05 January 2015

Publication of 'Securities Regulation - Primary Market Offerings in India

I'm delighted to announce the publication of 'Securities Regulation - Primary Market Offerings in India' by my colleagues Anil Choudhary and Rajneesh Deka, published by CCH Wolters Kluwer. The second book from the Finsec stables in as many years.

22 December 2014

AIFs Allowed To Invest Overseas! Half Baked Reform?

I have a piece with my colleague Shashank Prabhakar published on the Firm's website - arguing that the RBI circular allowing AIFs to invest abroad is half baked and copy-pasted circular. Below is the full piece and the link to the original is here.

The Reserve Bank of India has issued a Circular dated December 9, 2014, permitting SEBI registered alternative investment funds ("AIFs") to invest overseas, in accordance its Circular No. 49 dated April 30, 2007 and Circular No. 50, dated May 4, 2007 (the 2007 Circulars). The RBI, by its 2007 Circulars had allowed domestic venture capital funds, registered with SEBI under the SEBI VCF Regulations, 1996, to invest only in equity and equity-linked instruments of off-shore venture capital undertakings, subject to an overall limit of US$ 500 million for all VCFs collectively. Registered VCFs interested in investing in equity and equity linked instruments of off-shore VCUs were required to obtain prior approval of the SEBI, but no prior approval of the RBI was required. The 2007 Circulars stipulated that SEBI would provide limits to individual VCFs investing in off-shore VCUs.

The 2007 Circulars followed the amendment made to Regulation 12 (b) of the SEBI VCF Regulations, which introduced Regulation 12(ba) allowing VCFs to invest in securities of foreign companies, subject to such conditions or guidelines laid down by SEBI or RBI, from time to time. Subsequently, Regulation 39 of the SEBI AIF Regulations, 2012 has repealed the SEBI VCF Regulations. New VCFs are now required to be registered with SEBI as “Category I Alternative Investment Fund – Venture Capital Fund,” under the AIF Regulations. The SEBI has carried through Regulation 12 (ba) of the erstwhile VCF Regulations in Regulation 15(a) of the AIF Regulations. Needless to state, investment by AIFs in off-shore VCUs would also be subject to other investment conditions laid down under Regulation 16 of the AIF Regulations.
Prior to the issuance of the Circular, there was no provision in the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (FEMA ODI Regulations) and its circulars, which specifically enabled AIFs to invest in instruments or securities issued by overseas entities. In that sense, the Circular has now fully enabled AIFs to invest overseas without any further amendments required to be carried out to the AIF Regulations.

However, the investment opportunities made available to registered AIFs through the Circular are quite narrow in scope given that the 2007 Circulars only allow investments in equity and equity-linked instruments of off-shore VCUs. Regulation 2(aa) of the AIF Regulations defines a VCU only from the perspective of a domestic company. The AIF Regulations do not shed any light on what would constitute an “overseas VCU” or as to whether the parameters would be any different from what has been specified in the definition under the AIF Regulations. It has to be kept in mind that the 2007 Circulars were issued specifically to domestic VCFs, registered with SEBI, under the erstwhile VCF Regulations. The AIF Regulations now cover not just VCFs but other investment funds, social sector funds, infrastructure funds, private equity funds, hedge funds, etc. The rationale for limiting investment opportunities for such AIFs only to equity and equity linked instruments of off-shore VCUs is not clear and the Circular also does not provide any reasons for such a limitation. The only explanation of such a restriction for domestic pools is that the requirements were copy pasted from the old provisions. While it may be justifiable to restrict a VCF to invest only in off-shore VCUs, there is no reason why a private equity fund or hedge fund registered in India should not be allowed to invest in instruments issued by off-shore funds or other off-shore entities.
Further, given the range of funds that the Circular applies to, the overall limit of US$500 million appears to be too small. As of today, there are more than 100 AIFs registered with SEBI. Theoretically, if all the 100 AIFs would want to invest in off-shore entities, it would potentially leave them each with room to invest less than US$ 5 million. Additionally, the requirement of having to obtain prior approval from SEBI could potentially be time consuming and a dampner. There is no requirement for the AIFs to obtain prior approval for their investments in onshore entities in the AIF Regulations. The FEMA ODI Regulations allow Indian entities to invest under both automatic and approval routes. Entities investing overseas under the approval route are required to obtain prior approval of the RBI. It is quite strange that the RBI has allocated the responsibility of granting prior approval to SEBI in what is essentially a foreign exchange transaction, which falls within the exclusive domain of the RBI under the Foreign Exchange Management Act. The Circular also does not stipulate any parameters for SEBI to follow while granting approval.

