01 March 2024

Winning the battle only to lose the war – the saga of front-running

Aniket Singh Charan and I have a piece in today's Financial Express on the changing nature of 'front running' a type of securities fraud.

 

Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” – said the Red Queen to Alice in Through the Looking Glass. There are many examples in the securities market that perfectly demonstrate the wisdom of the Red Queen – if you want to make a profit, you need to be faster than the rest.

While, ordinarily, asymmetry of information in the securities market is often exploited to achieve profits, front-running abuses this in a nefarious manner. Front running involves the use of non-public information pertaining to a “substantial order”, and trading ahead of it to make profits or avoid losses. Recent orders by the Securities and Exchange Board of India (“SEBI”), in the matters of Experts appearing on Zee Business and Ketan Parekh indicate a rise in the number of enforcement actions taken by the regulator for this particular offence and throws light onto the evolving forms of front-running. They also provide interesting perspectives on approaches adopted towards ascertaining what a “substantial orderis and the “impact” such an order may have on the price and volume traded of a security.

Although front-running is a fraudulent practice, in Ketan Parekh (no relation of the first author), SEBI has done away with the requirement to prove dishonest intention. What is essential, however, is an inducement to deal in securities, which is sufficient to demonstrate fraud. A parallel may be drawn to the Supreme Court ruling in SEBI v. Abhijit Rajan, a case involving allegations of insider trading. The Supreme Court held that it was immaterial if actual profit or loss occurred, what is required is a motive to make a profit from the alleged trade. This motive is a key element in such trades.

In Ketan Parekh, Quest Investment Advisors Private Limited, a portfolio management company registered with SEBI, indulged in front-running while in possession of advance knowledge of impending orders. A key factor in the analysis of front-running revolved around the interpretation of what constitutes a substantial order and the impact it may have on the price of the securities. SEBI interpreted the meaning of the substantial order by placing reliance on the “reasonable person test” while noting that there was very little guidance, precedentially, available on what constitutes a substantial order. As per the whole time member (“WTM”), in this matter, a substantial order is one which, in the estimation of a reasonable person, would impact the price of the concerned securities. The WTM further stated that “when it is only the estimation of reasonable person then the assessment of actual impact of such substantial order is not necessary to determine the substance of the order”. Ideally, determination of what constitutes a substantial order should be followed by an assessment of the impact such a substantial order may have on the price of the securities traded. In the present case, there was no calculation of impact and the reasonable person test was used to conclude that front-running did in fact, occur.

In another matter, the front runner had undertaken trades in advance of an impending order. SEBI held that front-running occurs when an entity makes a trade on the basis of non-public information regarding a “large trade” from an investor, which may impact the price of such security. SEBI matched trades undertaken by the noticee with that of the impending large trade and found that in almost all instances the trades executed matched that of the impending order. Interestingly, the WTM observed that for front-running to occur it was not mandatory that the front-runner’s trades should match with that of the impending order. The essential element in establishing front-running is that the trades were made on the basis of non-public information. Whether the trades executed by the front-runner match the large order and whether they resulted in profits, are secondary considerations.

In Zee Business, a far more complicated picture emerges. The alleged violators belonged to three categories – (i) experts appearing on news channels; (ii) profit makers; and (iii) enablers. Experts appearing on news channels provided advance information about the recommendations that were going to be made on the news broadcast (which was held to be non-public information) to the enablers, who then used trading terminals provided by profit makers to trade based on such advance information. SEBI, in its order, analysed the fluctuations in the price and volume of securities, being traded, pre and post the news broadcast. Notably, a key ingredient of front-running i.e. the existence of an impending transaction/ substantial order was not directly present in this case. It was held that the popularity of these shows had equipped the noticees, with a deep awareness of the impact that expert recommendations wielded over the price and volume of the securities so recommended. Though there was no substantial order in place, it was argued that the noticees had a reasonable expectation of an increase in the price and volume of the securities recommended immediately following the news broadcast. The favourable movement in the price and trading volumes of the securities once such recommendations were made, further strengthened this argument. SEBI utilised a host of strategies to establish links between the parties – from call data records, WhatsApp/Telegram chats to geographic location analysis to further prove a nexus. It is rather interesting to note, that the reasonable person test as employed in Ketan Parekh, was not relied on in this order. Furthermore, this order did not discuss who a reasonable viewer is, and the only metric used to show inducement was the price/volume fluctuations pre and post the broadcast. Nevertheless, this order has expanded the contours of front-running (from a plain vanilla pump and dump scheme) to accommodate situations where there is an intent to defraud investors by abusing the trust which investors keep with certain individuals- such as the financial pundits in this case and a substantial order’s existence can be ascertained on the basis of the quantifiable response which viewers have for guest recommendations on channels, like Zee Business, and the change in the volume of trading in such securities. As has been expressed earlier, the motive is what counts towards making a case of front running, divorced from any actual profit making.

In all three cases, SEBI utilised different approaches to ascertain impact and knowledge of impending orders. On the road to determining substantiality of orders, the approach adopted by SEBI has seen several variations and the ever changing contours of front-running pose new challenges in determining liability. SEBI may have to relook at how it defines front-running in light of these changing dimensions. After all, a front-runner is not the only one who has to run twice as fast.

