Sophisticated New Securities and Exchange Board of India Insider Trading And Disclosure Regulations Present Interesting Comparisons To US Securities Laws
For India Business Council newsletter March 2015
With RAJIV DHARNIDHARKA
On January 15, 2015, the Securities and Exchange Board of India ("SEBI") published "SEBI (Prohibition Of Insider Trading) Regulations, 2015." The regulations take effect on May 15, 2015, replacing previous regulations issued in 1992. The regulations affect not only "traditional" insiders (corporate officers, directors and employees), but also professionals who work with such companies such as financial advisors, auditors and attorneys. To assist practitioners who may be familiar with the US securities laws and Securities & Exchange Commission ("SEC") regulations in understanding the new SEBI regulations, this article compares the most significant aspects of the regulations to their corresponding provisions in US law.
Who and what is regulated: trading
Well-defined, narrower territorial effect. Most of the key SEBI regulations refer to companies listed or proposed to be listed on a "stock exchange" and\or the securities of such companies. "Stock exchange" is not defined in the new regulations, which means that the prior statutory definition applies. Regulation 2(2). Chapter I, Section 2(73) of the Companies Act of 2013 defines "recognized stock exchange" by cross-reference to Section 2(f) of the Securities Contracts (Regulation) Act of 1956. That statute, in turn, defines the phrase as "a stock exchange which is for the time being recognized by the Central Government under section 4...." Per SEBI's Internet site, there currently are twenty-one recognized stock exchanges, all of which are in India. By comparison, after considerable debate, courts have held that the US securities laws generally extend to fraud involving securities traded on any US exchange and/or securities transactions that occur in the US.
Sophisticated phrase "unpublished price sensitive information." The phrase "material nonpublic information" is used throughout US law to label the type of information that may give rise to insider trading or securities fraud liability if misused. The corresponding phrase in the SEBI regulations is "unpublished price sensitive information," meaning information relating to a company or its securities, directly or indirectly, that is likely to materially affect the price of the securities upon becoming generally available. Regulation 2(1)(n). This sophisticated approach places the functional significance of this category of information into the very text and definition of the phrase.
Broader definition of "trading." Regulation 4(1) prohibits trading by insiders in securities of listed companies while in possession of unpublished price sensitive information. By definition, "trading" includes "dealing" in securities, which SEBI acknowledges in an accompanying guidance Note is not strictly buying, selling, or subscribing - "dealing" includes "pledging etc when in possession of unpublished price sensitive information." Regulation 2(1)(l), Note. In contrast, the principal US securities fraud laws, Exchange Act Section 10(b) and SEC Rule 10b-5, prohibits manipulation or deceit in connection with the purchase or sale of securities. "Purchase" and "sale" are only occasionally stretched to cover other types of activities, as the US Supreme Court held forty years ago that there must be an actual purchase or sale in order to implicate Rule 10b-5 for purposes of private litigation.
Broader definition of "insider." An "insider" is defined as a "connected person" or a person "in possession of or having access to unpublished price sensitive information." Regulation 2(1)(g). The corresponding Note confirms that this definition is to be taken literally: anyone in possession of or having access to unpublished price sensitive information "should be considered an 'insider' regardless of how one came into possession of or had access to such information." Likewise, the guidance to "connected persons" relates that insider status is meant to include persons with connections to a company expected to put him in possession of unpublished price sensitive information. Regulation (2)(1)(d), Note. These definitions are substantially broader than US law, which generally does not impose liability based merely on the possession of materially nonpublic information but instead examines who the trader is and how he or she came into possession of the information (with the exception of trading based on advance knowledge of a tender offer, which is per se not allowed).
