Insider Trading & Stock Market Regulations In India

With Judgements

Yash Aggarwal

10/27/202312 min read

INTRODUCTION

In the modern era, anyone with a working smartphone and a stable internet connection can invest in the stock market, contrary to the 80s or early 90s when only the rich who had enough money to burn invested in the stock market. Since then, we have seen many people build their empires, starting from scratch by investing in the stock market. The way the stock market works is that companies who are looking for additional investments list their companies in front of the public for them to invest in the companies in exchange for a small equity in the company, which entitles them to enjoy a share of any increase in profits that the company may have, they can also sell the stocks bought by them in the primary market in the secondary market for a price that is greater than the price which they bought it for, hence earning profit. The stock market ensembles an element of risk that only some are willing to take with their hard-earned money, especially in a country like India, where traditional ways of savings and investment, such as property and jewellery, are more prevalent and more trustworthy. But in the last few decades, through established and trusted channels such as SENSEX or the NSE, as well as the effective regulations put in place by the SEBI, the general public's trust in the stock market has increased. However, unethical and illegal practices such as Insider trading have caused hindrances in the trust that the people have developed over the past 2 decades in the transparency of the stock market. Further in this research paper, we will understand what insider trading is and how it is regulated in India.

WHAT IS INSIDER TRAINING?

The definition of Insider Trading is, “Insider trading is defined as a malpractice wherein trade of a company's securities is undertaken by people who under their work have access to the otherwise non-public information which can be crucial for making investment decisions.”. In simpler words, Insider trading, a term often used to describe the act of key employees or executives utilizing confidential, strategic information about their company for trading in its stocks or securities, is strongly discouraged by regulatory bodies such as the Securities and Exchange Board of India (SEBI). This regulatory stance fosters a fair and equitable trading environment in the financial markets, ultimately benefiting the broader community of investors.

Insider trading is fundamentally considered an unfair and unethical practice within the financial world. The primary reason for this viewpoint is its inherent disadvantage to other shareholders who need access to this critical insider information. When individuals with privileged knowledge exploit this information advantage, they can make more informed investment decisions, often at the expense of the uninformed public investors.

This unfair advantage undermines the foundational principles of transparency, equality, and fairness integral to well-functioning financial markets. It erodes the trust and integrity of these markets, as investors are meant to compete on a level playing field where the same information is available to all participants. Insider trading disrupts this equilibrium by creating an environment where certain individuals have access to information that others do not, leading to an uneven distribution of profits and losses.

In essence, insider trading is not merely a breach of regulatory rules but a breach of trust and fairness. It compromises the integrity of the financial system, damages investor confidence, and hampers the efficiency of the market. Regulatory bodies like SEBI strive to combat insider trading to ensure that financial markets remain open, equitable, and accessible to all participants, fostering an environment where the common investor can have confidence that they are competing on a level playing field.

INTRODUCTION OF SEBI AND IT’S FUNCTIONS

SEBI, a statutory organization serving as the securities market regulator in India, is responsible for overseeing and managing the securities market while safeguarding the interests of investors. It is governed by a board of members comprising a Chairman and various full-time and part-time members. The appointment of the Chairman is made by the central government, and the Board further includes two representatives from the finance ministry, one member nominated by the Reserve Bank of India, and five other members nominated by the central government. SEBI's headquarters are in Mumbai, with additional regional offices in Ahmedabad, Kolkata, Chennai, and Delhi. SEBI exercises control over stock exchanges, upholding the rights of shareholders while assuring the security of their investments. Its overarching objective is to combat fraudulent activities through a harmonious blend of statutory regulations and self-regulation within the business realm. The regulatory body, furthermore, fosters a competitive and professional marketplace for intermediaries. In addition to the mentioned functions, SEBI establishes a platform where issuers can responsibly raise capital, ensuring the safety and dissemination of accurate information to investors. SEBI meticulously scrutinizes stock trading, safeguarding the securities market against unscrupulous practices. It administers oversight over stockbrokers and sub-stockbrokers and imparts education to investors, enriching their understanding of the market. SEBI stands as the preeminent regulator of insider trading in India. SEBI recognized the problems and threats of insider trading in India and rolled out the “SEBI prohibition of insider trading regulations” in 2015.