07 February 2024

India Inc gets global play: Allowing public companies to list on IFSC will make them more competitive

I have a piece with Shivaang Maheshwari in today's Financial Express on the amendments paving the way for direct listing of Indian companies at the exchanges on the GIFT city. The move could help capital raising by Indian companies and help foreign investors to deal in shares of India based companies without going through complex investment procedures and without converting their hard currency.


On January 24, 2024, the Central Government notified the Companies (Listing of equity shares in permissible jurisdictions) Rules, 2024 (LEAP Rules) and amended the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) paving the way for certain public companies incorporated in India to list their equity shares directly on international exchanges situated in GIFT International Financial Services Centre (IFSC). These notifications are based on the recommendations of the Working Group which was tasked with suggesting a regulatory framework that facilitated direct listing of public Indian companies on international exchanges in IFSC.

 

Until now, Indian companies could only issue and list their securities in the overseas market through depository receipts such as American Depository Receipts (ADR) or Global Depository Receipts (GDR). Under this process, a company intending to raise capital from foreign jurisdictions would issue securities to the depositories incorporated in that particular jurisdiction and such depository in turn would issue depository receipts in the name of the company to the investors. Presently, only a handful of companies have opted for this route, given the stringent and tedious regulatory framework along with the time and costs associated with issuance of depository receipts. Moreover, unlike equity shareholders, the holders of the depository receipts are not entitled to vote unless they convert them into underlying shares. Fraudulent issuance of a company’s GDR and its manipulation are other risks associated with depository receipts.

 

Thus, with a view to address these challenges, the recent notifications have introduced a regulatory framework that allows both listed and unlisted public Indian companies to issue and list their equity shares (including by way of offer for sale) on permitted stock exchanges in permitted jurisdiction viz., India International Exchange and NSE International Exchange set up by BSE and NSE respectively in GIFT IFSC. The significance of this framework is crucial for India as it not only presents a roadmap for direct listings of public Indian companies but also aims to enhance the appeal of GIFT IFSC as a distinguished global financial hub. In the pursuit of global competitiveness, it is imperative for Indian companies to secure capital at the most favorable cost of capital. Foreign investors, known for their inclination towards securities listed in their home country, often assign disproportionate weightage to such assets in their portfolios. This inherent home bias placed Indian companies at a distinct disadvantage when courting foreign investments. Opting for foreign listings in the IFSC emerges as a strategic solution to mitigate this bias, effectively reducing the cost of capital for companies as investments in these companies can now be made in hard currency. Notably, companies are not obligated to undergo domestic listings concurrently, granting them the flexibility to establish a presence solely on an international exchange in IFSC.

 

The opportunities expected to be generated by the revised regulatory framework are immense. Companies incorporated in India can unlock several advantages by accessing capital markets outside their home country. One significant benefit is that Indian companies can now attract funds from international investors which often have the capacity to provide huge capital funds, keeping in mind the valuation of these companies based on global standards. Listing in IFSC is also likely to open up a broader investor base for companies as a diverse pool of investors would be interested in acquiring and trading their shares thus ultimately increasing the demand for the company's shares. For instance, a company listed on international exchanges in IFSC gains access to numerous investment funds also situated in IFSC. This opportunity wouldn't have been possible otherwise, as these international funds might not have considered investing in Indian companies, given the necessity to register as a portfolio investor with SEBI and dealing with conversion of the dollar or euro into the rupee. However, foreign investors however may prefer investing in only well-established and thriving companies.

 

Foreign listings are also likely to lead to better valuation as companies listed on international stock exchanges benefit from sophisticated asset management infrastructure, resulting in more accurate valuations of their securities. Companies will now have the option to access both markets, i.e., domestic market for raising capital in INR and the international market at IFSC for raising capital in foreign currency from the global investors. Startups would now gain access to funds from foreign investors instead of the traditional ways of crowdfunding and seed funding.  Overall, exploring capital markets beyond India's borders offers a range of advantages that can significantly contribute to a company's growth and success on the global stage.

However, the framework provides that in order to secure listing on international exchanges, the public Indian company, as well as its promoters, promoter group, directors, and selling shareholders, must not be debarred from accessing the capital market. Additionally, it is also a prerequisite that none of the promoters or directors of the public Indian company is a promoter or director in any other Indian company that is debarred from accessing the capital market. Further, any company which is under inspection or investigation under the provisions of the Companies Act, 2013 or whose promoters or directors are wilful defaulter or fugitive economic offenders are also not allowed to list their equity shares on international exchanges. While these stringent conditions are implemented to ensure that only financially sound and reliable companies secure listings in IFSC, the ineligibility on account of pending inspection/investigation may be revisited.

Further, only permissible holders, i.e., persons who are not residents of India are authorized to buy or sell equity shares of public Indian companies that are listed on international exchanges. Thus, an Indian resident cannot hold such shares, however a non-resident Indian can hold such shares. It is also pertinent to note that permissible holders belonging to countries that share a land border with India will require approval from the Central Government to engage in transactions in IFSC. This provision is likely to cause friction, but necessary friction, given the nature of some of our neighbours.

