Insider Trading Regime in India: Relevance of Mosaic Theory

This article is authored by Shubham Gupta, a 4th-year law student at Institute of Law, Nirma University

Insider trading is a serious white-collar crime in India. Insiders tend to manipulate the market movement by having the unpublished price sensitive information (UPSI) over the information available in the public domain. However, in India, certain aspects of USPI are still brusque and obscured in SEBI (PIT) 2015. In SEBI (PIT) 2015, the materiality of information is a key determinant factor that catalyzes insider trading. However, when the part of the non-material information is wiped out from an insider to an analyst which if collated with the generally available information would make the analyst in possession of Unpublished Price Sensitive Information, Indian legislation loses its sheen over this conditional situation.

Indian regime of Insider Trading is iced up on this issue and does not deliberate on this approach. In U.S. legislation, it has framed its approach regarding this issue of Insider Trading, namely Mosaic Theory of Materiality, but India is yet to begin its chapter. Tribunals and Courts have been unlettered on such issue, remarking a fundamental gap in determining the materiality of information. Many such cases are flowing in market and investor protection groups have failed to acknowledge the generous concern of Market effluence. This approach would not only soon find its space in India but will be lucidly deliberating on this approach to prevent insider trading. Rule of purposive interpretation would elucidate on this approach which deals with such significant ‘mosaic’ ovulated from a part of UPSI and a part of PSI.

In SEBI (PIT) Regulation, 2015, insider trading is an offense when there is a communication, counseling or procurement of UPSI from insider to non-insider, or when the trade has been done while in possession of UPSI. UPSI stipulated as any material information which is not generally available and which has a material effect on the price of securities listed or proposed to be listed. However, a part of UPSI is non-material in its sense but if collated with generally available information become material and create a significant mosaic of material information. This information which has been created through a matrix of information could be used by the analysts to do insider trading in the securities of a company and thus, regulations lose its efficiency. For e.g. if an analyst procured a part of UPSI through any means and collate it with the information already reeling in the market like media reports, press briefs, and public the announcement, but does brain-storming over the permutation and combination of the coming deal and trades while in the possession of this available information, would this act of trading amount to Insider Trading in India.

The fundamental issue revolves here is ‘Whether an analyst would be charged for the act of insider trading if he has edge over information due to his expertise skills and working on permutation and combinations of such half-received information’. This question has been marginally touched up by U.S. Court but failed to explain the cut and dried formula. In Elkind v. Liggett & Myers, Inc., U.S Court of Appeals in 2^nd Circuit address that any skilled analyst who has edge over information due to any use of any part of the non-material information, such procurement would amount to Insider trading. However, the U.S. had shown deviance from such approach in further cases. In Re Dirks, that an analyst may use UPSI which may be immaterial itself in order to fill in ‘interstices of analysis’; this process is legitimate even though ‘tidbit’ of such information may assume heightened significance when woven by the skilled analyst in the matrix of knowledge obtained elsewhere.

In Dirks v. SEC, the court acknowledged that the analyst must remain free to obtain information from the corporation to fill in the interstices in the analysis.  The rationale proof for this process is the skills and expertise employed by the analyst and essential for market efficiency. This information has not been merely gulped without the application of mind but due to his robust experience in the field. Therefore, this creates a serious doubt on the illegitimacy of such act. Thus, it would be a dilemma for Indian Courts to pope up according to the given jurisprudence in Securities Law because the SEBI Act and regulation thereof have been implemented with the purpose of market efficiency and investor protection.

Other facets that determine that materiality of information is such a situation is whether the disclosure of such omitted fact would be seen by the reasonable investor as significantly altered the total mixture of information available.[1] However, the debated jargon is ‘reasonable investor’. Whether the court must refer the ‘reasonable investor’ as in view of an ordinary investor or a sophisticated analyst having expertise in the market affluence. This aspect would pose a serious question ‘whether the skills and expertise employed by sophisticated analysts would rule over the interpretation of materiality in the evolving jurisprudence’.

