Defining USPI

Today's Financial Express has a piece by @_baldemort__ @JRishabh2001 and me on the proposed expansion of the definition of what would constitute material under a relook at the listing regulations, to make them more in line with the definition of material in the insider trading regulations. While broadly ok, there are certain areas of caution. For instance pre-mature disclosure will chill forensic audit, because no company would like to attract negative attention till the forensic report actually finds wrong-doing. That would be a regulatory self-goal. The full piece is copied below:

The Securities and Exchange Board of India (“SEBI”) released a consultation paper on November 9, 2024 proposing revisions to the definition of Unpublished Price Sensitive Information (“UPSI”) under the SEBI (Prohibition of Insider Trading) Regulations, 2015 (“PIT Regulations”). To this effect, SEBI has introduced thirteen (13) new proposals to broaden the scope of the UPSI definition to include certain material events specified under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”). These include, among others, upward or downward revisions of credit ratings, proposed fund-raising activities to be discussed at Board meetings, agreements impacting the management and control of the company, initiation of forensic audits, outcomes of certain litigations, and the award or termination of significant contracts or orders not in the ordinary course of business. Some additions are well-founded, as such events significantly influence investor decisions and market movements. However, certain inclusions may dilute the framework's purpose by covering routine operational matters or classifying less material disputes as UPSI.

The relationship between material events and UPSI has evolved over time. Initially, the definition of UPSI under the PIT Regulations included within its scope, information related to all material events as per the listing agreement. However, an amendment to the PIT Regulations in April 2019 removed the direct link to materiality. Instead, listed entities were required to exercise judgment and prudently classify information as UPSI to align with the intent of the PIT Regulations. Despite this, instances of failing to categorize information, apart from those explicitly specified under the PIT Regulations, continued to persist. SEBI noted that listed companies were not exercising due care to classify or consider certain price sensitive information as UPSI. To address this issue, SEBI released a consultation paper on May 18, 2023, proposing to align the definition of UPSI with material events under Regulation 30 of the LODR to improve clarity and ensure consistent compliance.

In its latest consultation paper released on November 9, 2024, SEBI aims to address concerns raised in public feedback regarding the proposal to include material events under Regulation 30 of the LODR Regulations within the definition of UPSI. These include concerns over the limited impact of all Regulation 30 events on securities prices, recommendations to prioritize specific material events, and difficulties in compliance management. In this context, determining whether a material event falls within the scope of UPSI requires evaluating whether events warranting disclosure are, in most cases, also price-sensitive.

The new proposals recommend including regulatory actions against the listed entity, its directors, key managerial personnel (“KMPs”), and subsidiaries within the definition of UPSI. However, not all regulatory actions or orders carry the same level of significance or are likely to impact prices. For example, regulatory actions such as notices resulting in minor penalties for technical defaults are unlikely to have a substantial effect on stock prices. Similarly, actions against non-material subsidiaries that are not directly involved in the listed entity’s core and major operations may not significantly alter market perception. More importantly, even if material, ‘action initiated’ should never be the standard for disclosure. Everyone is assumed innocent unless proven guilty. To put in public domain a very preliminary charge or prima facie case would be unfair to the individual or company being investigated, ruining their image, even if ultimately exonerated. The only acceptable standard must be when a person is indeed found to have committed a wrong.

The Consultation Paper also proposes including changes to KMPs within the UPSI definition, even in cases unrelated to governance concerns, disputes, or financial irregularities. Additionally, it suggests incorporating information about the outcomes of litigation or disputes that could impact the listed entity. While rulings that result in significant financial liability may affect stock prices, outcomes that are pre-disclosed or anticipated, where the market has already priced in the potential impact, may not always be price-sensitive. As a result, events covered under Regulation 30 of the LODR Regulations require further independent analysis of their price sensitivity to determine whether they should be included within the scope of UPSI.

However, proposals for information such as upward or downward changes in ratings are inherently price-sensitive, as they directly affect the perception of a company’s creditworthiness or risk profile and are closely monitored by investors. Similarly, including award or termination of order/contracts not in the ‘normal course of business’ is justified because both the award and termination of contracts outside the normal course of business often indicate significant changes to the company's future cash flows, market position, or operational strategy. These events could lead to price movements. Of course, a material filter should also be applied, as a Re. 1 outside normal course of business contract should not be required to be disclosed.