It remains to be seen whether a framework could be adopted which paves the way for presently foreign listed Indian companies to move from global exchanges to exchanges situated in GIFT IFSC. With respect to direct overseas listing of Indian public companies already listed in India, SEBI is expected to clarify the mechanism by issuing detailed operational guidelines in furtherance of the framework. These notifications are not only aimed at benefitting Indian companies in fund raising but also marks a significant step in realizing the Central Government's vision of promoting GIFT IFSC as a global financial hub. Nonetheless, prudent implementation and development of a well-defined framework addressing potential loopholes are imperative for ensuring the long-term effectiveness and sustainability of direct listing.


17 January 2024

Sebi’s rumour roulette: The proposed norms must be scrutinised for their likely impact on market dynamics

 

I have a piece with Manas Dhagat in today's Financial Express on the new norm for listed companies to come out with a clarification for certain market rumours. The full piece is reproduced below:

Introduction 

The Securities and Exchange Board of India (“SEBI”), through a consultation paper dated December 28, 2023, proposed amendments to address concerns related to market rumours. The consultation paper seeks a notable change from prioritizing material events to focusing on significant price movements for verification of rumours. Under the proposed amendments, any significant price movement triggered by a market rumour reported in the mainstream media would necessitate clarification from the concerned listed entity within 24 hours. At the outset, the extensive range of participants falling under the umbrella of 'mainstream media' poses a considerable challenge in meeting this time constraint. For instance, over 1.4 lakh newspapers and magazines registered with the Registrar of Newspapers for India (RNI), meet the criteria. Effectively monitoring all these mainstream media outlets becomes a daunting task for entities, demanding substantial resources merely for tracking these rumours.

Verifying Market rumours through price movements and the pricing of transactions

The proposed amendment places a distinct emphasis on price variation rather than the specific events outlined in Regulation 30 of LODR Regulations. The material price movement would be attributable only to the rumour, and shall require verification of the rumour by the listed entity. The consultation paper recognizes that a smaller percentage change in high-priced securities may result in a more substantial absolute price variation, necessitating distinct percentage variations for securities with different price levels. SEBI further proposes that the price fluctuations in listed entity securities be compared with the movements of Nifty50/Sensex to provide a comprehensive reflection of market dynamics. Another noteworthy change is the suggestion to verify market rumours within 24 hours of a material price movement, as opposed to the existing requirement of doing so within 24 hours from mainstream media reporting. This adjustment aims to enhance the timeliness and efficiency of addressing market speculations.

One of the major concerns is the potential for premature and potentially harmful disclosures due to the obligation imposed upon listed companies through the proposed changes. Not all market rumours merit immediate public disclosure, and such a requirement could inadvertently lead to market distortions.  For instance, in the case of preliminary merger talks, even minor leaks causing any price change could force companies to disclose sensitive information, potentially causing market disruptions and influencing negotiations adversely as the target market price would move up if the acquisition negotiations have been confirmed by the company.

SEBI proposes a mechanism to ensure that unaffected price is considered with respect to transactions relating to the securities of listed entities. There are difficulties that accompany the exclusion of price variation during the pricing of transactions. In a scenario where price movement occurs due to, inter alia, public announcements, sectoral trends, policy changes etc, in the same timeline wherein a rumour was clarified by a listing entity, such price movements shall be discounted for pricing guidelines for preferential issues of shares, Qualified Institutions Placement (QIPs), open offers etc. To protect the best interests of the investor, an approach is needed such that price variation due to genuine considerations is not discounted in transactions of listed securities.

Obligations on Directors, KMPs, senior management and designated persons

The consultation paper further raises practical challenges by imposing obligation upon the listed entity to clarify rumours pertaining to promoters, directors, and key managerial personnels (KMPs). In complex corporate scenarios, obtaining timely responses from these individuals may not always be feasible. This could result in delays in providing clarifications, impacting the credibility of the listed entity, which could potentially lead to market speculation. To ensure strict compliance, listed companies may need to cope up with an additional burden to set up separate departments solely for tracking and clarifying rumours to avoid delays. SEBI further proposes that a person may not use an information published in mainstream media as a defence for ‘generally available’, which is not confirmed, denied or clarified as it does not lead to a significant price movement, for allegations of insider trading, treating it as UPSI. The proposal tries to impose an high threshold for defence of insider trading allegations. It imposes an additional requirement upon a person who may be deemed to have knowledge of price-sensitive information to track the clarifications of listed entities even when such information is already available publicly.

The proposed amendments pose a challenge in achieving a delicate balance between regulatory oversight and allowing companies the flexibility to manage their affairs effectively. Encouraging collaboration between SEBI and exchanges for efficient rumour tracking and communication can help in establishing a seamless and responsive system by leveraging the strengths of both regulatory bodies and market intermediaries. This partnership would facilitate a more proactive approach to identifying and addressing market rumors. Providing companies with the option to request confidentiality and allowing exchanges to respect such requests would empower entities to manage information dissemination responsibly. This approach recognizes that not all market rumours require immediate public disclosure. American exchanges adopt this approach of selectively allowing confidentiality. Excessive regulation or a lack of clarity in the verification process may create an environment of uncertainty. SEBI must carefully weigh the potential consequences on investor sentiment and take measures to ensure that the regulatory framework inspires trust and confidence. 