All these factors add up to making it seem like the Circular is unattractive and very conservative in its approach. One hopes that the RBI would be willing to consider these factors and make the required changes to the Circular.

21 November 2014

Insider trading law's new avatar

I have a piece in today's Financial Express - expressing my opinion on the newly announced law prohibiting insider trading. Though we do not know the exact regulation, the approach of the Justice Sodhi Committee seems to be broadly adopted. Here is the link to the full piece and below is the full article.

The real new development is the expansion of the defences for honest conduct…
As was expected, Sebi came out with a spanking new regulation on insider-trading. While the new regulation is not yet in the public domain, a press release highlights the significant changes compared to the current regime. The new regulations seem to be squarely in line with the recommendations of the Justice Sodhi Committee report. The committee had done a great job with the report. There were some issues with the draft regulations the committee had attached to their report which, it is presumed, will be cleaned out. Similarly, some suggestions have been dropped from the regulations, such as the inclusion of public servants in the prohibition. There are significant changes in the new norms, but the changes are not the ones highlighted by most media.
There is no significant expansion of the definition of insider-trading, but there is an expansion of people who are deemed to be insiders. Thus, immediate relatives for example have been added to the list of deemed insiders. Such deemed insiders, if they trade in advance of publication of undisclosed price-sensitive information, would need to disprove that they in fact did not commit insider-trading. Or, as we lawyers like to call it, the burden of proof given a seemingly opportunist trade is on the deemed insider, and the person must disprove his guilt. The other class of people, or everyone else besides the deemed insiders, don’t have this albatross around their necks. So, Sebi must prove that they had access to privileged information which they misused. This is a useful expansion, but the real new development, which has not been highlighted by many, is the expansion of the defences for honest conduct.
Till now, many honest transactions used to fall within the prohibition. Many of those now have additional protection of the law. This is a great development, because the purpose of this law is to outlaw abuse of power, rather than outlaw legitimate commercial transactions. The Sebi press release specifically seeks to protect “legitimate purposes, performance of duties or discharge of legal obligations”. The classic example of such legitimate purpose is conducting of due diligence by an institutional investor or a private equity investor. Since due diligence, by its nature, means that the investor has access to price-sensitive unpublished information, the subsequent purchase after the diligence would fulfil the elements of the prohibition. That is, of trading based on access to unpublished price-sensitive information. This has been subjected to the requirement of advance disclosure of the information at least 2 days prior to the investment. The question of whether this condition imposed is practical will need to be debated. The exact impact of this to proprietary and confidential information which may become available to competitors will also need to be re-looked at by Sebi at some point of time. This point was of course hotly debated in the committee.
There has been a restriction on the definition of when price-sensitive information is considered generally available and, therefore, published. Information will be considered published only if made on the stock exchanges. This may unnecessarily chill the flow of information and reduce the flow of information. Thus, CNBC, which has viewers in the lakhs, would not be considered as a wide and simultaneous distribution of information even though many more live viewers would have simultaneous access to the information than those visiting the website of the exchange.
A provision of trading plans has been introduced as a defence to possible charges of insider-trading. The way this would work would be as follows. Let’s say a director who routinely has access to inside information needs to sell shares which are allotted to him by way of sweat equity or ESOPs. Such a person would find it quite difficult to sell shares since even though he is not exploiting an informational advantage of an insider, he could be charged of the offence. Such insiders now can plan to share their sale plans for the year ahead. For instance a sale of 50,000 shares each month, every month for the next year. Such a person would be obliged to sell, no matter how low the prices fall. But at the same time, he would be immune from charges of insider-trading since the sale was based not on the basis of inside information, but rather on the basis of a determinate and irrevocable plan. The problem with this well-meaning immunity is that it may not be practical. Since the plan has to be disclosed to the market at large, it would be easy for investors to front run the insider and exploit the fact that such insider is bound to sell no matter how low the price goes. There would be an incentive to cheat such an insider by artificially depressing prices just before the expected date of trading. This would therefore work only for companies whose shares are extremely liquid and where the trading plan is not for a very large quantity.
The scope of securities to which the prohibition applies has been expanded to include derivatives. This would be more by way of clarification, as even the old regulations would have covered such trades. A more explicit prohibition is good as an insider is more likely to use derivatives to maximise his exploits. After all derivatives provide the maximum bang for the buck if one has certain and privileged information.
Finally, a welcome move is to eliminate the multiple disclosures between the insider trading code and the takeover code. This norm of similar disclosures under different regulations caused multiplicity of disclosures, unnecessary compliance burden and no net benefit to investors.
Overall, the new regulations are welcome though they will need to be tested on the ground before a definitive conclusion can be drawn.
By Sandeep Parekh
Parekh is the founder of Finsec Law Advisors and author of the book Fraud, Manipulation and Insider Trading in the Indian Securities Market

