Regulating AI in the securities markets

 I have a piece in today's Financial Express with Parker Karia on the impact of AI (artificial intelligence) on securities markets. The full piece is as follows:

Fast on the heels of development of AI, which has already resulted in transformations across various industries and professions, the European Union is the first jurisdiction to introduce legislation that regulates AI. Broadly, those AIs which pose an unacceptable risk would be prohibited, whereas minimal risk AI systems are unregulated. The former category would include AIs that affect people’s rights, biometric categorisation systems, scraping of facial images from sources to create a facial recognition database, social scoring, predictive policing, or such AI that manipulates human behaviour or exploits people’s vulnerabilities. Additionally, the EU’s AI Act establishes the EU AI Authority, which will be the nodal agency for implementation and enforcement of the AI Act, which, like the GDPR, has an element of extraterritorial jurisdiction.

What is actually regulated is AIs that fall into neither unacceptable risk, nor the minimal risk category. These are high-risk and limited risk AI systems. High-risk AI systems pose a threat as its uses include deployment in critical infrastructure, education, essential services, law enforcement, dispensation of justice, governance, etc. Such systems would inter alia be required to register with the relevant EU database, assess and mitigate risks, ensure transparency and accuracy, and more importantly, ensure human oversight. Moreover, people would have a right to submit complaints about AI systems and would be entitled to explanations about decisions in relation to high-risk AI systems that affects the right of the aggrieved person. Non-compliances with the AI Act will attract fines ranging from €7.5 million or 1.5 percent of revenue, up to €35 million or 7 percent of global revenue, depending on the violation and the entity.

GPAI

General-purpose AI systems, such as ChatGPT, Gemini, etc., would face new transparency requirements. Such software, including those that create manipulated images such as “deepfakes” would have to make clear that what people were seeing was generated by AI.

AI and the Securities Market

The securities market will not be, or rather, is not an exception to the infiltration of AI. Although recent breakthroughs have been largely in the space of generative AI, gigantic steps are being taken to equip AI with further abilities, as well as expand the data the AI has access to

To put the timeline and development in perspective, till three decades ago, activities related to trading in the securities market, such as research, placement of orders, etc., hardly incorporated technology. The focus on use of technology began with some seriousness upon the introduction of dematerialized shares. From then, to today, India has taken the lead in introducing a ‘T + 0’ settlement cycle. Today, any step or activity relating to trading in the securities market, cannot be imagined without the use of technology. Now, with the introduction of AI, the securities market is set to witness another transformation. Today, AI can analyze vast amounts of data, identify patterns, and make informed decisions in real-time, execute orders at lightning speed, create investment strategies by itself, etc., as a result of which, the manner in which trading is conducted, risk is managed, and investments are made, are rapidly evolving. One of the pertinent concerns in this regard would be around data privacy.

As AI and AI-generated algorithms permeate various sectors, including the securities market, regulators face the challenge of crafting laws that govern these technologies effectively. In the following paragraphs, AI’s impact on the securities market and its regulation, are discussed.

Algo Trading & Robo Advisory

Currently, algo trading is defined as trading carried out through automated means, i.e., order are placed without any human intervention. Recent suggestions by SEBI to regulate algo trading have received mixed reviews, while majority views agree with the need for regulating algo trading, SEBI’s approach towards meeting that end has been the subject of some criticism. It would also be required to be borne in mind that AI can effectively write codes based on instructions fed to it. Thus, creating an algo, in the near future, may not be the exclusive domain of a trained professional in the field of IT systems. In a situation where the deployment of an AI created algo results in a violation of securities laws, the question that arises out of this is on the extent of culpability to be fastened on the person who used AI to create the algo. The principle that the developer of an AI, or the human behind the ‘machine’ is responsible, exists, however, with the advancements in AI, which are unpredictable at this stage, the above principle may have to be revisited. As AI changes the landscape around us, our laws must keep pace to ensure that rights and obligations of the concerned parties are laid down in advance.

Additionally, robo advisory is presumably going to take the center-stage in the distant future. For instance, with the vast amounts of data points analysed in a few moments and investment strategies being created in seconds instead of weeks, it is not too far-fetched to presume a considerable shift in the manner in which investment advisory service is carried out today, which may warrant a revisit to the extant regulatory framework requiring both strengthening and rationalisation of regulations. Strengthening for the reasons described above, and rationalising because some of the restrictions may no longer be relevant with AI generated work product.

Grievance Redressal and Enforcement

AI may eventually be used for dispensation of justice by appropriately (and safely) integrating it in our judicial systems. In fact, it was recently suggested that AI may be used to resolve minor traffic challans, to begin with, upon adequately building up such capability. Similarly, the securities regulator may consider initiating the process to develop AI that can effectively monitor, supervise and assist in the enforcement of securities laws.

Additionally, with the recent focus on online alternative dispute resolution mechanisms for resolution of disputes in the securities market, minor issues, depending on the complexity, quantum of money/ assets and the nature of the dispute, AI can serve as an arbiter or mediator.