Conclusion

The proposed amendments must be scrutinized for their potential impact on market dynamics. While these proposed amendments aim for increased transparency, they also raise concerns about potential unintended consequences such as market disruptions, micromanagement, and burdensome disclosures. In navigating the complexities of market regulation, SEBI’s commitment to an inclusive and thoughtful decision-making process will be pivotal. The financial markets require a regulatory framework that adapts to evolving challenges without compromising efficiency and innovation. As the consultation period ends, market participants, regulatory bodies, and investors alike await a framework that strikes the delicate balance needed for the sustained growth and integrity of India’s financial markets. The need for a balanced regulatory framework cannot be overstated. As SEBI reviews the feedback received during the consultation period, it should carefully consider the concerns raised and explore alternative approaches that maintain the delicate equilibrium between investor protection and market dynamism. In particular, an out for confidential treatment should seriously be considered.


19 December 2023

SEBI'S Materilaity Maths: Quantifying impact, subjectively intact

Suyash Sharma and I have a piece in today’s Financial express on SEBI’s new disclosure norms based on materiality:


In June 2023, the Securities and Exchange Board of India (SEBI) introduced extensive changes to the regulatory framework governing disclosures for listed companies through the SEBI (Listing Obligations and Disclosure Requirements) (Second Amendment) Regulations, 2023 (“Amendments”). These Amendments are largely based on the recommendations outlined in three consultation papers released by SEBI between November 2022 and February 2023. The Amendments, introduced a quantitative threshold for determining ‘materiality’ of events/information, which trigger a disclosure requirement once such threshold is met. 

Regulation 30 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”) mandates disclosure of material events to the stock exchanges by listed entities. Specifically, Para A of Part A of Schedule III of LODR Regulations (“Para A”) provides a list of events which are deemed material and require disclosure while Para B of Part A of Schedule III of LODR Regulations (“Para B”) specifies events which are required to be disclosed based on the application of ‘guidelines on materiality’. All listed entities are required to formulate a ‘Materiality Policy’ based on the criteria specified in regulation 30(4) of LODR Regulations, which essentially lay the groundwork for the entity to determine materiality of an event/information and whether it would require disclosure.

In the Consultation Paper dated November 12, 2023, SEBI noted that several complaints were being filed against listed entities for non-disclosure of material events and failure to comply with disclosure timelines. Moreover, several other listed entities had themselves sought uniformity in guidance regarding determining materiality and disclosure requirements. There seemed to be a gap in what SEBI intended with respect to the guidelines on determining materiality versus how the entities adopted it in their materiality policies. This led to several regulatory actions against entities for non-disclosure of ‘material’ events which, according to their policy, was not ‘material.’ 

The Consultation Paper sought to fill this gap by introducing an objective quantitative threshold which would be non-discretionary, based on the value or the expected quantitative impact of the event/information. A combination of the effect of events/information on turnover, net worth and profit/loss after taxes has been envisaged by the Amendments pursuant to the discourse in the Consultation Paper. It states that an event/information, whose value or the expected impact on value exceeds the lower of: 2% of turnover, 2% of net-worth, 5% of the average of absolute value of profit or loss after tax would be deemed material and would require disclosure.

This regulation finds some precedents globally, as countries such as Japan and the UK have quantitative thresholds for events/information, the crossing of which requires a listed entity to make disclosures to their respective exchanges. The quantitative thresholds however vary across jurisdictions, for example, UK has set the limit for ‘materiality’ at variation of 5% to gross assets, profits before taxes, consideration and gross capital. Japanese regulations are very precise, listing down the various numerical thresholds for various events. For example, an event in terms of the Japanese regulation would have to be disclosed- if 3% or more damages is caused to assets in case of natural disasters, 3% compensation is paid out of net consolidated assets in case of a lawsuit, there is a 30% increase in net consolidated assets in case of a merger, etc.

The SEC in the US follows a prescriptive approach as well, by laying down a comprehensive list of events that are presumptively material and require disclosure. However, the definition of materiality in the US has been developed by courts and is not delimited by the notion of the effect on the price of an issuer’s securities. On the other hand, jurisdictions such as the EU and Brazil opt for a more principle-based approach by laying down general obligation of materiality comprising price sensitive information and various other criteria, without specifically describing the types of events that would be deemed material. 

It is pertinent to understand that these differences in regulations have evolved due to differences in the characteristics of each market and its legal and institutional history. It may be difficult in determining which approach is objectively better and can serve the investors better. No doubt, the principle-based approach leaves room for entities to exploit the lack of a standard norms and get away with inadequate disclosures under the guise of deeming events immaterial. Stringent quantitative thresholds on the other hand might lead to overregulation and become unnecessarily burdensome on entities in terms of compliance. 

