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 This occurs because due diligence gives access to unpublished price-sensitive information.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.

No comments: