Discretionary Portfolio Management and Insider Trading

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 Several employees of the Bank could be in possession of unpublished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.
Implications
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.

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.

2 comments

  • A portfolio investment is an investment made by an investor who is not involved in the management of a company. This is in contrast to direct investment, which allows an investor to exercise a certain degree of managerial control over a company.

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