SEBI’s Amendments seem to take a middle ground by prescribing a numerical threshold but keeping it broad enough to encompass a wide range of events which could qualify as material. However, it may not completely address the core issue which the regulator was trying to address, which shall be discussed below with an example. If a bright-line test approach has to be followed, perhaps going the route the Japanese regulators took may be worth looking into by providing specific thresholds for various scenarios. This would ensure that the entire process of determining materiality is completely objective in every scenario and there is no room for manipulation, although at the cost of increased compliance.

Circling back to the core issue at the heart of the Amendments, i.e., a standard objective threshold for determining materiality; the ‘expected impact on value’ clause may not sufficiently address it. Considering that entities are required to disclose even those events which may affect the prescribed values, it boils down to subjective analysis as to when an event/information becomes material. To substantiate with a hypothetical: suppose a listed entity ‘A’ is engaged in the construction business and bags contracts which are usually worth INR 30 crores. A is in the final stages of negotiation with the government of India to secure contract worth INR 150 crores to develop metro infrastructure in Mumbai for the year 2024. This contract will likely substantially increase its revenue and profitability and affect the financials enough to be classified as material in light of the Amendments. However, the regulations in Para B specify that any contracts bagged ‘outside the normal course of business’ would have to be disclosed. The question then is whether such a contract would require disclosure? The work may be in the normal course of business for A but the value of the contract and its effect on the financials would be material based on the new norms. It leads to the same issue i.e., subjectivity in determining materiality which the regulators were trying to address, albeit with more complications. The economic cost of non-disclosure versus its benefit has to be considered as well. For events which can substantially alter (positively or negatively) the financials of an entity, the business owners might be willing risk regulatory action if the cost of disclosure far exceeds the cost of non-disclosure.

To summarise, in adopting a balanced approach, SEBI's introduction of quantitative thresholds for materiality may fall short in addressing the core issue. The "expected impact on value" clause introduces subjectivity, leaving room for ambiguity in determining materiality. While the attempt to find a middle ground is commendable, potential challenges suggest that a more nuanced and specific regulatory framework might achieve the intended objectives more effectively. In addition, we should also consider cases where confidentiality is necessary and premature disclosure may hurt, say a potential acquisition. In such cases, US has an informal system of dispensing confidential treatment after a discussion with the exchanges.

12 December 2023

Towards ease of trading: Adoption of trading plans faced significant challenges as current framework imposed stringent restrictions

Shivaang Maheshawari and I have a piece in today's Financial Express on the proposed reforms of 'Trading Plans', a means of achieving trades in advance, so as to protect oneself from charges of insider trading in the future. The full pieces is as below:


Ever since the inception of financial markets, the concept of insider trading has been subject to stringent regulatory oversight. Within this framework of regulating insider trading, trading plans emerged as a mechanism designed to facilitate trading by certain classes of insiders like senior management or key managerial personnel of a company who are consistently privy to Unpublished Price Sensitive Information (UPSI). It was recognized that insiders, even when in possession of UPSI, may need to trade for purposes such as creeping acquisitions, compliance with minimum public shareholding norms, exercise of ESOPs, etc. Thus, the concept of trading plans was introduced under the SEBI (Prohibition of Insider Trading) Regulations, 2015 (PIT Regulations) to enable such insiders to plan their trades in advance, thereby reducing the risk of trading based on UPSI.

 

However, despite their intended purpose, the adoption of trading plans faced significant challenges as the current framework imposed stringent restrictions, rendering the concept less popular among insiders in recent years. Recognizing the limitations, SEBI, on November 24, 2023, published a consultation paper outlining proposed measures to provide flexibility in provisions relating to trading plans with a view to facilitate adoption of such plans by insiders. The proposals are based on the recommendations of the Working Group (WG) tasked with reviewing existing provisions related to trading plans.

 

The consultation paper proposes a reduction in the minimum cool-off period between the disclosure and implementation of a trading plan from 6 months to 4 months, along with a decrease in the minimum coverage period requirement from 12 months to 2 months. Under the present framework, insiders formulating a trading plan are bound by a timeline of at least 18 months, encompassing a mandatory 6 month cool off period before executing trades and a minimum coverage period of 12 months. Thus presently, a trading plan is to be formulated with the assumption that a segment of the trade will extend into the 18th month which might render the trading plan unviable to an insider since he may not be comfortable planning a trade that would execute after 18 months at the then prevailing price. With the proposed reduced timelines, insiders can now formulate trading plans that align more closely with shorter-term outlooks, streamlining their strategies within a more manageable timeframe.

 

Notably, the paper proposes to eliminate the black-out period, which presently mandates the closure of the trading window for insiders between the 20th day prior to the last day of any financial period for which results are to be announced and the second day after the disclosure of such results. It is important to note that results for each quarter are typically disclosed within a month after the quarter concludes which further prolongs the black-out period four months in a year, consequently leaving only a few trading days available in the entire year. Further, the PIT Regulations already prohibit the implementation of trading plans until the UPSI, which the insider possessed while formulating the trading plan, ceases to be UPSI.[1] Thus, in the context of trading plans, black-out periods were rendered redundant, given that the existing regulations anyway prohibit insiders from implementing a trading plan even after the cool off period is over if the information based on which the trading plan was enacted is still privileged.

