Sketchy, but good in parts

Following a much-discussed report on the subject, the Securities and Exchange Board of India (Sebi) has finally published a new rule book against insider trading. The change was long overdue, as there was a need to not just improve the language of prohibition but also protect a large number of legitimate transactions that could potentially be seen as illegal from a very pedantic point of view of the law. The purpose of the law was to outlaw dishonest conduct, not be so broad so as to criminalise legitimate trades. What is interesting in the 2015 regulation is not just the prohibition part but also what is explicitly permitted. 

No-nos of insider trading

The prohibition comes in two parts. The first relates to communication of unpublished price-sensitive information. The prohibition outlaws not just communication of unpublished price-sensitive information but also those who allow access to such information or those who procure or cause communication by an insider. This is much broader than the 1992 regulation because it restricts the flow of information even without any trading occurring. It does, however, provide for flow of information for legitimate purposes, performance of duties or discharge of legal obligations.

For example, a friend gossiping to another about a company on whose board he or she sits, would be a criminal even if the other does not trade based on such information. This is not a great development, as it will chill communication even where no one has been hurt and there has been no intent or action to hurt investors. Though not clear, one hopes that this would be seen more as a violation of best practices of corporate governance rather than a substantive violation. Ideally, such innocuous talk should not be outlawed as there is no intent to cause or actual damage to anyone. 

Unfairness vs illegality

The other part related to the regulation is the classic prohibition against insider trading. The regulations prohibit an insider from trading in securities when in possession of unpublished price-sensitive information. While the scope of this point looks narrow and seems to apply only to insiders, the definition of insiders actually includes anyone who is in possession of inside information. For example, if a few pages from a company’s files blow away in the wind and land on someone’s front yard, the person who chances across this information and trades shares based on it would be guilty of insider trading. This is the broadest form — by global standards — of the definition of insider trading and relies on parity of information. It is hard to argue with the argument that all information should be equally shared and no one person should have an advantage over another.

But it is equally hard to argue with the fact that not everyone gets three square meals to eat every day. This is unfair. But all unfairness is not illegal. To use an analogy, comparing a person who finds a hundred rupee note flying around on a deserted road and keeps it with a person who picks someone’s pocket in a crowded train and giving both of these persons the same punishment is just wrong. One’s action is unfair but the other’s is both unfair and illegal.

To summarise the history of insider trading in a single sentence, the prohibition arose out of insiders — particularly, senior managers of a company — violating their fiduciary duty of placing the interests of their company and shareholders ahead of their own and instead trading in information and breaching that high trust.

But, unfortunately, the possession standard of this new regulation criminalises even random persons who didn’t steal or misappropriate information from inside a company. Many jurisdictions do — like India — impose this same measure when it comes to insider trading but I must assert my unequivocal opposition to this standard.

Benefits of doubt

The new law does provide a fair set of benefits and exemptions that were not present previously. This is, of course, a much-needed change from the previous regulation, which at times could be seen to outlaw not just unfairness but also totally honest conduct. The prime example was the ambiguity around due diligence, which amounted to access to inside information. Private equity (PE) or institutional shareholders often like conducting their due diligence on investee companies to verify facts presented to them by the company and its promoters. By definition, such investors would be given access to unpublished price-sensitive information not available to all shareholders.

Based on this due diligence, investment in the company would squarely fall within the prohibitory aspect of old regulations. This ambiguity was perverse because the interest of the PE players aligned very well with the interest of the minority shareholders. The PE player’s due diligence could potentially uncover misrepresentations in the financial books of the company. To virtually outlaw due diligence through an insider trading law was, in fact, hurting shareholders instead of helping them.

The new regulations provide several protections for honest conduct and also provide several safe alternatives through which insiders can trade by minimising the possibility of misuse of privileged, unpublished price-sensitive information. 

The first protection comes from communication in furtherance of legitimate purposes, performance of duties or discharge of legal obligations. While the prohibition is intended to restrict the free flow of information to only need-to-know basis, the regulation offers protection when the information is given in good faith but is misused. The giver of information, in that case, would be protected, though the one who misuses it will not. Similarly, any person in the chain of events who is passing on information for a good reason would stand protected.

The second protection is provided where a friendly takeover with an open offer is on the horizon. In such cases, the company can give access to price-sensitive information but only if the board of the company believes the transaction to be in the best interests of the company. While this comes with some interpretational complications, it is a useful addition to available exemption for honest conduct.

