By Jayant M. Thakur
Chartered Accountant
SEBI has released in April, 2021 a comprehensive set of Frequently Asked Questions (‘FAQs’) on the SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘the Insider Trading Regulations’). Several aspects of the subject have been clarified. A few important ones are discussed here.
BRIEF BACKGROUND OF THE INSIDER TRADING REGULATIONS
Insider trading is an evil of stock markets that is unacceptable across the globe and stringent laws are made against such acts. The concept of insider trading is simple enough. A person close to a company is entrusted with material information about the company and he is duty-bound not to abuse it for profit. It may be information about, say, substantial growth in profits of the company. Yet he goes ahead and buys shares of the company while the information is not yet public. When the information is released, the share price expectedly rises and he thus profits. Insider trading is condemned on several grounds. It reduces faith in the markets as there arises a feeling that the market is rigged against ‘outsiders’. It also amounts to a moral wrong by such a person against the company itself which also loses. The persons who actually invest in the company and thus put their money at risk may be at a loss. Therefore, there are comprehensive regulations against insider trading.
This evil is tackled in various ways under the law. The primary policy of course is to ban trading on the basis of Unpublished Price Sensitive Information (‘UPSI’). Communication of UPSI is also prohibited. Detailed rules are laid down for control over it. A comprehensive and very wide definition of an ‘insider’ is laid down. Several categories of persons who are connected with the company or even connected with connected persons are deemed to be insiders. Further, apart from the ban in law, the company itself is required to self-regulate trading by certain insiders by a code of conduct.
It is not surprising that many areas exist where the law does not appear to be clear. SEBI has now released a comprehensive set of FAQs on the Regulations.
MULTIPLE SOURCES OF GUIDANCE – NOTES, INFORMAL GUIDANCE AND FAQs
Before we proceed to some specific and important FAQs, it is interesting to note the several attempts made to give guidance in various forms to the admittedly complex set of Regulations. The Regulations have this fairly interesting feature of ‘Notes’ to some of them. The notes attempt to explain the nature of that particular regulation. The legal status of such notes is not wholly clear.
Then we have Informal Guidance issued by SEBI in reply to specific queries raised by market participants from time to time. Coincidentally, SEBI has compiled important Informal Guidances on insider trading and released them almost simultaneously with the FAQs. But the legal status of Informal Guidances, too, is ambiguous at best.
And now we have the FAQs which again are specifically stated to be not law and not binding!
Yet, the Notes, Informal Guidances and FAQs do throw light on the complex and loosely worded Regulations and also show the mind of SEBI on how it views the Regulations. The Regulations will, of course, always rule as law but in the field of Securities Laws such supporting material has always been relevant and indeed they enrich the law.
Let us now consider some important FAQs.
DO THE REGULATIONS APPLY ALSO TO DEALINGS IN DERIVATIVES, DEBENTURES, ETC.?
The common understanding of insider trading may be that the Regulations cover dealings in equity shares. This also makes general sense since it is typically equity shares that are affected by release of material information. For example, a jump in the performance of the company affects the price of its equity shares.
However, the Regulations refer to ‘securities’ and not merely to ‘equity shares’. The term ‘securities’ is very widely defined and includes shares of all types, derivatives, debt securities, etc. Thus, the FAQs clarify that such other types of securities (except units of mutual funds) are also covered by the Regulations. Dealings in ADRs / GDRs are also clarified to be covered.
CREATION / INVOCATION / REVOCATION OF PLEDGE AND OTHER FORM OF CHARGE ON SECURITIES
It is common for shareholders to raise loans against their securities or otherwise offer such securities as security for various obligations. The securities are thus subjected to a charge which may be a pledge, a hypothecation, etc. The question is whether the creation (as also the invocation / revocation) of such a charge would amount to ‘dealing’ which is regulated?
On first impression, it would appear counter-intuitive that such acts should be regulated. Pledging of the shares does not result in transfer of risk and reward. If the price of the shares rises or falls, it would be on account of the shareholder; unlike a sale where the risks and rewards get transferred. However, an insider in possession of UPSI may, for example, pledge his shares and obtain a loan. Once the UPSI is released, which, say, is seriously negative news, the price of the shares may fall sharply. The lender thus may suffer as he will not be able to recover his loan even if he had kept a margin.
