Applicability of insider trading regulations to pooled investment vehicles: A discussion on extent and rationale
- CS Sikha Bansal, Partner and CS Aisha Begum Ansari, Manager | corplaw@vinodkothari.com
| The article has also been published on IndiaCorpLaw – read here |
Regulatory framework for surveillance of DPs
SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT Regs.’), although prohibit trading on the basis of unpublished price sensitive information (UPSI) by any “insider” (which includes even an accidental insider or an outsider having come to possess UPSI); however, from a surveillance and compliance system perspective, the PIT Regs. focus on certain specific insiders called designated persons (DPs). Trading in securities of the listed company by the DPs is sought to be “regulated, monitored and reported” by the Code of Conduct (reg. 9 read with Schedule B) which, inter alia, provides for (a) bar on trading while the trading window is closed; (b) prior clearance by the compliance officer while the trading window is open subject to certain declarations; (c) bar on short-term reversal trades; etc. Another article deals with a detailed discussion on the manner in which ‘insiders’, ‘connected persons’ and ‘designated persons’ are dealt with under PIT Regs.
Similar framework has been envisaged in case of intermediaries and fiduciaries who deal with listed companies. In such cases, the compliance officer of such intermediary/ fiduciary is required to maintain a ‘restricted list’ of securities, which is used as the basis for approving or rejecting the application for pre-clearance of trades by the DP. The DP may trade in the securities of a listed client company which is not in the restricted list subject to pre-clearance by the compliance officer.
Hence, there is no blanket prohibition of trading in the listed securities by the DPs; although, there are conditionalities involved. Very recently, there have also been concerns around investment by DPs in the units of pooled investment vehicles (as we discuss below).
Pooled investment vehicles and possible concerns of insider trading
Briefly speaking, pooled investment funds are established in the form of trust or otherwise, which collect, raise funds from investors and invest such funds in accordance with the regulations framed by SEBI (refer, sec. 2(da) of SCRA). A mutual fund, an alternative investment fund, a collective investment fund, etc. are all pooled investment funds. Further, the units issued by these funds are securities within the meaning of sec. 2(h)(ida) of SCRA.
Now, as given, these pooled funds would make onward investments (depending upon the regulatory norms where it is permissible for such funds to make investments and their respective investment objectives), which may include investments in listed or to be listed securities. So, there can be cases, where the pooled fund itself is unlisted but makes investment is listed/to be listed securities. Questions have been raised as to whether PIT Regs. would apply in such cases. Clearly, when the units of such pooled funds are listed, PIT Regs. would apply vis-a-vis such listed units (except in case of mutual funds)[1]; however, when the units of the pooled fund are unlisted, is there any possibility of PIT implications vis-a-vis the underlying listed investments?
To illustrate with the help of an example, say, Mr. B is a DP of a bank which has access to UPSI of the listed companies. The DP wishes to invest in the units of unlisted AIFs which may invest in the securities of listed companies (which may include the bank itself and bank’s listed clients as well) whose UPSI is with the bank and in turn with the DP.
In such a scenario, can it be said the AIF is merely a pass-through? Can it be said that the AIF is merely a conduit, which the DP is using to make investments in underlying listed securities? Can it be said that the DP, in each case, needs to know the end use of the funds he puts in AIF? The discussion below is an attempt to find answers to these questions.
Applicability of PIT Regs. to investments in pooled investment vehicles
Indirect investments – whether covered?
Section 12A of SEBI Act, 1992 mandates that no person shall, directly or indirectly, engage in insider trading. As to what ‘insider trading’ is, has to come out from section 15G[2] of the SEBI Act. Further, regulation 4(1) of PIT Regs. states that “No insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information”. Further, the expression, “directly or indirectly” has to be read in proximity to “insider trading”. That is, it must be insider trading at the very first place to be hit by PIT Regs. – as to how it has been executed (directly or through conduits) is irrelevant. The SEBI Act or the PIT Regs. do not deal with scenarios where investments are made in pooled funds on which an investor has no control and the money so invested would percolate to investments in underlying listed securities. In such a case, can it be said that an insider may exploit non-public information by making investments in pooled funds, which, in turn, may have invested in listed securities? Note that, in order to establish that an intermediate vehicle was merely acting as a conduit, or the DP used the investment in the pooled fund as an instrumentality for exploiting insider information, there will have to be facts to substantiate that the “intent” and “effect” of the investment made in the vehicle is “insider trading” in underlying “listed securities”. Where such a nexus cannot be established (as we see below), it would be an extreme view to regard these funds, not as genuine investment pools, but as conduits or pass-through structures for investing in listed securities.
Investment in securities of listed companies and investment in units of funds should be distinguished. A person investing in securities of listed companies can leverage the UPSI he has, to the fullest possible extent. He has full control on his investment, and the information can be used for self-enrichment. In fact, in the case of a “connected person”, or by any person when in possession of UPSI, trades are ‘presumed’ to be motivated by the possession of such UPSI [see, explanation to reg. 4(1)]. However, when a person invests in pooled funds, there is commingling of funds. Several investors would pool in money in a common hotchpot. The investment manager would then use the money to invest in several investee companies, basis investment conditions/restrictions and investment strategy of the pooled fund.