The Courts or tribunals may view such a lurking question of the materiality of information, as the information obtained cannot be viewed in a vacuum and thus any kind of collation would amount to Insider Trading. However, the Rule of purposive interpretation avows that a liberal approach towards market efficiency because it reaffirms the established practice from which the benefit, relief, and remedy may flow. The striking outlook, here, is that the court or tribunals may resort to the purpose of enforcement of PIT regulations. That, so far as, the aspects of securities market concern, it is always a top-notch priority to protect investors from any kind of fraud. Therefore, the court should view such obtained information in the totality of the circumstances and whether the information is capable of changing the conclusive decision of the analysts in general. Not only, would this create a difference in a level of the approach adopted by an ordinary person and a skilled analyst, but significantly this would reform the existing modus operandi employed by other insiders including directors, promoters, KMP etc. by stimulating restrictive disclosure in the public or family events also.

The balance of mixed information and a UPSI must be addressed through a circumstantial approach in terms of ordinary categories in which such obtained information will create an asymmetry in the market. Sparingly, even information which is not material in nature but tends to become material in the near future must attract the prohibition of insider trading regulation.

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[1] Basic Inc. v Levinson

SEBI releases a Discussion paper on regulatory sandbox

This article is authored by Shubham Gupta, a 4th year Student at Institute of Law, Nirma University, Ahmedabad.

SEBI realized FinTech potential in effectuating investor protection and promoting the security market, SEBI releases a discussion paper on “Regulatory Sandbox” to boost development and adoption of FinTech solutions in the securities market. Regulatory Sandbox is a live testing environment where products, processes, services or business models can be deployed on a limited set of eligible customers for a certain period having exemption or relaxation from SEBI regulations and guidelines. Earlier this month, SEBI had proposed ‘Innovation Sandbox’ which was lubricated at providing information to FinTech companies which could not have been readily available to them, to enable their innovation on historical data in a closed system having regard to anonymity to promote innovation in the securities market before actually testing in a live environment on real customers. However, market players were concerned about the scope of its applicability to SEBI rules, to what extent exemptions may be granted. Thus, a notion of confusion had flown among market players and thus demanded a lot of clarity on the same.

 In that light, SEBI proposed a regulatory sandbox that would enable financial institutions regulated by SEBI to test their innovation and financial technology in a live environment and on real customers subject to necessary safeguards maintained for investor protection and provide the extent of exemptions, applicability, and procedural requirements. This regulatory sandbox came into light in the backdrop of innovations without proper regulatory oversight which has been detrimental to investors. SEBI believes that innovation investor-centric experimentation can bring about better financial outcomes and deeper penetration and enable large scale financial inclusion. However, lack of due diligence, proposed solution similar to the market offering, lack of intention of deployment, etc. would not be permitted to operate on Regulatory Sandbox. The purpose of Sandbox is to set off dialogue with the financial companies leveraging innovative technologies so that inventive step may be instituted in the regulatory framework of SEBI at an early stage and to identify and avoid the potential adverse events.

This mechanism would facilitate direct and seamless information sharing between innovative firms and SEBI. On one hand, it would give a chance to the FinTech industry to check their innovation while on others, it would help SEBI to frame policies that foster time saving and less transaction cost techniques and solutions for investors. A similar mechanism has been already devised by other regulators like RBI, IRDAI, etc. This mechanism would stimulate many benefits like greater participation of investor or people raising capital or providing services, increased financial inclusion and penetration of financial products in tier II or tier III town/cities and rural areas, easy accessibility for retail investors including reducing operational costs, increased transparency and lower transaction charges, etc. Applicability All the market participants registered under Section 12 of the SEBI Act will be eligible players for testing within the Regulatory Sandbox. The market participant can come their own or through the way of FinTech services; regardless of who applies, the market participant will be considered the applicant for the purpose of the application and be responsible solely for all testing solutions. Also, the paper fosters that depending on the application or response, the SEBI may consider other participants like FinTech Start-ups, and firms to be permitted for testing under a regulatory framework. For the interim solution, they may opt for innovation sandbox wherein they can do testing in a closed manner based on historical data. Regulatory Exemptions The exemptions that could be bestowed to the financial institution are – · No exemption would be provided in case of the overarching principle of investor protection and market integrity like investor protection framework, know your customer (KYC) and Anti-Money Laundering and thus, would quintessential to carry out proper due diligence. ·