 

The proposal to include information in relation to initiation of forensic audit or receipt of final forensic audit may raise speculations about potential mis-statements, misappropriations, or irregularities in a company’s financial dealings is too pre-mature. Indeed, if at the preliminary stage this is required to be disclosed, few companies would initiate a forensic audit for the fear of bad press. Indeed, the company would get bad press if and when a finding of mis-statement is found by the forensic report. Mandating a disclosure pre-maturely would be a regulatory self-goal.

At this juncture, it is important to note that the definition of UPSI is intended to be inclusive, already covering disclosures under the LODR Regulations that may be price-sensitive. The current proposals reflect SEBI's intention to better align its regulations with the realities of market dynamics. By broadening the definition of UPSI to include material events required to be disclosed under Regulation 30 of the LODR, SEBI acknowledges that certain events, even if they are not inherently market-sensitive at first glance, could have significant implications for investor perception and are not currently being disclosed. As a free market supporter, the authors believe in the current approach, but SEBI may be right in changing standards if it has data that people are being too cute with disclosures.

Through this approach, SEBI seeks to capture a wider range of corporate actions and events that could influence the financial standing or public perception of a listed entity. However, this broad interpretation introduces complexity, as it may lead to the classification of at least some routine operational events as UPSI, even if their market impact is limited or uncertain. Similarly, some other concerns with respect to forensic audits and under investigation or under enforcement events should not be disclosed till a finding of fault.

SEBI's proposed revisions to the UPSI definition aim to address changing market conditions and improve investor protection. Expanding the scope to include more material events under the LODR Regulations helps with clarity and compliance. However, it also creates challenges in distinguishing between price-sensitive information and routine operational matters. A consistent and focused approach, based on the likelihood of an event affecting market prices, reducing adverse impact on innocents and preventing self-audits by pre-mature disclosure would ensure that only truly relevant disclosures are classified as UPSI. This approach would help maintain the effectiveness of the insider trading regulations, reduce unnecessary compliance burdens while aligning the rules with current market practices.

 

From Reels To Rules: Sebi’s New Era Of Finfluencer Oversight

Rashmi Birmole,  Pranjal Kinjawadekar and I have a piece in the Financial Express of 30th Nov 2024 on the new structured digital platforms to regulate unregulated influencers being associated with registered SEBI intermediaries. The full piece is as below:

The regulation of finfluencers has been a subject of debate long before any attempts to bring them within the regulatory fold. Designing a framework to address the spread of unauthorized advice or misleading claims to an impressionable audience has had its own challenges, especially given the absence of fiduciary duties and a code of conduct. While such activities could be penalized as fraudulent practices or unregistered advisory, given the scale of misinformation and justifiable risks surrounding investor protection and financial stability, there was a growing need to also consider pre-emptive solutions.

To that end, in August 2023, SEBI proposed to limit the association of regulated entities with unregistered persons, like finfluencers, in a bid to disrupt their revenue model. The proposals culminated in amendments to certain key regulations on August 26, 2024, that barred regulated entities from associating with persons who provide advice, recommendations or performance claims, without being registered to do so by SEBI. However, such associations were allowed if carried out through a ‘Specified Digital Platforms’ (SDPs) recognized as such as SEBI, based on whether the specified preventive and curative measures could be demonstrated by such platforms. This was also followed by a directive to regulated entities to terminate all existing contracts with individuals providing unregistered advice or making performance claims.

On October 22, 2024, SEBI released proposed measures based on which digital platforms would be recognized as SDPs. Digital platforms have also been broadly defined to encompass any platform that facilitates communication between two or more individuals and allows user-generated content.

The criteria released by SEBI can be seen as two-fold – preventative and curative. Preventative measures are envisaged as proactive actions to prevent fraud, impersonation, unauthorized claims and presence of unregistered entities. Several of these measures, such as implementation of systems to identify and analyze content related to securities (including advanced artificial intelligence (AI) and machine learning (ML) tools), policies to take action against securities market violations and impersonation, allowing investor education content and use of verified labels to distinguish registered entities seem premised on creating a digital ecosystem that is well-equipped to identify and filter out unauthorized advice, claims or advertisements. However, what is truly striking, even upon a first reading of the proposals, is the breadth of power given to SEBI on multiple levels. Whether in terms of requiring an SDP to share securities-market related data on request, act on inputs received from SEBI, take measures to the satisfaction of SEBI and even periodically report to SEBI, in a manner akin to regulated entities.