14 February 2014

Statistical possibility of manipulation in the Indian securities markets.

My friends and colleagues at IIM,A have written a very interesting paper titled "High Frequency Manipulation at Futures Expiry: The Case of Cash Settled Indian Single Stock Futures", where they use a statistical/econometric tool to estimate the possibility of manipulation in the stock markets. The paper by Prof. Sobhesh Agarwalla, Prof. Joshy Jacob and Prof. JR Varma described in their own words is about:

Futures markets are known to be vulnerable to manipulation, and despite the presence of a variety of mechanisms to prevent such manipulation, instances of market manipulation have been found in some of the largest and most liquid futures markets worldwide. In 2013, the Securities and Exchange Board of India identified a case of alleged manipulation (in September 2012) of the settlement price of cash settled single stock futures based on high frequency circular trading. As is well known, it is easy for any well-endowed manipulator to manipulate the price; the real challenge for the manipulator is to make the manipulation profitable. The use of high frequency circular trading of the form alleged in the SEBI order makes many forms of manipulation profitable, and makes futures market manipulation a much bigger problem than previously thought. 

As argued by Pirrong (2004), it is more practical to detect and punish manipulation than to try and prevent it. We develop an econometric technique that uses high frequency data and which can be integrated with the automated surveillance system to identify suspected cases of high frequency manipulation at futures expiry. We then use these techniques to identify a few suspected cases of manipulation. Needless to say, human judgement needs to be applied to decide which, if any, of these cases need to be taken up for investigation (and, after that, possible prosecution). This judgement is beyond the scope of our paper, and we refrain from making any judgement on whether any of the identified cases constitutes actual market manipulation.

The paper can be downloaded from SSRN website.

Those who recall the US paper several years back by Prof. Erik Lie  which resulted in options backdating enforcement action or another paper further back in the 1990s by Prof. Christie and Schultz titled "Why do Nasdaq market makers avoid odd-eighth quotes"  on the Nasdaq's oddly priced trades which also resulted in extensive enforcement action against the exchange and the market makers would find this of substantial interest. This should of course be of interest to SEBI to dig deeper to uncover evidence of manipulation.

07 February 2014

Book review - Fraud, Manipulation and Insider Trading in the Indian Securities Market - Monika Halan

Sorry for the overload on my book. But the first review of the book Fraud, Manipulation and Insider Trading in the Indian Securities Markets is just out. Monika Halan, the reputed financial journalist has critiqued the book. Here is her piece which appeared in the FPSB's Financial Planning Journal:

"Fraud, Manipulation and Insider Trading in the Indian Securities Market
Sandeep Parekh
Publisher: CCH, a Wolters Kluwer business
Price: 795

Speak to average retail investors and they talk about the stock market with some bits of awe mixed with desire and fear. Awe, because smart looking people in movies seem to do complicated deals and get very rich. Desire, because of all the stories of the roulette-like stockmarket, that has the potential to make you seriously rich very quickly. You just need the right tip and do the trade. Fear, because of the frequent news stories about fraud and manipulation on the markets. How true are these stories? Is our stock market really a den of thieves as popular folk lore has it?