A ‘Note’ to the definition of ‘trading’ clarifies that this would include pledging, etc., while in possession of UPSI. The FAQs make this clear even further. Thus, creation, etc., of such a charge while in possession of UPSI would amount to dealing that is prohibited. However, the FAQs clarify that under certain specified circumstances such acts are permitted but it would be up to the pledger / pledgee to demonstrate that they were bona fide and prove their innocence.
CONTRA TRADES
As explained earlier, the Regulations attack the evil on several fronts. One of them is by way of ban on short-term trading by insiders which is also known as entering into contra trades within a specified period.
The basic rule is that an insider should not deal in the securities of the company on the basis of UPSI. However, to find him guilty of such an act, SEBI would have to prove several aspects. To avoid this, certain designated insiders have been banned from entering into contra trades within six months. To put this a little simply, if he purchases shares today, he cannot sell shares for six months. And vice versa. This places a brake on insiders doing quick trading which can expectedly be on the basis of UPSI.
However, some aspects are not clear and the FAQs have been released to clarify them.
Can such an insider buy a derivative and then reverse it within six months? The FAQs say he cannot, unless the closure of the derivative is by physical delivery. In other words, if he buys a future for, say, X number of shares, he can close the future by taking delivery and making the payment. However, he cannot close the future by selling it. This again makes sense because buying and selling futures / options may expectedly be on the basis of UPSI.
Can such an insider acquire shares by exercise of ESOPs and then sell them within six months? The FAQs says he can. The FAQs make some further clarifications. If he buys equity shares from the market on, say, 1st January and then acquires further equity shares by exercise of ESOPs, he can sell the shares acquired through ESOPs any time but he cannot sell the shares acquired from the market till 1st July. This would appear a little strange since usually both the categories of shares may be in the same demat account and hence not capable of being distinguished.
Then, the question is would the acquisition of shares through rights issues or public issue also amount to acquisition whereby one cannot sell the shares for the following six months? The FAQs clarify that you cannot sell the shares for such period.
Further, it is clarified that the ban on contra trades would apply not just to the designated insiders but also to their immediate relatives collectively.
IMMEDIATE RELATIVES
It is common, particularly in India, that family investment decisions are made by one person or at least jointly. One person may thus take decisions for himself / herself and other family members such as spouse, parents, children and even further. It would also be very easy for an insider to avoid the ban on trading on himself by trading in the name of a family member. Thus, the definition of insider for specified categories includes trading by ‘immediate relatives’ and they, too, are subject to certain similar regulations.
The question then is, who is an ‘immediate relative’? The definition under the Regulations creates two categories. One is the spouse, the other category is of the parent, sibling and child of such person or his / her spouse who is financially dependent on such person or consults such person while making an investment decision. The ‘Note’ to this definition clarifies this is a deeming fiction and hence rebuttable. The FAQs further emphasise this.
This clarification is important because often, being a mere relative does not necessarily mean that their dealings are in consultation with or even known to other members. A parent may not even know what are the dealings in securities of the child, particularly when the child is an adult, maybe with his own family. The same principle extends to siblings. Even spouses may want to carry out their own dealings. Hence, it would not be fair to extend an inflexible rule covering dealings of all relatives. Nevertheless, it would be more reasonable to expect, particularly in circumstances in India, that dealings of relatives are more likely based on information accessed by the insider. However, the insider can rebut this deeming fiction and establish that such persons do not consult him for their investment decisions and are not financially dependent on him.
CONCLUSION
Insider trading is not only an evil in the securities markets, but being held guilty of insider trading carries its own stigma. A person with such a track record may not get a job again in a reputed company. Investors, particularly those who are close to listed companies, would have to be familiar with the intricacies of these widely-framed Regulations so that they are not held liable under them. A Chartered Accountant in his professional dealings is very often an insider or deemed to be so by legal fiction. He may be a statutory or internal auditor, Independent Director, Adviser, Chief Financial Officer, financial adviser, merchant banker, etc., of listed companies. With his financial expertise, he would also typically deal in securities. Or he may simply park his savings in securities for his retirement. He would have to be even more careful in his dealings. The FAQs issued by SEBI thus help particularly the conservative investor who would educate himself and wade through the minefield of these Regulations safely.