With the intention of a less-burdened regulatory mechanism, SEBI has proposed specific relaxation according to the case to case basis after analyzing the testing requirements of Sandbox applications. The annexure 1 of Discussion Paper contains provisions that are mandatory to follow and also, categories where the exemption may be allowed. Mandatory regulatory compliances like confidentiality of information, handling of customer’s money and assets by intermediaries, prevention of money laundering and countering the financing of terrorism, Risk check, and KYC has to be maintained. However, relaxations may be provided in cases of net-worth, track record, registration fees, SEBI guidelines (technology risk management guidelines and outsourcing guidelines), financial soundness, etc. · Also, market participants have been enabled to request for relaxations from specific SEBI regulations/provisions if they think fit in terms of hampering their innovations or acting as a barrier to entry of products in the market. Eligibility criteria SEBI has stipulated certain eligibility criteria for the applicant like genuineness of innovation, a genuine need for testing, limited prior offline testing, beneficiary to users, no risk to the financial system, the readiness of application or software, deployment post-testing, etc. These conditions must be afforded by the applicant for use Regulatory Sandbox. If an applicant has devised application but does not contain any innovative step, or does not want to deploy it broadly, then such testing application cannot be proceeded with under the current proposal. The applicant must not only provide all details of the plans, scope but also identify potential risks about the testing application and must fully aware associated with plans and take an informed consent of the user. The applicant shall also follow appropriate disclosure to risk, protection and compensation norms and also set up a grievance redressal mechanism. Application and Approval Process If the applicant and project meet the eligibility criteria, the applicant may file an application (attached as Annexure 1) signed by the chief executive officer (CEO) or any officer authorized by him. SEBI shall review the application and within 30 days will inform the applicant about its suitability. Meanwhile, SEBI can also seek guidance from the applicant regarding the project. If the application is admitted, then SEBI will evaluate with the applicant’s specific regulatory requirement to be followed (including test parameters and control boundaries); then proceed with the application if the applicant is willing to adopt the suggested measures. The evaluation criteria would be scoring based upon information in the application on different parameters like profile, innovative technique, risk mitigation, feasibility to deploy, etc. After approval, the testing would be done, and the applicant is required to disclose potential risks to users and take informed consent or acknowledgment about the risk presented. If the applicant wants to do some material change after approval, then he should seek SEBI’s approval prior in 1 month specifying proposed plans with reasons. The duration of the testing period is a maximum of 9 months and can be extended up to 3 months upon request. He is also required to submit interim reports of testing. After the testing is done, the applicant is required to submit the final report containing key outcomes, performance indicators, findings of the test, etc. These reports shall be confirmed by CEO/authorized individual and a SEBI the officer would be assigned to guide application for deployment and testing in the sandbox. The application may also be revoked if undermining any of the eligibility criteria and provide false information, gone in liquidation, risk of cybersecurity involved, etc.

Thus, this mechanism will not only leverage future long term opportunities to FinTech Companies to expand its horizon its terms of innovation in better technologies but also provide end customers with a deeper sense of inclusion in financial service and make an environment investment friendly because of easy accessibility, lower transaction costs, and reliable software. Also, SEBI in a symbiotic relationship with FinTech Companies in the future as a direct applicant will foster a seamless information sharing system and would help in watching out the activities and transactions of the market players and avoiding white-collar crimes like insider trading, fraud, manipulation, etc. Thus, this can a remarkable step in boosting confidence in the securities market and make the country’s economy to a higher loop.