 

The paper also suggests introducing a provision regarding price limits within trading plans. According to the proposal, insiders will have the flexibility to place upper and lower price limits for buy and sell trades, respectively, within +/- 20% of the closing price on the date of submitting the trading plan. These flexible price limits have been adopted in order to ensure that insiders are protected from potential losses resulting from extreme market volatility or adverse conditions since trading plans are enacted well in advance and the final trade execution might occur at a price which is unfavourable for insiders. Further, in cases where the price moves beyond the limit set out in the trading plan, the WG recommended that the insiders should be prohibited from executing the trade and an option to execute the trade at the prevailing price cannot be given as the decision to exercise such an option by the insider may be influenced by new UPSI which did not exist at the time of formulating the trading plan. Additionally, in cases where no price limit is set out in the trading plan by insiders, the trade will be executed irrespective of the prevailing price.

 

With regard to disclosure of the trading plan, the consultation paper proposes three different alternatives. The first alternative proposes masking the personal details (such as name, designation, PAN) of insiders within the trading plan, with a view to protect their privacy. However, it was noted by the WG that this measure may raise concerns about potential misuse, as concealed personal details might allow an insider to execute trades using a trading plan that was submitted by another insider. Moreover, under the PIT Regulations, there is already a requirement to disclose all trades done by the promoters/designated persons above a specified threshold.[2] Thus, names are anyway disclosed to the public post execution of significant trades. The second alternative proposes to continue the current practice of disclosing all personal details, advocating for complete transparency through full disclosures. The third alternative endeavours to strike a balance between the challenges of potential misuse and the need for privacy. It suggests a dual disclosure method – a full and detailed disclosure of the trading plan to the stock exchanges and a masked disclosure to the public, thereby mitigating any potential misuse whilst safeguarding the privacy of the insider.

 

The paper further proposes to do away with the exemption granted to trades executed under a trading plan from applicability of contra-trade restrictions. Contra trade provisions restrict designated persons from taking opposing positions or entering into buy/sell trades within 6 months of an earlier sell/buy trade respectively. The WG noted that it is difficult to ascertain the reason for an insider to plan two opposing trades within a period of 6 months. Accordingly, it was recommended that contra trade restrictions should be made applicable to trades carried out in furtherance of a trading plan in order to restrict an insider from undertaking a contra-position under the protection of trading plan provisions.

 

The proposals signify the regulator’s attempt to streamline compliance requirements related to trading plans and allows for greater adaptability in accommodating the legitimate interests of insiders who may perpetually be in possession of UPSI. By virtue of being framed in response to market feedback, the proposals appear to be more attuned to implementation challenges, without detracting from the regulatory objective of minimizing insider trading risk. The consultation paper published by SEBI stands as a testament to the regulator’s proactive approach in ensuring that regulations are framed and altered keeping in view the market feedback and interests of the stakeholders involved. However, the proof of the pie is in the eating of it. So, the amendments would have achieved their goals if a relatively large number of people sign up for such plans, which till now were impractical for reasons mentioned in the working group. These authors advocate a tilt towards privacy of the insiders, while maintaining proper audit trail and also argue against the new restrictions on contra trades, as the purpose of the trading plan is the break the causal chain between inside information and wrongful trades. Once that is achieved, a contra trade in the other direction should be kosher.

 


[1] Proviso to Regulation 5(4) of PIT Regulations.

[2] Regulation 7(2) of PIT Regulations.


26 October 2023

A new era of competition law: Not only does this compel violators to make amends but also gives those affected a voice

I have a piece in today's Financial Express with Parker Karia and Manas Dhagat on the new settlement norms under competition law.

