Saturday, December 21, 2013

Overhauling the Insider Trading Regulations: Part 1

Background

The legal regime governing insider trading in India is at least two decades old. The SEBI (Prohibition of Insider Trading) Regulations, 1992 were one of the initial few regulations that were prescribed by SEBI upon its establishment. However, the experience regarding the implementation of the legal regime on insider trading has been fraught with considerable difficulties. Although several actions were initiated by SEBI, including a few high profile ones, its track record of success has been far from clear. A substantial part of it had been attributed to the lack of robustness in the SEBI Regulations.

Taking that into account, several incremental amendments were made to the Regulations in 2002 largely as a result of the lessons learnt from the experience until then. While these efforts were helpful in plugging some of the more obvious loopholes in the Regulations, SEBI more recently found the need for a complete overhaul of the Regulations so as to provide an efficient means to curb undesirable insider trading and to enhance fairness and information symmetry in the capital markets.

Towards this end, earlier this year SEBI appointed a committee under the chairmanship of Justice N.K. Sodhi to review the existing insider trading regulations and to propose necessary changes to the legal regime. After consultations and deliberations, the Committee issued its report last week along with the proposed draft of the SEBI (Prohibition of Insider Trading) Regulations, 2013.

The Committee’s report identifies the inadequacies of the current legal regime and seeks to address them not just through incremental changes, but by reconsidering the regulatory approach. Given the importance of robust regulation of insider trading as a means of ensuring confidence of investors in India’s capital markets, this represents an important step. The report and draft regulations seek to streamline the regulatory approach, to simplify the regulations and to reduce the ambiguity and amorphousness that pervaded the pre-existing regulations.

In this series of posts, I propose to highlight some of the key recommendations of the committee and discuss the likely impact it may have on combating insider trading in the Indian markets.

At the outset, it is interesting to note that the proposed regulations adopt the approach of setting out detailed definitions that are carefully constructed followed by relatively straightforward operative or charging provisions. Hence, there is a lot at play in the definitions.  It would be useful to discuss the scope of some of the definitions before dealing with the operative provisions.

Definitions

Applicability

The insider trading regulations apply to listed companies or those that are proposed to be listed on a stock exchange. The expression “company” would include other types of entities that are eligible to access the capital markets.

Since SEBI possesses jurisdiction over listed companies or those that are to be listed, there is no difficulty when it comes to the application of the insider trading regulations to such companies. This is also consistent with the provisions of the Companies Act, 2013, which the Committee has expressly taken note of.

One concern here relates to the application of the law against insider trading to public unlisted companies and private companies.  This is not within the purview of SEBI and hence the beyond the scope of the Committee.  However, at a more general level the provisions of the Companies Act, 2013 (primarily section 195) that contain a prohibition against insider trading also apply to public unlisted companies and to private companies. This is bound to give rise to practical difficulties. Not only will the prohibition against insider trading become applicable in an unnecessarily wide manner, but it also militates against the concept and understanding that insider trading is relevant only in a market that is capable of price discovery, i.e. where there is a market for securities and therefore liquidity, which arise only in the case of listed companies.

Securities

As far as the types of instruments to which the prohibition applies, the Committee was of the view that it would apply to all types of “securities”, a term which has been defined in the Securities Contracts (Regulation) Act, 1956. Hence, the scope of the regulations would cover plain vanilla instruments such as shares, debentures and bonds, as well as more sophisticated instruments such as hybrids and derivatives.

Insider

The definition of an “insider” has been considerably streamlined. It now means either a “connected person” or any person who is in possession of unpublished price sensitive information (UPSI). The previous distinction between a connected person and deemed connected person has been done away with.

In this scheme of things, every connected person would be an insider. Apart from that, any outsider who may be in possession of UPSI would also be considered an insider.

The definition of a  “connected person” has received greater attention. According to the Committee’s recommendations, such a person requires association with the company in any capacity due to which it may receive access to UPSI. The immediate relatives of such a person are also generally considered to be connected persons unless they can establish otherwise.

Two aspects of this definition require greater discussion. First, a person may become a “connected person” even if such person does not carry a formal position within the company. Therefore, advisers, external consultants and the like (whether in a formal or informal capacity) would be captured within the definition. The relevant test is whether the person is “associated with a company in any capacity including by reason of frequent communication with its officers or being in any contractual, fiduciary or employment relationship”.  Compared to this, the approach under the existing regulations appears to require the existence of a formal capacity, as SEBI had decided in an earlier order discussed here. The scope of a connected person is therefore somewhat widened.

Second, the expression “connected person” is defined to encompass any person who is a public servant or occupies a statutory position that allows such person access to UPSI.  As discussed in the Committee’s report, such persons would include a judge deciding a case pertaining to the company, or a public servant who maybe involving in formulating policy that may affect the operations of the company. Although the express statements in the report only cover members of the judiciary and the executive, the scope of the prohibition may very well extend to members of the legislative arm of the government. The committee may have drawn inspiration from the legislative developments in the US where the STOCK Act or the Stop Trading on Congressional Knowledge Act seeks to apply insider trading rules to members of Congress and their staff. While the inclusion of public servants within the scope of the insider trading regime is necessary and overdue, much will depend upon how forcefully the legal regime is implemented against them.

UPSI and Generally Available Information

The committee has sought to provide a somewhat exclusionary definition of UPSI.  It means any information that is not generally available and which, if made available, is likely to materially affect the company’s securities. Although the definition of UPSI includes certain specific matters such as financial results, dividends, changes in capital structure, M&A and changes in key management personnel, these are only indicative in nature and do not constitute mandatory UPSI. This represents a significant departure from the existing regulations where such significant pieces of information are deemed to constitute UPSI.

Since UPSI is defined with reference to information that is not generally available, the expression “generally available information” acquires importance. It is defined to mean information that is accessible to the public on a non-discriminatory basis and includes research and analysis based thereon.  Although the definition itself is fairly simplistic, it is accompanied by a detailed explanation on what amounts to generally available information. A parallel to this is the concept of publication under the existing regulations, which has been the subject matter of a great deal of consternation. For example, there have been questions as to whether the publication has to be by the company itself or by third parties such as the media, and whether the information has to be general in nature or specific as to the details. This was the basis on which the appellate authority was unable to find a charge of insider trading against Hindustan Lever Limited and certain of its officials in the first high-profile case of insider trading in the mid-1990s.

While the Committee report and the draft regulations seek to provide the much necessary explanation and categorization of what amounts to generally available information, it might be too much to expect complete certainty in this behalf, as much would also depend on the facts of specific cases which would have to be interpreted by the regulators and the courts.

Trading

Finally, in terms of definitions the Committee seeks to clearly define the expression “trading” in order to distinguish it from the wider expression “dealing”. “Trading” means the acquisition and disposal of securities. Hence, creating a security over the shares of a company would not amount to “trading” in those securities.

In the next post, I will discuss some of the more operative provisions proposed by the Committee.

(continued in Parts 2 and 3)

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