The concept of discretionary portfolio management (“DPM”) is one whereby a portfolio manager makes investments on behalf of a client. The decisions regarding which investments must be made, and on what terms, are left to the portfolio manager. The client neither influences the decision-making of the portfolio manager nor does the client get involved in day-to-day investment decisions.
Request and Guidance
In the context of DPM, a question arose as to whether the possession of insider information by a client would vitiate a trade by the portfolio manager in terms of the regulations governing insider trading. This came up in a request for informal guidance made by HDFC Bank to the Securities and Exchange Board of India (“SEBI”). HDFC Bank set out the broad circumstances where such an issue arose. Several employees of the Bank could be in possession of unpublished price sensitive information (“UPSI”) pertaining to the Bank or other listed companies with which it deals. Hence, they would be prohibited by the SEBI (Prohibition of Insider Trading) Regulations, 2015 (the “Insider Trading Regulations”) from dealing in those securities. They would also be subject to closures of trading windows by the Bank or other listed companies. In this context, it may be necessary for such employees to make investments through other means such as mutual funds or DPM. The core issue was whether they could make investments through DPM while in possession of UPSI.
HDFC Bank’s request letter sets out details regarding the functioning of DPM, and how the client has no control or influence whatsoever on the investment decisions made by the portfolio managers. Hence, even though the clients (in this case employees) are in possession of UPSI, that ought not to matter as, decisions are taken by portfolio managers who are not privy to that information. In essence, the Bank’s case is that the information available with the clients should not be attributed to the portfolio managers, thereby rendering a wider (and arguably lenient) interpretation to the provisions of the Insider Trading Regulations.
However, in its informal guidance, SEBI refused to accept the request made by HDFC Bank, and opined that investments made by employees of the Bank who are in possession of UPSI will be in violation of the Insider Trading Regulations if portfolio managers carry out trades for them under the DPM scheme. SEBI’s reasoning is as follows:
i. Regulation 4(1) of the [Insider Trading] Regulations unambiguously states that no insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information.
ii. Further, in the explanatory notes to Regulation 4 of PIT Regulations it is mentioned that when a person who has traded in securities has been in possession of UPSI, his trades would be presumed to have been motivated by the knowledge and awareness of such information in his possession.
iii. It is therefore inferred from the above that dealing in securities, whether it is direct or indirect, is not relevant, but that any insider when in possession of UPSI should not deal in securities of the company to which the UPSI pertains. Even while dealing in such securities through a discretionary portfolio management scheme, the trades of insider shall be presumed to be motivated by the knowledge and awareness of UPSI.
On similar grounds, SEBI concluded that employees would be prohibited from undertaking any trading through DPM when the trading window is closed.
At a broad level, SEBI’s approach in the guidance is consistent with a rather strict approach adopted by the Regulations towards insider trading. As I had discussed in a recent paper (pages 5 to 8), SEBI as well as other jurisdictions such as the United Kingdom and Singapore adopt the “parity of information” approach towards insider trading whereby the focus is on whether the person trading had UPSI, and not whether that information influenced the dealing in shares or whether the person had a blameworthy state of mind. This effectively broadens the scope of the insider trading regime. Consequently, in its guidance, SEBI simply looked at whether the employees had UPSI and, if so, their actions were presumed to have motivated the trades in shares. Such a presumptive approach was put to full use by SEBI in this guidance.
This much is understandable. But, it is somewhat intriguing that SEBI used such a strict “parity of information” approach even in the scenario of trading through DPM rather than when employees (or possessors of UPSI) trade by themselves. SEBI did not place the requisite emphasis on the fact that the decisions are made by the portfolio managers independent of any UPSI that their clients in the form of employees may possess. SEBI effectively treated the UPSI in the hands of the clients as if the portfolio managers held it. If it is indeed the case that there is an opaque wall between the portfolio managers and clients in a DPM, then that conclusion is somewhat perplexing. It has the effect of expanding the scope of the insider trading prohibition when employees invest through indirect means. Although SEBI has not specifically considered mutual funds in this guidance, it is not clear whether its expansive interpretation may rein in other forms of investment management.