The Government of India recently paved the way for the Competition Commission of India (CCI) to enforce competition laws by allowing violators to enter into a settlement with the CCI, or make certain commitments to refrain from carrying out anti-competitive activities. Pursuant to the amendment, the CCI has recently proposed the framework for such settlement or commitment mechanism.
Commitment Mechanism Typically, if, upon receipt of information, reference from the government, or on its own motion, the CCI is of a prima facie view that there exists a contravention of the Competition Act, 2002, it orders the Director General to carry out an investigation. According to the proposed framework, it is only at this stage than the alleged violator can file a commitment application, within 45 days of the CCI’s order directing an investigation. Delay of upto 30 days may be condoned by the CCI, if sufficient cause for delay is shown. Further, a period of 10 days is proposed to be granted in case of defective or incomplete applications. The entire proceedings must culminate within 90 days of receipt of information of violation(s); however, this period may be extended.
Under this framework, in the commitment application, the alleged violator would have to provide the true and complete facts, including the gravity and impact of the contraventions and how the commitments offered would address the alleged contraventions as well as the modalities for implementation and monitoring of the commitments offered.
While considering the commitment application, the CCI would share a non-confidential summary of its prima facie opinion on the basis of which the investigation was initiated, the alleged contraventions and the commitments offered by the alleged violator, and other details it deems fit. Basis such summary, the Director General, alleged violator and any other party may submit their comments, objections or suggestions. Interestingly, in ‘appropriate’ cases, the CCI may even invite comments from the public. However, what criteria would be adopted to consider a matter for invitation of public comments is not known. It is also interesting that the alleged violator would get an opportunity to be heard only when the CCI is going to reject the application.
Pertinently, if the commitment application is accepted, it would not operate as an order containing a finding of contravention by the alleged violator, and would not be appealable. However, if the commitment application is rejected or withdrawn, the CCI’s inquiry would resume. Further, if the commitments offered pertain to only some of the allegations, the CCI can continue to proceed with respect to the remaining allegations, and information submitted by the alleged violator can be used in such investigation.
Lastly, a commitment order may be revoked in the event of false or incomplete disclosure, material changes in facts. Such revocation may be accompanied with costs upto ₹1 crore and re-opening of the investigation.
Settlement Mechanism An alleged violator may file a settlement application within 45 days of receipt of the Director General’s report pursuant to its investigation. Similar to the commitment application, a delay of upto 30 days may be condoned upon showing sufficient cause, and in case the application is defective or incomplete, the alleged violator will be granted 10 days’ time to rectify the same. Settlement proceedings must culminate within 120 days of the filing of the application, which may be extended by the CCI.
Similar to the process under the commitment mechanism, in the settlement application, the alleged violator would have to, among other things, provide true and complete facts in relation to the allegations, findings of the Director General, how the settlement proposal would address the allegations, details of previous contraventions (if any), gravity and impact of the contraventions, method of implementations of the settlement proposal, etc.
Thereafter, a non-confidential summary would be shared by the CCI, similar to the one under the commitment mechanism. Curiously, there is no provision for seeking public comments under the settlement mechanism. Pertinently, the settlement amount may go upto the maximum penalty that can be levied for the alleged violations, however, based on factors such as co-operation and disclosures made, a ‘discount’ of upto 15% may be applied.
In the event the CCI accepts the settlement application, it will pass a settlement order, which will not act as a finding of contravention. In case of rejection or withdrawal of the settlement application, the proceedings under the Competition Act, 2002 will be restored.
It is important to note that unlike SEBI’s settlement regime, upon filing of a commitment or settlement application, the draft regulations provide that CCI’s inquiry would be kept in abeyance till the disposal of the application, thereby saving regulatory time and resources. In our view, the settlement and commitment frameworks incentivize early engagement and cooperation between enterprises under investigation and the CCI, thereby fostering quicker corrections. The proposed frameworks enhance enforcement and resolution of antitrust matters, and would aid in reduction of protracted litigation, thereby giving real effect to the CCI’s mandate. In fact, subject to implementation, the proposed frameworks may significantly enhance the enforcement mechanism and also reduce litigation costs.
The proposed frameworks are broad, and thus allow for flexible mechanisms that can be tailored to address specific issues on a case-to-case basis, and commitments or settlement terms, as the case may be, can be designed to restore competition by measures such as divestitures, behavioral changes or such measures to address the anticompetitive effects of the alleged violation. By providing for comments from the other parties (as well as the public, albeit only in commitment framework), those affected by the alleged anti-competitive practices have been given a voice, and further transparency has been sought to be introduced in antitrust enforcement.
Further, the frameworks can enhance the operational certainty for businesses due to the ease of anticipating the potential consequences and the remedies, in an event of a breach. As a result, such businesses can minimise their risks accordingly. The mechanism can also help in preserving the reputation of the business, if they show willingness to address past mistakes and maintain fair competition.
However, owing to the fact that a commitment application is made at the stage of investigation by the Director General, and the settlement application can be made after the Director General’s report, there may be instances of parties filing both applications at the appropriate stages, thereby causing avoidable delays. In such instances, there may exist a risk of destruction of evidence by the alleged violator. Thus, there may be merit in reconsidering whether proceedings should be kept in abeyance during the pendency of a commitment or settlement application.
Further, while determining the settlement amount, the CCI must strike a delicate balance between deterring anticompetitive behavior and allowing for the benefits of cooperation in appropriate cases, all while safeguarding the public interest. It must carefully evaluate each case on its individual merits, considering the severity and impact of the violations, as well as co-operation and disclosures by the alleged violator. Furthermore, an applicant’s history of compliance with competition laws and its efforts to establish effective compliance programs should be considered when determining leniency. Keeping in mind the broader public interest, consumer welfare, and competitive markets shall help the commission to ensure that settlements ultimately serve the public interest.
Lastly, as the commitment and settlement orders are not appealable, and while there exist provisions in the draft framework for engagement between the CCI and the alleged violator, the Director General, other parties, and even the public at large (in ‘appropriate’ commitment applications), it is of significant importance that the applicants have adequate opportunities to engage in discussions related to commitment and settlement. Thus, in addition to seeking suggestions and comments on the summary prepared by the CCI under the proposed frameworks, an opportunity to be heard should be granted to the applicant, in order to make the process more meaningful.

