Saturday, September 26, 2015

The Satyam Case: Insider Trading and Pledge

[The following guest post is contributed by Shashank Prabhakar, a Senior Associate with Finsec Law Advisors. These are the author’s personal views]

The Whole Time Member of SEBI (‘WTM’) recently passed an order against certain relatives of Mr. Ramalinga Raju and entities belonging to the promoter group of Satyam Computers for violation of Section 12A of the Securities and Exchange Board of India Act, 1992 (‘SEBI Act’), Regulations 3 and 4 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003 (‘PFUTP Regulations’) and Regulation 3 of the SEBI (Prevention of Insider Trading) Regulations, 1992 (‘PIT Regulations’). The order was passed under Section 11(1), 11(4) and 11(B) of the SEBI Act.

One of the entities against whom the order was passed is SRSR Holdings Pvt. Ltd., a holding company, which owned almost all of the shares held by the promoter group of Satyam (SRSR Holdings held 8.27% of the total shareholding of Satyam while the total shareholding of the promoter / promoter group of Satyam was about 8.6%). The shareholders of SRSR Holdings were Mr. Ramalinga Raju, his brother Mr. Rama Raju and their respective spouses. I propose to analyze only that part of the order which deals with SRSR Holdings.

The facts are that during the period between August 2007 and November 2008, various promoter group entities of Satyam had taken loans amounting to Rs. 1,258 crores from financial institutions and SRSR Holdings had pledged the shares of Satyam on their behalf as security for the loans. The weighted average price at which the shares were pledged was Rs. 402.80 and most of the lenders required the borrowers to pledge about 2.25 times the value of the loan as security. The lenders started invoking the pledge between December 23, 2008 and January 7, 2009, on account of shortfall in the margins. It may be recalled that Mr. Ramalinga Raju issued the infamous letter disclosing financial irregularities in Satyam on January 7, 2009.

SEBI issued a notice to SRSR Holdings asking it to show cause as to why action should not be taken against it under Section 12A of the SEBI Act read with Regulation 3 of the PIT Regulations. SEBI alleged that SRSR Holdings had pledged shares of Satyam when it had full knowledge of the ongoing financial irregularities in Satyam and that these shares were pledged to obtain funds for the personal benefit of promoters / directors of Satyam and entities connected to them. This, according to SEBI, amounted to insider trading under the PIT Regulations. SRSR Holdings in its reply claimed that it was not an “insider” as per the definition under the PIT Regulations. SRSR Holdings claimed that it had no “unpublished price sensitive information” or in other words, that it did not have any knowledge about financial irregularities in Satyam. Although Mr. Ramalinga Raju and Mr. Rama Raju were both directors in the company, it claimed that their personal knowledge of financial irregularities in Satyam could not be attributed to the company. Further, the company argued that in any case pledging of shares did not amount to “dealing in securities” under the PIT Regulations and for that reason Regulation 3 of the PIT Regulations was not violated in this case.[1]

The WTM in his order disregarded the claims made by SRSR Holdings and held that it was a “person deemed to be a connected person” under Regulation 2(h)(i) of the PIT Regulations as Mr. Ramalinga Raju and Mr. Rama Raju, who were chairman and managing director of Satyam respectively, were also directors of SRSR Holdings. Therefore, SRSR Holdings was held to be an “insider” as they were both under same management, as per Regulation 2(e)(i) of the PIT Regulations.

As regards the claim that personal knowledge of the directors could be attributed to the company, it was held that since the shares could not have been pledged without the active connivance of Mr. Ramalinga Raju and Mr. Rama Raju who were in involved in and were fully aware of the financial irregularities in Satyam, SRSR Holdings was very much in possession of UPSI when the shares were pledged. The WTM does not provide any other reasons for arriving at this conclusion nor does he cite any authority in support of his conclusion.

Further, the WTM also held that pledging of shares amounted to “dealing in securities” under the PIT Regulations. Regulation 2(d) of the PIT Regulations defines the phrase to mean “an act of subscribing, buying, selling or agreeing to subscribe, buy, sell or deal in any securities by any person either as principal or agent”. [Emphasis Supplied] The circular definition notwithstanding, the WTM concluded that from the plain reading of the definition it was clear that the phrase would include “all commercial dealings related to the securities which involve transfer of securities or any rights or interests therein or issuance of securities.” He also held that the mode of transfer is immaterial for the dealings to fall within the ambit of this definition. No further authority has been cited by the WTM in support of his conclusion.

It is hard to see how the plain reading of the aforementioned definition suggests that it includes all commercial dealings related to securities, or in any case pledge of shares. The last part of the definition uses the very term that is being defined as part of the definition and the WTM assumes a prior understanding of the phrase “dealing in securities” to include all commercial dealings related to securities. While it is true that it has been given the widest of meanings in various decisions by the SAT and other courts, this is the first time that the phrase has been used to include within its scope pledge of shares, in the context of insider trading under the erstwhile PIT Regulations. The WTM could have used this opportunity to carefully outline the scope of the phrase “dealing in securities” in the context of insider trading. To state that the definition also does not concern itself with the mode of transfer in order for pledge to fall within its ambit is also incorrect because pledge does not involve transfer of shares.