Pattern recognition and Predictive Analysis

In a potential game-changer for regulators, developing AI models are becoming increasingly efficient at recognizing patterns, and thus predicting the ‘future’, depending on the data points that the AI has access to, and how it is ‘coded’ to ‘think’. While algos are already deployed by financial sector regulators around the world to identify and/or track suspicious activity, AI can be of immeasurable assistance in this regard. For instance, SEBI has in the recent past issued circulars introducing the use of blockchain to verify information, and to ensure transparency amongst intermediaries and entities. The integration of AI in such systems can lead to predicting any defaults, or preventing violations, thus safeguarding investor interest. However, any such technology should be used with caution, and strict safeguards should be built around such systems to prevent any misuse.

To conclude, while the adoption of AI in the securities market would lead to increased efficiency, reduced costs, and enhanced decision-making capabilities for market participants, it raises significant concerns regarding market manipulation, algorithmic biases, data privacy and systemic risks, which warrants regulatory scrutiny and the need for comprehensive legal frameworks to address the issues emanating out of using AI. As AI continues to evolve and reshape the landscape of securities trading, regulatory authorities must remain vigilant, adaptive, and forward-thinking in their approach, and strike a balance between innovation and regulation, thereby navigating the complexities arising out of the intersection of AI and securities market. While this piece has focused more on the challenges posed, overwhelmingly, the use of AI will be a force for good, bringing speed, productivity, innovation and removal of human errors and biases. Thus, it would be better to delay introducing too many regulations till the dust has settled on the field.

Regulating Index Providers: Navigating the Transition from Carte Blanche

I have a piece in today's Financial Express with Rashmi Birmole and Navneeta Shankar on SEBI's new regulations on index creators (effective after 6 months). Good move, but a light touch regulation in practice would be recommended.

In the coming months, Indian bonds will feature in JP Morgan’s Government Bond Index – Emerging Markets, a move that is being heralded as a game-changer by many and that is expected to attract significant foreign investment into the country. The inclusion of Indian bonds on a globally recognized index, a milestone in its own right, also speaks to the significance of indices in the broader context of the financial landscape. Simply stated, an ‘index’ is simply a collection of traded securities (known as constituents), which represents a segment of the financial markets. One of its myriad functions is to serve as a benchmark to measure the performance of an actively managed fund or the economy, as a whole. The function that holds greater relevance for investors is an index’s use in the creation of passive investment products, which are typically present in most investment portfolios. These products may range from index funds, which mimic the performance of broad-based market indices, to thematic or sector-based funds, which rely on customized or bespoke indices, available in the public domain or designed at the behest of fund managers.

The construction and management of an index is based on methods and criterion adopted by index providers, who operate with a high degree of autonomy, with the inclusion or exclusion of a constituent security resulting in observable signaling effects in the financial markets. It stands to reason that, given that indices are foundational for the creation of passive products, any decisions regarding the constitution of an index can substantially impact the overall performance and direction of the markets. The resultant conflicts of interest that may arise, coupled with the steady rise in passive investing, were the key drivers of the SEBI (Index Providers) Regulations, 2024, which were notified on March 8, 2024. The regulations emanate from the recommendations of a working group, which were released for public comments in December 2022, to address the regulatory vacuum that index providers have operated hitherto, specially given the apprehensions that such providers enjoy an element of carte blanche despite their critical importance within the financial ecosystem. The regulations are modeled on the IOSCO Principles for Financial Benchmarks, a set of globally accepted standards adopted by index providers worldwide, and by and large, follow a principle-based approach and relegate the nitty gritties of implementation to the index provider. The regulations target index providers that administer ‘significant indices’ for use in the Indian securities market. This essentially means that only the indices, both paid or freely available, which consist of securities listed on Indian exchanges and which are tracked by domestic mutual fund schemes whose cumulative assets exceed a predetermined threshold shall be regulated. It follows that the framework will not apply to indices consisting of foreign securities or used exclusively in foreign jurisdictions.

The regulations, which are focused on addressing concerns around the discretion exercised by index providers, are framed on three overarching themes - conflict of interest, integrity and accountability.

The possibility of conflict of interest in index construction and rebalancing is apparent. For instance, in private arrangements where bespoke indices are designed by index providers for funds, the risk of the index construction being influenced to benefit certain players is inherent and cannot be ruled out. Moreover, individuals responsible for index construction may be incentivized to alter the indices in a manner that suits the commercial interests of the index provider. Information regarding confidential decisions on index composition, or weightage of constituents, also runs the risk of being leaked to the advantage of front runners.

To address conflicting interests, the regulations make it compulsory for index provider activities to be carried out through a separate legal entity. Appropriate governance arrangements will also need to be put in place to protect the index determination process and individuals responsible for index governance must be segregated from the commercial function of the index provider. Among the salient provisions include the constitution of an oversight committee, separate from personnel engaged in indexing activities on a day-to-day basis, to oversee the methodology employed to design indices, review the need for changes and examine whether such methodology reflects the description of the index. The regulations also place the onus of formulating policies and procedures to address conflict of interest on the index provider. These procedures must also effectively control exchange of information among personnel involved in activities involving potential conflicts of interest and ensure confidentiality of information. The regulations further require index providers to institute a control framework to facilitate early detection of potential misconduct and complaint management within the index provider.

