code of Criminal Procedure (CrPC) details how the police authorities will investigate and how a judge will determine the guilt of the accused. The IPC and the CrPC are both controlled by the legislative branch. It is the legislative branch and not the executive branch which has the final say in defining the permissible conduct of private persons (i.e. what constitutes theft) or in determining the rules of fair play that is required of it.

The phrase “separation of powers” describes the vertical divisions of the state into three branches, the legislature, the executive and the judiciary. Such thinking is a part of the constitutional scheme in India. The drafters of the Sebi Act were aware of these issues. Regulators are an exceptional situation where unelected officials are given the power to make law.

Modern markets evolve at a high pace and the content of the law requires domain expertise and technical detail. The entrustment of the legislative function to the regulator has its origins in these considerations. However,

when unelected officials are given the power to define the law, this creates a democratic deficit, a gap in legitimacy. An array of procedures is required for achieving legitimacy. It is generally agreed that there are three essential elements for achieving legitimacy in the legislative function of a regulator:

(a) The regulator must achieve and display technical expertise;

(b) The regulator must consult the public and

(c) The regulation-making process must be controlled by a Board that has a majority of independent directors.

Consultation helps avoid mistakes, creates space for discovering a middle ground in contentious situations, and avoids embarrassing situations. Although there is no legal obligation for a consultation process in the Sebi Act, Sebi has adopted the practice of consultation when the law that it issues is called a “regulation”. However, when law is issued by Sebi and is called a “circular”, there is normally no public consultation.

The Indian judiciary was relatively indulgent towards regulators for a long time, but has increasingly started becoming concerned about these foundational questions. In Cellular Operators Association vs Trai, the Supreme Court observed that Parliament must enact a law like the US Administrative Procedure Act, 1946, which imposes a transparent consultative process upon all creatures of Parliament that have the authority to make law.


In 2019, in the case of Dharani Sugar and Chemicals Ltd, the Supreme Court struck down the RBI “circular” on resolution of stressed assets for being ultra-vires the Act.

In a narrow legal perspective, the present circular has been issued under section 11(1) of the Sebi Act and regulation 77 of the Mutual Fund Regulations. While the scope of section 11 is too broad, regulation 77 states that circulars can be issued only for a limited purpose like clarifying an existing regulation. However, this Sebi circular substantially alters the obligation of mutual funds investing in perpetual bonds. A formal process, which required displaying technical expertise and undergoing consultation, under the supervision of the board, would have improved the work.

Regulators in India issue a diverse array of instruments, including regulations, circulars, guidelines, FAQs, press releases, etc. All of them coerce private persons to varying degrees, and thus constitute law. Good governance practices for regulators involve only one legal instrument that a regulator can issue — a “regulation” — and an elaborate formal process for regulation-making that is written into Parliamentary law.

The writer, a retired secretary to GoI, is now a professor at the National Council of Applied Economic Research and non-executive chairman of Shriram Capital.