Friday, December 5, 2008

No penal consequences for violating the new trading restrictions on Insiders?!

Poor drafting of the recent amendments to the SEBI Insider Trading Regulations has made the bar on six month reverse trading/ derivatives substantively ineffective.

The SEBI Insider Trading Regulations were amended vide notification dated 19th November 2008 available here and some issues relating to these amendments were discussed by me here.

The Model Code relating to procedures, etc. to prevent Insider Trading has been amended to introduce two major bars. Firstly, directors, etc. are now barred from carrying out an opposite transaction for six months. Thus, if such person buys even one share, he cannot sell any shares and if he sells one share, he cannot sell any shares for the next six months. Further, another clause absolutely barred such persons from taking any positions in derivatives. Let us call these two sets of transactions as “Specified Transactions”.

The question is what are the consequences of violation of these two restrictions?

The SEBI Act provides for severe punishment for Insider Trading. Under Section 15G, the specified acts by an Insider attract a penalty of Rs. 25 crores or 3 times the profits made from Insider Trading, whichever is higher. Under Section 24, violation of the Regulations could result in imprisonment upto 10 years or a fine of upto Rs. 25 crores or both. There can be other consequences also.

Would any of such consequences be attracted for violating the bar on carrying out such Specified Transactions i.e, such opposite transactions or derivatives? The answer seems to be No.

Violations of the Code are to be punished by the Company internally and the Model Code suggests that they “may be penalised and appropriate action may be taken by the company”. The violators shall also be “subject to disciplinary action by the company, which may include wage freeze, suspension, ineligible for future participation in employee stock option plans, etc..

Beyond this, it appears that SEBI cannot levy the said penalties of Rs. 25 crores, etc. or prosecute and get such person imprisoned, etc. The reason is the peculiar placement of the amendments. The bar on Specified Transactions is contained in the Model Code. Regulation 12 merely requires listed companies and other entities to “frame” and “enforce” a Code in the lines of the Model Code. There is no requirement in the Act or the Regulations that the Code so made should be followed. While an obligation and enforcement relation has been created between the Company, etc. and such persons, no such obligation or enforcement relation has been created between SEBI and such persons.

If, e.g., the Company does not frame such Code as prescribed, SEBI can levy the said penalties, etc. and take other penal and other action. Further, if the Company does not enforce this Code, then also such penal consequences would follow. But the Regulations do not go further and require that the Code so framed should also be complied with by the directors, etc.

Is this intentional or is it an unintentional drafting lapse? On first impression, one could be tempted to consider that this is intentional. The Consultative Paper on proposed amendments to Insider Trading of March 2008 did consider the requirements of the Model Code to be akin to corporate governance requirements. In fact, it discussed that disclosure of non-compliance was perhaps a better way to punish the Company economically through the markets. It also recommended dilution of the punitive requirements. Effectively, it appeared to suggest a change in approach. However, even considering these original thoughts, it still appears to me that it is not intended by SEBI that such violations should not attract penal consequences.

I think it is not only an unintentional lapse and this also arises on account of an improper appreciation of the structure of the Regulations. SEBI has all along assumed that violations of the Code as framed by the Company are not only punishable with monetary penalties and directions but also subject to prosecution. In the aforesaid Consultative Paper of March 2008, SEBI recommended that the violations of the Code should not result in imprisonment. It further said that “other powers of monetary penalties and directions should be continued”. Thus, SEBI assumed that the violations already attracted all these penal consequences.

On this erroneous presumption, perhaps, SEBI placed the bar on the Specified Transactions in the Model Code.

But where is the provision, in the Act or the Regulations, saying that violations of the Code will attract such penal consequences? Nowhere, I think.

Thus, by possibly an unintentional drafting lapse, the bar on the Specified Transactions will not attract the penalties, prosecution, etc. Taking this further, even violation of the 30 day lock in for shares acquired in IPO or, for that matter, violation of any other provision of the Code, would not attract such punishment.

Of course, this does not mean that such persons can merrily carry out Insider Trading as defined i.e., trade in shares on the basis of unpublished price sensitive information or communicate such information, etc. Also, persons violating the bars on Specified Transactions would also face, as discussed above, action by the Company for violation of the Code.

-       Jayant Thakur


Bruce Carton said...

I enjoy your blog very much, it is very helpful to US lawyers and I've linked to it several times.

Keep up the good work!

Jayant Thakur, CA said...

Thanks, Bruce!

Emil said...

The author here contends that SEBI cannot levy penalty for an alleged violation of the Model Code of Conduct (more specifically the new trading restrictions) provided in Schedule I (or a similar Code framed by the company without diluting the Model). I beg to defer with the above stated position in law. Clause 6.3 of the Model Code of Conduct states that the action by the company (for violation of trading restrictions) shall not preclude SEBI from taking any action in case of violation of SEBI (Prohibition of Insider Trading) Regulations, 1992. Also Regulation 12 (4) of the SEBI (Prohibition of Insider Trading) Regulations, 1992 states that an action taken by the company against any person for violation of the code shall not preclude the Board from initiating proceedings for violation of these Regulations. Thus SEBI can effectively initiate proceedings against a director who has violated the trading restrictions placed in Model Code of Conduct. Such a person cannot be punished under Section 15G of the Act, as this specifically deals with the punishment of Insider Trading. But he can be punished under section 15HB of the Act (penalty for contravention when no separate penalty has been provided) and a penalty up to one crore (10 million) can be imposed on him. (Correct me if I am wrong).

Jayant Thakur, CA said...

Hi Emil, Thanks for your feedback.

The difficulty is that while SEBI has said in the Code that action can be taken for violation of the Insider Trading Regulations, there are no provisions in the Regulations that say that violation of the Code would be violation of the Regulations. This, in fact, is the theme and central point of my post.

The Regulations provide that the Company should frame the Code and so if the Company does not, it is a violation of the Regulations.

The Regulations then say, under the recent amendments, that the Company should enforce the Code. So, if the Company does not enforce it, it is a violation of the Regulations.

However, the Regulations do not place any obligations on the directors, etc. to comply with the Code. This could be intentional (though I am not wholly sure) because the Code contain certain internal procedural requirements which the Company should follow so that insider trading is prevented. Regulation 12 refers to it as a Code for "internal procedures" and the Code is for "prevention of insider trading".

There can be a violation of the Regulations only if there is a regulation placing an obligation on the directors, etc. to comply with the Code. This, intentionally or otherwise, is missing.

The reference in the Model Code to SEBI's right to take action for "violation of the Regulations" is wholly consistent with the above. It clarifies that even if the Company takes action for violation of the Code, SEBI can still take further action for violation of the Regulations, if indeed there is a violation. Thus, for example, if the violation of the Code is also a violation of the Regulation (e.g., if the director, etc. has committed insider trading), then SEBI may take action. But obviously, the action is possible only if, as both the provisions of the Code which you have referred to state, there is a "violation of the Regulations".

This whole problem has arisen, I think, because SEBI has placed a substantive requirement of the new six month and other bars in the Code rather than in the Regulations themselves. Of course, there is also a confusion in SEBI's mind that violation of the Code is also a violation of the Regulations, as the Consultation Paper states.

In view of the above, SEBI cannot, whether under 15G or 15HB (which too requires a "violation of the Regulations" to be triggered), levy such penalties for violation of the Code.

- Jayant

Emil said...

Thanks... It clears my doubt...