[Pranshu and Harshal are students at National Law School of India University and Gujarat National Law University, respectively.]
Contra-trades, or reversals of initial securities transactions, have become a focal point in the realm of corporate regulation. These ‘opposite’ trades involve buying or selling company securities and executing an opposite transaction within 6 months to gain short-term profits. As Umakanth Varottil explains, contra-trading regulation, particularly in the Indian context, stems from broader concerns about insider trading and its disruptive potential for the securities market.
The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations 2015 (PIT Regulations) cast a wide net to catch all insiders and designated persons. Their scope hinges critically on the definition of 'connected persons', a term subject to ongoing scrutiny and potential reform. The Securities and Exchange Board of India (SEBI) has recently contemplated a significant overhaul to this definition by broadening its horizons and introducing new categories, signaling a potential shift in the contra-regulatory landscape. This two-part blog series critically examines the proposed expansion of 'connected persons', as outlined in SEBI’s recent consultation paper published in July 2024. In the first part, the authors delineate the current framework and the proposed changes and explore the rationale underpinning this potential expansion. In the second part, we critically evaluate SEBI’s proposals against recent judicial and theoretical standards, both in India and abroad, to conclude that it is not necessarily a “step in the right direction”.
The Regulatory Framework for Contra-Trading Restrictions
The SEBI has addressed contra-trading within the framework of the PIT Regulations. Sub-clauses (g) and (n) of Regulation 2(1) specifically target ‘insiders’, who can be 'connected persons' or individuals in possession or having access to unpublished price sensitive information (UPSI). Regulation 4(1) prohibits them from trading while in possession of UPSI. To operationalize its intent, Regulation 9 read with Schedule B-Clause 3 mandates the Board of Directors to frame a code of conduct to monitor, regulate and report trading by ‘designated persons’ and their immediate relatives in the company. Further, the board appoints a compliance officer to administer the code and specify the individuals subject to its provisions under Regulation 9(4). Within Regulation 9(4), the code encompasses a wide range of ‘designated persons’ including employees, promoters, CEOs, and support staff, along with their immediate relatives. This regulation extends beyond considering their seniority and professional designation; it not only recognises their role and function as the criteria but also examines their access to UPSI, by virtue of their role and function, in Regulation 9(4).
Further, the code must adhere to certain minimum standards laid down in Schedule B for trading window timeframes, legal sanctions for violations, and disclosure obligations. Clause 10 of the Schedule stipulates a minimum six-month period for contra-trade restrictions on designated persons. At the same time, it empowers compliance officers to grant relaxations in appropriate cases, provided such exemptions do not violate PIT Regulations otherwise under Reg. 10. Exceptions include transactions like the creation of pledges and the exercise of ESOPs.
Delineating the Current Framework and the Proposed Changes
The PIT Regulations aim to regulate insiders or designated persons, including ‘connected persons”. Regulation 2(1)(d) defines a ‘connected person’ as an individual associated with a company in any capacity within the 6 months preceding a trade, such that his association potentially allows access to UPSI. The current framework also delineates ‘deemed connected persons’, which include ‘immediate relatives’ and certain corporate entities such as holding companies, intermediaries, and trustees. As the Note to Regulation 2(1)(d) clarifies, they are presumed to have potential UPSI access by their relationship with the company, irrespective of their formal position.
Importantly, SEBI has envisaged significant expansion of this definition in its recent Consultation Paper. First, it introduces additional categories of 'deemed connected persons', including partners in firms where a connected person is a partner, individuals whose advice influences the connected person, and persons sharing households or having material financial relationships with the connected persons. Second, it proposes redefining ‘immediate relatives’ and ‘relatives. It seeks to replace ‘immediate relative’ in sub-clause (a) with a broader category of ‘relatives’ for determining connected persons. While retaining the definition of ‘immediate relatives’ for disclosure purposes, SEBI proposes a more expansive definition for ‘relatives’ under a new Regulation 2(1)(hc), extending to a wider circle of family members such as siblings of spouses and parents, lineal ascendents and descendants, and spouses of siblings. Significantly, these proposed changes shift the burden of proof onto the deemed connected persons when charged under Regulation 4(1). They must demonstrate the non-possession of UPSI, as per Regulation 4(2), potentially increasing the regulatory scrutiny on a wider range of individuals and entities through an expansive definition.
