New insider trading rules: Issues for due diligence

The Securities and Exchange Board of India (SEBI) has recently published the SEBI (Prohibition of Insider Trading) Regulations, 2015, which, once effective, will replace the SEBI (Prohibition of Insider Trading) Regulations, 1992.

An inherent problem under the 1992 regulations was the difficulty in conducting detailed due diligence on listed companies. Given that during the due diligence process a potential acquirer is likely to access unpublished price-sensitive information (UPSI), such an acquirer was liable to be regarded as an insider under the regulations and thus prohibited from dealing in securities of the listed company. Acquirers therefore had to conduct their investigations based on information in the public domain.

At the same time, acquirers seeking to withdraw open offers in relation to acquisitions of listed companies because of previously unknown red flags were not permitted to withdraw based on the reasoning that they should have conducted due diligence.

Conscious of the shortcomings of the 1992 regulations, SEBI had set up a committee under the chairmanship of Justice NK Sodhi, which recommended draft regulations to replace the 1992 regulations.

Among other changes, the 2015 regulations, in an attempt to address a long-standing industry demand, permit the communication and procurement of UPSI in connection with a transaction, provided the following conditions are met: (a) the board of directors of the target company is of the informed opinion that the proposed transaction is in the best interests of the company; (b) either the transaction entails an obligation to make an open offer under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, or the UPSI so disseminated is made generally available at least two trading days prior to the proposed transaction being effected in such form as the board may determine; and (c) the parties enter into confidentiality and non-disclosure agreements in relation to the UPSI.

Potential issues

While welcome, the provisions allowing due diligence on listed companies in the 2015 regulations might need further clarification.

Section 195 of the Companies Act, 2013 (CA 2013), prohibits any person from engaging in insider trading (which includes counselling about procuring or communicating non-public price sensitive information). The section is broad in scope and does not contain any exemption for due diligence specifically. This leads to the incongruous position where, while permissible under the 2015 regulations, disclosure of UPSI for due diligence purposes may run afoul of section 195.

Further, UPSI can be disclosed only if the target company’s board decides that the proposed transaction is in the company’s best interests. The directors will therefore have to do a tough balancing act between commercial considerations and their duties to the company and shareholders enumerated in CA 2013, leaving open the possibility of shareholders challenging the board’s decision to disclose UPSI.

In particular, secondary transactions between promoters and acquirers involving due diligence conducted through the promoters instead of the target company may be difficult to justify since, although the need for due diligence may be as compelling, the company does not benefit directly from such transactions. Where a transaction does not entail an open offer, the board will have to determine which portion of the information constitutes UPSI and is therefore required to be disclosed, providing wide discretion to the board.

The Sodhi Committee was of the view that in cases where an open offer was triggered, UPSI disclosed to the acquirer would be made available through the letter of offer. The legislative note under regulation 3(3) of the 2015 regulations provides that all information necessary to enable an informed divestment or retention decision by the public shareholders is required to be made available to all shareholders in the letter of offer. However, as per the existing format for a letter of offer under the takeover regulations, the minimum disclosures mandated in relation to the target company are with respect to relevant information from the public domain. The letter of offer may require appropriate revision by SEBI to specifically provide for disclosure of UPSI received by the acquirer. The acquirer will need to prepare the letter of offer in coordination with the board, which will decide what information constitutes UPSI to be disclosed in the letter of offer.

Finally, the question of whether the board has to make generally available the UPSI given to a proposed acquirer if the transaction is aborted may be debated.

In conclusion, permitting the communication of UPSI in due diligence exercises in the context of transactions would undoubtedly benefit public M&A, thereby ultimately benefiting the shareholders. However, as illustrated above, certain issues inherent in the conditions imposed for such communication may need to be clarified.

Puja Sondhi is a partner, Sumeet Singh is a senior associate and Kaustuv Banerjee is an associate at Amarchand & Mangaldas & Suresh A Shroff & Co, New Delhi. The views expressed in this article are those of the authors and do not reflect the position of the firm.