I wrote a piece in the Economic Times recently on the 'short swing profit' rule, which was proposed some time back. However, what has been passed by the regulator is a short swing prohibition. This kind of prohibition is unprecedented anywhere in the world and was passed without the time tested rule of posting proposals for public comment. Here is the piece before I puzzle you with the lingo:
The Securities and Exchange of India (Sebi) recently made some changes in the regulations pertaining to insider trading. The amendments prohibit transactions in securities by designated insiders within six months. In other words, no securities may be sold for six months after being purchased by a designated insider (or sold before being purchased).
The origin of this regulation arises from a US law commonly referred to as the ‘short swing profit’ rule. This rule exists only in the US market. It states that any purchase/sale followed by a sale/purchase within a six-month period resulting in a profit by a designated insider must be handed over to the company where the insider works. The phrase also includes 10% shareholders of the company who must also do the same whether they are insiders or not. It is assumed that insiders have a long-term investment in the company and are not expected to make rapid buy/sell transactions, which are apparently based on at least some level of superior access to information.
If one were to categorise the rule, it pertains more to corporate governance than insider trading. Liability is imposed strictly without any necessity for guilt or wrongfulness and conversely a direction to surrender profits made in a short swing transaction does not imply any form of guilt. I had discussed this and other proposals for changes to the insider trading regulations in a working paper of Indian Institute of Ahmedabad (IIM-A) in 2003.
To introduce a similar rule in India, Sebi, while I was there, had brought out a concept paper and sought public comment on it in January. The paper sought comments on the rule generally, and also on three specific issues.
Firstly, it sought a definition of the new category of ‘designated insiders‘ and whether 10% owners of shares should be included in this class. Secondly, comments were sought on what types of transactions need to be exempted from those which result in short swing profits including transactions approved by a regulatory authority, employee benefit plans, bona fide gifts and inheritances, mergers and acquisitions. Thirdly, whether the last in-first out method should be used to calculate profits.
Now, Sebi has come out with a entirely different regulation which, instead of handing over profits to the company by designated insiders, simply prohibits opposing trades in a six-month period by an existing class of directors/officers/designated employees. The new regulations also prohibit exposure to the derivatives market of the company’s stock. This is an extreme approach to the problem of insider trading.
Firstly, it is too broad. It prohibits every transaction if one has occurred within six months of the other. To treat every insider as a criminal and impose these chains is hardly fair.
Secondly, it converts a corporate governance measure into an anti-fraud provision with heavy penalties attached even though no fraud is attached to a simple transactional violation by an insider without any inside information. Thirdly, the language seems to suggest that buying one share will prohibit that person from selling a million shares for six months. There is no reference to the bought shares or to the numbers to which the prohibition applies.
Similarly, there is no last-in first-out or other measure of restriction on the shares bought and sold, it is a blanket prohibition. Fourthly, the clause suffers from basic errors. This includes equating primary market with initial public offers (the latter is a narrow part of the former). Fifthly, there are no exemptions for genuine transactions — so a person who gets employee stock options (Esops) on a regular basis will never be able to sell his shares.
There are no exemptions for court-approved mergers, so a purchase of one share will bar mergers involving sale of the shares of the company. No exemption exists for a pre-planned and systematic sale of securities, say 25,000 shares every quarter. Lastly, 10% shareholders who can be assumed to have access to inside information are not included in the definition of designated insider.
Even, if the basic prohibition is retained, which itself, in my opinion, is unfairly harsh towards honest people, the scheme suffers from lack of exemptions from hundred types of genuine transactions conducted by insiders. Inadvertent violations, with no inside information, will be common. Following the restrain will be very difficult and there will be frequent requests for exemptions, clarifications and dilutions. Much of this could be avoided if the law was put out for public comment in the shape it has come out in.
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