Additionally, the regulations also provide for maintaining the quality of the index, the methodology used for index calculation and protecting the integrity of data. To maintain the quality of indices, the regulations mandate index providers to consider factors which represent the underlying interest that the index seeks to measure, while eliminating any factors that may result in distortion of price, rate or value. Index providers have also been given the leeway to formulate a code of conduct for their data submitters to address quality, oversight, conflict of interest management, record-keeping and whistleblowing and perform due diligence on such entities. The regulations also strive for complete transparency in dissemination of information so as to promote investor confidence by making it compulsory for index providers to document and make information relating to the methodology used for index calculation and maintenance publicly available. This will not only allow an understanding of the manner in which the index is derived but will also encourage a fair assessment of its representativeness, relevance and appropriateness as a reference for passive investments. Moreover, the regulations also place an obligation on regulated markets and stock exchanges to ensure equal, unrestricted, transparent and fair access of data to all index providers having a data sharing agreement with them so as to avoid any disparity in timing, format and manner of such information dissemination.

Another theme around which the regulations revolve is accountability and disclosure. The regulations mandate index providers to establish an accountability mechanism by putting in place a complaint redressal policy for facilitating submission of complaints pertaining to whether a specific index represents the underlying interest it seeks to measure and application of the methodology to a specific index calculation. Index providers are also required to provide for a dispute resolution mechanism for resolution of all claims, differences and disputes between their subscribers and them arising out of their business in the securities market. Apart from furnishing timely information to SEBI, when called upon to do so, index providers are also required to assess their adherence to the IOSCO Principles through an independent external auditor, on a biennial basis, to ensure fairness and complete transparency in such evaluation. Any evaluation report of an independent external auditor has to be compulsorily disclosed on the website of the provider.

Considering the explosive growth of passive investing in recent years, the regulator’s focus on index providers, which wield significant influence in the financial markets and are dubbed as ‘power brokers’ in the western markets, comes as no surprise. The principle-based nature of the regulations give index providers ample room to maneuver, providing necessary flexibility to support the passive investing momentum. It must be stated that index based investment has been a force for good, providing benchmarks for providing low cost and market based returns to investors, which have escaped major scandal with one big exception (the LIBOR scandal). Given the track record, a light touch approach in practice would be useful, where the regulator comes in only in relatively egregious actions.

Winning the battle only to lose the war – the saga of front-running

Aniket Singh Charan and I have a piece in today's Financial Express on the changing nature of 'front running' a type of securities fraud.

 

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” – said the Red Queen to Alice in Through the Looking Glass. There are many examples in the securities market that perfectly demonstrate the wisdom of the Red Queen – if you want to make a profit, you need to be faster than the rest.

While, ordinarily, asymmetry of information in the securities market is often exploited to achieve profits, front-running abuses this in a nefarious manner. Front running involves the use of non-public information pertaining to a “substantial order”, and trading ahead of it to make profits or avoid losses. Recent orders by the Securities and Exchange Board of India (“SEBI”), in the matters of Experts appearing on Zee Business and Ketan Parekh indicate a rise in the number of enforcement actions taken by the regulator for this particular offence and throws light onto the evolving forms of front-running. They also provide interesting perspectives on approaches adopted towards ascertaining what a “substantial order” is and the “impact” such an order may have on the price and volume traded of a security.

Although front-running is a fraudulent practice, in Ketan Parekh (no relation of the first author), SEBI has done away with the requirement to prove dishonest intention. What is essential, however, is an inducement to deal in securities, which is sufficient to demonstrate fraud. A parallel may be drawn to the Supreme Court ruling in SEBI v. Abhijit Rajan, a case involving allegations of insider trading. The Supreme Court held that it was immaterial if actual profit or loss occurred, what is required is a motive to make a profit from the alleged trade. This motive is a key element in such trades.

In Ketan Parekh, Quest Investment Advisors Private Limited, a portfolio management company registered with SEBI, indulged in front-running while in possession of advance knowledge of impending orders. A key factor in the analysis of front-running revolved around the interpretation of what constitutes a substantial order and the impact it may have on the price of the securities. SEBI interpreted the meaning of the substantial order by placing reliance on the “reasonable person test” while noting that there was very little guidance, precedentially, available on what constitutes a substantial order. As per the whole time member (“WTM”), in this matter, a substantial order is one which, in the estimation of a reasonable person, would impact the price of the concerned securities. The WTM further stated that “when it is only the estimation of reasonable person then the assessment of actual impact of such substantial order is not necessary to determine the substance of the order”. Ideally, determination of what constitutes a substantial order should be followed by an assessment of the impact such a substantial order may have on the price of the securities traded. In the present case, there was no calculation of impact and the reasonable person test was used to conclude that front-running did in fact, occur.

In another matter, the front runner had undertaken trades in advance of an impending order. SEBI held that front-running occurs when an entity makes a trade on the basis of non-public information regarding a “large trade” from an investor, which may impact the price of such security. SEBI matched trades undertaken by the noticee with that of the impending large trade and found that in almost all instances the trades executed matched that of the impending order. Interestingly, the WTM observed that for front-running to occur it was not mandatory that the front-runner’s trades should match with that of the impending order. The essential element in establishing front-running is that the trades were made on the basis of non-public information. Whether the trades executed by the front-runner match the large order and whether they resulted in profits, are secondary considerations.

