The 2018 Insider Trading Amendment: A Step in The Right Direction?

Sara Jain and Swapnil Singh comment on whether the 2018 Insider Trading Amendment is step in the right direction or not.

1. INTRODUCTION

Insider Trading, a crime that often involves the wealthy getting wealthier, is a behavior associated with cheating and greed.¹

-Emily A. Malone

‘Insider trading’ can be construed as the illegal activity of subscribing, buying, selling, dealing, or agreeing to subscribe, buy, sell, deal in any securities² by a connected person or any other person in possession of or having access to unpublished price sensitive information³. The primary goal behind prohibition of insider trading is to ensure that some individuals are prevented from taking advantage of the information asymmetry in the market and generating profits at the cost of innocent investors.

In E. Sudhir Reddy v. SEBI, the Securities Appellate Tribunal (SAT) highlighted the significance of preventing insider trading by stating that not only is it against ensuring a level-playing field but is also detrimental to the interests of the ordinary shareholders and general public⁴. It has also been viewed as a breach of the fiduciary duty an insider owes by virtue of his position⁵. Thus, stringent provisions prohibiting insider trading have been enacted across various jurisdictions in order to promote investor confidence in the securities market.

In India, the erstwhile SEBI (Prohibition of Insider Trading) Regulations, 1992 was enacted with a similar objective. The 1992 Regulations were replaced by the current SEBI (Prohibition of Insider Trading) Regulations, 2015 causing substantial changes in the insider trading regime of India. Recently, on December 31, 2018, the SEBI amended the 2015 Regulations in order to bring in greater clarity considering the Report of the Committee on Fair Market Conduct headed by T.K. Viswanathan⁶. The Committee comprised of legal luminaries with expertise in the field including Shri Anup Bagchi, Shri Rajat Sethi, Shri Arun Kumar, Shri Haigreve Khaitan etc. While the Amendment brought in the much-needed reform in the Insider Trading Regulations, it is not devoid of shortcomings.

This article is divided into 4 parts. This part i.e. Part I provided a brief introduction to the concept of insider trading while stressing on the necessity to regulate and prevent it. Part II highlights the need of the 2018 Amendment and enlists the merits of the same. Part III emphasizes upon the issues and inadequacies that would emerge due to the amendment. Lastly, Part IV provides the conclusion of the article.

2. THE MUCH-NEEDED REFORM: POSITIVE ASPECTS OF THE AMENDMENT

The Amendment Regulations have brought in a series of advantages for all stakeholders. Some of them are as follows:

(a) Insertion of additional definitions for clarity

The 2018 Amendment has enhanced clarity by defining three significant terms- 'financially literate', 'proposed to be listed' and 'legitimate purpose'.

In accordance with Regulation 2(1)(c), a compliance officer (a person who is responsible for the adherence of the SEBI (PIT) Regulations, 2015) is required to be financially literate.⁷ In the absence of a definition of ‘financially literate’, there existed an ambiguity with respect to the threshold of financial understanding that was a pre-requisite for becoming a compliance officer.

Thus, SEBI inserted the definition of financially literate⁸ which is the same as provided in the SEBI (Listing and Disclosure Obligations) Regulations, 2015.⁹

The definition of ‘proposed to be listed’ was an extremely significant insertion as the applicability of the Insider Trading Regulations on unlisted companies is dependent on the same. Although Section 195 read with Section 458 of the Companies Act, 2013 prohibited insider trading of securities even in unlisted companies, the threshold is much higher as compared to the SEBI Regulations.¹⁰ Section 195 has now been deleted under the Companies (Amendment) Act, 2017.¹¹ Prior to the amendment, there was uncertainty regarding the stage at which an unlisted company can be called a ‘proposed to be listed company’- whether it would be from the date of passing of a board resolution approving the IPO, the date of appointment of merchant bankers or the date of filing the DRHP or RHP.¹² The amendment clarifies the position that a company would be ‘proposed to be listed’ after filing of the offer documents with SEBI as only at that stage the concrete intention of a company to get listed can be accurately established.¹³ An unlisted company would also be termed ‘proposed to be listed’ when such company is getting listed pursuant to any merger or amalgamation and has filed a copy of such scheme of merger or amalgamation under the Companies Act, 2013.¹⁴

