[Parth Dixit is a 4th Year, BA/LLB (Hons.) student at Symbiosis Law School, Pune.]
By way of its order dated August 11, 2017 in the case of SRSR Holdings Private Limited v. Securities and Exchange Board of India, the Securities Appellate Tribunal (SAT) has provided a degree of finality to an important question raised in the aftermath of the infamous Satyam scam of 2009-2010. The question was whether the SEBI (Prohibition on Insider Trading) Regulations, 1992, (PIT Regulations) apply to instances of pledge created by corporate insiders while in possession of unpublished price sensitive information. In the past, interesting discussions on this question have occurred on this very blog. However, the SAT order in paragraph 9(j) notes that the definition of the term ‘dealing in securities’ is broad enough to cover a pledge transaction as well. Reproduced below is the relevant passage from the order:
Argument advanced by Mr. Kadam, learned Senior Advocate appearing on behalf of SRSR that pledging shares of Satyam by SRSR would not amount to dealing in securities is without any merit. Expression ‘dealing in securities’ as defined under regulation 2(d) of the PIT Regulations is not restricted to any particular type of dealing but is wide enough to cover all types of dealing in securities including the activity of pledging the securities. Although pledging of securities is not per se illegal under the PIT Regulations, regulation 3 of the PIT Regulations prohibits an ‘insider’ from pledging the securities when in possession of UPSI. Thus, the prohibition contained in the PIT Regulations do not apply to bonafide pledge of securities, but apply only to pledge of securities by an insider when in possession of UPSI.
Further, in paragraph 9(k), the following observations are offered:
Argument advanced on behalf of SRSR that the ‘Model Code of Conduct for Prevention of Insider Trading for listed Companies’ does not refer to ‘pledge’ and therefore pledging the shares does not amount to dealing in securities is without any merit. Model Code is only a Model and is not illustrative of all the dealings covered under the expression ‘dealing in securities’. Therefore, fact that the Model Code of Conduct does not specifically refer to ‘pledge’, cannot be a ground to hold that the expression ‘dealing in securities’ defined under regulation 2(d) of the PIT Regulations would not include pledge of shares.
As is evident from SAT’s order, the Presiding Officer has chosen neither to record all the arguments made by the SRSR Holdings, nor has he elaborated upon the judicial reasoning followed to reach the conclusion stated, that is, the interpretation given to the relevant term(s) of the PIT Regulations. However, this judgement is likely to hold ground for all future pledge transactions in similar context. Even if the only argument raised by SRSR Holdings in the present case pertained to the Model Code of Conduct for Prevention of Insider Trading, there is considerable room for an elaborate academic discussion on the question. Through the present post, I seek to consolidate some arguments against the conclusion given by SAT.
The relevant law
In accordance with regulation 3(i) of the PIT Regulations:
No insider shall—
[…], deal in securities of a company listed on any stock exchange when in possession of any unpublished price sensitive information [….]
As per Regulation 2(d), of the PIT Regulations:
“dealing in securities” means 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;
Whether a pledge can be read into the definition of the term “dealing in securities”
The Supreme Court, in P. Kalingan v. PSG College of Technology (1995), has held that the use of the word ‘means’ indicates that the ‘definition is a hard-and-fast definition and no other meaning can be assigned to the expression that is put down in definition.’
Creation of pledge over shares of a company is certainly neither an act of subscription nor an act of buying of shares. Therefore, the question is whether pledge can be categorized as sale within the term dealing in securities.
Here, one may rely on decision rendered in the case of National Bank of Commerce, Dallas v. All American Assurance Company by the United States Court of Appeals for the Fifth Circuit, wherein the Court held that a pledge cannot be categorized as “sale” within the ambit of anti-fraud provisions of the concerned federal securities law due to the following reasons:
- Firstly, had the legislature intended to categorize pledge within the term sale, it would have explicitly done so.
- Secondly, such a categorization does not promote the objective of investor protection as lenders cannot be categorized as investors so far as the activity of loan sanction on the basis of a collateral pledge is concerned. A bank when sanctioning a loan does not assume the same risk as assumed by a share subscriber/buyer because of the existence of multiple common law as well as dedicated statutory remedies in favour of a bank to upset a default in repayment.
This reasoning can be harmonized within the framework of Indian law as well.
- Firstly, that the intention of the legislature, insofar as the PIT Regulations are concerned, was not to cover pledge transactions can be ascertained from the fact that the 2015 Regulations specifically include pledge as a form of “trading in securities” by virtue of the “Note” attached to regulation 2 (l).