Curative measures, on the other hand, are intended to address the gaps in preventive measures. The requirement for prompt escalation of reports regarding unlawful content and unauthorized entities by SEBI, regulated entities and users alike, is intended to restore confidence and enable prompt identification of such content. The SDPs would also be bound to act on such reported content within strict turnaround times, which may also include takedown or blocking of content and blacklisting of repeat offenders. Interestingly, the action that a platform takes should be to SEBI’s satisfaction. This leaves little to no room for the platform to arrive at objective conclusions based on its own verification and is essentially a carve-out for SEBI to direct content to be blocked or taken down, without further scrutiny.

Considering the growing influence of social media and influencers in today’s day and age, it is evident that the prospect of being recognised as an SDP would appeal to a number of digital platforms. While the implications of SEBI’s extensive powers under the SDP proposals on free speech and the legality of creating substantive obligations through a circular warrant a separate conversation of its own, digital platforms considering recognition as SDPs must be cognizant of the extent of SEBI’s potential involvement in their activities, if they were to succeed. Moreover, given that SEBI’s decision as to whether certain content qualifies as ‘advice’ or ‘performance claims’ is likely to be the end all, with platforms bound to take action to its satisfaction, it is possible that legitimate conduct may also be impacted, unless stronger controls are worked into the framework.

The proposals also call for platforms to implement policies for providing data upon request, thus increasing SEBI’s oversight of financial activities in digital media. However, the lack of clarity on the specific data to be shared may create compliance challenges, particularly in respect of end-to-end encrypted data, which may deter them from seeking recognition. Further, the costs of integrating advance AI systems could potentially deter new entrants and smaller platforms. Automated systems may also unintentionally flag legitimate content as violative, resulting in unwarranted disruptions. This risk extends to lawful content or advertisements being mistakenly identified as violations, which is precipitated by the absence of any redressal mechanism apart from approaching SEBI.

When compared to international practices, SEBI’s approach seems to be comparatively more intrusive and wider. The Financial Conduct Authority (FCA) in the United Kingdom employs a collaborative model, integrating its oversight with existing digital regulations rather than introducing standalone frameworks for financial content. The FCA partners with Ofcom under the Online Safety Act, emphasizing shared responsibility for online platforms while avoiding the role of a direct regulator. Similarly, in Australia, the Australian Securities and Investments Commission (ASIC) has partnered with online platforms to enforce verification processes for financial services advertisements. This collaboration reduces fraudulent promotions while minimizing compliance burdens on digital platforms. For instance, Google now mandates that financial services providers verify their Australian Financial Services licenses, issued by ASIC, before advertising. Providers must also complete Google’s advertiser verification program, a policy aimed at curbing financial fraud through online advertising.

While SEBI’s initiative to regulate digital platforms is a welcome step towards addressing the proliferation of unregistered financial advice, the framework’s stringent requirements raise several practical and legal concerns. Ultimately, the SDP proposals represent a significant shift in its regulatory strategy, signaling a move towards tighter control and attempting to bring platforms that fall outside SEBI’s jurisdiction, within its regulatory ambit by reason of having facilitated the publishing and availability of financial content. The new norms must face three challenges. One, of how it acts within the framework of freedom of speech, specially in borderline cases. Two, whether the regulator has the bandwidth to administer such a large mass of the regulatory unwashed masses and whether this SEBI-Administered Facebook (SAF) will have any takers. Third and most importantly, whether any of the millions of people with views and youtubers would at all want to be on a platform where the SEBI-Suaron’s eye is ever-watching. How these proposals unfold in response to the financial sector and social media platforms alike remain to be seen. 

From Roadblocks to Runways: SEBI’s New Exit Strategy Provides for Smoother Take Off

 I have a piece in today’s Financial Express on the delisting norms introduced by SEBI with Navneeta Shankar and Pragya Garg - it’s a welcome reform, long due which will remove the ‘hotel California’ of Indian markets.

The concept of ‘delisting’ of securities, as the word suggests, allows publicly traded companies to remove their securities from being listed on stock exchanges, either voluntarily or by regulatory mandate.  It signifies a company’s transition from being publicly traded to becoming privately held, by providing an exit route to the existing shareholders of the company. While voluntary delisting typically occurs for strategic reasons—such as restructuring or shifting to private ownership—compulsory delisting may be enforced on account of regulatory non-compliance with applicable laws.

While the Securities and Exchange Board of India (SEBI) had put in place an elaborate delisting process by way of the SEBI (Delisting of Equity Shares) Regulations, 2021 (Delisting Regulations), however, instances of delisting in India have been rather uncommon given the cumbersome nature of the process through the reverse book building (RBB) mechanism. The old delisting norms have often left companies trapped, with speculative bidding and artificial inflation of the exit price, hindering their ability to garner sufficient interest from public shareholders and exit the market efficiently.

