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What Sebi’s new insider trading rules mean, and where they fall short

The Insider: Good movie (but not about trading)
The Insider: Good movie (but not about trading)
Most financial regulations require constant modifications to keep pace with the ever evolving market dynamics. Insider trading is no different, explain Khaitan & Co’s Ganesh Prasad and Sanjay Khan.

Why is everyone talking about insider trading right now?

Insider trading as a subject – as well as the laws around it – has always generated interest.

In a nutshell, insider trading prohibits ‘connected persons’ (i.e., anyone who has access to a company’s insider information) from dealing in that company’s publicly traded shares. If convicted, the insider may go to jail for up to 10 years or be required to pay a fine of up to the higher of Rs 25 crores or thrice the amount of profits made.

But as you might imagine, that’s just scratching the surface and there are lots of possible complications. Those come about, in no small part, because unscrupulous traders will always have incentives to find new loopholes in insider trading laws or ways for them to continue making millions in new and secretive ways that will avoid prosecution.

On the other hand, insider trading ruins the efficient functioning of the stock markets and can lose honest investors millions.

It’s indeed a fascinating area.

But there is something particularly special going on now, right?

Yes, the Securities and Exchange Board of India (SEBI) has been busy.

On 15 May 2015, new insider trading regulations (i.e., the Securities and Exchanges Board of India (Prohibition of Insider Trading) Regulations, 2015) will replace the existing regulations (i.e., the Securities and Exchanges Board of India (Prohibition of Insider Trading) Regulations, 1992).

Do people like the new regulations?

The new regulations appear to be promising, more practical, and largely in line with the global approach to insider trading. They also seem to be equipped to ensure better compliance and enforcement.

It is, therefore, only natural for everyone to be talking about the new regulations.

Why did SEBI feel like it had to change things up?

Most financial regulations require constant modifications to keep pace with the ever evolving market dynamics. Insider trading is no different.

The existing regulations were notified in 1992.

In the past two decades, the laws and understanding of insider trading (both globally and in India) have evolved significantly.

Despite several amendments, certain provisions of the existing regulations were proving to be (albeit unintentional) impediments in allowing for smooth transactions of listed securities.

For example, the existing regulations do not explain properly how to regulate due diligence. This becomes an issue because financial investors, such as private equity funds, usually invest only after conducting thorough legal and financial investigation on the target company.

More often than not, this results in such investors getting access to insider information about the target company prior to buying the shares, which in turn results in the offence of insider trading.

Similarly, in the absence of a specific definition, nobody clearly understood what is meant by ‘trading’.

SEBI, therefore, constituted a committee under the chairmanship of Justice NK Sodhi to undertake a comprehensive review of the existing regulations, as a result of which, the new regulations came into being.

It sounds like some housecleaning was much in order. Have the new rules fixed those issues?

Yes, the new regulations are definitely a big step forward.

For example, among other things, the new regulations specifically define ‘trading’, prescribe a more structured disclosure regime, and permit due diligence exercises when someone wants to buy a listed company (subject, of course, to appropriate disclosures and compliance).

So all is hunky dory then?

Apart from the housecleaning and simple fixes, the new regulations also bring about some significant changes that will have very practical effects that are perhaps not very well understood yet, as is to be expected in an area this complex.

For instance, in addition to listed companies, the new regulations apply even to companies that are ‘proposed to be listed’.

What does 'proposed to be listed' mean? Does that mean that if I get some insider information about a company which intends to go for an IPO in a couple of years, I wouldn't be able to trade in the securities of such company?

Unfortunately, it’s really unclear as to what is meant by the phrase ‘proposed to be listed’. It may be intended to cover companies that have filed draft red herring prospectus with SEBI.

Well that sounds like it could cause issues. What else is there?

The definition of ‘connected persons’ now covers anyone who has a connection with a company that is expected to put him in possession of insider information.

The existing regulations covered a specific set of people under the definition of ‘connected person’. However, the new regulations cover even public servants such as judges and bureaucrats (who may not have any professional relationship with the company, but who may be aware of a judgment or policy which, when made public, may impact the price of shares of the company).

Also, the new regulations require the compliance officer of the company to monitor trading by employees and connected persons. Given the wide ambit of the definition of ‘connected person’, it may be an uphill task for the compliance officer to do so.

So I can’t trade while in possession of insider information. What if I am a director of a company, for example, and will likely always be in possession of some insider information or other? Does that mean I can’t trade at all?

No, you can.

The new regulations allow for the formation of ‘trading plans’. Under this, you can formulate a trading plan, get it approved by the compliance officer, and trade in accordance with it.

However, such trading needs to comply with certain specific conditions to ensure that you are not misusing any insider information.

For instance, the trading plan would be disclosed to the public and you cannot trade within 6 months of such public disclosure. Further, once approved, you cannot back-out or deviate from the plan.

Are there any other issues with the new rules?

Yes, a few.

The new regulations prohibit not only dealing in securities when in possession of insider information, but also the communicating or procuing insider information, except where this is in furtherance of, among other things, ‘legitimate purposes’.

The phrase ‘legitimate purposes’ has not be defined. Accordingly, it is unclear what purposes are legitimate enough to alllow insider information to be communicated or procured.

The new regulations also require companies to come up with codes for regulating, monitoring and reporting trading by employees/connected persons and fair disclosure of material information (such as financial information, key business decisions, etc.) by the company.

Compliance with these codes appears to be very cumbersome, particularly for companies with large shareholder and employee bases. For instance, in a company with 10,000 employees, it would require dedicated resources just to monitor trading activities of the employees.

Will SEBI clarify some of these issues before the rules kick in?

It looks highly unlikely that there would be any clarification before the new regulations kick in.

However, let’s hope the regulations are interpreted by courts/authorities in a progressive manner, and timely clarifications are issued by SEBI going forward.

Trade safely!

Ganesh Prasad is a partner and Sanjay Khan is an associate at Khaitan & Co in Bangalore

A version of this article was first published in Mint.

Mint's association with LegallyIndia.com will bring you regular insight and analysis of major developments in law and the legal world.

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