Insider status continues after connection to company ends. "Connected person" is defined to include any person associated with a company in any capacity (including by frequent communications with officers); any person in any contractual, fiduciary or employment relationship with a company; any director, officer or employee; and persons in professionals or business relationships with a company, whether temporary or permanent, that allows or reasonably is expected to allow such persons access to unpublished price sensitive information. Regulation 2(1)(d)(i). Interestingly, "connected person" status remains in place for six months after a person ceases to be a director, officer, employee, or temporary insider. Id. This per se continuation of insider status moots any question under US law as to whether a departing director, officer or employee is no longer under an obligation not to trade based on information obtained through one's prior service with the company on the grounds that the fiduciary duty to the company terminates once the fiduciary relationship terminates. Another distinction with US law is that immediate relatives of connected persons presumptively are also considered to be "connected persons." Regulation 2(1)(d)(ii)(a). SEC Rule 10b5-2(b)(3) addresses duties not to trade on insider information by spouses, parents or children of insiders, but does not go so far as to create a presumption of insider status.
Presumption of insider trading subject to affirmative defenses, including a much narrower trading plan defense
US courts have debated exactly what must be proven in order to establish "insider trading" since the beginning of its regulation. In 2000, the SEC promulgated new rules (Rules 10b5-1 and 10b5-2) to try to resolve some open issues in these debates in its favor. The SEBI regulations take the SEC rules as a starting point, and then move beyond them.
Trading with possession states a prima facie case subject to affirmative defenses. The guidance to the prohibition on trading explains that when a person trades when in possession of unpublished price sensitive information, "his trades would be presumed to have been motivated by the knowledge and awareness of such information in his possession," regardless of the reasons for the trades or intended use of proceeds; and hence trading in possession "is what would be need to be demonstrated at the outset to bring a charge." It is then the burden of a person who traded such information "to prove his innocence by demonstrating" the circumstances set forth in a list of defenses. Regulation 4(1), Note. (Similar statements appear in the Note to the definition of "insider.") This mirrors SEC Rule 10b5-1, which creates a presumption of illegality for trades made with awareness of material nonpublic information in breach of a fiduciary duty of trust and confidence, subject to affirmative defenses. It also mirrors case law favored by the SEC that does not requiring the government to prove a defendant's "use" of material nonpublic information in a challenged trade.
Higher burdens for connected persons. The SEBI regulations go beyond US law by placing the burden on connected persons to establish that they were not in possession of unpublished price sensitive information at the time of their trades. Regulation 4(2). Thus, if a trader is an officer, director, employee or temporary insider, it is up to him or her to prove that he did not know of the inside information within the company, if that is part of the defense. (For other persons accused of insider trading, the burden is on SEBI.) Coupled with the broad definitions of "insider" and "connected persons" described above, the SEBI regulations place substantial risk on any securities trading by a broad set of persons affiliated with listed companies or their officers.
Trading plan must be approved by a compliance officer and publicly disclosed. The first two affirmative defenses to insider trading in the SEBI regulations cover transfers between promoters and trades made on behalf of the insider by separate persons insulated from the unpublished price sensitive information. Regulations 4(1)(i), (ii). The third affirmative defense is for trades made pursuant to a pre-existing trading plan. Regulation 4(1)(iii). This tracks SEC Rule 10b5-1(c), which was promulgated in 2000 to ameliorate the presumption of insider trading arising from trades made with awareness of material nonpublic information. Unlike US law, however, the SEBI regulations require that an insider who wants to use a trading plan must present it to a company's compliance officer for review, comment, approval, and disclosure to the public and any exchanges on which the security is listed. Regulations 5(1), 5(3), 5(5). The SEC had proposed a public disclosure requirement, but the proposal was set aside for more immediate regulatory tasks arising from the wake of Enron, Worldcom, and the Sarbanes-Oxley Act.
Explicit limitations on trading plans. The SEBI regulations also include explicit limitations for trading plans that are not found in US law but have been suggested by some regulators and commentators. A plan cannot allow trading in a trading window around the release of financial results; a plan must extend for at least twelve months in duration; there can only be one plan at a time; and the plan cannot be used for "market abuse," which includes manipulating the timing the release of unpublished price sensitive information. Regulation 5(2) & Notes. In addition, once approved, a trading plan is irrevocable and must be executed to its completion without any trades outside the plan. Regulation 5(4). This addresses criticism that insiders have benefitted from trading plans because they can cancel a plan and forestall the sales that otherwise would have been made without violating the US securities laws.