In Zee Business, a far more complicated picture emerges. The alleged violators belonged to three categories – (i) experts appearing on news channels; (ii) profit makers; and (iii) enablers. Experts appearing on news channels provided advance information about the recommendations that were going to be made on the news broadcast (which was held to be non-public information) to the enablers, who then used trading terminals provided by profit makers to trade based on such advance information. SEBI, in its order, analysed the fluctuations in the price and volume of securities, being traded, pre and post the news broadcast. Notably, a key ingredient of front-running i.e. the existence of an impending transaction/ substantial order was not directly present in this case. It was held that the popularity of these shows had equipped the noticees, with a deep awareness of the impact that expert recommendations wielded over the price and volume of the securities so recommended. Though there was no substantial order in place, it was argued that the noticees had a reasonable expectation of an increase in the price and volume of the securities recommended immediately following the news broadcast. The favourable movement in the price and trading volumes of the securities once such recommendations were made, further strengthened this argument. SEBI utilised a host of strategies to establish links between the parties – from call data records, WhatsApp/Telegram chats to geographic location analysis to further prove a nexus. It is rather interesting to note, that the reasonable person test as employed in Ketan Parekh, was not relied on in this order. Furthermore, this order did not discuss who a reasonable viewer is, and the only metric used to show inducement was the price/volume fluctuations pre and post the broadcast. Nevertheless, this order has expanded the contours of front-running (from a plain vanilla pump and dump scheme) to accommodate situations where there is an intent to defraud investors by abusing the trust which investors keep with certain individuals- such as the financial pundits in this case and a substantial order’s existence can be ascertained on the basis of the quantifiable response which viewers have for guest recommendations on channels, like Zee Business, and the change in the volume of trading in such securities. As has been expressed earlier, the motive is what counts towards making a case of front running, divorced from any actual profit making.

In all three cases, SEBI utilised different approaches to ascertain impact and knowledge of impending orders. On the road to determining substantiality of orders, the approach adopted by SEBI has seen several variations and the ever changing contours of front-running pose new challenges in determining liability. SEBI may have to relook at how it defines front-running in light of these changing dimensions. After all, a front-runner is not the only one who has to run twice as fast.

India Inc gets global play: Allowing public companies to list on IFSC will make them more competitive

I have a piece with Shivaang Maheshwari in today's Financial Express on the amendments paving the way for direct listing of Indian companies at the exchanges on the GIFT city. The move could help capital raising by Indian companies and help foreign investors to deal in shares of India based companies without going through complex investment procedures and without converting their hard currency.

On January 24, 2024, the Central Government notified the Companies (Listing of equity shares in permissible jurisdictions) Rules, 2024 (LEAP Rules) and amended the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) paving the way for certain public companies incorporated in India to list their equity shares directly on international exchanges situated in GIFT International Financial Services Centre (IFSC). These notifications are based on the recommendations of the Working Group which was tasked with suggesting a regulatory framework that facilitated direct listing of public Indian companies on international exchanges in IFSC.

 

Until now, Indian companies could only issue and list their securities in the overseas market through depository receipts such as American Depository Receipts (ADR) or Global Depository Receipts (GDR). Under this process, a company intending to raise capital from foreign jurisdictions would issue securities to the depositories incorporated in that particular jurisdiction and such depository in turn would issue depository receipts in the name of the company to the investors. Presently, only a handful of companies have opted for this route, given the stringent and tedious regulatory framework along with the time and costs associated with issuance of depository receipts. Moreover, unlike equity shareholders, the holders of the depository receipts are not entitled to vote unless they convert them into underlying shares. Fraudulent issuance of a company’s GDR and its manipulation are other risks associated with depository receipts.

 

Thus, with a view to address these challenges, the recent notifications have introduced a regulatory framework that allows both listed and unlisted public Indian companies to issue and list their equity shares (including by way of offer for sale) on permitted stock exchanges in permitted jurisdiction viz., India International Exchange and NSE International Exchange set up by BSE and NSE respectively in GIFT IFSC. The significance of this framework is crucial for India as it not only presents a roadmap for direct listings of public Indian companies but also aims to enhance the appeal of GIFT IFSC as a distinguished global financial hub. In the pursuit of global competitiveness, it is imperative for Indian companies to secure capital at the most favorable cost of capital. Foreign investors, known for their inclination towards securities listed in their home country, often assign disproportionate weightage to such assets in their portfolios. This inherent home bias placed Indian companies at a distinct disadvantage when courting foreign investments. Opting for foreign listings in the IFSC emerges as a strategic solution to mitigate this bias, effectively reducing the cost of capital for companies as investments in these companies can now be made in hard currency. Notably, companies are not obligated to undergo domestic listings concurrently, granting them the flexibility to establish a presence solely on an international exchange in IFSC.

