To bring Indian insider trading laws in line with global best practices, Securities and Exchange Board of India (SEBI) set up an 18-member advisory committee under the chairmanship of Justice N.K. Sodhi. In a welcome development, the committee has suggested fundamental changes to current regulations, aimed at improving predictability, clarity and deterrence. Investors in capital markets rely on the concept of fair dealing and efficient markets, and this is exactly where the malady of insider trading strikes, eroding investor confidence and the integrity of the price discovery mechanism.
The draft SEBI (Prohibition of Insider Trading) Regulations, 2013, proposed by the committee, seek to reshape the definition of 'insider'. The existing regulations are vague and open to discretionary interpretation, but the revised definition is both clearer and broader. The draft regulations define an insider in two ways: one, as any 'connected person', and two, as any outsider is in possession of unpublished price-sensitive information.
Interestingly, the definition of a 'connected person' which includes someone who has been in frequent communication with the officers of a company in a contractual or fiduciary capacity, means that a person not engaged with the company in a formal capacity can still be counted as an 'insider'. In other words, the proposed insider trading law extends even to the usual appointments of external consultants and advisors. This extended definition gives SEBI sharper teeth, and is a departure from existing regulations, under which the element of formal position has often been deemed necessary.
The committee has also extended the definition of a 'connected person' to include persons occupying statutory positions - such as a judge authorised to adjudicate a case of the company - and public servants concerned with devising a policy that could affect the market price of a company. This move could have significant ramifications, but its effectiveness would be judged by its aggressive implementation.
The draft regulations, if notified, would apply to listed companies, and companies proposed to be listed on a stock exchange. Since SEBI has jurisdiction over these companies, including overseeing the implementation of the existing regulations, it would not be hard for the regulator to implement the new insider trading norms.
However, the scope of SEBI (and thus the regulations) stops short of overseeing public unlisted companies and private companies. Further, in order to combat the sophisticated tangle in insider trading cases, the draft regulations would not be limited to equity shares and would apply to all types of securities as defined in the Securities Contract (Regulation) Act, 1956. In other words, evolved instruments such as hybrids and derivatives have now been expressly brought under the ambit of insider trading laws, apart from the usual ones such as shares, debentures and bonds.
An important feature that may be viewed as a major relief for investors, funds and other M&A players in the listed space is the recognition provided to the exercise of 'due diligence'. Prior to any takeover or investment, information asymmetries mean that investors are understandably cautious about a company's legal and financial health, and thus typically conduct due diligence on the company. Although, the legality of such an exercise was never red-flagged, it still remained a contentious point from an insider trading perspective, given that price-sensitive information is disclosed throughout the due diligence process.
However, in an encouraging move, the committee has carved out an exception for due diligence in particular cases. In transactions requiring a mandatory open offer under the SEBI takeover regulations, due diligence has been specifically permitted. In other instances as well, one can instruct due diligence; however, price-sensitive information revealed in the course of the exercise has to made publicly available two days before effecting the transaction. As an additional safeguard, the nod for this exercise would also have to be given by the board of directors of the target company, who would have to ensure that the said due diligence is in the best interest of the company.
Lastly, the probative burden of establishing an insider trading violation seems to be in congruity with the existing regulations. To prove an offence, the regulator would be required to merely show that trading was done while in possession of unpublished price-sensitive information - a standard that has been in effect since 2002 in the existing regulations (though not mapped in the SEBI Act). Yet, this standard has been recently read down to suggest that the trade should also have been 'on the basis of' such sensitive information.
The recent SAT order in Chandrakala v. SEBI is a case in point. In this case, it was held that since Section 15G of SEBI Act still carries the expression 'on the basis of', an accused cannot be held guilty merely on the grounds that trading was done while 'in possession of' unpublished price-sensitive information. It is thought-provoking that the charging section in the existing regulations is incompatible with the penal provision in the SEBI Act. Thus, any effective implementation of the new regulations would require corresponding amendments and updates to other regulations and laws, including the SEBI Act. This inherent defect needs to be worked out by SEBI at the earliest, for it seems to be a potential loophole, as the Chandrakala case demonstrates.
Certainly the committee has done a good job by updating the rules of an ever-evolving game. In the past, players have often pulled a fast one on the umpire (read: SEBI) and the audience (ordinary shareholders). With the revamped framework, will the umpires be able to enforce the rules? Or will it just be another piece of legislation? Let's hope for the best.
Sidharrth Shankar is a Partner and Rishabh Gupta is an Associate at J. Sagar Associates, Advocates and Solicitors. Views are personal.