To address these inefficiencies, SEBI, on September 25, 2024, introduced the SEBI (Delisting of Equity Shares) (Amendment) Regulations, 2024 (Delisting Amendment), following a series of proposals floated in August 2023 and approved in June 2024, marking a pivotal moment in the evolution of the delisting framework. The changes are aimed at reducing friction in the delisting process, offering acquirers more flexibility, and ensuring fair outcomes for shareholders.

Prior to the Delisting Amendment, the exit price for voluntary delisting was determined exclusively through RBB. In this process, the price was set based on bids submitted by shareholders, benchmarked against a floor price or an indicative price. The indicative price is the upfront price declared by the acquirer, which must be higher than the floor price, reflecting the acquirer’s willingness to buy out shares at a specified rate. Since the announcement of a voluntary delisting is usually followed by increased volatility and increased activity in the trading of the company’s scrip given that the exit price was earlier determined by the RBB process, a group of bidders acting together could shoot up the exit price, causing the delisting efforts to collapse. While in theory RBB appears to be a fair and transparent process of determining an exit price (similar to the entry price in IPOs), in reality it is controlled by a handful of speculators who cartelise and ensure failure of delisting, in fact hurting the genuine investor who could have gained an attractive premium had a realistic, though high, clearing price been allowed to be determined.

SEBI has now attempted to remedy this through the Delisting Amendment by providing listed companies with an alternative to delisting through a fixed price mechanism (FPM), apart from the existing RBB method. Under the FPM system, acquirers can set a fixed delisting price at least 15% above the floor price and must accept the equity shares tendered by the public shareholders if the acquirer’s post offer shareholding along with the tendered shares reaches 90% of the issued share capital of that class. As opposed to the RBB method, this mechanism is likely to offer greater transparency and price certainty by eliminating speculative bidding and inflated exit prices which are currently hindering the process of voluntary delisting. It will also reduce volatility and allow the acquirer to arrange funds for the offer in advance, thereby streamlining the delisting process.

The stringent counter-offer conditions under the older delisting norms meant that acquirers could only make a counter-offer in the RBB process if they reached a post-offer shareholding of 90%—a threshold that frequently led to failed delisting attempts. With the Delisting Amendment, SEBI has reduced this requirement to 75%, provided that at least 50% of the public shareholding is tendered. SEBI has also revised the norms concerning the counter offer price, which could not be lower than the book value of the company under the earlier framework. Now, however, the counter price cannot be less than higher of (a) the volume weighted average price of the shares tendered/offered in the RBB process; and (b) indicative price, if any. These revised norms are likely to be more effective in safeguarding the public interest while also increasing the likelihood of successful delisting by allowing the acquirers to negotiate more effectively with shareholders and make a productive counter offer.

Another significant change has been the method of determining the floor price which is no longer required to be computed in the context of an open offer, wherein a company continues to remain listed, as opposed to in voluntary delisting, where a company ceases to remain listed. SEBI now requires companies to use the adjusted book value (ABV) of assets as a key parameter in setting the floor price, ensuring that shareholders receive compensation aligned with the company’s intrinsic value. The floor price will be calculated based on a reference date, which shall now be the date of the initial public announcement and not the date on which the exchanges are notified of the board meeting in which the delisting proposal was considered, as under the older norms. This change mitigates the risk of abnormal trading activity and will align the floor price more accurately with market conditions.

The new delisting norms also introduce a concrete framework for delisting of an Investment Holding Company (IHC). An IHC is a company holding investments in listed or unlisted companies or holding assets other than such investments. Since there existed no separate framework for delisting of IHCs, this led to the equity shares of a listed IHC being traded at a discount compared to the true value of its investments in listed and unlisted companies. Consequently, the floor price set under Delisting Regulations more often than not did not reflect the true intrinsic value of these investments.

With the Delisting Amendment, IHCs now have an alternate delisting route, allowing them to transfer shares of underlying listed companies to public shareholders proportionally after cash payments for unlisted investments and other assets. This will be followed by a scheme of selective capital reduction to extinguish the public shareholding in the IHCs in terms of the provisions of the Companies Act, 2013. However, only IHCs with at least 75% of their fair value in direct investments in listed companies can avail this alternative, potentially leading to more voluntary delisting offers from such IHCs.