Those looking for answers may do well to read Sandeep Parekh’s book titled Fraud, Manipulation and Insider Trading in the Indian Securities Market. A racy Michael Lewis read this is not since the book is about regulations in the securities market, their evolution and the role of the regulator. The text-bookish treatment of the subject and the text-book like design feel will put off a casual reader, but for students of finance, would-be securities market lawyers, and other participants in the market will do well to invest time to read the book. Financial planners will find it useful as well, specially the chapter on ‘Mis-selling and Unsuitability’. Heavy reading the book may be, but persist and get rewarded with gems such as: “..the purpose of modern securities regulations is not to remove stupidity from the capital markets – only ignorance.” You chance upon another one while reading about how market upticks and bubbles are fertile grounds for fraud: “the beta of the market hides the negative alpha of frauds.”

The key focus of the book is how fraud, manipulation and insider trading is defined by regulators and how it is dealt with. In fact, stock markets have been in operation much longer than regulations and people have been defrauding each other since the beginning of time. It isn’t as if till the anti fraud regulations came into being there was no legal recourse for a person who felt cheated or defrauded in the market. Even before written law, fraud has been prohibited under common law, or “law as decided without statutes and passed on and evolved from generations through court decided cases”. Read through the Sebi (Prohibition of Fraudulent and Unfair Trade practices relating to Securities Market) Regulations 2003 (FUTP Regulations) and the use of common law principles of fraud show up clearly. The bedrock for anti-fraud regulations is the tort of deceit. Writes Parekh: “Since Pasley v Freeman in 1789, it has been the rule that A is liable in tort to B if he knowingly or recklessly makes a false statement to B with intent that it shall be acted upon by B, who does act upon it and thereby suffers damage.” The six ingredients that make up the common law fraud are intention, materiality, mis-representation of fact, transaction, loss and damage. Financial sector regulation and the appellate bodies have the delicate task of deciding ‘intent’ and that means either getting into somebody’s head or using circumstantial evidence to prove it.

Though the book is about the securities market and the regulations to prevent fraud and manipulation are about stocks, the book is relevant for those preparing for the future of Indian finance according to the road map laid down by the Financial Sector Legislative Reforms Commission (FSLRC). The draft Indian Financial Code envisages a collapse of the current multiple regulators into one United Financial Agency (UFA). Given the roots of current security market regulation from common law fraud, other regulators like the Irda, PFRDA and RBI must begin to use the common law fraud to think about fraud in their areas. The Rs 1.5 trillion of loss caused to individual investors in bundled life insurance products over seven years fits the five step definition of common law fraud to a T.

Ideally I would like Parekh to write a non-text book next, where he writes about securities market regulation for the interested, but lay reader. The glimpses of story in an otherwise dry book (and it needs to be dry because it deals with actual regulation) are fascinating. And the average reader would understand markets much better, lifting the veil of high finance and its seeming complication.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com"

20 December 2013

Insider trading - time for a requiem

In continuation to my piece from yesterday on the proposed Insider Trading regulations, my column in today's Financial Express discusses some of the defenses against a charge of insider trading. One key defense relates to conduct of due diligence. This and other defenses are discussed on today's column titled "Differentiating due diligence from insider trading". Below is the full piece:

The advisory committee for the review of the Sebi (Prohibition of Insider Trading) Regulations, 1992, constituted under the chairmanship of Justice NK Sodhi has submitted its report to Sebi. This is an overdue overhaul of the insider trading norms. In my column here yesterday, I had discussed the need for the overhaul proposed and some of the significant additions and changes which will help the regulator and market participants focus on the right issues. The current formless, vague and amoeba-like development of the law which confuses the market participants and sometimes harms legitimate conduct required an overhaul.

There are many well-thought and sophisticated defences provided in the draft regulations. This column seeks to discuss a few. These include defences like trading against the insider’s interest. Thus, a person who has good news—before the good news is publicly available—and sells in the market would not be charged with insider trading. While this may be somewhat obvious, providing a clear framework giving such a defence provides clarity even to non-experts in the field.

