SEBI (Prohibition of Insider Trading) Regulations, 2015: An Understanding of Insider Trading Regulations in India and Major Obstacles in its Implementation

Introduction

Insider trading can be understood as an illegal practice of trading in the securities of the company in a way that has been influenced by having certain “Unpublished Price Sensitive Information” (hereinafter referred to as “UPSI”), which is unknown to the public at large. A UPSI is any information which is not generally available to the public at large and once it is published, it might have an effect on the prices of the securities. These two features act as a test to identify which information can be termed as UPSI.¹

Insider trading has been a root cause of many monetary scams which have become a household name in the share market. It is considered as one of the important areas to be effectively and efficiently regulated for not only providing for a more transparent and fair return to the shareholders of the company but also to maintain public confidence and reliability in the share market to retain the investors. The Companies Act, 1956² did not have any provision for insider trading and the Securities and Exchange Board of India (hereinafter referred to as “SEBI”), established in the year 1988, became the regulatory authority to keep in check any circumstances of insider trading. Section 12-A³ of the SEBI Act, 1992 empowers SEBI to regulate matters of insider trading and under this section it is also empowered to publish regulations for regulating insider trading. Due to the power bestowed in SEBI by the virtue of this section, the SEBI Prohibition of Insider Trading Regulations, 2015 (hereinafter referred to as “the PIT Regulations”)⁴ came into effect.

The first Regulations for the same were published in 1992 and they lacked a robust mechanism to trace instances of insider trading owing to the several loopholes in them.⁵ As a step in furtherance to cure this issue, the PIT Regulations, 2015, further amended in 2018, were formulated to ensure a more comprehensive and broad mechanism to check for insider trading and ensure no such instances are left unattended.

This paper aims firstly at highlighting the main features of PIT Regulations and secondly, analysing the loopholes in the Regulations which have been a hindrance in its systematic operation.

Key features of Insider Regulations by SEBI and their trajectory

On a reading of the Regulations as a whole, the general pattern that can be gathered from it is that the legislative intent behind these amended regulations was to broaden the coverage and interpretation of these Insider Trading Regulations. This has been done in several ways such as:

1. Providing for inclusive definitions of “connected persons”, “designated persons”, UPSI, “trading”.

2. Including various safeguards to the exceptions of trading plans and disclosures in fiduciary capacity for the best interests of the company which are in contrary to the general rule.

3. Providing for special notes specifying the legislative intent under most of the regulations which need further interpretation and have been left to the discretionary power of the Board to define. These notes help in guiding the Board to take steps in furtherance of such legislative intent and to uphold the purpose of the Regulations.⁶

Expanded scope

The Regulations have also been extended to not only the “listed securities” but also “proposed to be listed securities”. This has been to prevent any insider, who is in possession of information regarding these “proposed to be listed”, from trading in them as such trading can have a potential effect on the price of securities and market-decisions made by the shareholders, causing them undue advantage to maximise profits and returns from such securities. This was previously not mentioned in the 1992 SEBI Regulations⁷ on Insider Trading. Further, by a recent amendment to the PIT Regulations in 2022, SEBI introduced Chapter II-A to the Regulations which provides for restrictions on trading by insiders in the units of mutual funds or any communication regarding it. Units of mutual funds are treated in the same manner as that of securities when it comes to matters of insider trading and any insider engaging in trading of mutual funds while being in possession of any UPSI regarding them shall be considered to be in violation of these Regulations.

Nature of UPSI

In Samir C. Arora v. SEBI, it was established that in order to hold an insider liable for insider trading, the UPSI needs to be true. Disclosure of an UPSI which ultimately turns out to be false will not come under the ambit on PIT Regulations as it does not fulfil the test of an information qualifying as an UPSI i.e. it does not affect the prices of the securities in consideration.⁸

Penalty

Section 15-G⁹ of the Securities and Exchange Board of India Act, 1992 provides that any person violating these regulations shall be penalised with a fine not less than 10 lakhs which can be extended up to 25 crore rupees or three-times the profit made out from insider trading transaction, whichever is higher.

Discretionary power to the Board of Directors

Another prevailing trend in the Regulations are the wide discretionary powers that have been given to the Board of Directors and compliance officer for deciding matters related to insider trading. Regulation 3(3) provides for communication or procurement of UPSI shall not be in violation of these regulations provided that such communication or procurement entails an obligation to make an open offer under the Takeover Regulations provided that the Board of Directors are convinced that such a decision has to be taken for the “best interests of the company”. What constitutes “best interests of the company” has neither been defined in the Regulations nor has been provided for in the legislative notes. Hence, it has been left to the Board to decide on it.