SEBI’s newly implemented delisting reforms mark a transformative step towards resolving the long-standing challenges in India’s capital markets. These changes are likely to encourage smoother transactions and enhance the efficiency of market exits without compromising investor interests. The improved predictability of the delisting process will inspire confidence among both promoters and investors, balancing ease of exit with protection for minority shareholders. Counter-intuitively, easier delisting can also foster more IPOs by reassuring companies that exiting the market, when necessary, will not be overly cumbersome or costly. With these reforms, SEBI has aligned India’s delisting norms with global standards, paving the way for a more robust, efficient, and balanced market conditions.

Curbing Merchant Bankers

I have a piece with Aniket Singh Charan and Rishabh Jain in today's Financial Express where we argue that SEBI's proposal on curbing business of merchant bankers should be re-thought through. 

The securities market plays a role akin to the nervous system and arteries for the economy, facilitating price discovery in securities and allocating funds to companies that seem most promising. To ensure that this mechanism is not disturbed by information asymmetries favouring the issuer or its insiders, and to ensure liquidity and stability during and immediately following an issue of securities, a merchant banker is engaged to ‘manage’ the issue of securities. A merchant banker essentially oversees critical aspects such as undertaking due diligence of the issuer, undertaking valuation of the issuer’s securities and preparation of the prospectus, on top of its core job of marketing securities. Further, as an underwriter, a merchant banker may buy securities that have remained unsold at the end of an issue, thus ensuring adequate subscription. On August 28, 2024, SEBI released a consultation paper proposing changes to the Securities and Exchange Board of India (Merchant Bankers) Regulations, 1992.

Many key changes pertain to the eligibility and obligations of merchant bankers. Merchant bankers are proposed to be recategorized into Category-1 (possessing a net worth not less than Rs. 50 crores, and authorized to undertake all permitted activities) and Category-2 (possessing a net worth not less than Rs. 10 crores, and authorized to undertake all permitted activities except Main Board Issues). It is unclear why non-underwriting bankers require a networth.

SEBI further proposes to introduce the concept of liquid net worth, which for Category-1 merchant bankers would be not less than  Rs. 12.5 crores and for Category-2 merchant bankers would be Rs. 2.5 crores. The maximum underwriting obligations of merchant bankers, currently at 20 times their net worth, are proposed to be reduced to 20 times the liquid net worth for a merchant banker that has maintained 35% of its net worth as liquid, or otherwise the lesser of 7 times the net worth or 20 times the liquid net worth.

Another key set of changes pertains to the activities merchant bankers may undertake. Merchant bankers have traditionally performed a variety of roles, including providing advisory services for projects and syndication of rupee term loans. Further, upon obtaining appropriate registrations, merchant bankers also act in other regulated roles pertaining to the securities market, such as dealers of government securities or stockbrokers. Additionally, merchant bankers as a class have also been specifically recognized as providers of valuation services, both by SEBI for the purposes of acquisitions and share-based employee benefits and sweat equity, and by other authorities, particularly in respect of fair market value of unquoted securities for income tax purposes and pricing of non-debt instruments under foreign exchange rules.

SEBI has now proposed to specifically define the permitted activities for merchant bankers. These would include only activities related to the securities market that are under the jurisdiction of SEBI, and would not include any activity requiring a separate registration. To this effect, a list of permitted activities is provided, although it is not clear whether list is exhaustive. Apart from managing international offering of securities, which may not necessarily fall under the jurisdiction of SEBI, a perusal of the list of permitted activities indicates an intent to confine the activities of merchant bankers to those that are specifically permitted by SEBI under the relevant regulatory framework. What is truly concerning is that an adequate rationale has not been furnished for such a restrictive approach.

Firstly, prohibiting merchant bankers from carrying on activities regulated by other financial sector authorities is not consonant with SEBI’s own approach elsewhere. For instance, in its consultation paper reviewing the regulatory framework concerning Investment Advisers and Research Analysts, dated August 06, 2024, SEBI had proposed to permit investment advisers to advise on products regulated by other financial sector authorities. Further, where other financial sector authorities, such as the Reserve Bank of India, have found merchant bankers suitable to act as dealers of government securities, it is puzzling why SEBI adopts such a restrictive stance. Particularly in the case of valuation activities, as noted by SEBI, other authorities have recognized the validity of valuation by merchant bankers. SEBI has proposed to retain the permissibility of valuation activities by merchant bankers where specified under its own regulations. It is debatable that SEBI, being at most a co-equal authority, now prohibits merchant bankers from valuation activities that may be administered by other authorities. The idea that such activities may still be undertaken through separate divisions, could have been a better alternative to outright prohibition.