Another significant defence against the charge of illegal insider trading is the one relating to due diligence, which caused heartburn to institutional and private equity investors under the current regulations. The current regulations virtually deem illegal all due diligence of a company before making significant investments. This occurs because due diligence gives access to unpublished price-sensitive information. Since investment is partly made on the basis of the due diligence, this falls under the informational advantage definition of insider trading. This is, of course, wrong and hurts India without providing any benefit to the investors.

Any strategic investor or even a large passive investor in a company will want to conduct due diligence before investing—the purpose of which is never to get access to inside information, but to make sure the representations made to them are correct and accurate. While reviewing the information, the person conducting the diligence—and there are many areas where due diligence is needed, such as legal or financial—may chance across a fair amount of confidential information. After all, information doesn't sit in one room with the label 'legal documents' and in another with the label 'financial documents'! In this task, there will rarely be undiscovered happy news. More likely will be the discovery of undisclosed contracts which may create legal liability or litigation or other bad news. This is, of course, the purpose of due diligence. A company will market to the investor that it has the performance of Google and the corporate governance of Infosys. To verify the company's claim, the investor will want to dig further. As discussed, information doesn't sit in sealed rooms. In the due diligence processes, the person conducting them is bound to come across significant confidential information. To give just one example, while inspecting contracts for their enforceability, the person may need to see a database of all the customers of the company and the pricing of the company's product.

The draft regulations prescribe that the company must disclose the diligence findings that constitute unpublished price-sensitive information. This is a good exemption. It will not impose an obligation to share the customer database and customer-specific pricing to the public, as some commentators will surely argue ought to be put in the public domain. If that stand were taken, the competitors will grab such information with eagerness and not only have a ready list for their marketing departments but also price their products more competitively. This, by all accounts, would hurt the company and the shareholders. In my view, due diligence should get the protection of the law so long as the board trusts the potential investor. This judgment should be left to the wisdom of the board. In any case, if an individual in the diligence team commits insider trading based on access to price-sensitive information, he can be caught and penalised. But to scare potential investors in a company from protecting their interest or alternatively, hurt the company by mandating them to act against their own interest would harm the common investors rather than protect them. It may be recalled that the interest of the potential investor who conducts due diligence is typically identical to the interests of the minority investor. Of course, any negative information, which has been suppressed from the common investors ought to be disclosed if such information has been uncovered in the due diligence. This is what the exemption provides and will be a big relief to large investors and will also provide a lot of significant hidden information to the common investors.

There are some areas which have not been considered by the committee and which need some attention. These include instruments and transactions which cannot, except in some extreme events, be subject to mischief. The focus of the regulations ought to be on equity instruments, convertibles and derivatives on equity. Also, there should be an explicit shifting of focus from very low-risk transactions. Other instruments and transactions—the LIBOR rate manipulation comes to mind—if fraudulent will, of course, already be covered by the anti-fraud rule of Sebi as discussed below.

What the regulations should do is cover insider trading and not try to capture all securities frauds. Such frauds are captured in another regulation of Sebi. Thus, the attempt to extend the regulations to market-timing mutual fund units should be avoided. That is best left to the anti-fraud Sebi (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, commonly called FUTP regulations, which in any case require a complete over-haul themselves. Similarly, countries are slowly moving towards making public authorities accountable for misusing certain confidential information in public policy. The committee makes a brave thrust in this direction by requiring public officials whose actions would impact the price of listed securities from trading in advance of making such policy or judicial pronouncements public. While this is a laudable move, the change should not be contained in the insider trading regulations but in the FUTP Regulations of Sebi.

19 December 2013

Insider trading proposals - good overhaul

In the first part of a two part article on the insider trading regulations as proposed by a committee of SEBI, I discuss why punishing fraud and focusing less on “unfairness” should be at the heart of laws against insider-trading.

Copied below is the full piece Overhauling insider trading laws from the Financial Express. The second part will follow tomorrow.

