Ensuring compliance with amended insider trading regulations. By Ashwinee Oturkar

At the turn of the year, the Securities and Exchange Board of India (SEBI) notified amendments to the country’s insider trading regulations, bringing about some pragmatic amendments and much-needed clarifications.

SEBI had constituted the Committee on Fair Market Conduct in August 2017 to review the existing legal framework dealing with market abuse and ensuring fair conduct in the Indian securities market. Fair market conduct can only be ensured by prohibiting, preventing, detecting and punishing market abuse, which is generally understood to include market manipulation and insider trading, and activities that erode investor confidence and impair economic growth.

SEBI regulates market abuse through the SEBI Prohibition of Insider Trading Regulations, 2015 (PIT regulations), and the SEBI Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market Regulations, 2003 (PFUTP regulations).

The committee presented its report to SEBI in August last year. Following public consultation, the final recommendations were codified on 31 December 2018 by amending the PIT regulations and the PFUTP regulations.

The amended regulations came into force on 1 April 2019, leaving listed companies and market intermediaries in a rush to comply with the new rules.

Financial literacy

One of the most important clarifications in the new rules is the meaning of the term “financially literate”. The PIT regulations require companies to appoint a compliance officer who is financially literate, but they did not explain the term.

The amended regulations explain the term to mean a person who has the ability to read and understand basic financial statements, i.e., balance sheet, profit and loss account, and cash flow statement. The explanation was adopted from the SEBI Listing Obligations and Disclosure Requirements Regulations, 2015 (LODR regulations).

Again, in the PIT regulations, it was unclear at what point the regulations became applicable to companies that were about to get listed. The market generally understood it to be the filing of the draft red herring prospectus.

Ashwinee-Oturkar-BNP-Paribas
Ashwinee Oturkar

The amended regulations clarify that the regulations apply only to those unlisted companies that have filed “offer documents” with SEBI, the stock exchanges or the Registrar of Companies in connection with their listing, or a scheme of merger or amalgamation (with the intention of getting listed) under the Companies Act, 2013. Offer documents under the SEBI Issue of Capital and Disclosure Requirements Regulations, 2018 (ICDR regulations), means a red herring prospectus, prospectus, or shelf prospectus in case of a public issue, and a letter of offer in the case of a rights issue.

Therefore, all intermediaries will be required to include securities of the company in a grey list, or a restricted list of securities, upon the filing of a red herring prospectus for an equity public offering, a letter of offer for a rights issue, and a prospectus or shelf prospectus for a public debt issue. This clarification excludes draft offer documents. Intermediaries will also have to include securities that will get listed following a merger or amalgamation in the restricted list.

Price sensitive information

A significant change that the amended regulations make is allowing intermediaries to handle material events in accordance with the LODR regulations without necessarily triggering unpublished price sensitive information (UPSI) requirements under the PIT regulations.

The amended regulations note that all material events that are required to be disclosed by the LODR regulations may not necessarily be UPSI under the PIT regulations. Therefore, it has removed the explicit inclusion of “material events in accordance with the listing agreement” from the definition of UPSI.

Regulation 3 of the PIT regulations prohibits the communication and procurement of UPSI unless such communication or procurement is in the furtherance of legitimate purposes, the performance of duties or discharge of legal obligations. The term “legitimate purpose” is vague, but the amended regulations illustrate that it includes the sharing of UPSI in the ordinary course of business with other parties. They also require the board of directors of the listed company to formulate and publish a policy for the determination of legitimate purposes. The intermediaries should ensure that receiving UPSI shall be only for legitimate purposes, in the ordinary course of business, and within the board-determined policy in this regard. This amendment is important in light of the provisions that make intermediaries insiders upon the receipt of UPSI.

The amended regulations rightly state that instead of evaluating whether a transaction is in the best interest of a company, the board of directors may evaluate whether the sharing of UPSI for due diligence is in the best interests of the company.

They also assume abuse of UPSI when a person trades in securities while in possession of such information. The burden of proof has been shifted to the person charged.

In a welcome change, the amended regulations have provided additional defences for trades done with symmetric UPSI, bringing India in line with internationally prevalent concepts of issuing “big boy letters”. These defences include: (1) off-market inter-se transfers between non-promoters (provided that the possession of UPSI is not as a result of information shared for the purpose of conducting due diligence for acquisition transactions); (2) transactions carried out through the block deal window mechanism among persons possessing the same UPSI; (3) transactions carried out in a bona fide manner in accordance with a statutory or regulatory obligation; and (4) transactions undertaken in accordance with to the exercise of stock options.

The intermediaries will also be required to maintain a structured digital database containing names and permanent account numbers (PANs) of persons or entities that have access to UPSI. The database shall be maintained with adequate internal controls, time stamping and audit trails to ensure non-tampering.

In addition, the amended regulations specify separate codes of conduct for listed companies and intermediaries, while the PIT regulations have a common code for both. From a practical viewpoint, the provisions of the code of conduct were not equally applicable to listed companies and intermediaries. For instance, the requirement of a trading window in which employees can trade in the company stock is applicable only to listed companies and not to intermediaries. This is not applicable for intermediaries that may have access to UPSI related to multiple companies with which they have business dealings. Thus, intermediaries are required to use grey lists or restricted lists of securities in which trading is restricted. The amendment regulations specify a separate code of conduct for companies and intermediaries, which will have to be adopted by each of them. Further, listed intermediaries will have to adopt two codes of conduct – one code with respect to trading by their designated persons in their own securities, and a second code with respect to trading in other securities.

Material financial relationships

The designated persons of intermediaries should disclose, on an annual basis, the names, phone numbers and PANs, or any other identifier authorized by the law, of immediate relatives and persons with whom such designated persons share a material financial relationship. Material financial relationship is one in which a person is a recipient of any kind of payment, such as by way of a loan or gift during the preceding 12 months, equivalent to at least 25% of the payer’s annual income, excluding transactions on an arm’s length basis. This amendment is relevant from a SEBI investigation perspective, especially for trading done through third-party accounts.

Insider trading investigation is a challenging task and it is not possible to easily establish links between insiders that have access to UPSI and the persons who traded on it. The amendment is primarily based on building a database of people who are connected to the designated persons, so that the chain of connections can be traced quickly. All intermediaries will have to create and update this database.

The amended regulations have created an institutional framework to ensure that all intermediaries set up internal control mechanisms for prevention of insider trading. The audit committees of intermediaries should review compliance and formulate a whistleblower policy and a written procedure for inquiries in case of a leak or a suspected leak of UPSI. The amended regulations place responsibilities on the intermediary to initiate inquiries on its own initiative when becoming aware of a leak or a suspected leak of UPSI.

While some of the amendments, like the structured digital database and identification of material financial relationships, are onerous for intermediaries and their employees, they may aid the investigation process of SEBI. There may also be concerns of privacy around the collection of information for the databases. However, in the light of recent events in the securities markets, the amended regulations have offered several pragmatic changes. Having said this, all insiders will have to act in a bona fide manner to make the new enforcement mechanism effective.

Ashwinee Oturkar is vice president – legal at BNP Paribas. The views presented in this article are personal.