SEBI INSIDER TRADING PROHIBITION REGULATIONS, 2015

The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015, came into force on May 15 2015. The following is an overview of the regulations –

CHAPTER 2- RESTRICTIONS ON COMMUNICATION AND TRADING BY INSIDERS

Chapter II of the regulation focuses on restrictions on communication and trading by insiders. It is divided into several sections, each addressing different aspects related to the handling of unpublished price-sensitive information (UPSI) and insider trading:

Section 3 - Communication or procurement of UPSI:

- Prohibits insiders from sharing or providing UPSI to anyone except for legitimate purposes, duties, or legal obligations.

- Also prohibits anyone from inducing or causing insiders to share UPSI unless for legitimate purposes or legal duties.

- Provides exceptions for certain transactions, such as takeovers, mergers, and acquisitions, when the Board of Directors believes they are in the company's best interests.

- Requires parties involved in such transactions to execute confidentiality agreements.

Section 4 - Trading when in possession of UPSI:

- Forbids insiders from trading in securities listed or proposed to be listed while possessing UPSI.

- Allows insiders to prove their innocence under specific circumstances, including off-market transfers, non-individual insiders with appropriate arrangements, or trades under an approved trading plan.

- Shifts the burden of proof onto connected persons to demonstrate they did not have UPSI.

Section 5 - Trading Plans:

- Permits insiders to create trading plans for trading securities in compliance with regulations.

- Specifies requirements for trading plans, including a six-month waiting period, restrictions around financial result announcements, a minimum trading period of twelve months, and no overlap of multiple plans.

- Requires trading plans to outline trade values, quantities, nature, and execution dates.

- Prohibits trading plans that could be used for market abuse.

- Trading plans are irrevocable once approved, and the insider must adhere to the plan without deviation.

- Commencing a trading plan is deferred if the associated UPSI still needs to be generally available at implementation.

- The compliance officer must notify the stock exchanges upon the approval of the trading plan.

CHAPTER 3 –DISCLOSURES OF TRADING BY INSIDERS

Chapter III of the regulation pertains to insiders' disclosure of trading activities. This chapter outlines various provisions and requirements related to public disclosure, including who must disclose their securities holdings, transactions, and other information:

Section 6 - General Provisions:

- Specifies the form in which public disclosures under this chapter should be made.

- Requires the disclosure of trading activities by the immediate relatives of insiders and by those for whom an insider makes trading decisions.

- Mandates that trading in securities derivatives should be considered when calculating disclosure requirements provided such trading is permitted by law.

- States that the company must maintain the disclosures made under this chapter for at least five years.

Section 7 - Disclosures by Certain Persons:

- Subsection 1 - Initial Disclosures:

- Requires promoters, key managerial personnel, and directors of listed companies to disclose their securities holdings on the date when these regulations take effect, within thirty days of these regulations taking effect.

- Mandates that persons who become key managerial personnel, directors, or promoters disclose their securities holdings as of their appointment or becoming a promoter within seven days.

- Subsection 2 - Continual Disclosures:

- Requires promoters, employees, and directors to disclose the number of securities acquired or disposed of within two trading days of such transactions if the value of the securities traded in a calendar quarter exceeds a specified threshold (e.g., ten lakh rupees or as specified).

- Companies must notify the stock exchange of such trading within two trading days of receiving the disclosure or becoming aware of the information.

- Explains that incremental transactions should be disclosed when they cross the specified threshold after any prior disclosure.

Disclosures by Other Connected Persons:

- Allows listed companies to require other connected persons, at their discretion, to make disclosures of their securities holdings and trading activities in a manner and frequency determined by the company to monitor compliance with these regulations.

CHAPTER – IV - CODES OF FAIR DISCLOSURE AND CONDUCT

Chapter IV of the regulation focuses on formulating codes of practices, procedures, and conduct related to the fair disclosure of unpublished price-sensitive information and regulating trading activities.:

Section 8 - Code of Practices and Procedures for Fair Disclosure:

- Subsection 1:

- Mandates that the Board of Directors of every listed company formulates and publishes a code of practices and procedures for the fair disclosure of unpublished price-sensitive information on the company's official website.

- Requires adherence to the principles outlined in Schedule A to the regulations.