 

The opportunities expected to be generated by the revised regulatory framework are immense. Companies incorporated in India can unlock several advantages by accessing capital markets outside their home country. One significant benefit is that Indian companies can now attract funds from international investors which often have the capacity to provide huge capital funds, keeping in mind the valuation of these companies based on global standards. Listing in IFSC is also likely to open up a broader investor base for companies as a diverse pool of investors would be interested in acquiring and trading their shares thus ultimately increasing the demand for the company's shares. For instance, a company listed on international exchanges in IFSC gains access to numerous investment funds also situated in IFSC. This opportunity wouldn't have been possible otherwise, as these international funds might not have considered investing in Indian companies, given the necessity to register as a portfolio investor with SEBI and dealing with conversion of the dollar or euro into the rupee. However, foreign investors however may prefer investing in only well-established and thriving companies.

 

Foreign listings are also likely to lead to better valuation as companies listed on international stock exchanges benefit from sophisticated asset management infrastructure, resulting in more accurate valuations of their securities. Companies will now have the option to access both markets, i.e., domestic market for raising capital in INR and the international market at IFSC for raising capital in foreign currency from the global investors. Startups would now gain access to funds from foreign investors instead of the traditional ways of crowdfunding and seed funding.  Overall, exploring capital markets beyond India's borders offers a range of advantages that can significantly contribute to a company's growth and success on the global stage.

However, the framework provides that in order to secure listing on international exchanges, the public Indian company, as well as its promoters, promoter group, directors, and selling shareholders, must not be debarred from accessing the capital market. Additionally, it is also a prerequisite that none of the promoters or directors of the public Indian company is a promoter or director in any other Indian company that is debarred from accessing the capital market. Further, any company which is under inspection or investigation under the provisions of the Companies Act, 2013 or whose promoters or directors are wilful defaulter or fugitive economic offenders are also not allowed to list their equity shares on international exchanges. While these stringent conditions are implemented to ensure that only financially sound and reliable companies secure listings in IFSC, the ineligibility on account of pending inspection/investigation may be revisited.

Further, only permissible holders, i.e., persons who are not residents of India are authorized to buy or sell equity shares of public Indian companies that are listed on international exchanges. Thus, an Indian resident cannot hold such shares, however a non-resident Indian can hold such shares. It is also pertinent to note that permissible holders belonging to countries that share a land border with India will require approval from the Central Government to engage in transactions in IFSC. This provision is likely to cause friction, but necessary friction, given the nature of some of our neighbours.

It remains to be seen whether a framework could be adopted which paves the way for presently foreign listed Indian companies to move from global exchanges to exchanges situated in GIFT IFSC. With respect to direct overseas listing of Indian public companies already listed in India, SEBI is expected to clarify the mechanism by issuing detailed operational guidelines in furtherance of the framework. These notifications are not only aimed at benefitting Indian companies in fund raising but also marks a significant step in realizing the Central Government's vision of promoting GIFT IFSC as a global financial hub. Nonetheless, prudent implementation and development of a well-defined framework addressing potential loopholes are imperative for ensuring the long-term effectiveness and sustainability of direct listing.

Sebi’s rumour roulette: The proposed norms must be scrutinised for their likely impact on market dynamics

 

I have a piece with Manas Dhagat in today's Financial Express on the new norm for listed companies to come out with a clarification for certain market rumours. The full piece is reproduced below:

Introduction 

The Securities and Exchange Board of India (“SEBI”), through a consultation paper dated December 28, 2023, proposed amendments to address concerns related to market rumours. The consultation paper seeks a notable change from prioritizing material events to focusing on significant price movements for verification of rumours. Under the proposed amendments, any significant price movement triggered by a market rumour reported in the mainstream media would necessitate clarification from the concerned listed entity within 24 hours. At the outset, the extensive range of participants falling under the umbrella of 'mainstream media' poses a considerable challenge in meeting this time constraint. For instance, over 1.4 lakh newspapers and magazines registered with the Registrar of Newspapers for India (RNI), meet the criteria. Effectively monitoring all these mainstream media outlets becomes a daunting task for entities, demanding substantial resources merely for tracking these rumours.

Verifying Market rumours through price movements and the pricing of transactions

The proposed amendment places a distinct emphasis on price variation rather than the specific events outlined in Regulation 30 of LODR Regulations. The material price movement would be attributable only to the rumour, and shall require verification of the rumour by the listed entity. The consultation paper recognizes that a smaller percentage change in high-priced securities may result in a more substantial absolute price variation, necessitating distinct percentage variations for securities with different price levels. SEBI further proposes that the price fluctuations in listed entity securities be compared with the movements of Nifty50/Sensex to provide a comprehensive reflection of market dynamics. Another noteworthy change is the suggestion to verify market rumours within 24 hours of a material price movement, as opposed to the existing requirement of doing so within 24 hours from mainstream media reporting. This adjustment aims to enhance the timeliness and efficiency of addressing market speculations.

One of the major concerns is the potential for premature and potentially harmful disclosures due to the obligation imposed upon listed companies through the proposed changes. Not all market rumours merit immediate public disclosure, and such a requirement could inadvertently lead to market distortions.  For instance, in the case of preliminary merger talks, even minor leaks causing any price change could force companies to disclose sensitive information, potentially causing market disruptions and influencing negotiations adversely as the target market price would move up if the acquisition negotiations have been confirmed by the company.

