[The following post is contributed by Aparna Ravi, a researcher at the Centre for Law and Policy Research, Bangalore and previously a capital markets lawyer in London. She can be contacted at firstname.lastname@example.org
She presents an interesting critique of the new SEBI insider trading regulations on matters relating to due diligence set in the backdrop of international experience]
In January 2012, the UK Financial Services Authority (“FSA”) charged a U.S. hedge fund manager, David Einhorn, and his hedge fund, Greenlight Capital Inc., with “trading on the basis of inside information” and imposed upon them civil penalties of about £7.2 million (approximately $11.6 million). This case attracted a lot of attention in the US and the UK as, in addition to being an example of the FSA’s heightened resolve to aggressively pursue cases of insider trading, it highlighted significant differences between the insider trading regimes in the two countries. I bring it up here because it involved a case of “inadvertent” wall crossing (explained below), which is worth revisiting in the context of the new SEBI (Prohibition of Insider Trading) Regulations, 2015 (“Insider Trading Regulations”) notified last week, that now explicitly permits the communication of unpublished price sensitive information (“UPSI”) for purposes of due diligence in connection with a potential transaction.
Funds managed by Greenlight owned approximately a 13.2% stake in Punch Tavern plc, a company listed on the London Stock Exchange. The Board of Directors of Punch was contemplating a private placement transaction and engaged an investment bank to make calls to existing shareholders to assess their interest in the transaction. Shareholders were told that they would need to sign a non-disclosure agreement, which would require them to keep the information confidential and restrict them from trading in Punch’s shares, before they could receive any information, a process termed as being “wall crossed.” Einhorn declined to sign the non-disclosure agreement, but nevertheless agreed to participate in a conference call where he claimed to have stated that he did not want to receive inside information. During the course of the conference call, Einhorn learned that Punch was at advanced stages of planning an equity offering and that the proceeds of the offering would be used to repay the company’s convertible debt and to create headroom with respect to certain covenants on Punch’s securitization vehicles.
In the three days following the conference call, Greenlight began selling its shares in Punch and drastically reduced its shareholding to 8.9%. Punch announced its equity offering six days after the conference call and its share price fell by about 30%, which meant that Greenlight had avoided losses of approximately £5.8 million by selling in advance of the public announcement. The Einhorn case is an example of an “inadvertent” wall crossing, where the FSA held that Einhorn had received inside information even though he had declined to sign the non-disclosure agreement. The FSA further stated that while none of the individual pieces of information Einhorn had received constituted inside information, the totality of the information met the relevant tests to amount to inside information.
The provision of inside information in the course of granting due diligence access is a common practice across a number of jurisdictions and the new Insider Trading Regulations have now been brought in line with international practice in this regard. SEBI has rightly recognized the practical realities of commercial transactions that prospective investors may often require non-public information about a company in order to assess the merits of a particular transaction. In these situations, investors look to obtain UPSI not for insider trading but for due diligence on a company’s finances and business, which ultimately benefits all investors by unearthing facts that the company might have otherwise been reluctant to disclose. Taking these factors into account, Regulation 3(3) of the Insider Trading Regulations allows for firms to communicate UPSI in connection with a contemplated transaction subject to certain conditions:
(i) in situations that would trigger an obligation for the company to make an open offer under the Takeover Regulations, if the board determines the proposed transaction to be in the best interests of the company; and
(ii) in situations that do not trigger an obligation to make an open offer, if the board determines the proposed transaction to be in the best interests of the company and any UPSI provided to potential investors as part of due diligence is made public at least two days prior to the contemplated transaction taking place.
(The disclosure requirement is not specified in the case of open offers because such transactions would in any event require the company to make any information necessary to arrive at an informed decision available to all shareholders.)
The regulations also require the parties receiving UPSI as part of their due diligence to sign confidentiality agreements and agree not to trade in the securities of the listed company while in possession of inside information.