Moreover, no rationale has been furnished for prohibiting merchant bankers from carrying on activities that require separate registration with SEBI, nor does there appear to be international precedent for this. In fact, activities corresponding to merchant banking in India are usually carried on by broker-dealers in the United States, recognized as one of the most mature and well-regulated markets. Therefore, SEBI’s proposals, if brought into effect, would require the merchant banking industry in India to restructure its business in ways dissimilar to both existing practice and the rest of the world, for no perceptible regulatory benefit.

Further, SEBI has proposed to cancel the registration granted to a merchant banker if it fails to earn a minimum revenue from its activities. This too is an extreme step, given that revenue from permitted activities, unlike capital adequacy, does not impact the ability of a merchant banker to carry out its obligations. Moreover, there is no international precedent for such a requirement. Indeed, such a requirement may perversely incentivize merchant bankers to procure business by inappropriate means and would entrench existing players.

Another proposal that ought to be reconsidered is the confinement of underwriting activities of merchant bankers to those specifically permitted by SEBI. This proposal appears directed at least partly at curbing the market practice of underwriting private placements of debt securities by listed entities. Yet, this proposal misses the market reality that private placements of debt securities are often the first step to their introduction on the public market, akin to an initial public offering of equity shares in respect of the usual lack of a pre-existing liquid market in them. Absent underwriting by merchant bankers to make a market in such securities, private placements may often fall through. Therefore, we believe that merchant bankers ought to be allowed to underwrite private placements of debt securities.

It is also proposed that merchant bankers not act for an issuer, if the merchant banker’s directors, key personnel, compliance officer, and their relatives, individually or in aggregate hold, more than 0.1% of the issuer's paid up share capital or nominal value of Rs. 10,00,000, whichever is lower, save through mutual funds. Given that such personnel have significant financial expertise and experience, and are likely to hold large portfolios of investments, such a requirement may unnecessarily disqualify many suitable merchant bankers. Rather, it would be sufficient to require disclosure of such shareholding as conflict of interest.

By and large, it is commendable that SEBI has updated its regulatory framework on merchant bankers in line with the changing realities of the market and the regulatory framework. However, there is much to be reconsidered in order to ensure that unduly onerous restrictions that do not serve the interests of the market are not placed on merchant bankers.

Proposed Insider Trading Framework will criminalise the innocent

I have a piece with Manas Dhagat and Pranjal Kinjawdekar in today’s Economic Times on the proposed changes on insider trading regulations. These proposals with have the disadvantage of 100% false negatives AND 100% false positives. In other words it will only catch the innocent in a quasi-criminal proceeding. In fact, the deeming provisions in insider trading regulations should be completly abandoned. Here is the full piece:

“SEBI has recently proposed amendments to the SEBI (Prohibition of Insider Trading) Regulations, 2015 ("PIT Regulations") through a consultation paper. The proposed changes pose risks, not to wrongdoers, but rather to innocent people. Under the PIT Regulations, an "insider" is someone who has access to unpublished price-sensitive information ("UPSI") or is a "connected person." The proposal expands the current law, which already criminalizes certain conduct by creating a presumption, effectively overturning the principle of "innocent until proven guilty." The PIT Regulations currently identify specific categories of individuals presumed or deemed to be connected persons to the insider, including immediate dependent relatives (such as parents, siblings, and children) and certain corporate entities, based on their connection and presumed access to such information. SEBI's proposal aims to broaden this definition by adding new categories of deemed connected persons and replacing "immediate relatives" with the broader term "relative," aligning it with the Income Tax Act. Additionally, SEBI has proposed including six new categories of individuals as connected persons, referencing the definition of "related party" under the Companies Act, 2013. The expansion includes ‘material financial relationship …for reasons of …frequent financial transactions’. This could literally be thousands of vendors of a single public company.

 

The lack of clear justification for SEBI's proposed changes, particularly the shift from "immediate relatives" to the broader term "relatives," raises significant concerns. While SEBI suggests aligning definitions with those in the Income Tax Act and the Companies Act, the consultation paper fails to adequately explain the need for such changes. In fact, the definition of relatives in the Income Tax Act is used for providing benefits to taxpayers, not for criminalizing them. The current inclusion of "immediate relatives" in the PIT Regulations was a deliberate choice, made to address the specific nuances of insider trading, which even in its limited scope often inverts justice. Broadening this scope to include all relatives, risks implicating individuals who may have no direct or material connection to sensitive information, leading to a potential increase in the number of people subject to insider trading punishment without sufficient justification.