Regulation 2(b) of the PFUTP Regulations also defines the phrase “dealing in securities” to include “an act of buying, selling or subscribing pursuant to any issue of any security or agreeing to buy, sell or subscribe to any issue of any security or otherwise transacting in any way in any security by any person as principal, agent or intermediary referred to in section 12 of the Act.” The definition of the phrase under PFUTP Regulations is far more precise and it is clear from a plain reading of the definition that it would include pledge of shares within its ambit. However, there is no provision either in the PIT Regulations or the SEBI Act or the PFUTP Regulations that allows SEBI to supplant the definition in PIT Regulations by a definition of the phrase in PFUTP Regulations.

Be that as it may, the WTM states that in order to prove the charge of insider trading under Regulation 3(i), SEBI must prove that (a) the person is an 'insider', (b) he is in possession of UPSI and (c) he deals in securities of the company while in possession of the UPSI either on his own behalf or on behalf of any other person. Since all the elements were present in the case of SRSR Holdings, he concludes that SRSR Holdings is guilty of insider trading. As has been stated above, the reasons provided by the WTM for arriving at this conclusion are far from adequate.

Furthermore, the line of reasoning adopted by the WTM renders all pledge transactions by promoters of listed companies vulnerable to the charge of insider trading. All promoters are insiders and they tend to have UPSI of their companies on an ongoing basis and a transaction involving even a bona fide pledge of shares will squarely fall within Regulation 3(i) of the PIT Regulations. The issue of what constitutes a bona fide pledge transaction is also far from clear. The WTM in his order has not inquired into whether or not the pledge of shares by SRSR Holdings was genuine or bona fide. That does not seem to be a factor that needs to be taken into consideration in order to decide whether a pledge transaction amounts to insider trading. What remains to be seen is whether SEBI, based on this decision, will now start looking into old pledge transactions to see whether there was any “insider trading”.

The WTM also makes a rather specious claim that the “act was manipulative and deceptive in nature devised to defraud unsuspecting investors” and concludes that the SRSR Holdings has made a “wrongful gain” of Rs. 1,258 crores, presumably at the expense of unsuspecting investors and ordered SRSR Holdings to disgorge the said amount along with a simple interest of 12% p.a. from January 7, 2009 till the date of repayment. The WTM could have used this opportunity to articulate as to how pledge of shares affects the interests of the investor community as a whole instead of treating it in a self-evidentiary manner. It is hard to understand just how the mere act of pledging shares by SRSR Holdings resulted in defrauding investors. Further, he could have also provided reasons as to how these transactions resulted in a wrongful gain to SRSR Holdings at the expense of investors and not the lenders. It is probable that the borrowers and the pledgor may have misrepresented or even defrauded the lenders in order to induce them to advance loans, but it is hard to see how it affects the investor community as a whole. The WTM has also not considered the fact that the lenders would have recovered at least a part of their dues from the borrowers after having sold the pledged shares upon invocation, between December 23, 2008 and January 7, 2009 and the lenders would have a right to legal recourse to recover the remaining dues from the borrower and / or enforce other security that they may have obtained, based on the loan documents. Assuming for a moment that the lenders have already been paid off, any “wrongful gains” made by SRSR Holdings would have been duly paid back and there is also no evidence of any shareholders having suffered any injury on account of these transactions.

To state that SRSR Holdings made a wrongful gain of Rs. 1,258 crores would, therefore, be incorrect. In any event, the rightful recipients of the loan amount and interest thereon are the lenders. Issuing directions under Regulation 11(1), 11(4) and 11(B) to remit the funds to SEBI’s Investor Protection Fund as they are required to under this order is neither fair nor just and it does not serve the investor community in any way other than adding to the substantial cash pile that SEBI is already sitting on. SEBI has wide powers to issue directions under the aforementioned provisions and the importance of using them wisely and judiciously can never be overstated.      


The SEBI order is the first of its kind – where a pledge transaction has been held to be insider trading under the erstwhile PIT Regulations. As has been stated above, the order of the WTM does not seem to consider genuineness or bona fides of the pledge transaction to be one of the factors in deciding whether it amounts to insider trading. This aspect of the order does not portend well for promoters of listed companies, given the proclivity of SEBI to investigate old cases. Perhaps it would have been wiser to have charged SRSR Holdings under the PFUTP Regulations given the clarity in the definition of “dealing of shares” and the wide definition of “fraud” under Regulation 2(c) of the PFUTP Regulations. However, in that case, the burden of proof would have been on SEBI to prove that the pledge transaction was fraudulent, unlike the PIT Regulations where the burden of proof is on SRSR Holdings to prove its innocence.

However, the new SEBI PIT Regulations, 2015 and the Guidance Note that was issued recently by SEBI explicitly states that SEBI’s intent is to prohibit creation and invocation of pledge when in possession of UPSI. The silver lining, if one can call it that, is that the pledgor or pledgee can use the defenses available to them under Regulation 4 and demonstrate that the creation or invocation of the pledge was bona fide, unlike the view taken by the WTM in this order.   

- Shashank Prabhakar

[1] Regulation 3 (1) of the PIT Regulations states that no “insider” shall either on his own behalf or on behalf of any other person, deal in securities of a company listed on any stock exchange when in possession of any unpublished price sensitive information. 

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