Code of conduct

Similarly, the code of fair disclosure and conduct, which has to be formulated as per Regulation 8 has been left at the discretion of the Board to decide and can vary from company to company. Though, Schedule 2 of the Regulations provides for a format of such code of conduct, it is not mandatory for the Board to follow the same.

Structure digital database

Among the various disclosure procedures provided for in the Regulations, constituting a Structured Digital Database (SDD) has been mandated by Regulation 3(5). This database is supposed to maintain records of persons who are in possession of UPSI of the company.¹⁰ This has been mandated to ensure that no insider trades in securities while in possession of UPSI for personal gains, being detrimental to the interests of the company and other shareholders and also serves as evidence in court while deciding cases on violation of these regulations. Such a database has to be maintained in a non-tamperable manner and must include timestamping and audit trail to ensure transparency and avoid any fabrication of data through editing. This implies that SDD has to be maintained in a trusted database software and cannot be done on software such as MS Word, MS Excel, MS PowerPoint because data can be edited on these softwares. Further, the database has to be maintained by the compliance officer of the company or any other person authorised by the Board, for a period not less than 8 years after the aforesaid transaction is completed. Such a timeline can be extended if any SEBI proceedings or investigation are taking place in which case the additional time taken by SEBI to complete its investigation/proceedings plus at least 8 years from the time the transaction was completed becomes the mandated time period to maintain SDD. A compliance certificate has to be filed by the Compliance Officer with SEBI which acts as a certification regarding maintenance of SDD of the company.

Trading plan

The Regulations have been framed in a way that insiders cannot trade in securities of the company while they are in possession of UPSI regarding them. Though, people who are in the key managerial position of the company such as the directors and promoters are always in possession of UPSI as they have to carry out decision-making responsibilities and other fiduciary duties for which access to UPSI is always needed. To enable them to trade in securities, Regulation 5 provides for a trading plan which is an exception to the general rule of insiders being prohibited from trading in securities while in possession of UPSI. The legislative note under this regulation explains that a trading plan is a plan that is formulated much before it is to be executed on a future date. This ensures that the trading plan is decided much before UPSI related to those particular securities comes to being. Regulation 5(2) provides for a cool-off period of six months to such trading plan where the insider shall not entail the commencement of the trading plan earlier than six months from the public disclosure of the plan. This is done so that the UPSI connected with the security becomes public and everyone has access to it in a non-discriminatory manner and any additional UPSI which comes into being later does not affect the trading plan disproportionately. Further, such trading plans are barred from entailment during the time close to declaration of financial results and the trading has to go on for a period not less than 12 months. This has been provided to ensure that sensitive times when an insider may potentially be in possession of an UPSI is barred from trading and such trading plans do not occur frequently and defeat the purposes of the Regulations. The emphasis on preserving the purposes of the Regulations has been strengthened by making sure that once a trading plan has been formulated and approved by the compliance officer, it cannot be revoked. This removes any possibility of an insider not wanting to execute the trading plan anymore by possessing an UPSI later which indicates that there is a possible situation of incurring loss if the trading plan is executed. The insider formulating a trading plan has to get a pre-clearance from the Compliance Officer to check if the trading plan consists of any possible violation of the Regulations and the Compliance Officer has to notify such plans to the stock exchanges on which those particular securities are listed.

These were few of the relevant features of the Regulations which indicate a positive step towards curbing instances of insider trading and building public confidence in the market by ensuring no one is unduly advantaged in the entire process. Though, on an analysation, there are certain leakages in these regulations which can be detrimental to the entire purpose behind it. These have been highlighted in the next part of this paper.