Another much-needed clarification was regarding the interpretation of the term 'legitimate purpose'. Regulation 3 of the SEBI (PIT) Regulations, 2015 prescribes three circumstances namely, legitimate purposes, performance of duties or discharge of legal obligations under which communication of unpublished price sensitive information (UPSI) is permitted.

The interpretation of the term ‘legitimate purpose’ became important when Cyrus Mistry alleged Insider Trading rules violation by Ratan Tata. Mistry alleged that Ratan Tata had sought information including UPSI on the operating firms.¹⁵ However, SEBI stated that sharing information with the Chairman emeritus would be considered a legitimate purpose as the "benefit of his expertise would be invaluable to the company".¹⁶ This raised questions regarding the ambit of the exception considering the SEBI Regulations were silent on its definition. Thus, the Fair Market Conduct Committee identified this issue and concluded that as the term was very subjective making it extremely difficult to define.¹⁷

Resolving this issue, the Committee recommended that it would be the responsibility of the board of directors of the company to make a policy for determination of "legitimate purposes" as a part of "Codes of Fair Disclosure and Conduct" formulated under regulation 8, which was accepted by the legislature.¹⁸ In order to provide guidance to the board of directors, the Amendment also provides for an illustrative list in the explanation to Regulation 3(2A), SEBI (PIT) Regulations determining what could constitute 'legitimate purpose'. It is pertinent to observe at this point that the legal enforceability of this explanation is not clear. In other words, there is uncertainty as to whether this explanation is merely illustrative in nature or provides a mandatory bare minimum circumstance which should be included within the ambit of legitimate purpose.

The Amendment also clarifies that persons who have received UPSI pursuant to a "legitimate purpose" shall be considered insiders and due notice shall be given to them to maintain confidentiality.¹⁹

(b) Sharing of information for due-diligence purposes

Prior to the Amendment, the SEBI (PIT) Regulations, 2015 access to UPSI could be provided in case of open offer under the SEBI (Substantial Acquisition and Shares and Takeovers)

Regulations, 2011 only when the board of directors of the company were of informed opinion that the proposed transaction is in the best interests²⁰ of the company. The Committee observed that it was impractical for the board of directors to be able to form an opinion regarding whether the transaction was in the best interests of the company or not at the preliminary stage of conducting due-diligence exercises.²¹ Considering this anomaly, an amendment was made stating that the board may opine on whether the sharing of the UPSI for due diligence is in the best interests of the company instead of determining the same for the proposed transaction.²²

(c) Maintenance of digital database

In accordance with the new provision, the board of directors are required to ensure that a structured digital database is maintained comprising the names of such persons or entities with whom information is shared under Regulation 3 of the SEBI (PIT) Regulations, 2015 along with the Permanent Account Number. These structural databases are to be maintained sufficient internal controls in order to avoid tampering of the same.²³ Thus, this would be beneficial in maintaining a record of the persons who have UPSI of the company and would help in investigative purposes.

(d) Restriction of ambit by introducing additional defenses

India is known to have one of the most stringent insider trading laws in the world.²⁴ Instead of the classical insider standard, we adopt the possession standard while imposing liability on persons.²⁵ While the classical theory refers to criminalizing trading by insiders (or their tippees) in the stocks of their own companies²⁶, the possession standard affixes liability on the mere possession of information²⁷. The Amendment sought to reasonably dilute the ambit of the applicability of insider trading in order to save innocent persons from unnecessary litigation. Thus, the following defenses have been added:

Regarding ESOPs, SEBI had clarified through the Guidance Note on SEBI (Prohibition of Insider Trading) Regulations, 2015 dated August 24, 2015 that the exercise of ESOPs would not be considered trading.²⁸ Nevertheless, all these defenses have been inserted after considering practices around the world.²⁹

