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)

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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