The Applicability of Insider Trading Regulations to Pooled Investment Vehicles

[Sikha Bansal is a Partner and Aisha Begum Ansari a Manager at Vinod Kothari & Co]

From a surveillance and compliance perspective, the SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT Regulations’) focus on designated persons (DPs). Trading in securities of the listed company by DPs is sought to be “regulated, monitored and reported” by the Code of Conduct (regulation 9 read with Schedule B). This, inter alia, includes trading window closure restrictions, pre-clearance by the compliance officer while the trading window is open, contra-trade restrictions, and the like. Another article discusses how ‘insiders’, ‘connected persons’ and ‘designated persons’ are dealt with under PIT Regs. In case of intermediaries and fiduciaries, a DP may trade in the securities of a listed client company subject to pre-clearance by the compliance officer who, in turn, maintains a restricted list to decide on such applications. Hence, there is no blanket prohibition of trading in listed securities by DPs. Recently, though, concerns have arisen around investment by DPs in the units of pooled investment vehicles.

In this post, the authors have tried to analyse to what extent would the PIT Regulations apply to the DPs investing in the units of AIF and the contradictory views of SEBI.

Pooled investment vehicles and possible concerns of insider trading

Pooled investment funds raise funds from investors and invest them in accordance with the regulations framed by SEBI. Reference may be made to section 2(da) of the Securities Contracts (Regulation) Act, 1956 (‘SCRA’). A mutual fund, alternative investment fund, or collective investment fund are all pooled investment funds. Further, the units issued by these funds are securities within the meaning of section 2(h)(ida) of the SCRA.

These pooled funds make onward investments, including investments in listed securities. A question arises as to whether the PIT Regulations apply vis-a-vis the underlying listed investments. Say, Mr. B is a DP of a bank that has access to unpublished price sensitive information (‘UPSI’) of listed companies. The DP wishes to invest in the units of unlisted alternative investment funds (‘AIFs’), which may invest in the securities of listed companies whose UPSI is with the bank and, in turn, with the DP. In such a scenario, can it be said that the AIF is merely a conduit, which the DP is using to make investments in underlying listed securities? Can it be said that the DP needs to know the end-use of funds he puts in AIF? The discussion below is an attempt to find answers to these questions.

Applicability of PIT Regulations to investments in pooled funds

Section 12A of the SEBI Act, 1992 mandates that no person shall, directly or indirectly, engage in insider trading. The nature and scope of insider trading for this purpose emanates from section 15G of the SEBI Act. Further, regulation 4(1) of PIT Regulations states: “No insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of UPSI”. The expression “directly or indirectly” has to be read in proximity to “insider trading”. That is, it must be insider trading in the very first place; the precise manner of its execution (directly or indirectly) is irrelevant. Neither the SEBI Act nor the PIT Regulations deal with scenarios where the investments in pooled funds would percolate to investments in underlying listed securities. In such a case, can it be said that an insider may exploit UPSI by making investments in pooled funds, which, in turn, may have invested in listed securities? To establish this, there will have to be facts to substantiate that the “intent” and “effect” of the investment is “insider trading” in underlying “listed securities”. Where such a nexus cannot be established, it would be an extreme view to regard these funds as conduits for investing in listed securities.

Secondly, in the case of pooled funds, the investor is not taking investment decisions; the investment manager takes such decisions. The investment manager has to follow prudential guidelines, including those around conflict of interest, as stipulated under the respective regulations.

Thirdly, the pooled funds invest in securities in accordance with investment conditions, e.g. Cat-I/II AIFs can invest up to a maximum of 25% of the investible funds in an investee company. Since the funds will have to adhere to maximum limits while investing in the investee’s securities, the portfolio of the funds would be diversified. Persons investing in securities of listed companies can leverage the UPSI they have; however, the fund’s units would, thus, derive their value from the portfolio of investments and not from single security. One cannot say that an investor with UPSI is dealing in ‘securities’ of underlying investees. The investor has invested in the common fund, and such a pooled fund would be investing in several investees, and the units would derive the value from all such investments taken together.