- Secondly, such a categorization shall neither serve the objectives of investor protection under the SEBI Act, nor does it serve the rationale under which insider trading is prohibited. Jurisprudentially, at least in the US context, insider trading is viewed as violation of fiduciary duty owed by the corporate insider to the investors of the company. Additionally, new age scholars have analysed it under the concept of informational asymmetry and the consequential economic harm perpetrated when insiders misuse their position with respect to trading in the shares of their companies. To such extent, it is submitted that:
- Firstly, a pledgor does not owe any fiduciary duty to a pledgee. The creation of fiduciary duty rests on principles of trust. It is the pledgor who entrusts the pledgee with the pledged goods and not vice versa. A pledge once created limits the rights of the pledgor to collection of dividends from the company, exercise of voting rights, etc.
- Secondly, there is greater informational parity between a bank and the borrower seeking loan facilities. As a matter of business practise as well as the relevant RBI Guidelines, banks are required to pursue thorough due diligence before sanctioning any corporate loans. In light of such scrutiny, it is difficult to assume that corporate insiders shall be in any position to deceive a commercial bank with respect to information about the company, unless, of course, such deception is effected by some form of fraud or manipulation of the books of accounts of the company.
The aforementioned reasoning proceeds on the underlying economic reality concerned with the anti-fraud provision of securities law. In the case of McClure v. First National Bank, the same question was analyzed from a commercial perspective. The Court therein opined that while the objective of securities law unequivocally remained the protection of investors and capital markets, a bank, in its capacity at a pledgee, cannot be regarded as an investor, or, an internal component of the capital markets. A commercial bank, in accepting a pledge of stock as additional consideration for the extension of a commercial loan, does not necessarily affect the securities industry. This is so, because, a crucial element of any investment is the associated risks inherent to such investment. A bank does not assume any risk insofar as the sanctioned loan is concerned. Thus, economically, because loans granted by commercial banks, on the basis of collateral securities and backed by statutory protection, cannot be termed as risk induced investments, therefore, sale categorization of pledge ought to be beyond the ambit of the objectives of the law.
In light of the above arguments, I argue that sale categorization of pledge under the 1992 Regulations is unfounded and should be limited to the 2015 Regulations. Assuming that SEBI and/or SAT continues with the ratio adopted in SRSR Holdings case, I propose that the appropriate test to determine the applicability of PIT Regulations to pledge transactions should depend on the following two pronged “risk centric” analysis: (i) whether the concerned pledge transaction shifts the risk associated with default in repayment of sanctioned loan against the lender bank, and (ii) whether in light of the loan agreement and the accompanying circumstances, the lender assumes risk based on the effective market value of the securities pledged.
– Parth Dixit
Dear Parth,
Please consider the following –
1) It is pertinent to note that while no fiduciary duty is owed to the commercial banks by a corporate insider pledging securities of a company as collateral for a loan, Indian jurisprudence on insider trading does not seem to follow the ‘classical theory’ of insider trading as is the case in the United States of America. There is no concept of ‘fiduciary duty’ under Indian insider trading jurisprudence, which seems to have as its basis, information asymmetry between corporate insiders and others.
2) Further, it is pertinent to note that the argument pertaining to commercial banks being on an approximate equal footing with corporate insiders with regards to access to unpublished price sensitive information by virtue of diligence requirements vested on the latter seems to be flawed because banks may not have access to undocumented – price sensitive information during their diligence exercises.
3) Given the current NPA crisis India Inc. is faced with, banks have to be considered to be important components of the Indian securities markets. The RBI, in its financial stability report, has documented that out of over 5000 listed companies in India, promoters of over 4000 companies have pledged a substantial portion of their holdings. In light of such fact, a commercial bank in India sanctioning loans on the basis of listed securities as collateral is an important component of Indian securities markets by virtue of the fact that pledging of shares may result in greater volatility in the markets. Banks often ask for additional securities if the prices of securities pledged with them as collateral for a loan goes down. Further, banks are often called upon to invoke pledges. In case of pledging of shares by a corporate insider when in possession of unpublished price sensitive information that when published may materially mark down the price of pledged securities, the risk of increased volatility is heightened.
4) While pledgee banks are not ‘investors’, they are ‘potential investors’ in my opinion as upon invocation of pledge ownership therein is transferred to them. A reading of the anti-fraud provision in India, namely Section 12 – A of the SEBI Act, reveals that it is aimed at protecting not only existing investors, but also potential investors. Thus, it may be in line with the objective of the regulations to include pledging of securities under the term ‘dealing’.
Thank you.