06 October 2023

Valid performance validation? The intent behind the proposed agency is laudable, but it may be a double-edged sword

Suyash Sharma and I have a piece in today's Financial Express linked here on SEBI's proposed performance validation process of investment advisors and RAs by an external agency. While useful, it would impose substantial costs on an already over-regulated arena:

In a bid to bolster the credibility of various market players and protect investor interests, SEBI issued a consultation paper to establish a ‘Performance Validation Agency’ (“PVA”). The proposal comes in the backdrop of an increased demand by market players including research analysts and investment advisers to advertise their performance claims. An investor’s choice of an investment adviser is largely dependent on the past performance capabilities demonstrated by the latter. Therefore, from a business perspective, it is necessary for such investment advisers to be able to showcase their performance to attract clients. Presently, the regulations governing different intermediaries have imposed varying restrictions in terms of what such intermediaries can advertise. Entities like asset management companies and portfolio managers are permitted to report their self-verified performance vis-à-vis certain benchmarks while stockbrokers, IAs and RAs are not permitted to make any reference to past performances as per the relevant advertisement codes. Thus, there is a lacuna in the market which prevents intermediaries from showcasing their performances and thus prevents them from advertising their services.

On the other hand, the regulator has also noted an increase in untrue performance claims being made by various intermediaries, notably in the form of doctored P&L statements on twitter (X) and other social media platforms. These claims are mostly self-verified which makes it easy to manipulate and mislead investors for the sake of attracting clients. Thus, the proposed PVA has been devised by SEBI to serve the dual purpose of addressing the demand by market players to showcase their performance and to protect investors from being misled by false claims of performances. The proposed agency will be an independent body, created as a wholly owned subsidiary of a Market Infrastructure Institution (“MII”). The paper has discussed that sufficient infrastructure requirements may be specified by regulator but is silent on the specifics.

The proposed PVA, for a fee, will validate claims of performance made by the registered intermediaries based on parameters like returns, risk, volatility and other suitable parameters as may be decided by industry forums in consultation with PVA and SEBI. The verification of claims regarding performance of the different classes of financial instruments have been described in the consultation paper. Broadly, the PVA would validate claims by the registered intermediaries of the actual profits made by their clients on the basis of advice/recommendations made. Such validation however shall be carried out for all clients of the intermediary and not selective clients to prevent cherry-picking and misleading claims. It will also validate the claims regarding performance of trading algorithms by testing the algorithm over a reasonable period of time to ensure a fair and accurate result. Claims regarding any other performance metrics will be subject to the core principle that there will be no cherry-picking of favourable events/strategies/client to prevent statistically biased numbers.

To ensure confidentiality, the proposal specifies that client specific recommendations by intermediaries would be displayed on the intermediaries’ website only to the client as opposed to generic recommendations whose performance metrics may be made available publicly post verification. For claims of performance of stock/portfolios, the performance of such stocks/portfolios shall be done for a reasonable period before and after the recommendation, to ensure a realistic picture is portrayed. 

The intent behind this proposal is laudable and there is a need to ensure that investors are not misled by false claims of performance but the proposal may be a double-edged sword. There are two points of concern which stem from the proposals (i) additional costs and time and (ii) data privacy concerns. Primarily, the creation of an entirely new entity would require a substantial capital input and time costs. Considering the PVA would validate claims of performance for a fee, it imposes an additional burden on the intermediaries in terms of compliances and costs. The fees which an intermediary can charge has been capped by the various regulations which govern them; therefore, it is an additional cost on the intermediaries for making factual claims regarding their performance.

There is also an additional risk of data privacy. The various intermediaries would be required to share data of their clients with the PVA, including sensitive personal data, to get their performance claims verified which invariably creates exposure to breach of data privacy. For example, we take an investment adviser’s recommendation through the proposed PVA mechanism. For an investment adviser to get his claims of performance validated, it would have to collect the relevant data from the client who in turn would have to extract the data from the stockbroker. Thereafter, the data would be shared with the PVA for validation before it can be displayed upon verification. The mere transfer of data through the various intermediaries creates a risk of data leakage. The consultation paper seeks to address this concern by proposing that the PVA would be owned by MIIs which already process large amounts of data and as such it would ensure that the PVA is capable of shouldering the burden of data privacy. However, even with a robust internal mechanism to ensure data privacy, it is impossible for the PVA to plug all the holes.

Another facet of this proposal is the lack of discussion surrounding existing market infrastructure which may be used to conduct validation of performance claims. ‘Zerodha’, a leading stockbroker, recently launched its ‘Verified P&L’ initiative which enables users to share their profit and loss report publicly through a link and the veracity of the report is guaranteed by the broker itself. Similarly, other entities have designed systems and mechanisms to verify claims of performances, albeit such claims are self-verified and systems are devised internally. It does not take away from the efficacy of such systems to conduct verification of performance claims. It may be prudent to look into the systems developed by such market intermediaries to create a holistic mechanism of verification which can leverage the existing infrastructure and reduce both the regulators and intermediaries’ burden in terms of costs while ensuring that the investors are protected in the market.