 

Under the current framework, connected persons are presumed to possess UPSI unless they can prove otherwise. This creates a rebuttable presumption, placing the burden of proof on the accused to demonstrate their innocence. While this may be somewhat logical for individuals reasonably assumed to have access to UPSI, expanding the definition of connected persons significantly increases the number of people unjustly burdened by this presumption. The proposed changes would require individuals, who might only be related to someone with UPSI, to prove a negative—that they did not have access to or act upon insider information. This shift in the burden of proof is not only unfair but also creates a potential for significant injustice, as it effectively presumes guilt rather than innocence. While one might argue that the presumption is rebuttable, in reality, proving innocence under these circumstances is nearly impossible without a camara on everyone’s head recording every breath. How does one prove that a distant relative did not pass on information? Under the current framework, a financially independent relative who lives separately and does not seek advice on trading decisions would not be classified as a deemed connected person. However, with the proposed change to "relative," such second-degree relatives would be included solely due to their familial connection, regardless of financial independence or involvement in trading decisions.

If one assumes this is a theoretical problem, one needs to look only at caselaw. In the Balram Garg case which went all the way to the Supreme Court of India, SEBI accused a person of insider trading merely because the two were residing in the same residential complex. In fact, the two did not get along and were quarreling. In addition, even the pattern of insider trading was the opposite of what was logical (sale before good news). Yet, SEBI charged the person with insider trading. It took the Supreme Court to say: “it is only through producing cogent materials (letters, emails, witnesses, etc.) that the said communication of UPSI could be proved and not by deeming the communication to have happened owing to the alleged proximity between the parties.”. After losing, SEBI choose to file a review petition instead of reviewing its actions. With the proposed law, the parties could be deemed criminals and it would be more difficult for even the Supreme Court to defend the innocent.

 

Instead of expanding the definition and increasing the burden on individuals, it would be more prudent for SEBI to focus on enhancing its investigative capabilities. This would enable SEBI to build stronger cases based on actual evidence rather than relying on presumptions that may not hold true. The proposed regulatory changes represent a significant shift in SEBI’s approach towards addressing insider trading, with far-reaching implications. The approach indicates a tendency to shift the burden of proof onto the accused rather than carrying it themselves. While improving SEBI's investigative capacity is crucial, granting the regulator unchecked power to label individuals as "connected persons" without concrete evidence risks regulatory overreach. It would not be an exaggeration to say that the new law would be the first which has a possible 100% false positives and 100% false negatives. How many criminally minded would trade through their uncles? The proposed law is designed to indict the innocent and perhaps the not very smart criminal (presumably a small class). In 1769 William Blackstone said that “the law holds that it is better that 10 guilty persons escape, than that 1 innocent suffer”. The proposed law would free the 1 guilty to use their artifice and imprison the 10 innocent. The proposal should be abandoned and even the current law on presumption needs to be rationalised.”

 

 

Striking the Balance: Salt and spice for investors

I have a piece with Navneeta Shankar in today’s Financial Express on the new Alt-Fund proposed by SEBI. It’s a good idea to permit a new category which allows higher risk taking than a classic mutual fund. The full piece is as below:

The current investment landscape in India is designed to cater to various investor categories. Retail investors typically have access to mutual fund schemes with a low entry point, while high net-worth individuals (HNIs) and institutional investors can opt for Portfolio Management Services (PMS) with a minimum investment of INR 50 lakhs and Alternative Investment Funds (AIFs) with a minimum investment value of Rs 1 crore. However, there exists a notable gap for retail investors who wish to invest, say, Rs. 20 lakhs in direct equityand who want to take a much higher risk. 

To address this issue, the Securities and Exchange Board of India (SEBI) issued a consultation Paper dated July 16, 2024, proposing a new asset class that will permit Asset Management Companies (AMCs) to offer new sets of investment products, including investment in derivatives or derivative strategies, to Indian investors. The proposed semi-alternate asset (Salt Asset class) is aimed at bridging this gap between mutual funds and PMS and is envisaged to provide investors with a regulated investment product with higher risk-taking capabilities.

