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Can a Director be punished for violating the Company’s Code of Conduct on insider trading? What is the implication if the law only requires that the Company frame a Code, but does not make violations of the Code punishable? The answer to this question is not just critical for all listed companies that have framed fairly stringent Code of Conduct for insider trading, but is also relevant as a fundamental question of law. It should make companies also pause before drafting any Code of Conduct — whether for insider trading or otherwise. This question arises for consideration on account of a recent decision of the Securities Appellate Tribunal (‘SAT’) which has held that violation of the Code of Conduct is punishable with penalty. And, if extended to its logical end, this conclusion would imply that other penal consequences could also follow.
It is worth discussing the background and general context of this issue first. Generally, SEBI provides detailed Regulations for orderly development of capital markets, etc. It regulates and punishes evils such as price manipulation, fraudulent market practices, insider trading, etc. and also provides for other regulations for investor protection, etc. SEBI did attempt to delegate some self-regulatory powers to bodies such as intermediaries, associations and even the companies themselves. The objective seemed to ensure self-discipline so that the burden on SEBI is reduced and SEBI comes into the picture for serious violations or where the self-regulating body itself is negligent. To that effect, the idea was also to circulate model Codes of Conduct which the self-regulating body could follow. Such model also helps in creating a sense of voluntary self-discipline.
However, SEBI often does lay down such Code of Conduct as part of Regulations to be followed without option and in other cases, it requires that the Company frame a Code and gives a model draft. Thus, for example, in cases of stock-brokers, the Code of Conduct laid down for them is prescribed as part of the Regulations which they have to follow and in case of violations, penal consequences follow.
In the SEBI (Prohibition of Insider Trading) Regulations, 1992 (‘the Regulations’), companies and other entities were required to draft a Code of Conduct (for which a model was given) and then they were left to enforce it in the manner they deemed fit. It is important to note that the basic act of insider trading was defined in great detail in the Regulations itself. Insider trading was made punishable with penalty, apart from other penal consequences. However, to ensure that even companies take preventive steps to ensure that insider trading does not actually happen, a ‘model code of conduct’ was provided and the Regulations stated that the companies “shall frame a code of internal procedures and conduct as near thereto the Model Code . . . . . without diluting it in any manner and ensure compliance of the same”. Further, the companies were also required to “adopt appropriate mechanisms and procedures to enforce the Code”. It was also clarified that “action taken by the (company) for violation of the code . . . . . . shall not preclude (SEBI) from initiating proceedings for violation of these Regulations”. The Code consists of procedures like ensuring control over sensitive information, procedures for purchase/sale of shares by the employees, etc., prohibition on sale/purchase in short gaps, etc.
The Code itself provides that for violation of the provisions of the Code, the person concerned “may be penalised and appropriate action may be taken by the company” and “shall also be subject to disciplinary action by the company” of various types which may include wage freeze, etc.
Clearly, if the Company does not frame such a Code of Conduct, it would have violated the Regulations which would result in appropriate penal and other action. However, the question then is if an employee or director violates the Code, and it is not a case of insider trading under the Regulations, can SEBI take action against such employee/director? That was the issue raised in the present case.
The facts of this case can be summarised as follows. The listed company had proposed to carry out certain restructuring transactions which were price-sensitive. The Board of the Company met and passed resolution for such transactions. The Company duly disseminated to the stock exchanges the fact that such decisions were taken. The Managing Director of the Company (‘the MD’), however, sold shares of the Company.
Insider trading is essentially an act where an insider deals in securities of a Company on the basis of unpublished price-sensitive information. Now it is important to note that in the present case, there was no allegation that the MD engaged in insider trading. However, he sold the shares before expiry of 24 hours of the outcome of such Board Meeting being made public. Thus, he was alleged to have violated the Code of Conduct of the Company.
The MD resigned as a Managing Director of the Company and thereafter the Company did not take any action against him apparently satisfied with his voluntary act of resigning as the Managing Director.
However, SEBI initiated action against the MD alleging that he had violated the Code of Conduct. The MD’s contention that violation of the Code was not violation of the Regulations was not accepted and a penalty of Rs.1 crore was levied on him. The MD appealed to SAT which upheld the order of the Adjudicating Officer, but reduced the penalty to Rs.25 lakhs.
Some important extracts from the SAT order are given in the following paragraphs (emphasis provided).
“It needs to be noted that the charge against the appellant in the show-cause notice is of violating Regulation 12(1) read with clause 3.2-3 and 3.2-5 of the code of conduct specified under Part A of Schedule I of the Regulations. In the impugned order, the appellant has been held to be guilty of violating the provisions of the code of conduct only. There is no allegation of insider trading against the appellant. It is not in dispute that the appellant had sold shares within the period when trading window was closed and thus violated the code of conduct prescribed by the company in terms of the obligations imposed upon it under the Regulations. The case of the appellant is that such violation of the code of conduct does not amount to violation of the provisions of the Act or the Regulations framed thereunder and hence not punishable by the Board. It is for the company alone to take action against the appellant. The question that needs to be answered, therefore, is whether violation of the code of conduct formulated by the company in compliance with the requirements of Regulations amounts to violation of Regulations
. . . . . Paragraph 5 of the code of conduct provides for reporting requirements for transactions in securities by all directors/officers/ designated employees and the compliance officer of the company is required to maintain records of all such declarations in the appropriate form.