SEBI proposes a mechanism to ensure that unaffected price is considered with respect to transactions relating to the securities of listed entities. There are difficulties that accompany the exclusion of price variation during the pricing of transactions. In a scenario where price movement occurs due to, inter alia, public announcements, sectoral trends, policy changes etc, in the same timeline wherein a rumour was clarified by a listing entity, such price movements shall be discounted for pricing guidelines for preferential issues of shares, Qualified Institutions Placement (QIPs), open offers etc. To protect the best interests of the investor, an approach is needed such that price variation due to genuine considerations is not discounted in transactions of listed securities.

Obligations on Directors, KMPs, senior management and designated persons

The consultation paper further raises practical challenges by imposing obligation upon the listed entity to clarify rumours pertaining to promoters, directors, and key managerial personnels (KMPs). In complex corporate scenarios, obtaining timely responses from these individuals may not always be feasible. This could result in delays in providing clarifications, impacting the credibility of the listed entity, which could potentially lead to market speculation. To ensure strict compliance, listed companies may need to cope up with an additional burden to set up separate departments solely for tracking and clarifying rumours to avoid delays. SEBI further proposes that a person may not use an information published in mainstream media as a defence for ‘generally available’, which is not confirmed, denied or clarified as it does not lead to a significant price movement, for allegations of insider trading, treating it as UPSI. The proposal tries to impose an high threshold for defence of insider trading allegations. It imposes an additional requirement upon a person who may be deemed to have knowledge of price-sensitive information to track the clarifications of listed entities even when such information is already available publicly.

The proposed amendments pose a challenge in achieving a delicate balance between regulatory oversight and allowing companies the flexibility to manage their affairs effectively. Encouraging collaboration between SEBI and exchanges for efficient rumour tracking and communication can help in establishing a seamless and responsive system by leveraging the strengths of both regulatory bodies and market intermediaries. This partnership would facilitate a more proactive approach to identifying and addressing market rumors. Providing companies with the option to request confidentiality and allowing exchanges to respect such requests would empower entities to manage information dissemination responsibly. This approach recognizes that not all market rumours require immediate public disclosure. American exchanges adopt this approach of selectively allowing confidentiality. Excessive regulation or a lack of clarity in the verification process may create an environment of uncertainty. SEBI must carefully weigh the potential consequences on investor sentiment and take measures to ensure that the regulatory framework inspires trust and confidence. 

Conclusion

The proposed amendments must be scrutinized for their potential impact on market dynamics. While these proposed amendments aim for increased transparency, they also raise concerns about potential unintended consequences such as market disruptions, micromanagement, and burdensome disclosures. In navigating the complexities of market regulation, SEBI’s commitment to an inclusive and thoughtful decision-making process will be pivotal. The financial markets require a regulatory framework that adapts to evolving challenges without compromising efficiency and innovation. As the consultation period ends, market participants, regulatory bodies, and investors alike await a framework that strikes the delicate balance needed for the sustained growth and integrity of India’s financial markets. The need for a balanced regulatory framework cannot be overstated. As SEBI reviews the feedback received during the consultation period, it should carefully consider the concerns raised and explore alternative approaches that maintain the delicate equilibrium between investor protection and market dynamism. In particular, an out for confidential treatment should seriously be considered.

SEBI'S Materilaity Maths: Quantifying impact, subjectively intact

Suyash Sharma and I have a piece in today’s Financial express on SEBI’s new disclosure norms based on materiality:

In June 2023, the Securities and Exchange Board of India (SEBI) introduced extensive changes to the regulatory framework governing disclosures for listed companies through the SEBI (Listing Obligations and Disclosure Requirements) (Second Amendment) Regulations, 2023 (“Amendments”). These Amendments are largely based on the recommendations outlined in three consultation papers released by SEBI between November 2022 and February 2023. The Amendments, introduced a quantitative threshold for determining ‘materiality’ of events/information, which trigger a disclosure requirement once such threshold is met. 

Regulation 30 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”) mandates disclosure of material events to the stock exchanges by listed entities. Specifically, Para A of Part A of Schedule III of LODR Regulations (“Para A”) provides a list of events which are deemed material and require disclosure while Para B of Part A of Schedule III of LODR Regulations (“Para B”) specifies events which are required to be disclosed based on the application of ‘guidelines on materiality’. All listed entities are required to formulate a ‘Materiality Policy’ based on the criteria specified in regulation 30(4) of LODR Regulations, which essentially lay the groundwork for the entity to determine materiality of an event/information and whether it would require disclosure.

In the Consultation Paper dated November 12, 2023, SEBI noted that several complaints were being filed against listed entities for non-disclosure of material events and failure to comply with disclosure timelines. Moreover, several other listed entities had themselves sought uniformity in guidance regarding determining materiality and disclosure requirements. There seemed to be a gap in what SEBI intended with respect to the guidelines on determining materiality versus how the entities adopted it in their materiality policies. This led to several regulatory actions against entities for non-disclosure of ‘material’ events which, according to their policy, was not ‘material.’ 

The Consultation Paper sought to fill this gap by introducing an objective quantitative threshold which would be non-discretionary, based on the value or the expected quantitative impact of the event/information. A combination of the effect of events/information on turnover, net worth and profit/loss after taxes has been envisaged by the Amendments pursuant to the discourse in the Consultation Paper. It states that an event/information, whose value or the expected impact on value exceeds the lower of: 2% of turnover, 2% of net-worth, 5% of the average of absolute value of profit or loss after tax would be deemed material and would require disclosure.