(e) Separation of Code of Conduct for listed entities and fiduciaries

Under the 1992 Insider Trading Regulations, there was a separate code of conduct for listed entities (Part A- Model Code of Conduct for Prevention of insider trading for Listed companies) and other entities (Part B- Model Code of Conduct for Prevention of insider trading for other entities).³⁰ However, this was consolidated into one under the 2015 Regulations. But having one Code of Conduct applicable to all entities was not practical as some provisions are only applicable to listed companies, not intermediaries and other entities and vice-versa.³¹ Thus under the 2018 Amendment Act two separate Codes of Conduct have been prescribed for listed companies (Schedule B) and other persons, known as fiduciaries, who are required to handle UPSI during the course of their business operations such as market intermediaries and fiduciaries which include auditors, accountancy firms, law firms, consultants etc. (Schedule C).

(f) Reduction of scope and applicability of Code of Conduct and disclosure of trades

The restriction of the applicability of the Code of Conduct from ‘employees and connected persons’ to ‘designated person and their immediate relatives’ through the Amendment brought a major respite for all the concerned stakeholders.³² The earlier provision was not pragmatic as it imposed unreasonable duties on a lot of persons unnecessarily.

The requirement of disclosing to the company of such transaction wherein the value of the securities traded aggregates to a traded value in excess of ten lakh rupees or such other value as may be specified under Regulation 7(2) has also been restricted to promoters, directors and designated persons only.

(g) Introduction of institutional responsibility for Insider Trading

The new Regulation 9A provides for an entire institutional framework for prevention of insider trading. The responsibility of establishing internal controls has been placed on the Chief Executive Officer, Managing Director or such other analogous person of a listed company, intermediary or fiduciary to ensure the requirements to prevent insider trading are met.³³ Additionally, the board of directors and Audit Committee have been instructed to keep a check on the CEO/MD/other person to ensure his compliance.³⁴

(h) Addressing concerns regarding leakage of UPSI

Recently, there have been a plethora of instances where USPI has been leaked on WhatsApp and other social media.³⁵ During investigation, SEBI found that the inadequate controls even in the top companies like HDFC Bank is the primary reason for such leakage.³⁶ Therefore, in order to eliminate such instances in future, SEBI has provided that every listed company is required to formulate written policies and procedures for inquiry in case of leak or suspected leak of UPSI.³⁷ Moreover, all entities are required to formulate a whistle blower policy and make employees aware of such policy to enable employees to report instances of leak of UPSI.³⁸

(i) Provision for aiding investigations on insider trading

In order to aid in the challenging task of investigation, the Amendment has provided that designated persons shall be required to disclose the name and Permanent Account Number or any other identifier authorized by law of the following to the intermediary or fiduciary on an annual basis and as and when the information changes:

It is pertinent to note that the term “material financial relationship” has been defined to mean a relationship in which one person is a recipient of any kind of payment such as by way of a loan or gift during the immediately preceding twelve months, equivalent to at least 25% of such payer’s annual income but shall exclude relationships in which the payment is based on arm’s length transactions.⁴⁰ Such information not only serve as beneficial during investigations but will also reduce insider trading activity as persons would be aware that the regulatory body has all this information.

3. THE 2018 AMENDMENT: ISSUES AND CHALLENGES

Despite the plethora of merits of the Amendment, it cannot be said that it is flawless. Moreover, there are certain aspects which have still not been addressed. Some of them are:

(a) Ambiguity regarding the person responsible for sending notices

In accordance with Regulation 3(2A), SEBI (Prohibition of Insider Trading) Regulations, 2015, any person possessing UPSI pursuant to a legitimate purpose is required to be sent a notice for maintaining confidentiality. However, the responsibility of sending the same has not been accorded to any person. While the compliance officer is responsible for the general compliance of the regulations⁴¹, with the amendment now, the Chief Executive Officer, Managing Director or other person is required to establish controls to prevent insider trading.⁴² Thus, there exists a serious ambiguity in the current provision which might lead to issues in attaching liability and responsibility in insider trading matters.⁴³

