I have a piece in the current issue of Outlook business on the new insider trading regulations. Broadly they look good, but of course like any new legislation, many questions will remain unanswered for the time being. This is of course also a great time to peddle my book on fraud and insider trading - Fraud Manipulation and Insider Trading in the Indian Securities Markets available from Amazon India.
After a much discussed report on the subject, SEBI has finally published a new rule book for prohibiting insider trading. The change was overdue as there was a need to not only improve the language of the prohibition, but also protect a large number of legitimate transactions which could potentially be seen as illegal if a very pedantic view of the law was taken. The purpose of the law was to outlaw dishonest conduct, not be so broad as to catch legitimate trades. What is interesting in the 2015 regulations is not just the prohibition part, but more so what is explicitly permitted.
The no-no of insider trading
First, of course, the actual prohibition. The prohibition comes in two parts. The first relates to communication of unpublished price sensitive information. The prohibition outlaws not just communication of unpublished price sensitive information, but also one who allows access or one who procures or causes the communication by an insider. This is much broader than the 1992 regulations, because it restricts the flow of information even without any trading occurring. It does however, provide for flow of information for legitimate purposes, performance of duties or discharge of legal obligations. To give an example, two friends gossiping about one friend’s company on whose board he sits, would be illegal even if the other does not trade based on such information. This is not a great development, as it will chill communication even where no one has been hurt and there has been no intent or action to hurt investors. While not clear, it is hoped that this would be seen more as a violation of best practices of corporate governance rather than a substantive violation. Ideally such innocuous talk should not be outlawed as there is neither intent to cause nor any actual damage to anyone.
All unfairness should not be made illegal
The other part related to the prohibition is the classic prohibition on insider trading. The regulations prohibit an insider from trading in securities when in possession of unpublished price sensitive information. While this looks narrow and seems to apply to insiders, the definition of insider includes anyone who is in possession of inside information. To give an example if a few pages from a company blew away in the wind, landed on someone’s front yard and that person who chanced across the information were to trade, such possessor would be guilty of insider trading. This is the broadest form of definition, by global standards, which relies on ‘parity of information’. It is hard to dispute with the argument that all information should be equally shared, and no one person should have an advantage over another. But equally hard to argue is the fact that not everyone gets three square meals to eat everyday. It is unfair. But all unfairness is not illegal. To use an analogy, comparing a person who finds a hundred rupee note flying around on a deserted road and keeps it with another case of a person picking a pocket in a crowded train and giving both of these persons the same punishment is just wrong. One is unfair, the other is unfair and illegal. To summarise the history of insider trading in a single sentence, the prohibition arose out of the fiduciary duty of insiders, particularly senior persons of a company, who owe their company and their shareholders the duty to place their interest ahead of their own, and by trading in information which they have in fiduciary capacity to their own benefit breach that high trust. To place a random person who did not even steal or misappropriate that information from the inside of a company is what the possession standard imposes. Many jurisdictions do, like India, impose the possession standard, but I must assert my unequivocal opposition to it.
Benefits of doubt - exemptions
Having said that the new law provides a fair set of benefits and exemptions which were not present previously. This is of course a much needed change from the previous regulation, which at times could be seen to outlaw not just unfairness but also totally honest conduct. The prime example was the ambiguity surrounding due diligence amounting to access to inside information. Specifically, private equity or institutional shareholders would often like to do a due diligence on the investee company so as to verify facts represented to them by the company and its promoters. By definitions such investors would be given access to unpublished price sensitive information not available to all shareholders. Based on the due diligence, investment into the company would squarely fall within the prohibition of the old regulations. This ambiguity was of course perverse, because the interest of the private equity player aligned very well with the interest of the minority shareholder. The due diligence could potentially uncover mis-representation in the financial books of the company. To virtually outlaw due diligence by insider trading law was in fact hurting shareholders rather than helping them.
The new regulations provide several protections for honest conduct and also provide several safe ways by which insiders could trade by minimising the possibility of mis-use of privileged unpublished price sensitive information.
The first protection comes from communication in furtherance of legitimate purposes, performance of duties or discharge of legal obligations. While the prohibition is intended to restrict the free flow of information to only need to know basis, the protection offers protection when the information is given in good faith but is mis-used. The giver of information in that case would be protected, though the one who mis-uses it would not be. Similarly, any person in the chain of persons who is passing on information for a good reason would stand protected.