Decision-making as to investments
In the case of pooled funds, the investor is not taking decisions as to investing; such decisions are taken by the investment manager. The investment manager, in turn, has to follow the prudential guidelines including those pertaining to conflict of interest, as stipulated under the respective regulations. For example, reg. 20 read with Fourth Schedule of AIF Regs. lists down the code of conduct to be followed by the investment manager and its employees, such as, the investment manager has to ensure proper care, exercise due diligence and independent professional judgement in all its decisions, maintain ethical standards of conduct and deal fairly and honestly with investee companies at all times.
Investment limits/conditions
The pooled funds invest in securities in accordance with investment conditions such as:
- Category I and II AIF can invest not more than 25% of the investable funds of the scheme in an investee company. Large value funds for accredited investors can invest up to 50% of the investable funds in an investee company (Reg. 15 (1) (c) of AIF Regulations).
- Category III AIF can invest not more than 10% of the net asset value in listed equity of an investee company (Reg. 15 (1) (c) of AIF Regs.)
Given that the funds would need to adhere to maximum limits while investing in a particular investee’s securities, the portfolio of the funds would be diversified. The fund’s units would, thus, derive their value from the portfolio of investments done by the fund, and not from any single security. As a consequence, one cannot say that an investor even in possession of UPSI, is dealing in ‘securities’ of the underlying investees. The investor has invested in the common hotchpot, and has no say in investment decisions. The pooled fund would be investing in several investees and the units would derive the value from all such investments taken together.
General prohibition on UPSI communication and insider trading
In any case, PIT Regs. do curb misuse of UPSI by ‘tipper’ and ‘tippee’. Any person who is privy to inside information is under legal obligation not to communicate, provide or allow access to UPSI to any other person (including other insiders) except where such communication is in furtherance of legitimate purposes, performance of duties or discharge of legal obligations (refer, reg. 3(1) of PIT Regs.). Further, any person in receipt of UPSI is under legal mandate to protect confidentiality of such UPSI (refer, reg. 3(2B)). In countries like the US too, there are antifraud provisions contained in section 10(b) Securities Exchange Act, 1934, which have been invoked in “tipping” cases.[3]
Having said that, however, it must be noted that, insider trading controls are always founded on principles of fair conduct, and therefore, the authors’ observations cannot be generalised. For instance, there may be an AIF where the investors are several DPs of the same entity. Additionally, the fund may be heavily invested into specified securities, that is, investments by funds may be concentrated in a few investees. There may also be instances where the investment decisions are influenced by the DP (that is, the investment manager shares any kind of interface with the DP). It is notable that there are scores of cases where trading by hedge funds and other asset managers has been successfully held by SEC investigations in the USA as being cases of insider trading. In such cases, it might not be possible to take a generalised view that irrespective of surrounding facts, the investment by insiders into pooled funds may never be taken as a case of insider trading. There might be circumstances which warrant that appropriate regulations be put in place. In that case, the listed entity may have to put appropriate protection in its Code of Conduct, which, in our submission, becomes an extension of the PIT Regs. for safeguarding against insider trading. To that extent, SEBI’s observation that “the provisions of PIT Regulations may get attracted based on facts and circumstances of each case” is completely justified.
What SEBI thinks
On March 16, 2022, SEBI issued an informal guidance to Yes Bank Ltd. (‘Applicant’) wherein the moot question was whether the employees of the bank covered as DPs and their immediate relatives are allowed to invest in AIF. SEBI allowed the bank’s DPs and their immediate relatives to invest in the units of AIF; however, subject to compliance with applicable provisions of PIT Regulations and SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’).
The Applicant, a listed company, has adopted a referral model, whereby the Applicant’s customers would be referred to the AMCs of AIFs (which have signed up with the Applicant), and for such referral, the Applicant would get commission from such AMCs. The employees of the Applicant too, may choose to invest their funds through these AIFs. The Applicant submitted that the investment by the fund manager of AIF may include investment in the companies whose UPSI is with the applicant (in the capacity of bank) and in turn, with its DPs. It also submitted that the investors of AIF do not have any direct/ indirect control or influence over the investment decision of AIF. In this regard, the applicant raised a query as to whether its DPs and their immediate relatives can invest in the units of AIF.
SEBI observed that the investments made by the fund manager in the AIF schemes on behalf of DPs and their immediate relatives may include investments in the companies whose UPSI is with the bank and in turn with the DP. Considering the same and regs. 3, 4 and 9 of PIT Regs., SEBI concluded that DPs investing in such schemes may have access to UPSI in relation to such securities. DP would be considered as insider and the provisions of PIT Regulations may get attracted based on the facts and circumstances of a specific case. Hence, Reg. 3, 4, 9(1) read with Schedule B may get attracted when there is trading/ investment in the units of AIF by the DPs and their immediate relatives when the DP is in possession of UPSI in relation to such securities.