Further, the PIT Regulations curb misuse of UPSI by ‘tipper’ and ‘tippee’. Any person privy to inside information is under legal obligation not to communicate UPSI to any other person except in furtherance of legitimate purposes (see, regulation 3(1) of the PIT Regulations). Further, any person in receipt of UPSI has to protect the confidentiality of such UPSI (see, regulation 3(2B)). In jurisdictions such as the United States of America (‘US’), there are antifraud provisions contained in section 10(b) of the Securities Exchange Act, 1934, which have been invoked in “tipping” cases.

Having said that, insider trading controls are always founded on principles of fair conduct, and, therefore, the authors’ observations cannot be generalised. For instance, there may be an AIF where the investors are several DPs of the same entity. The fund may be heavily concentrated in a few investees. The DP may influence investment decisions. In such cases, it might not be possible to say that the investment by insiders into pooled funds may never be taken as insider trading. To that extent, SEBI’s observation that “the provisions of PIT Regulations may get attracted based on facts and circumstances of each case” is completely justified.

What does SEBI think?

On March 16, 2022, SEBI issued informal guidance to Yes Bank Ltd. wherein the moot question was whether the employees of the bank covered as DPs and their immediate relatives are allowed to invest in an AIF. SEBI answered in the affirmative, however, subject to compliance with applicable provisions of its PIT Regulations and AIF Regulations.

Yes Bank, a listed company, has adopted a referral model, whereby its customers would be referred to the asset management companies (‘AMCs’) of AIFs. In turn, Yes Bank would obtain a commission from such AMCs. The employees of Yes Bank, too, may choose to invest in AIFs. Yes Bank submitted that the investment by the fund manager may include investment in the companies whose UPSI is with Yes Bank and, in turn, with its DPs. It also submitted that the investors do not have any direct or indirect control over the investment decision of AIF.

SEBI considered regulations 3, 4 and 9 of the PIT Regulations and concluded that DPs investing in such schemes might have access to UPSI in relation to such securities. DP would be considered as an insider and the provisions of the PIT Regulations may get attracted based on the facts and circumstances of a specific case. Hence, regulations 3, 4, 9(1) read with Schedule B may get attracted when there is trading or investment in the units of AIF by the DPs and their immediate relatives when the DP has UPSI in relation to such securities.

The authors note that SEBI’s informal guidance may not be clear. SEBI says that DPs would be considered as ‘insider’ and provisions may get attracted depending upon facts and circumstances of each case; however, it also refers to regulation 9 of the PIT Regulations read with Schedule B (which talks about trading window closure restrictions, pre-clearance, contra-trade restrictions, and the like). Further, the informal guidance does not consider the fact that the decision of a DP to invest in a fund and the decision of an investment manager to invest in securities are not linked.

SEBI has, in its circular, prescribed norms for AMCs and their employees to deal with insider trading issues. In another informal guidance, SEBI opined that the Code of Conduct under the PIT Regulations applies to trading by the employees of AIFs or AMCs in the units of AIF scheme that invests in securities listed or proposed to be listed, given that the employees would have access to the information about potential buying and selling of securities by the manager. While the Circular addresses the concerns of self-trading and front-running, the regulation on employees or DPs of the AMC (and their immediate relatives) is completely understandable. However, the rationale for imposing the same set of regulations on DPs of all listed entities is not clear.

Closing remarks

Pooled funds are regulated funds. The applicable regulations define the eligibility criteria for sponsors, trustees and investment managers, regulate the quantum of corpus to be accepted from investors and place investment conditions. As stipulated by the abovementioned circular, there may be conditions for investment by employees of managers and trustees. Hence, assuming that the DPs (of listed entity) do not share any interface with the investment managers and have no say in investment decisions, it may not be right to say that such funds can be used as conduits by such DPs to exploit the UPSI of listed company. For reasons explained above, unless specific circumstances warrant otherwise, the authors do not see any reason to apply the surveillance systems of the PIT Regulations to the DPs. Of course, the umbrella provisions of regulations 3 and 4 would anyway apply to the DPs i.e., the DPs should not indulge in the communication of UPSI and insider trading in violation of the PIT Regulations.

Sikha Bansal & Aisha Begum Ansari

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