Exploring the Rationale for the Proposal
The proposed expansion of ‘connected persons’ is rooted in fundamental securities market principles and the need to address contemporary regulatory challenges. This section adopts a three-pronged analytical approach: firstly, locating the broad theoretical foundations of the current framework, secondly, investigating the specific rationale behind the proposal, and thirdly, examining these changes in the backdrop of SEBI’s evolving approach to contra-trades.
Theoretical foundations vis-à-vis parity of information principle
The primary objective of insider trading regulations is to create a level playing field for all market participants by preventing UPSI exploitation. This is premised on the theory that the usage of privileged information diminishes its value and eliminates further profit opportunities for others. As Frank Sensenbrenner and Margaret Ryznar posit, insider trading imposes costs on public investors by:
systematically diverting value from public shareholders to insiders, and
distorting insider’s incentives to generate further economic value.
Insiders, by virtue of their access to UPSI, may contra-trade at inflated prices, disrupting market integrity, eroding investor confidence and violating fairness. Consequently, SEBI, through Regulation 4 of the PIT Regulations prohibits trading while in UPSI possession. Umakanth Varottil explains that this is founded on the ‘parity of information’ principle, focusing on UPSI possession during trading rather than intent. It is irrelevant whether the offender came into possession of such information deliberately or accidentally. The 2018 amendment to Regulation 4 crystalised this principle, creating the presumption that trading while in UPSI possession is motivated by such information. The Securities Appellate Tribunal in the Chandrakala case ruled that it is presumed that a person possessing inside information has traded “on the basis of” or “used” the information. The Note to Regulation 2(1)(d) establishes that the onus of rebutting the presumption lies with the alleged insider. This is because the possession of UPSI places such individuals on a ‘pedestal’, necessitating a higher level of compliance to ensure ‘parity of information’.
Rationalizing the proposed amendments
As per SEBI, any person could be deemed as a 'connected person' by virtue of their connection with the company potentially giving them possession of UPSI. This broad definition ensures wide regulatory scrutiny of all those who could potentially exploit UPSI, regardless of their formal relationship with the company. This has been concretized in SEBI’s recent Consultation Paper that proposes expanding ‘connected persons’ to plug current framework loopholes. SEBI in its consultation paper has observed that certain individuals, currently excluded from the definition, may access UPSI through close relationships with connected persons. By broadening the scope, SEBI intends to bring these “deemed connected persons” under regulatory scrutiny.
SEBI’s evolving approach in contra-trade restrictions
SEBI’s expansive approach is reflected elsewhere, especially in its evolving contra-trade restrictions on promoters. While SEBI’s previous Informal Guidance suggests that contra-trade restrictions apply to promoters individually rather than the entire promoter group, recent interpretations indicate a shift towards considering common and tiered shareholding structures. This evolution signifies SEBI’s focus on identifying ultimate transaction beneficiaries and underlying trade objectives. Essentially, the rationale behind the proposed expansion is to create a more robust and comprehensive regulatory framework that can effectively prevent insider trading in its various forms.
Conclusion
SEBI’s proposed expansion of ‘connected persons’ represents a pivotal shift in insider trading regulation, aiming to address existing loopholes and enhance market integrity. By extending regulatory scrutiny to individuals with indirect access to UPSI and shifting the burden of proof under Regulation 4(1), SEBI seeks to strengthen compliance and deter misconduct. However, these changes introduce complex challenges, including heightened compliance burdens and potential overreach, raising concerns about their proportionality and effectiveness. While the proposal aligns with the ‘parity of information’ principle and SEBI’s evolving stance on contra-trades, its broader implications demand critical examination. In the second part of this series, we will analyze whether this expansion truly serves its intended purpose or risks undermining fundamental principles of fairness and efficiency in securities regulation. Through a comparative and doctrinal critique, we argue that SEBI’s approach may not necessarily be a step in the right direction.
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