The advisory committee for the review of the SEBI (Prohibition of Insider Trading) Regulations, 1992, constituted under the chairmanship of Justice NK Sodhi has submitted its report to SEBI and is in the public domain for comments. The report, along with draft regulations, would form the foundation for a new law governing insider trading laws in India. The draft regulations proposed under the report seek to infuse clarity and predictability into the regulatory mechanism.

While I am rarely an advocate of the complete re-writing of a law, I believe the prohibition of insider trading is one of those few areas which actually needs an overhaul. The reason I am usually against re-writing a law is because the decades long jurisprudence which has formed around the legal provision as interpreted by courts is lost. The beauty of the common law system is that statutory provisions provide the broad skeleton to the law while the flesh and ligaments to the body are provided by case law. This provides a human form to the rather inert written-law and also gives flexibility to the law to grow and adapt. Unfortunately, the case law on insider trading till now has created an amoeba rather than an agile human being. The case law till now is both amorphous and unclear. For instance, despite the name of the regulations, trading based on outside information has been prohibited. A classic example is a hostile acquirer whose acquisition plan of a target company will increase the price of such target. This is by no stretch of imagination inside information. Yet more than one case has held it to be. While courts can stretch the definition at times, it is almost perverse to use the antonym of the word used in the title of the regulation to pass a penal order, i.e., ‘insider’. The law is against insider trading with its origins in fraud, not outsider trading based on some perception of unfairness.

Before we can get into the recommendations, it would be useful to peep into the soul of the prohibition against insider trading. The origins and soul of insider trading lie in the general rule against fraud in securities markets. In fact, one securities appellate tribunal case explicitly connects the two despite the regulations not requiring fraudulent conduct as an element of insider trading. Since an insider, say a director, has a fiduciary duty to the company/shareholder, such insider is supposed to put the interest of the shareholder ahead of their own interest. With special information available to them as a fiduciary, trading against such shareholders in the absence of disclosure would amount to breach of a fiduciary duty and fraudulent conduct.

There is a significant and important distinction between fraud and unfairness. The former is illegal, the latter merely undesirable. Income inequality may be unfair, but we don't penalise rich people. More accurately, one can draw an analogy between theft from someone's pocket which is illegal and a situation where a person finds a hundred rupee note on an empty road and picks it up, which is not illegal but can be called unfair. Equating the two is treating unequals as equals, and therefore is wrong. This, in summary, is the debate worldwide between classical insider trading (fraudulent) and parity of information rule (unfairness). While India has, in the past and in the report, chosen the latter route, my own preference is for the former. The report does however make an effort to pull towards the anti-fraud definition as explained later in this piece.
There are two ways to prohibit insider trading. One is to rely on the law against securities fraud to capture insider trading. This is the route the US law has taken—they have assiduously avoided defining insider trading for the past half-century, even though they have provided penalties for insider trading. This route leaves the prohibition completely in the territory of the courts without any guidance from written law. The US had the luxury of time as the law evolved slowly over decades out of case law on fraud. The other is the path of trying to define insider trading and prohibiting it. This is of course the easier path, but runs the risk of being both over-broad and over-narrow depending on which sub-area one looks at. Though only the second route is open to us, there is a need to draft this law extremely carefully. It is very easy to get the law over-broad and over-narrow, over-specific and too-vague all at the same time.

Keeping this in mind, the committee has done a commendable job in drafting the regulations. The prohibition reads as “No insider shall trade in securities that are listed on a stock exchange when in possession of unpublished price sensitive information relating to such securities". As the word 'possession' should alert the reader, the committee recommends the unfairness standard rather than the fiduciary/anti-fraud standard. To give a practical example, imagine two directors who have exchanged price-sensitive information through email. The email is marked by mistake to a third party, this third party trades based on such information. Under the possession theory, the third party would be liable even though neither the director has tipped the information dishonestly, nor has the third party stolen the information or breached any duty. This standard penalises unfairness rather than fraud. While I support the latter standard, the committee has while supporting the possession standard, somewhat veered towards the anti-fraud rule. This it does through providing a defence in the draft regulations, which protects an "innocent recipient" of unpublished price sensitive information. This is an acceptable, if not the perfect answer, to the unfairness versus illegal debate.