(b) Inability to make trading plans viable and popular

The Fair Market Conduct Committee observed that trading plans remain unpopular⁴⁴ because the restrictions Regulation 7 imposes on them might cause detriment to the interests of the insider.⁴⁵ Nevertheless, as they were unable to reach a consensus to resolve this issue⁴⁶, the drawback still exists. Although the Committee did provide clarifications regarding pre-clearance of trade and adherence to trading window norms⁴⁷, they were unsuccessful in resolving the primary issue.

(c) Issues regarding privacy and abuse of information

Schedule C of the 2018 Amendment prescribes minimum standards for Code of Conduct for inter alia designated persons. Designated persons, their immediate relatives and persons with whom such designated persons share a material financial relationship are required to provide their phone, mobile, cell numbers and Permanent Account Number.⁴⁸ In today’s modern era, individuals are concerned about privacy issues and thus, the latter two persons may not be comfortable sharing the said information. There is also a huge possibility of misuse of such personal information in case of data leakage.

(d) Increase in cost of compliance

The new amendment requires firms to formulate a policy for defining the scope of legitimate purpose⁴⁹, protection of whistle blowers⁵⁰, procedure for conducting inquiry in case of leakage of UPSI⁵¹ etc. Thus, firms are working hard to meet the April 1, 2019 deadline.⁵² Not only does all this require immense efforts, it involves undertaking huge compliance costs. Costs would also have to be incurred on the maintenance of the internal control mechanisms established in order to comply with the amended regulations.

(e) 'Performance of duties' still not defined

Although the Amendment provided the definition of the term 'legitimate purposes', it failed to express the ambiguity that persists regarding the definition of 'performance of duties'. The Oxford dictionary defines the term 'duty' as 'a moral or legal obligation'.⁵³ A question that arises is whether both performance of both moral or legal obligations is an exception, or is the ambit restricted to statutory obligations only? Section 166 of the Companies Act, 2013 enlists the duties a director is required to perform. If the director communicates the information in pursuance of some duty not provided in the said provision, will the exception still hold? These questions are of prime significance and thus seek immediate clarification.

(f) Ambiguity regarding definition of 'legitimate purposes'

The new amendment has provided for the company’s board of directors to formulate a policy defining ‘legitimate purposes’. In order to provide guidance, they have inserted an explanation which illustrates what could constitute legitimate purpose. However, if a company deviates from the definition provided in the explanation and provides a restricted definition, can the aggrieved person approach SEBI alleging violation of the regulation? In other words, is there any justiciability attached to the said explanation or is it a derogable provision? A clarification in that regard would avoid future complications.

4. CONCLUSION

The 2018 Amendment to the SEBI (Prohibition of Insider Trading) Regulations, 2015 were welcomed by all stakeholders alike as it brought in changes that were the need of the hour. Moreover, the promptness with which SEBI implemented the recommendations of the Fair Market Conduct Committee is also commendable. While the advantages of this amendment are numerous, it has come with its own share of weaknesses.

The overall net effect of the Amendment has been to restrict the applicability of the Insider Trading Regulations by providing additional defenses and clarifying important terms, while confirming that the burden of proving innocence would be on the ‘insider’. Although this goes against the general principle followed in other cases of fraudulent activity where the burden of proof is on the person alleging the act, India continues to make this distinction between insider trading and fraudulent activities. Other jurisdictions like the United States do not have such a distinction.

The insider trading regime in India has extremely benefitted with this amendment. The strengthening of system of internal controls and providing for whistle blower policies indicates that the Securities and Exchange Board of India is determined to resolve contemporary issues like social media leakage of UPSI. However, some clarifications relating to the definition of ‘performance of duties’, person responsible for providing notices etc. would help in better implementation.