This regulation finds some precedents globally, as countries such as Japan and the UK have quantitative thresholds for events/information, the crossing of which requires a listed entity to make disclosures to their respective exchanges. The quantitative thresholds however vary across jurisdictions, for example, UK has set the limit for ‘materiality’ at variation of 5% to gross assets, profits before taxes, consideration and gross capital. Japanese regulations are very precise, listing down the various numerical thresholds for various events. For example, an event in terms of the Japanese regulation would have to be disclosed- if 3% or more damages is caused to assets in case of natural disasters, 3% compensation is paid out of net consolidated assets in case of a lawsuit, there is a 30% increase in net consolidated assets in case of a merger, etc.

The SEC in the US follows a prescriptive approach as well, by laying down a comprehensive list of events that are presumptively material and require disclosure. However, the definition of materiality in the US has been developed by courts and is not delimited by the notion of the effect on the price of an issuer’s securities. On the other hand, jurisdictions such as the EU and Brazil opt for a more principle-based approach by laying down general obligation of materiality comprising price sensitive information and various other criteria, without specifically describing the types of events that would be deemed material. 

It is pertinent to understand that these differences in regulations have evolved due to differences in the characteristics of each market and its legal and institutional history. It may be difficult in determining which approach is objectively better and can serve the investors better. No doubt, the principle-based approach leaves room for entities to exploit the lack of a standard norms and get away with inadequate disclosures under the guise of deeming events immaterial. Stringent quantitative thresholds on the other hand might lead to overregulation and become unnecessarily burdensome on entities in terms of compliance. 

SEBI’s Amendments seem to take a middle ground by prescribing a numerical threshold but keeping it broad enough to encompass a wide range of events which could qualify as material. However, it may not completely address the core issue which the regulator was trying to address, which shall be discussed below with an example. If a bright-line test approach has to be followed, perhaps going the route the Japanese regulators took may be worth looking into by providing specific thresholds for various scenarios. This would ensure that the entire process of determining materiality is completely objective in every scenario and there is no room for manipulation, although at the cost of increased compliance.

Circling back to the core issue at the heart of the Amendments, i.e., a standard objective threshold for determining materiality; the ‘expected impact on value’ clause may not sufficiently address it. Considering that entities are required to disclose even those events which may affect the prescribed values, it boils down to subjective analysis as to when an event/information becomes material. To substantiate with a hypothetical: suppose a listed entity ‘A’ is engaged in the construction business and bags contracts which are usually worth INR 30 crores. A is in the final stages of negotiation with the government of India to secure contract worth INR 150 crores to develop metro infrastructure in Mumbai for the year 2024. This contract will likely substantially increase its revenue and profitability and affect the financials enough to be classified as material in light of the Amendments. However, the regulations in Para B specify that any contracts bagged ‘outside the normal course of business’ would have to be disclosed. The question then is whether such a contract would require disclosure? The work may be in the normal course of business for A but the value of the contract and its effect on the financials would be material based on the new norms. It leads to the same issue i.e., subjectivity in determining materiality which the regulators were trying to address, albeit with more complications. The economic cost of non-disclosure versus its benefit has to be considered as well. For events which can substantially alter (positively or negatively) the financials of an entity, the business owners might be willing risk regulatory action if the cost of disclosure far exceeds the cost of non-disclosure.

To summarise, in adopting a balanced approach, SEBI's introduction of quantitative thresholds for materiality may fall short in addressing the core issue. The "expected impact on value" clause introduces subjectivity, leaving room for ambiguity in determining materiality. While the attempt to find a middle ground is commendable, potential challenges suggest that a more nuanced and specific regulatory framework might achieve the intended objectives more effectively. In addition, we should also consider cases where confidentiality is necessary and premature disclosure may hurt, say a potential acquisition. In such cases, US has an informal system of dispensing confidential treatment after a discussion with the exchanges.

Towards ease of trading: Adoption of trading plans faced significant challenges as current framework imposed stringent restrictions

Shivaang Maheshawari and I have a piece in today's Financial Express on the proposed reforms of 'Trading Plans', a means of achieving trades in advance, so as to protect oneself from charges of insider trading in the future. The full pieces is as below:

Ever since the inception of financial markets, the concept of insider trading has been subject to stringent regulatory oversight. Within this framework of regulating insider trading, trading plans emerged as a mechanism designed to facilitate trading by certain classes of insiders like senior management or key managerial personnel of a company who are consistently privy to Unpublished Price Sensitive Information (UPSI). It was recognized that insiders, even when in possession of UPSI, may need to trade for purposes such as creeping acquisitions, compliance with minimum public shareholding norms, exercise of ESOPs, etc. Thus, the concept of trading plans was introduced under the SEBI (Prohibition of Insider Trading) Regulations, 2015 (PIT Regulations) to enable such insiders to plan their trades in advance, thereby reducing the risk of trading based on UPSI.