The third protection is in similar cases of due diligence where the board of the company believes the access to be in the best interest of the company but where there is no open offer on the horizon. In such cases, the price-sensitive information needs to be disseminated to the public two trading days before the transaction. This exemption will causes some problems at the time of its implementation, as people do not ordinarily wish to announce deals before they are signed or executed.

The fourth exemption is provided where two persons — for instance, promoters in possession of unequal information not widely available — enter into a mutual off-market transaction so as to not impact the market with a differing price. This is a useful and logical exemption that permits trades between two people who have access to privileged information as long as they don’t hurt the market with their trade.

The fifth exemption is where individuals in possession of unpublished price-sensitive information are not the ones who take the decision to trade. In other words, where a causal link can be shown between a person or group with superior information and another person or group trading in securities, the unfairness does not arise out of uneven ownership of information and its misuse. This is a sensible exemption and rooted in logic.

The sixth exemption arises out of a trading plan. A trading plan would be a plan to sell (or buy) a fixed number of securities, say, every week or month for at least a year after the plan begins. The plan provides a defence to those insiders who are perpetually in possession of unpublished price-sensitive information, particularly non-promoter senior management, who depend on ESOPs or sweat equity for their compensation.

The exemption would allow such employees and senior management to encash their shareholding without being wrongly accused of insider trading. Of course, to get the protection of law, several safeguards are built into the law, including the period after which the plan would start (six months), how long it must stay in place (at least a year), public disclosure of the plan, its irrevocability and certain freezeout dates and a requirement that it be the exclusive form of trading (no contra trades or other plans being used simultaneously).

Again, the purpose is to break the causal link between having privileged information and its actual misuse based on the information. The plan, though unlikely to be popular with promoters because of the stringency of its exercise, may just turn out to be popular with senior professional management with large ESOP and sweat equity grants.  

Finally, and most importantly, the new regulations provide for an exemption for innocent behaviour. The exact text is: “Provided that the insider may prove his innocence by demonstrating the circumstances including the following:-”. Lawyers, of course, get very exciting every time they see the word “including” in a legislation. It is actually a secret word used by legislators to say that whatever follow is only an indication and not an exhaustive list. The use of the words ‘innocence’ and use of the word ‘including’ seems to suggest that some level of fraud or intention (or mens rea, as we lawyers — pretending to speak Latin -— say) to defraud must be present.

This aligns the definition more closely to the American definition of insider trading, which is a derivative of the anti-fraud rule, there being no specific law defining insider trading. This is a welcome addition and it is hoped that judicial precedent will create a definition closer to the classical definition of insider trading (which is based on fraud and breach of fiduciary duty) rather than the over-broad possession theory that we seem to have adopted.

Principle-based approach

The simplification of the law to make it more principle-based in many aspects is a positive development and will allow companies to craft internal policies in the context of the inherent risks within the organisation. An auditor would need very different internal procedures compared with merchant bankers working for a listed company. 

The disclosure norms have been simplified and a high (from a previously very low) threshold provided (namely, sale or purchase of ₹10 lakh over a quarter) though the disclosure norms have been expanded to include all employees rather than select ones.

Explanatory tangent

One of the few negatives of the regulations is the addition of explanatory notes below every point. These have added no clarity in interpretation, as was intended, ranging instead from a very poor rephrasing of the same at best to contradicting the actual provision contained in the regulation at worst. Perhaps it is time to either junk the concept or, at least, make it more useful instead if creating more confusion. An example of an instance where the note contradicts the regulation is the definition of trading. While the regulation defines it as including subscribing, buying, selling, dealing or agreeing to subscribe, buy, sell, deal in any securities, the note includes pledging of securities while in possession of unpublished price-sensitive information. Including pledging of shares in the term trading not just attacks the concept of trading and dealing but also dilutes the impact of the objective sought to be achieved. It will also cause pain in genuine pledge transactions and provide no benefit to investors.

In conclusion, the new regulations have come as a big change from the past set of regulations. But new cases interpreting the revised rules will actually show the way forward in both the interpretation and reform of the provisions, if the need arises. 

The writer is also the author of the book Fraud, Manipulation and Insider Trading in the Indian Securities Market, published by CCH, a Wolters Kluwer business