(The Code) also provides that any sale/purchase or acquisition of shares and securities by all directors/ officers/designated employees shall not be allowed during a period of one exclusive day and conclude one exclusive day after the specified corporate action including declaration of financial results and declaration of dividends.
9. Having considered the submissions made by learned counsel for the parties and after going through the records and the provisions of the regulations referred to above, we are of the considered view that the only possible conclusion that can be arrived at is
that the code of conduct prescribed by the company for prevention of insider trading as mandated by the Regulations for all practical purposes is to be treated as a part of the Regulations and any violation of the code of conduct can be dealt with by the Board as violation of the Regulations framed by it. It needs to be appreciated that each company may like to add certain activities regulation of which may be necessary for preservation of price-sensitive information. The Board, cannot foresee all such contingencies and, therefore, it has laid down model code of conduct prescribing bare minimum conduct expected from the directors/ designated employees of the companies. The framing of code of conduct as near to the model code of conduct specified in the Schedule to the Regulations is mandatory for each company. The use of the word ‘shall’ makes it abundantly clear that this is a bare minimum conduct expected from the employees of the company. Paragraph 6 of the model code of conduct also makes it clear that the action by the company shall not preclude the Board from taking any action in case of violation of the Regulations.
…..the different nomenclature given to the code of conduct as a model code of conduct is to provide sufficient leverage to the company to make additions to the bare minimum code as prescribed in the Schedule to the Regulations.
11. The provisions of the Regulations have to be interpreted keeping in view the aims and objectives of the Act. The main object of the Act is to protect the interest of investors in securities and to promote the development of and to regulate the securities market. In case the interpretation given by learned senior counsel for the appellant is accepted, it may lead to a situation where a person is not punished by the company for violating the code of conduct based on the model code of conduct prescribed in the Regulations and the Board finds itself unable to take action because the code of conduct is framed by the company. In fact this is what has precisely happened in this case. The company vide its letter dated February 11, 2008 has informed the Board that the appellant resigned from the office of the Managing Director and it was not possible to persue any action against him and the company decided to close the matter…. The purpose of the insider trading regulations is to prohibit trading by which an insider gains advantages by virtue of his access to price-sensitive information. The evil of insider trading is well recognised. A construction should be adopted that advance rather than suppress this object. To adopt the construction as suggested by the learned senior counsel for the appellant would result in allowing insider trading within a period set by the Board or by the company during which no trading is permissible.
12. We are, therefore, of the considered view that violation of the code of conduct, as framed by the company in accordance with the mandates prescribed in the Regulations, is nothing but part of the Regulations and any violation thereof is punishable by the Board also as violation of the Regulations in addition to such action that may be taken by the company. Any other view taken in the facts and circumstances of the case will defeat the very purpose of the Regulations in question.”
It is submitted with respect that the decision of SAT is erroneous in law. It goes against the wording of the law as well as the nature of the Code of Conduct prescribed in the insider trading Regulations. The only requirement under the Regulations is that the Company should frame the Code of Conduct. If the Company does not frame the Code of Conduct, there is a violation by the Company. If the Company frames the Code of Conduct and if an employee violates it and the Company does not take action, then too the Company may be held liable. However, there is no requirement in the Regulations that employees should follow the Code and if they do not, there would be punishment. Neither is there such a requirement nor is any penal consequences provided. It is not clear how an act can be punished when there is no requirement in law to follow it and also no requirement in law providing for punishment.
If SEBI is deemed to have the power to punish violations of the Code of Conduct, then the provision that the Company ‘may’ take action for violation of the Code of Conduct and this not preclude power of SEBI to punish for violations of the Regulations may be redundant.
The concern of SAT that persons may get away with insider trading if such an interpretation is taken is totally misplaced. The Regulations clearly cover cases of insider trading. In this case, no allegation at all was made of an act of insider trading. The violation was of a procedure to prevent insider trading. If there was no insider trading at all, then there is no question of any punishment. A preventive provision is to ensure that insider trading does not take place. If a person does not follow the preventive step, then the Company may punish such person. If the person does not follow the preventive step and also commits insider trading, then the Company and SEBI both may punish such person. But merely for not carrying out the preventive step which is regulated by the Company and when there is no insider trading at all, SEBI has no role to play.
Insider trading is certainly a bane in the capital markets and needs sternest of action. However, it is submitted that this decision needs reconsideration. It creates a wrong precedent and uncertainty as to the manner in which laws would be framed and enforced.
