Sunday, December 22, 2013

Overhauling the Insider Trading Regulations: Part 2

[This is a continuation of a previous post in this series]

Operative Provisions

The operative provisions (or charging provisions, as they are referred to by the Committee) go to the heart of the prohibition on insider trading, which also constitutes an offence for the breach thereof.

 The scope of insider trading usually tends to capture two somewhat distinct but related aspects:

1. The communication or procurement of UPSI by an insider; and

2. The trading in securities by an insider while in possession of UPSI.

Each of these aspects has been considered distinctively in the Committee’s report, which are accordingly discussed here as well.

Communication or counseling

The proposed insider trading regulations stipulate that an insider shall not communicate or provide access to UPSI, except where such communication is in furtherance of legitimate purposes, performance of duties or discharge of legal obligations. This would ensure that insiders communicate UPSI only on a need basis, and not such that the information is liable to be misused by the recipients to indulge in trading in the company’s securities.

Due Diligence

While the aspect of communication or counseling is understandable as an integral part of the offence of insider trading, this prohibition has hitherto given rise to several practical difficulties. Primary among them is the fact that this prohibition makes it impossible for companies to provide information to potential investors who may be willing to invest in the company only after conducting the customary due diligence by investigating into the affairs of the company. Since the benefit of such due diligence is not available to other shareholders or potential investors in the company, it could create an informational disparity.

Although facilitating such due diligence would cause the company to breach its obligation not to communicate UPSI, there are sound arguments put forward to justify such due diligence efforts.  No investor would be willing to infuse a substantial amount of funds in a company without conducting due diligence. This is particularly the case with long-term investors, both strategic as well as financial (such as private equity funds), or even in the case of an M&A such as a takeover that may be in the overall interest of the company. The argument is that such investment would benefit the company as a whole and therefore the release of information in due diligence ought not to breach the rationale against insider trading. This argument tends to have greater force when such investor is investing in new shares to be issued by the company because the company thereby obtains additional funding for its business requirements. It may have lesser force when the investor is buying shares in the secondary market from an existing shareholder because the proceeds of such an acquisition go to the shareholders rather than to the company, although the company may derive indirect benefits.

Under the existing Regulations, there is considerable ambiguity about the workability of the arguments and rationale discussed above. Going by the plain wording of the Regulations, it appears that communication of information during due diligence would amount to a technical breach. While SEBI does not appear to have initiated legal action against any company for violation of insider trading regulations merely on account of facilitating a due diligence, it has refrained from positively acknowledging that such due diligence is permissible. This has given rise to a great deal of ambiguity, due to which parties have been compelled to either conduct a limited due diligence so as to not constitute a technical breach of the regulations, or to follow other methods such as disclosing any such information before the investment actually occurs so as to not fall afoul of the regulations.

Fortunately, the Committee has addressed this practical issue head-on, which is likely to put at rest this thorny issue which has been daunting transactional lawyers in India for several years now. Under the proposed regulations, due diligence would be permitted in specific circumstances. A distinction has been made in cases where the investment or acquisition would result in an open offer under the takeover regulations, and in other cases where no such open offer is attracted. When an open offer is attracted, the board of the company must be of the informed opinion that the transaction and the due diligence are in the best interests of the company. This would enable M&A transactions such as mandatory takeover offers to be accompanied by due diligence that would benefit the potential investors/acquirers. Arguably, since the mandatory takeover offer would be made to all shareholders uniformly at a minimum price to be determined under the takeover regulations, the disclosure of selective information to the acquirer would not materially jeopardize the interests of the other shareholders.

Where the obligation to make an open offer is not attracted under the takeover regulations, an additional condition has been imposed. That is, the due diligence findings that constitute UPSI are disseminated to be made generally available at least 2 trading days to the effective date of the transaction. While the concerns of the Committee are understandable, this requirement could give rise to some concerns.  It is not clear as to how the markets would deal with the disclosure of such information, and whether this could result in some sort of speculative trading or other unintended consequences. This aspect will have to be carefully considered not just from a regulatory perspective, but also from transactional planning perspective when parties are considering the structuring and implementation of a transaction and the manner in which they would disclose specific information. A lot would depend on the manner in which market practice evolves on this count.

Trading and UPSI

The principal charging provision in the regulations prohibits an insider from trading in securities when in possession of UPSI relating to such securities. This is a considerably wide provision. All that is required for an offence to be committed is that the insider was in possession of UPSI at the time of trading.

The wording of this proposed regulation is consistent with the 2002 amendments to the existing Regulations, but is wider than its original form introduced in 1992. In the original form, the prohibition applied only if the trading was “on the basis of” the UPSI.  This required an element of correlation such that the trading was occasioned by the presence of the UPSI, which was an element always difficult to prove on the part of the regulator. In order to avoid the need for such a correlation, the wording was altered in 2002 to read that the insider ought to be merely “in possession of” the UPSI  at the time of trading. While this wording should have made it easier for the regulator to initiate and successfully conclude insider trading actions, that has not been the case due to the higher burden imposed by the Securities Appellate Tribunal (SAT) in various cases.  Although not entirely evident from these rulings, the higher burden may have been a result of the fact that the penalty section for insider trading under section 15G of the SEBI Act continues to carry the words “on the basis of”.  This results in an incongruous position whereby the charging provision is considerably wider than the penal provision, thereby resulting in the inability of the regulator or the appellate authority from successfully imposing a penalty using a reduced burden of proving a case of insider trading.

In order to obviate this incongruity, it is necessary that section 15G of the SEBI Act be amended to bring it in line with the regulations on insider trading. Of course, this requires legislative intervention and is beyond the purview of the Committee, but it is hoped that the final recommendations of the committee as well as SEBI’s efforts in implementing it would include persuading the Central Government to initiate and ensure the passage of the requisite amendment to section 15G. Failing this, the efforts of the Committee in streamlining the regulations on insider trading would be set at naught due to this somewhat minor incongruity which may have rather severe ramifications in the implementation of the regulations.

Defences

The scheme adopted in the proposed regulations is to have an omnibus charging provision relating to insider trading, which would be carved out by specific defences available to the insiders. Such an approach creates a carefully crafted balance between the duties and obligations of the regulator on the one hand and the insiders on the other. To start with, the regulator would have to demonstrate only that the insider had possession of UPSI while trading in the securities of the company. The burden then shifts to the insider to demonstrate that he did not have the UPSI in or that he was entitled to one or more of the defences made available.

The defences set out by the Committee take into account several practical considerations where the direct prohibition on insider trading may not have the requisite effect. Some of the differences set out are as follows:

1.  Where the trading by insider is contrary to the nature of the UPSI, for example where an insider sells the shares of a company when the UPSI is of a positive nature, and vice versa;

2. Where a tippee has received information from a tipper and had no reason to believe that the information he possessed was UPSI;

3.  Where the counterparty in a transaction has the same level of UPSI as the insider, due to which there exists no informational disparity;

4.  Where an insider exercises stock options for which the exercise price was predetermined in accordance with the regulations applicable to stock options;

5. In case of companies and other entities, where the individual making the decision to trade in the securities of a company is different from the individual who has position of UPSI, which is a classic instance that occurs when there are systems and procedures for separating information through appropriate Chinese walls.

These defences could be useful for insiders who can demonstrate that they were not motivated by the existence of the UPSI when they carried out  trades in the securities of a company, although the burden of establishing the application of  one or more of the differences would lie on the insider.

In the next and final post, I discuss some of the other miscellaneous provisions of the regulations proposed by the committee, and conclude by making some general observations on the overall tenor and approach of the report.

(continued in Part 3)

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