Analysing the Regulations along with other relevant provisions of the Companies Act, SEBI Act and Master Circulars published by SEBI

Applicability

The first and foremost hindrance in the applicability and coverage of these Regulations is that is it only applicable on national public companies and its individuals. Private companies and foreign nationals are excluded from its purview. This expressly limits the efficiency and effectiveness of the Regulations as only a few per cent of all the insider trading which takes place would be traced. Even though one may argue that the stock market runs on the securities that are listed on the stock exchange, influential decisions from the individuals of these private companies or foreign nationals who are actively involved in market-decisions might have a price-sensitive effect. Moreover, cases such as that of Sahara India serves as an example for this where a strong influence on the market decisions was felt by actions and decisions of private companies and foreign investment by foreign nationals.¹¹

Coverage

One of the contentions regarding the Regulations have been regarding the people who are covered under these regulations. In general parlance, people who hold Key Managerial Positions (KMP) such as directors, promoters, Chief Executive Officer (CEO), Company Secretary (CS), etc. and other employees of the company are considered as insiders. Regulation 2(1)(g) of the PIT Regulations, 2015 provides that an insider can be not only a “designated person” as defined by the Regulations but also a “connected person” or any other person who is in possession of or has access to UPSI. Connected person is defined in Regulation 2(1)(d)(i) as any person who directly or indirectly, permanently or temporarily, has been in frequent communication with the company in professional relation, fiduciary capacity, employment contract, or any other form which establishes a ground for believing that the person could have been in possession of an UPSI, he/she will be considered as a connected person. Regulation 2(1)(d)(ii) also provides a list of people who can be considered as “connected persons” under the Regulations and this also includes an immediate relative of connected persons.¹² This implies that even non-employees of the company or people unconnected to the company can be considered insiders for the purposes of these regulations if they possess UPSI. The meaning of an insider was broadened specifically to ensure persons such as accountants, lawyers, advisors, banks, agents, brokers, etc., who often have UPSI with them due to the nature of their job, are also covered under these regulations and no unregulated trading takes place by them as a result of being instructed by the designated persons as per their whims and fancies.¹³ While this is a much-appreciated step for broadening the scope of the Regulations, Regulation 2(1)(d)(ii) is not inclusive in nature. This may act as a hindrance in including any person who might be considered a connected person but is left outside the purview of the Regulations due to the non-inclusive nature of this regulation. With increase in outsourcing of business activities and technological advancement, inclusivity is a desired feature to uphold the purposes of the Act even with changing times.

The Regulations come well-equipped with Notes to clarify legislative intent, which is an appreciated step.¹⁴

Definitional issues

These notes showcase the inclination of Indian laws leaning towards substance approach instead of form approach, a change that has been noted in recent years. Though, there are a few definitional issues in the Regulations despite these comprehensive notes present. In Regulation 3(3), the phrase “best interests of the company” has been used which has to be determined by the Board of Directors through their discretionary power. While this can be a feasible provision to allow for flexibility and inclusion of diverse situations, it could also result in the purposes of the Regulations being compromised as these discretionary powers remain unchecked. Even though one can argue that SEBI can regulate the matter if the Board takes a decision under the ambit of “best interests of the company” while violating the Regulations and stop the occurrence of any such situation, the timeframe involved in it makes it the real issue. By the time SEBI is intimidated of the violation of regulations and conducts its investigation and proceedings, a lot of damage must have already been done with many shareholders and investors being unfairly disadvantaged for that time period. This goes against the ultimate purposes of the Regulations and would also result in lack of public confidence in the regulatory. Hence, it is desirable to provide for a basic outline as to what constitutes “best interest of the company” and make it an inclusive provision to allow for the addition of more situations provided it is passed through a clearance from the compliance officer. Such a compliance officer will ensure that the decision taken by the Board is not in violation of the Regulations and provide them with clearance accordingly. This way it is also ensured that the duty of the directors, as prescribed under Section 166¹⁵ of the Companies Act, 2013, is also upheld.

Mens rea and evidentiary value

Another issue that has been circumventing the Regulations on insider trading has been the question of evidence and mens rea i.e. intent. In V.K. Kaul v. SEBI the Court used circumstantial evidence to decide if Mr Kaul has violated the Regulations or not.¹⁶ The Court highlighted that it is difficult to procure direct evidence in cases of insider trading due to multiplicity of transactions as well as many steps in the procedure being unrecorded/unofficial. Hence, looking at the relationship between the parties, the sources of receiving insider information, the involvement of different corporate entities with each other (holding company and subsidiary company relationships), control and management of the company, Articles of Association, frequency of communication between the parties (call and data records) etc. serve as an important source of evidence. The Court also emphasised on the threshold of preponderance of probability being high in insider cases as most of the times, it is merely circumstantial evidence on which the guilt is decided on. Though, it is unclear if this is the mechanism adopted in every case as in cases such as Cyrus Investments (P) Ltd. v. Tata Sons Ltd., the NCLT refused to look into the allegations of insider trading due to lack of any direct evidence present regarding the same.¹⁷