The authors humbly note that SEBI’s informal guidance in Yes Bank, may not be as clear as required, at certain places, e.g. at one place, SEBI says that DPs would be considered as ‘insider’ and provisions may get attracted depending upon facts and circumstances of each case; however, in the very next statement, it refers to reg. 9 of PIT Regs. read with Schedule B (which talks about compliance with trading window closure restrictions, obtaining pre-clearance, contra-trade restrictions, etc), among other provisions of PIT Regs. Further, the informal guidance does not consider the fact that the decision of a DP to invest in a fund and decision of an investment manager to invest in selected securities are not linked.
Notably, SEBI has prescribed separate norms for AMCs and their employees and DPs to deal with insider trading issues (see, Circular dated November 17, 2016). In another informal guidance, the question was whether the employees of the manager of AIF can invest in the units of AIF. SEBI observed that AIF schemes can invest in the listed securities of the companies and such listed securities are amenable for insider trading and the intended employees would have access to the information about potential buying and selling of securities by the asset manager. Referring to the said Circular, SEBI opined that the Code of Conduct under reg. 9 read with Schedule B[4], as the case may be, of PIT Regs. is applicable to trading/ investment by the employees of AIFs/ AMCs in the units of AIF scheme that invests in securities listed or proposed to be listed. Given that the Circular seeks to address the concerns of self-trading and front-running, etc., the regulation on employees/DPs of the AMC (and their immediate relatives) is completely understandable. However, the rationale of imposing the same set of regulations to DPs of all listed entities (who may not have any connection whatsoever with the AMCs) is not clear.
Closing Remarks
Pooled funds, as we discussed above, are regulated funds. The applicable regulations define the eligibility criteria for the sponsors, trustees, investment managers, etc., regulate the quantum and proportion of corpus which may be accepted from investors and above all, put investment conditions which shall be adhered to, by these pooled funds. There may be conditions for investment by employees of managers/trustees too, as stipulated by SEBI’s 2016 circular (referred above). Hence, assuming that the DPs (of any listed entity other than that of AMCs/trustees) do not share any interface with the investment managers and have no say in investment decisions, it may not be right to say that such funds can be used as conduits or as proxy investments by such DPs to exploit the UPSI in relation to the listed company. For this and other reasons as explained above, unless there are specific circumstances which warrant otherwise, the authors do not see any reason to apply the surveillance systems of the PIT Regs. (pre-clearance, etc.) on the DPs. Ofcourse, the umbrella provisions of Regs. 3 and 4 would anyway apply to the DPs (as is applicable to any person who has UPSI). That is, the DPs should not indulge in communication of UPSI and insider trading in violation of the PIT Regs.
Similar principles as discussed above, may also be applied in case of investment entities which obtain funds from one or more investors and further invest with the sole purpose of gaining returns from capital appreciation, and investment income. Typically, an investment entity has more than one investment, more than one investor, it has investors that are not related parties of the entity and has ownership interests in the form of equity or similar interests (para 27 and 28 of Ind AS 110).
However, the regulators’ unambiguous stand is yet to arrive.
[1] Reg. 2(1)(i) of PIT Regs. excludes mutual fund from the definition of securities
[2] Section 15G of the SEBI Act, 1992 provides for penalty for insider trading. It states that “If any insider who,— (i) either on his own behalf or on behalf of any other person, deals in securities of a body corporate listed on any stock exchange on the basis of any unpublished price-sensitive information; or (ii) communicates any unpublished price-sensitive information to any person, with or without his request for such information except as required in the ordinary course of business or under any law; or (iii) counsels, or procures for any other person to deal in any securities of any body corporate on the basis of unpublished price-sensitive information, shall be liable to a penalty which shall not be less than ten lakh rupees but which may extend to twenty-five crore rupees or three times the amount of profits made out of insider trading, whichever is higher.”
[3] See for example, here: https://www.sec.gov/news/press/2011/2011-40.htm. The Securities and Exchange Commission charged certain network consultants and employees with insider trading for illegally tipping hedge funds and other investors to generate illicit gains. The SEC alleged that the technology company employees, while moonlighting as consultants or “experts” without the knowledge of their employers, abused their access to inside information about technology companies.
Also, in the matter of Cady, Roberts & Co. (US case), where partner of registered broker-dealer firm was informed by associate in firm, who was also a director of issuer of a security listed on national securities exchange, of dividend reduction applicable to such security, and such partner knowing that such information has not yet been released to the public, executed orders for discretionary accounts on the exchange for the sale of shares of such security without waiting for the public announcement of or disclosing the dividend action, held, willful violation of anti-fraud provisions of securities acts by broker-dealer firm and partner and under all the circumstances it is in the public interest to suspend partner from exchange. See here: https://insidertrading.procon.org/sourcefiles/CadyRobertsCo.pdf
[4] Pursuant to SEBI (PIT) (Amendment) Regulations, 2018 – Schedule C has been inserted providing Minimum Standards for Code of Conduct for Intermediaries and Fiduciaries to Regulate, Monitor and Report Trading by DPs
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