While perhaps a necessity, the provision of due diligence access needs to be closely monitored as it leaves much scope for abuse. Einhorn is perhaps an extreme example as the broker was trudging into dangerous territory when he offered Einhorn a conference call without being wall-crossed. Yet this case highlights the perils associated with providing due diligence access to investors ahead of a potential transaction and the need for stringent controls over the process. In this regard, the new regulations as they relate to diligence access leave much unsaid and SEBI will most likely need to issue additional guidance to ensure that these regulations facilitate legitimate transactions while minimizing the possibility for abuse. Some areas that I believe SEBI would need to clarify are:
(1) Process for providing UPSI: The process employed for selectively communicating UPSI in connection with a contemplated transaction needs to be carefully thought out to ensure that both sides have the same understanding of what constitutes UPSI and the implications of receiving UPSI. Before being provided with any UPSI, potential investors must be told that they are to be (i) provided with UPSI that they would need to keep confidential and which would restrict them from trading and (ii) given an opportunity to decline to receive the information. This initial conversation is critical as great care needs to be taken not to inadvertently divulge any information that could constitute UPSI at this stage. Further, there needs to be great clarity on precisely which information constitutes UPSI and how long the trading restrictions would apply. While some of these issues will develop as part of market practice, guidelines from SEBI on best practices, as well as a requirement for compliance officers at the relevant parties to be involved when UPSI is provided, could help ensure discipline in the process.
(2) Form of Disclosure: The regulations do not prescribe the form in which a company would need to communicate UPSI to the market prior to the transaction taking place, which has been left to the discretion of the company’s directors. It is also interesting to note that only non-public information that is price sensitive (as opposed to all the non-public information that has been shared with investors during the course of due diligence) will need to be communicated to the market. While there is logic to this requirement as companies are not expected or required to communicate very detailed, granular or commercially sensitive information (such as targets or customers) that is not price sensitive to the public, this requirement together with leeway on the form of disclosure leaves much scope for interpretation by a company’s directors. Sifting through the due diligence information provided to potential investors ahead of a transaction to determine the extent of the information that constitutes UPSI may prove to be a challenging task for directors. SEBI will need to monitor how companies interpret this requirement and may need to provide additional guidance to ensure that it achieves the regulation’s objective of providing parity of information to the market.
(3) Cleansing: Nowhere do the new regulations deal with all too common a situation. What happens if investors are provided with UPSI in connection with a contemplated transaction that does not take place, or, as often happens, is placed on hold for an indefinite period of time? In such situations, the question of when a recipient of UPSI on an aborted transaction can resume trading on the listed company’s securities assumes great significance. Trading restrictions can only be lifted when investors have been “cleansed” of the UPSI that they received, i.e., when the UPSI in their possession no longer gives them an information advantage over other market participants.
If the transaction does go ahead, the cleansing process is automatic as the new regulations require disclosure of any UPSI to the market at least two days ahead of the transaction. On the other hand, if the transaction does not occur or is postponed, companies are not in the habit of putting out announcements regarding aborted or postponed transactions. Potential investors who receive UPSI find themselves in the difficult situation of not knowing whether the information they have received still constitutes UPSI or when they can resume trading. Typically, to cleanse these investors, a company would either need to make a public disclosure of the UPSI provided to select investors or the UPSI must no longer be relevant (for example, the transaction terms of an aborted transaction or if the UPSI has been superseded by subsequent events that have been disclosed). As potential investors are unlikely to agree to be restricted in the absence of a clearly articulated cleansing strategy if the transaction does not take place, SEBI will need to provide much needed guidance in this complex area.
While essential for facilitating commercial transactions and capital raising, providing UPSI to potential investors as part of due diligence access is fraught with difficulties. Investors need to be told that they are being provided with UPSI, the expected time period during which they cannot trade, and the cleansing strategy if the transaction does not take place. Great care must also be taken to ensure that potential investors are not provided with any information on the potential transaction unless they agree to the confidentiality obligations and trading restrictions to minimize the risk of inadvertently providing UPSI. Some of these issues may be clarified in the implementation of the new regulations and will evolve as market practice in this area develops, but SEBI will most likely need to provide further guidance regarding due diligence access that walks the tightrope between facilitating legitimate transactions while ensuring that any information flow of UPSI is tightly regulated.
- Aparna Ravi
 FSA’s decision notice, dated January 12, 2012, available at http://www.fsa.gov.uk/pubs/decisions/dn-einhorn-greenlight.pdf