The second protection is provided where a friendly takeover with an open offer is on horizon. In such cases the company can give access to price sensitive information but only if the board of the company believes the transaction to be in the best interests of the company. While this comes with some interpretational complications, it is a useful addition to the available exemptions for honest conduct.
The third protection is in similar cases of due diligence where the board of the company believes the access to be in the best interest of the company, but where there is no open offer on the horizon. In such cases, the price sensitive information needs to be disseminated to the public two trading days before the transaction. This exemption will causes some problems in its implementation as people do not ordinarily wish to announce the deal before its signing or execution.
The fourth exemption is provided where two persons, both persons being promoters, choose to transact between each other when both are in possession of unequal information which is not widely available - so long as the transaction is off market, so as to not pollute the market with a differing price. This is a useful and logical exemption which permits trades between two people who have access to privileged information as they are not hurting the market with their trade.
The fifth exemption is where individuals in possession of unpublished price sensitive information were not the ones who took the decision to trade. In other words where the causal link can demonstrably be broken between a person or group of persons having superior information and other person or group of persons who trade in the securities, the unfairness does not arise out of uneven ownership of information and its misuse. This is a sensible exemption and rooted in logic.
The sixth exemption arises out of a trading plan. A trading plan would be a plan to sell (or buy) a fixed number of securities (say) every week or month for at least a year after the plan begins. The plan provides a defence to those insiders who are perpetually in possession of unpublished price sensitive information, particularly non promoter senior management, who depend on ESOPs or sweat equity for their compensation. The exemption would allow such employees and senior management to encash their shareholding without being wrongly accused of insider trading. Of course to get the protection of law, several safeguards are provided including the period after which the plan would start (after six months), how long it must stay in place (at least a year), public disclosure of the plan, its irrevocability and certain freezeout dates and a requirement that it be the exclusive form of trading (no contra trades or other plans being used simultaneously). Again the purpose is to break the causal link between having privileged information and its actual mis-use based on that information. The plan, though unlikely to be popular with promoters because of the stringency of its exercise, may just turn out to be popular with senior professional management with large ESOP and sweat equity grants.
Finally, and most importantly, the new regulations provide for an exemption for innocent behaviour. The exact text is “Provided that the insider may prove his innocence by demonstrating the circumstances including the following: -”. Lawyers of course get very exciting every time they see the word including in a legislation. It is actually a secret word used by legislators to say that whatever follow is only an indication and not an exhaustive list. The use of the words ‘innocence’ and the use of the word ‘including’ seems to suggest that some level of fraud or intention (or mens rea as we lawyers pretending to speak latin must say) to defraud must be present. This aligns the definition more closely to the American definition of insider trading which is a derivative of the anti-fraud rule, there being no specific law defining insider trading. This is a welcome addition and it is hoped that judicial precedent will create a definition closer to the classical definition of insider trading (which is based on fraud and breach of fiduciary duty) rather than the over-broad possession theory that we seem to have adopted.
Principle based code of conduct
The simplification of the law to make it more principle based in many aspects is a positive development and would allow companies to craft internal policies in the context of the risks inherent in their organisation. An auditor would need very different internal procedures compared to a merchant bankers working for a listed company.
The disclosure norms have been simplified and a high (from a previously very low) threshold provided (sale or purchase of ten lac rupees over a quarter) though the disclosure norms have been expanded to all employees rather than select ones.
Breathing space for corporates to implement new law
Finally, it is a good development that SEBI has provided a period of 120 days for the regulations to become effective. This would save the industry the pain of sudden change in the law before understanding its implications.
Use of explanatory notes – not particularly useful
One of the few cons of the regulations is the addition of explanatory notes below every regulation. These have added no clarity in interpreting, as was intended, but range from a very poor rephrasing of the same to at its worst contradicting the actual provision contained in the regulation. Perhaps it is time to either junk the concept or at least develop it more so that it is useful rather be the origin of confusion. An example where the note contradicts the regulation is the definition of trading. While the regulation defines it as includes subscribing, buying, selling, dealing or agreeing to subscribe, buy, sell deal in any securities, the note includes pledging of securities while in possession of unpublished price sensitive information. Including pledging of shares in the term trading does violence not only to the concept of trading and dealing, but also does not make a meaningful impact on the object sought to be achieved. It will also cause pain in genuine pledge transactions and provide no benefit to investors.
ConclusionIn conclusion, the new regulations are a big reform from the past set of regulations. But new cases interpreting the new regulations and also logistical problems in implementing the exemptions would guide us with the way forward in both interpreting the provisions and also in guiding us where further reform is needed in the regulations.