15 March 2014

Demagogues turned tyrants

In light of yesterday's naked threat of Arvind Kejriwal to the 'entire' media to put them in jail, I couldn't resist quoting from the famous founder of the US and of its constitution. Alexander Hamilton says in "the Federalist" papers:

"A torrent of angry and malignant passions will be let loose. To judge from the conduct of the opposite parties, we shall be led to conclude that they will mutually hope to evince the justness of their opinions, and to increase the number of their converts by the loudness of their declamations and the bitterness of their invectives. An enlightened zeal for the energy and efficiency of government will be stigmatized as the offspring of a temper fond of despotic power and hostile to the principles of liberty. An over-scrupulous jealousy of danger to the rights of the people, which is more commonly the fault of the head than of the heart, will be represented as mere pretense and artifice, the stale bait for popularity at the expense of the public good. It will be forgotten, on the one hand, that jealousy is the usual concomitant of love, and that the noble enthusiasm of liberty is apt to be infected with a spirit of narrow and illiberal distrust. On the other hand, it will be equally forgotten that the vigor of government is essential to the security of liberty; that, in the contemplation of a sound and well-informed judgment, their interest can never be separated; and that a dangerous ambition more often lurks behind the specious mask of zeal for the rights of the people than under the forbidden appearance of zeal for the firmness and efficiency of government. History will teach us that the former has been found a much more certain road to the introduction of despotism than the latter, and that of those men who have overturned the liberties of republics, the greatest number have begun their career by paying an obsequious court to the people; commencing demagogues, and ending tyrants."

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.

27 November 2013

New book - Fraud, Manipulation and Insider Trading in the Indian Securities Markets

I am delighted to announce the publication of my first book “Fraud, Manipulation and Insider Trading in the Indian Securities Markets” by CCH, Wolters Kluwer. The foreword to the book is given by Mr. M Damodaran, former Chairman of SEBI. The book covers important aspects of securities regulations – fraud, manipulation and insider trading. The book also looks at common law fraud, mis-statements in public offers, mis-selling and recommending unsuitable products and carries a detailed coverage of powers of SEBI, enforcement action and remedies for investors. It covers landmark domestic as well as international cases.

I hope you will find it useful and I look forward to hearing your thought about the book and its contents on the micro-site of the book linked here.

An ebook will be available shortly, possibly today - availability at Flipkart etc. will also happen in a day or two. I will put updates on the micro site with respect to the availability.

You can buy the book today from this link.

04 October 2013

Options in shareholder agreements - no longer 'nonsense'

I have a piece in today's Financial Express on the repeal of the prohibition on put/call options in commercial agreements by SEBI. While the amendment is prospective, there is scope for some creativity by lawyers. It would be easy to tear the old agreements and draw up new and identical ones which would protect the investors from the prohibition. This should be known as the "should be torn up and thrown away as nonsense" strategy.

Here is the full piece:
Sebi has finally put an end to the uncertainty that has haunted investors for several decades. It all began with the circular of 1969 passed under the Securities Contracts (Regulation) Act which virtually banned all forwards and options in securities. Spot delivery contracts, contracts traded on exchange, certain pre-emption rights, warrants and convertibles, and securities of private limited companies were the few exceptions to the otherwise overarching ban. While the original circular was not used much to invalidate contracts, over the past two decades and in particular the past five years, more and more genuine commercial contracts were being challenged in courts of law stating that the contracts were in violation of this prohibition. Sebi had hitherto held that transactions involving options which may be exercisable at a future date would be invalid and would not be considered as a spot delivery contract. Therefore, a contract to buyback shares in the future was not valid and enforceable until today. This position was confirmed through the informal guidance in the matter of Vulcan Engineers Ltd.

Although, there was some speculation in the year 2000 that the repeal of the 1969 circular and omission of Section 20 of the SCRA may pave the way for validating the enforceability of options, such hopes were soon shattered with Sebi issuing a notification in the same year which brought back the 1969 circular’s ban back to life.

The original intent of the prohibition was in fact an attempt to curb speculative transactions off exchanges including in shadow exchanges. The aim was to prohibit what used to be called dabba trading, usually carried out at a corner street near formal exchanges. In today’s world, speculation is no longer a dirty word, and nearly all economists would agree that speculators not only provide liquidity and price discovery in the market, but often offer trades on the other side of hedgers. But in its broad drafting, the circular ended up hurting genuine transactions. This prohibition was detrimental because it not only outlawed speculative trades (which anyway it shouldn’t have) but also outlawed legitimate commercial transactions (which it definitely shouldn’t have).

A majority of private equity investments have various put and call options in the shareholder agreements as a common means of protecting their investments against the dominant interest of promoters. This uncertainty lurked over hundreds of investment agreements, private equity deals, joint venture agreements and other commercial contracts.

Sebi in yesterday’s notification under Section 16 of the Securities Contracts (Regulation) Act has finally removed uncertainty regarding the issue by rescinding the notification dated March 1, 2000. Although the new notification would be applicable prospectively, it brings a sigh of relief to thousands of investors who were apprehensive about bringing their money to India not to mention thousands of domestic contracts of investments. The notification provides that spot delivery contracts, contracts for sale or purchase of securities or contracts in derivatives and contracts for pre-emption including right of first refusal, or tag-along or drag-along rights contained in shareholders agreements or articles of association of companies or other body corporates would now be valid and enforceable. Thus, contracts entered into after today will subject to some conditions, get the protection from the prohibition.

In relation to contracts in shareholders’ agreements or articles of association of companies or other body corporate, for purchase or sale of securities pursuant to exercise of an option contained therein to buy or sell the securities, Sebi has prescribed three conditions:

  • The title and ownership of the underlying securities is held continuously by the selling party for a year.
  • The price or consideration must be determined in compliance to all laws.
  • There must be actual delivery of the underlying securities for the settlement of the contract.

Subject to the fulfilment of these three conditions, such contracts would be valid and enforceable. These conditions are probably intended to ensure that the transactions are genuinely commercial since ownership for a period and actual delivery would minimise the chance of them being categorised as speculative. Similarly, there is an emphasis on transparency, fairness and conformity with the law.

There are still two areas of concern. One, the circular is not clear whether this new law applies to securities of public unlisted companies or not. Given several Supreme Court rulings which have explored this question, till now, the courts have interpreted the prohibition broadly and thus options even in unlisted shares of a public company have been captured within the sweep of the 1969/2000 circular. Sebi lost the chance to clarify and restrict the scope of the prohibition to only listed securities. Extending the prohibition to unlisted securities does not serve any purpose, and the courts have only interpreted the provisions as they exist in the prohibition. It would have been a progressive move to restrict the prohibition to only listed securities where there is any public concern. The second area of concern is that the lifting of the prohibition is only prospective. This would mean that past agreements by joint venture partners, private equity investors, domestic investors would all still face the challenge of the old and perverse prohibition. This should have ideally been avoided, as all investors ought to have been allowed the protection of the new law. However, there is scope for some creativity by lawyers in this respect. It would be easy to tear the old agreements and draw up new and identical ones which would protect the investors from the prohibition.

In a nutshell, this notification has introduced the much needed and much awaited certainty that was required for various genuine commercial contracts which were being hampered by the excessively suspicious attitude of the regulator. But of course like all other things, it could have been even better.

Post script: Interestingly Prof. Umakanth has written a piece in his blog which is quite similar to my piece. He also recommends re-writing the agreements to escape the past prohibition.