In the absence of a favourable regulatory architecture, retail investors were becoming vulnerable to falling for unregistered and unauthorized investment products, which often promise unrealistically high returns and exploit the investors’ expectations for better yields.  The Salt Asset, with a return risk-profile positioned between mutual funds and PMS, is intended to provide investors with a secure and regulated option. This new class would serve as a customized investment product offering greater flexibility, higher risk-taking capability and a higher ticket size, catering specifically to this emerging category of investors. 

SEBI has proposed for this to operate under the mutual fund structure but with relaxed prudential norms. In order to enable existing and newly registered mutual funds/ AMCs to offer products, SEBI has proposed two routes of eligibility criteria. Existing mutual funds would be required to demonstrate a strong track record by being in operation for at least three years with an average Assets Under Management (AUM) of Rs. 10,000 crores over preceding three years, and no regulatory actions in the previous three years. For newly registered mutual funds or existing ones that are unable to show strong track record, requiring experienced fund manager and chief investment officer with demonstrable experience, and no regulatory actions against the sponsor/AMC in the last three years.

Since the products offered under the Salt Asset Class will be relatively riskier than the schemes offered by traditional mutual funds, there is a need to maintain a clear distinction between the branding of products under the Salt Asset and those under the traditional mutual funds. To achieve this, SEBI has proposed that the Salt Asset be branded and advertised as a product distinct from the traditional mutual funds. This, in SEBI’s view, will ensure that any potential misconduct/ failure in the performance does not negatively impact the confidence of retail investors in traditional mutual funds.  

Under the proposal, AMCs can offer ‘Investment Strategies’ with flexible redemption frequencies tailored to the nature of investments, allowing investment managers to adequately manage liquidity without imposing undue constraints on the investors. Importantly, no investment strategy under the Salt Asset class may be launched by an AMC unless the same is specified by SEBI and approved by the trustees, subject to final observations on the offer documents by SEBI. 

SEBI has proposed a minimum investment amount of Rs. 10 lakhs per investor, across one or more Investment Strategies under the Salt-y Assets offered by an AMC. This threshold, in SEBI’s view, will deter retail investors from investing in this product, while attracting investors with investible funds between Rs. 10 lakhs – Rs. 50 lakhs who are being drawn to unregistered PMS providers and those who perhaps cannot commit to an investment in an alternative investment fund (AIF) which requires a commitment of Rs. 1 crore per investment. 

It has also been proposed that all investments permissible to mutual funds under the current regulatory framework will also be available for the Salt Asset. Additionally, it will be permitted to take exposure in derivatives for purposes other than hedging and portfolio rebalancing to allow more flexibility and risk-taking in investments. Investors will also be given the option of systematic plans, including withdrawals and transfers, for investment strategies, though at no point in time the total invested amount of an investor should fall below Rs. 10 lakhs for reasons other than depletion in the value of the investments. 

SEBI’s proposal is a significant step towards democratizing the securities market and makingit more accessible to average Indians. With the proliferation of ‘finfluencers’ and the consequent rise in misinformation in the investment advisory space, the proposed Salt Assetoffers new avenues specifically for this emerging category of investors, who are likely to be propelled towards unregistered and unauthorized investment schemes while seeking flexibility in portfolio construction along with higher risks and returns. The initiative also paves the way for adopting thematic investment strategies like electric vehicles, water management, recycling, and renewable energy. The Salt Asset is likely to attract both the mass affluent and high net-worth individual investors by offering them new avenues for investment in emerging sectors. 

A Salt Asset coupled with the convenience provided by regulated mutual fund platforms will not only facilitate ease of investment but will also promote the concept of domestic mutual fund participation in sophisticated investment strategies, including in long-short equity and inverse ETF. That being said, SEBI is encouraged to not restrict the proposed investment product to only AMCs but consider permitting other registered intermediaries to offer products under the Salt Asset as well. Alternatively, SEBI may consider creating an altogether new category of a registered intermediary to provide this investment option, which could be regulated by a separate set of rules with much less compliance burden and restrictions than those on mutual funds/AMCs.

SEBI's introduction of Salt Assets reflects its commitment to fostering innovation and growth in the Indian financial markets, while also weening investors off spicier unregulated productsor unregulated offerings. While the success of this initiative remains to be seen, it promises to create a dynamic and inclusive financial market. This move will offer diverse investment opportunities, catering to the varied needs of Indian investors and contributing to the development of a more robust and resilient financial ecosystem. Similar to Mini-Reitsintroduced by SEBI, this move will bring in players and investors outside the margins of the securities market into a formal, regulated sphere of predictability and regulatory comfort.