- Subsection 2:

- Demands that any amendments made to the code be promptly intimated to the stock exchanges where the securities are listed.

Section 9 - Code of Conduct:

- Subsection 1:

- Requires the Board of Directors of every listed company and market intermediary to formulate a code of conduct to regulate, monitor, and report trading by their employees and connected persons.

- Mandates that the code of conduct adheres to the minimum standards set out in Schedule B to the regulations.

- Subsection 2:

- Obliges any person handling unpublished price-sensitive information during business operations to formulate a code of conduct for regulating trading by employees and connected persons.

- Specifies that such a code of conduct should also adopt the minimum standards in Schedule B.

- Subsection 3:

- Mandates that every listed company, market intermediary, and other entity formulating a code of conduct designate a compliance officer responsible for administering the code of conduct and ensuring compliance with the regulations.

SCHEDULE A- Principles of Fair Disclosure for purposes of Code of Practices and Procedures for Fair Disclosure of Unpublished Price Sensitive Information:

1. Timely Disclosure:

- Price-sensitive information impacting price discovery should be publicly disclosed when credible and concrete information becomes available, ensuring no undue delay.

2. Universal Dissemination:

- Price-sensitive information should be uniformly and universally disseminated to prevent selective or preferential disclosure.

3. Senior Officer Designation:

- A senior officer should be designated as the Chief Investor Relations Officer responsible for information dissemination and the disclosure of price-sensitive data.

4. Prompt Rectification:

- Any selective, accidental, or unauthorized disclosure of price-sensitive information should be rectified by making that information generally available.

5. Responsiveness to Queries:

- Regulatory authorities' queries and market rumours should be appropriately and fairly responded to, ensuring accurate verification of news reports.

6. Analyst Information:

- Information shared with analysts and research personnel should not include unpublished price-sensitive data.

7. Record Transparency:

- Transcripts or records of meetings with analysts and investor relations conferences should be posted on the official website to confirm and document disclosures.

8. Need-to-Know Basis:

- Unpublished price-sensitive information should be handled on a strict need-to-know basis, ensuring limited access to such information.

SCHEDULE B- Minimum Standards for Code of Conduct to Regulate, Monitor and Report Trading by Insiders

1. The compliance officer reports to the Board, particularly to the Audit Committee or the Chairman of the Board, as directed by the Board.

2. All information should be handled on a need-to-know basis. No price-sensitive information can be shared except for legitimate purposes, job duties, or legal obligations.

3. based on their functional role, designated persons must follow an internal code of conduct regarding securities dealing.

4. Designated persons can trade, but a trading window is used to monitor when they can trade, closing when they might have access to price-sensitive information.

5. The trading window reopens based on factors like information becoming generally available, but not earlier than 48 hours afterwards.

6. When the window is open, trading by designated persons must be pre-cleared if above certain thresholds set by the Board.

7. The compliance officer maintains a "restricted list" of securities for pre-clearance approval.

8. The compliance officer can seek declarations regarding possessing price-sensitive information before approving trades.

9. A timeframe is specified (up to seven trading days) for executing pre-cleared trades.

10. A designated person must not execute a contra trade for a specified period (at least six months). The compliance officer can grant exceptions.

11. Profits from unauthorized contra trades are disgorged for investor protection and education.

12. The code of conduct stipulates formats for applications, trade reporting, decisions not to trade, and holdings reporting.

13. The code outlines sanctions and disciplinary actions for infringement, and reporting violations to the Board is mandatory.

RECENT LANDMARK JUDGEMENTS IN THE SUPREME COURT

Shruti Vora v. SEBI

The issue at hand revolves around the dissemination of WhatsApp messages just before the release of the Financial Statements but before their finalization within the organization. Remarkably, these messages' content closely resembled the Financial Statements of the six involved companies. This raised the question of whether such information, labelled as "forwarded as received," falls under the category of "Unpublished Price Sensitive Information" (UPSI) as defined in the PIT Regulations. It also questioned whether transmitting these messages onward would trigger the provisions of Regulation 3(1) of the Insider Trading Regulations.

The Adjudicating Officer (AO) initially classified this information as UPSI and imposed a penalty. However, in the subsequent appeal, the Appellants drew attention to the prevalent market practice of making estimates before the official disclosure of financial results, a practice similar to the concept of "Heard on Street," wherein unverified information is widely circulated. This information is typically monitored and reported by news agencies such as CNBC, Reuters, and Bloomberg.