Disclosure and nondisclosure
Notwithstanding its title, the SEBI regulations address more than just insider trading. Chapter II of the regulations also includes restrictions communicating unpublished price sensitive information, and Chapter III sets forth disclosure requirements. In addressing these multiple topics in a single instance of rulemaking, SEBI followed the historical lead of the SEC, which in 2000 promulgated rules and regulations addressing both trading (Rules 10b5-1 and 10b5-2) and disclosure (Regulation FD).
Prohibition on communicating information. Regulation 3(1) prohibits communicating or allowing access to unpublished price sensitive information relating to a listed company or its securities to any person-even other insiders-except where this is in furtherance of legitimate purposes, performance of duties or discharge of legal obligations. The Note explains that this regulation is designed to lead organizations to develop practices based on need-to-know principles. This extends beyond the prohibition in US securities and corporation law against disclosing or using material nonpublic information for personal benefit, although it does track Regulation FD in that it prohibits selective disclosure outside of a company. As in SEC Regulation FD, the SEBI regulations include carve-outs for M&A related disclosures under confidentiality agreements. Regulation 3(3), 3(4). Regulation FD, however, contains exceptions not found in the SEBI regulations, for disclosures to the press and to rating agencies.
Prohibition on asking for information. Regulation 3(2) is an innovative provision that to our knowledge has no counterpart in the US securities laws: it prohibits procuring from or causing the communication by any insider of unpublished price sensitive information relating to a listed company or its securities, again except when in furtherance of legitimate purposes, performance of duties, or discharge of legal obligations. Speaking colloquially, the SEBI regulations envision a "don't ask, don't tell" regime for internal corporate information.
Requirement to disclose trades to the company. Chapter III of the SEBI regulations requires disclosures to the company of the securities holdings by broad set of persons (which includes all "key managerial personnel"). Regulation 7(1). All promoters, directors and employees must disclose all acquisitions or disposals of securities to the company within two days of the trade, if the value of the traded securities is over 10 lakh rupees. The company then must disclose the transactions to the exchange. Regulation 7(2). This information also includes trades by immediate family members and other persons for whom the reporting person makes trading decisions. Regulation 6(2). The company also may require other connected persons (such as management consultants) to make disclosures. Regulation 7(3) & Note. In US law, by contrast, Exchange Act Section 16 requires public disclosure of trades with two days of the trades, but apply only to a narrow set of senior officers, directors and large shareholders.
The SEBI regulations also include substantial "corporate" governance requirements, as set forth in Chapter IV. We place the word "corporate" in quotations because, unlike US law, some of the obligations are placed on entities beyond listed companies.
Code of Conduct for companies and advisers. Listed companies and other persons required to handle unpublished price sensitive information in the course of business operations must formulate a Code of Conduct to regulate, monitor and report trading by employees with an eye towards achieving compliance with the regulations and a model Code attached as Schedule B. Regulations 9(1), 9(2). This includes auditors and law firms assisting or advising listed companies, and market intermediaries, all of which are mentioned in the accompanying Note. Schedule B, the minimum standards for a Code of Conduct, is lengthy and detailed. It requires "Chinese Walls procedures" (sic), trading windows, pre-clearance of trades by the compliance officer (who is authorized to seek declarations from prospective traders that they are not in possession of any unpublished price sensitive information), and lists of disciplinary actions for violations of the rules.
Compliance officer for companies and advisers. Regulation 9(3) requires listed companies, market intermediaries and all other persons formulating a Code of Conduct to identify and designate a compliance office to administer the Code and the other requirements of the SEBI regulations.
Code of Fair Disclosure for companies. Boards of listed companies must formulate a Code of Fair Disclosure of unpublished price sensitive information and publish it on the company's Internet site. Regulation 8(1). Schedule A, the minimum standards for a Code of Fair Disclosure, is short but detailed. It requires (since this a minimum) listed companies to designate a senior officer as chief investor relations officer, and to set policies to advance such ends as ensuring that information shared with analyst and research personnel is not unpublished price sensitive information.