 

However, despite their intended purpose, the adoption of trading plans faced significant challenges as the current framework imposed stringent restrictions, rendering the concept less popular among insiders in recent years. Recognizing the limitations, SEBI, on November 24, 2023, published a consultation paper outlining proposed measures to provide flexibility in provisions relating to trading plans with a view to facilitate adoption of such plans by insiders. The proposals are based on the recommendations of the Working Group (WG) tasked with reviewing existing provisions related to trading plans.

 

The consultation paper proposes a reduction in the minimum cool-off period between the disclosure and implementation of a trading plan from 6 months to 4 months, along with a decrease in the minimum coverage period requirement from 12 months to 2 months. Under the present framework, insiders formulating a trading plan are bound by a timeline of at least 18 months, encompassing a mandatory 6 month cool off period before executing trades and a minimum coverage period of 12 months. Thus presently, a trading plan is to be formulated with the assumption that a segment of the trade will extend into the 18th month which might render the trading plan unviable to an insider since he may not be comfortable planning a trade that would execute after 18 months at the then prevailing price. With the proposed reduced timelines, insiders can now formulate trading plans that align more closely with shorter-term outlooks, streamlining their strategies within a more manageable timeframe.

 

Notably, the paper proposes to eliminate the black-out period, which presently mandates the closure of the trading window for insiders between the 20^th day prior to the last day of any financial period for which results are to be announced and the second day after the disclosure of such results. It is important to note that results for each quarter are typically disclosed within a month after the quarter concludes which further prolongs the black-out period four months in a year, consequently leaving only a few trading days available in the entire year. Further, the PIT Regulations already prohibit the implementation of trading plans until the UPSI, which the insider possessed while formulating the trading plan, ceases to be UPSI.[1] Thus, in the context of trading plans, black-out periods were rendered redundant, given that the existing regulations anyway prohibit insiders from implementing a trading plan even after the cool off period is over if the information based on which the trading plan was enacted is still privileged.

 

The paper also suggests introducing a provision regarding price limits within trading plans. According to the proposal, insiders will have the flexibility to place upper and lower price limits for buy and sell trades, respectively, within +/- 20% of the closing price on the date of submitting the trading plan. These flexible price limits have been adopted in order to ensure that insiders are protected from potential losses resulting from extreme market volatility or adverse conditions since trading plans are enacted well in advance and the final trade execution might occur at a price which is unfavourable for insiders. Further, in cases where the price moves beyond the limit set out in the trading plan, the WG recommended that the insiders should be prohibited from executing the trade and an option to execute the trade at the prevailing price cannot be given as the decision to exercise such an option by the insider may be influenced by new UPSI which did not exist at the time of formulating the trading plan. Additionally, in cases where no price limit is set out in the trading plan by insiders, the trade will be executed irrespective of the prevailing price.

 

With regard to disclosure of the trading plan, the consultation paper proposes three different alternatives. The first alternative proposes masking the personal details (such as name, designation, PAN) of insiders within the trading plan, with a view to protect their privacy. However, it was noted by the WG that this measure may raise concerns about potential misuse, as concealed personal details might allow an insider to execute trades using a trading plan that was submitted by another insider. Moreover, under the PIT Regulations, there is already a requirement to disclose all trades done by the promoters/designated persons above a specified threshold.[2] Thus, names are anyway disclosed to the public post execution of significant trades. The second alternative proposes to continue the current practice of disclosing all personal details, advocating for complete transparency through full disclosures. The third alternative endeavours to strike a balance between the challenges of potential misuse and the need for privacy. It suggests a dual disclosure method – a full and detailed disclosure of the trading plan to the stock exchanges and a masked disclosure to the public, thereby mitigating any potential misuse whilst safeguarding the privacy of the insider.

 

The paper further proposes to do away with the exemption granted to trades executed under a trading plan from applicability of contra-trade restrictions. Contra trade provisions restrict designated persons from taking opposing positions or entering into buy/sell trades within 6 months of an earlier sell/buy trade respectively. The WG noted that it is difficult to ascertain the reason for an insider to plan two opposing trades within a period of 6 months. Accordingly, it was recommended that contra trade restrictions should be made applicable to trades carried out in furtherance of a trading plan in order to restrict an insider from undertaking a contra-position under the protection of trading plan provisions.

 

The proposals signify the regulator’s attempt to streamline compliance requirements related to trading plans and allows for greater adaptability in accommodating the legitimate interests of insiders who may perpetually be in possession of UPSI. By virtue of being framed in response to market feedback, the proposals appear to be more attuned to implementation challenges, without detracting from the regulatory objective of minimizing insider trading risk. The consultation paper published by SEBI stands as a testament to the regulator’s proactive approach in ensuring that regulations are framed and altered keeping in view the market feedback and interests of the stakeholders involved. However, the proof of the pie is in the eating of it. So, the amendments would have achieved their goals if a relatively large number of people sign up for such plans, which till now were impractical for reasons mentioned in the working group. These authors advocate a tilt towards privacy of the insiders, while maintaining proper audit trail and also argue against the new restrictions on contra trades, as the purpose of the trading plan is the break the causal chain between inside information and wrongful trades. Once that is achieved, a contra trade in the other direction should be kosher.

 

---

[1] Proviso to Regulation 5(4) of PIT Regulations.

[2] Regulation 7(2) of PIT Regulations.