A critical point highlighted by the Securities Appellate Tribunal (SAT) was the AO's recurrent inability to trace the originator of the text messages. Furthermore, the Tribunal found that while numerous messages were extracted from the Appellant's phone, only those related to the financial statements of six companies matched the actual results. These messages were swiftly forwarded to multiple recipients upon receipt. The SAT also noted that the financial results might have originated from brokerage houses or other public sources unknown to the Investigating Authority, and information available in the public domain cannot be considered UPSI. Ultimately, the SAT concluded that without a direct link between the potential source of UPSI and the person allegedly possessing it, the information could not be classified as UPSI.

SEBI filed an appeal against the SAT Order under Section 15Z of the SEBI Act. However, the Hon'ble Supreme Court, in its order dated September 26, 2022, dismissed the appeal while leaving all legal questions open.

The foundation of SAT's findings was the inability to identify the originator of the forwarded messages, which led to the absence of a connection between the originator and those forwarding the financial results. Nevertheless, it is our opinion that such a basis for determining UPSI in a case related to Regulation 3(1) of Insider Trading Regulations may be insufficient. An examination of the materiality of the forwarded information and the underlying reasons for the involvement of these appellants in sharing the financial results of publicly listed companies with investors at large is an aspect that should have been thoroughly explored.

The International Organization of Securities Commissions, in its 2003 report on Insider Trading, noted that in addition to prohibiting trading based on inside information or tipping others about such information, some jurisdictions have enacted general regulations that prohibit an individual's improper "use" of inside information.

SEBI vs Abhijit Rajan

In this case, the Respondent served as the managing director of Gammon Infra Projects Limited ("GIPL"). GIPL had secured a contract from the National Highway Authority of India (NHAI) valued at ₹648 crores. Simultaneously, another company, Simplex Infrastructure Ltd ("SIL"), had also been awarded a contract by NHAI worth ₹940 crores. Both companies had established Special Purpose Vehicles (SPVs) to execute these projects, and they entered into a shareholder's agreement to hold 49% equity in each other's SPVs. Eventually, these contracts were terminated.

Following the termination and before the public disclosure of this information, the Respondent, Rajan, sold approximately 70% of his holdings in GIPL. The regulatory authority found this transaction violated Insider Trading Regulations, as Rajan had engaged in trading while having Unpublished Price Sensitive Information (UPSI). Rajan challenged the regulator's decision before the Securities Appellate Tribunal (SAT), which ultimately ruled in his favour, setting aside the order issued by the Adjudicating Officer (AO). Subsequently, SEBI appealed SAT's decision to the Supreme Court.

The Supreme Court, while dismissing SEBI's appeal, took a different approach. It highlighted that Gammon's contract was larger, making the news of its termination a significant piece of UPSI. Consequently, the trading actions of the Respondent, involving the sale of his holdings when the share price was about to rise, indicated an absence of any intent to exploit or capitalize on the information.

Balram Garg vs SEBI

The Supreme Court addressed the issue of evidentiary burden in cases of Insider Trading. In this case, the close relatives of a publicly-listed company's Chairman and Managing Director engaged in trading the company's shares, allegedly based on Unpublished Price Sensitive Information (UPSI) they received from the Chairman and Managing Director. SEBI contended that the Chairman and Managing Director had shared UPSI, thereby violating legal prohibitions.

Similarly, the relatives were accused of violating the law by trading while possessing such UPSI. The Supreme Court, however, concluded that the decision to sell shares and the timing of these transactions were primarily personal and commercial choices made by the Appellant. These actions could not be automatically interpreted as evidence of the communication of UPSI.

The Court emphasized that proving the communication of UPSI required concrete evidence, such as documents, emails, witness testimonies, and so on, rather than relying on assumptions based on the alleged proximity of the parties. Furthermore, the Supreme Court clarified that the presumption under Regulation 4 did not apply to Regulation 3. In the absence of any substantial evidence indicating frequent communication, there could be no presumption of the communication of UPSI.

(Edited and Posted By Iswari Legality LLP Team)

Submitted by - YASH AGGARWAL, IIM ROHTAK