In Rakesh Agrawal v. SEBI, the Court laid down that motive can be an important element in determining the guilt in insider trading cases.¹⁸ That is to say that if an insider trades in securities while being in possession of an UPSI, he could be acquitted from the violation of Insider Trading Regulations if he proves that his intent behind the same was not to maximise profit or any other personal gains. Such an interpretation of the law becomes problematic especially when the cases are mostly being decided on circumstantial evidence. Moreover, Regulation 4 allows for off-market trading of securities between persons who are in possession of the same UPSI. Such a provision ignores the possibility of such trade also affecting the market situations and other investors when such persons have high influence in the market or when they belong to two different corporate entities while they are about to merge or demerge. The reading of this provision with the inclusion of intent as an element to determine guilt, the resultant effect is that there might be majority of cases where a lot of insiders might get away with violation of these regulations by proving that they took such decision for the “best interest of the company” or without the motive of profit maximisation. Hence, it is desirable if the Regulations include a provision guiding the applicability of mens rea and the type of evidence to be used while deciding on insider trading cases.

Inclusion of mutual funds unit under PIT Regulations

With a recent consultation paper released by SEBI in October 2022, there is an attempt to bring mutual funds under the ambit of PIT Regulations.¹⁹ The need for this amendment was realised during the pandemic when a number of well-known mutual funds decided to wind-up its schemes, affecting large number of people who invested in them. Around a reasonable time before the announcement of winding-up was made public, the major investors of these schemes withdrew from such schemes, indicating a presence of forward-running practices taking place. With these incidents taking place in the past as well, SEBI is attempting to take a strong stance to tackle this issue and include mutual funds in PIT Regulations.

Though, there are several obstacles involved in this route which remain unaddressed as of now. Firstly, the difference in nature of securities listed or proposed to be listed on stock exchanges and mutual funds create uncertainty as to how will these mutual funds be interpreted under the Regulations. In the case of the former, connected/designated persons are separately or jointly liable with investment spread across a wide-section of the investors who may have a say in decision-making process or influencing the pricing of the securities while being in possession of UPSI whereas in the latter, investment is in a pooled form where investors rarely are any say in the decision-making process even after being in possession of any UPSI related to the mutual fund and moreover, their possession of such UPSI may not affect the net asset value of the scheme. Secondly, the very broad definition of “connected persons” under the PIT Regulations makes it even more uncertain as to who can be held liable if mutual funds are included under the Regulations, unreasonably increasing the disclosure and compliance requirements under it. Further, as per the consultation paper released by SEBI, mutual funds are included in the Regulations as a completely different chapter in itself with the lack of clarity as to whether the provisions under other chapters of the Regulations will be applicable to mutual funds or not. These hurdles call for more clarity from the regulator’s end to either amend the Regulations in a way that it provides a clear understanding as to how will mutual funds be included and interpreted under the Regulations or to make a separate regulation for the same.

Penalty

Lastly, it has to also duly be noted that the penalty imposed by these regulations might be a meagre amount for many insiders who engage in insider trading as the amount they receive from such an insider trade might be multifold to the maximum penalty of 25 crore rupees. Thus, this becomes more of a “cost” for them rather than a “penalty”. Such penalty ignores the fact that the effect of the Regulations is not uniform on every corporate entity/ individual it covers and other relevant factors which are an obstacle to uniform application of the Regulations such as the differences between standalone firms v. business group firms, high market power firms v. low market power firms and emerging markets v. developed markets. In such scenarios, to bring in the real effect of a penalty, penalty other than monetary ones need to be prescribed to ensure that insider trading is prohibited from its root cause and not just at the surface level.²⁰

Conclusion

Insider trading has been one of the major causes of concerns in the market at large and SEBI has been engaged in regulating the same since 1992, amending the Regulations from time to time and publishing circulars for the same to ensure every loophole in the regulating mechanism is covered. The PIT Regulations, 2015 have provided for various feasible provisions for developing a wide coverage and applicability of the Regulations and has been successful in tracing insider trading to some extent. Though, there are some prominent leakages that are still prevalent and have been a hindrance in the systematic operation.