The Corporate & Commercial Law Society Blog, HNLU

Category: Securities Law

  • Rationalizing the Need for Inclusion of Mens Rea in Insider Trading Regulations

    Rationalizing the Need for Inclusion of Mens Rea in Insider Trading Regulations

    By Sezal Mishra, fourth-year student at NLIU, Bhopal

    Introduction

    Securities Regulations in India prohibit the offence of Insider Trading under the SEBI (Prohibition of Insider Trading Regulations), 2015. (‘PIT Regulations’) Insider Trading is the offence of dealing in the securities of a company on the basis of unpublished price sensitive information (‘UPSI’) in order to gain an unfair advantage over the general public. UPSI refers to any information relating to a company or its securities, directly or indirectly, that is not generally available and which upon becoming generally available is likely to materially affect the price of the securities. In simple words, information which relates to internal matters of a company and is not disclosed by it in the regular course of business can be considered as UPSI. Communication of UPSI by an insider without any legitimate reason is prohibited under Regulation 3 of the PIT Regulations.

    Recently, through a series of orders, SEBI penalized several individuals in the ‘WhatsApp Leak Case’ for the unlawful communication of UPSI relating to several companies like Asian Paints, Wipro, and Mindtree through the popular messaging app. An exorbitant penalty of Rs 45 Lakh was levied upon these individuals who were found to be in violation of Regulation 3. These orders interpret some of the most important aspects of Regulation 3 of the PIT Regulations and have severe implications in deciding the liability of insiders in communication of UPSI. Through this article the author advocates the need of taking cognizance of mens rea while adjudicating liability in insider trading cases to ensure just penalization of offences.

    Communication of UPSI and the Need for Mens Rea

    The PIT Regulations have been enacted in accordance with Section 12A of the Securities and Exchange Board of India Act, 1992 with a purpose of ensuring a level playing field and to prevent undue benefit to any individual at the expense of public investors. Regulation 3(1) of the PIT Regulations prohibits an insider from communicating any UPSI, relating to a company, to any person except for legitimate purposes or in discharge of legal obligations. The aim of the legislature in enacting such regulations is to oblige all insiders to handle sensitive information with care since a leak of such information can lead to an undue advantage to both – the tipper and the tippee. The legislature, however, fails to take into consideration a scenario entailing an accidental leak of information which yields no benefit to the tipper or the tippee. Since it has already been established that the purpose of insider trading regulations is to prevent undue advantage to the tipper or the tippee over public investors, a paradox is created when regulation agencies seek to punish even the accidental communication of UPSI which entails no profit to the parties.

    In India, at present, communication of UPSI without personal benefit or even unknowingly, is a ground for liability under the insider trading regulations. Mens rea or intention of the tipper is considered irrelevant under the PIT Regulations. The only available means of solving this paradox lies in the insertion of the element of mens rea in insider trading regulations. The consideration of mens rea at the time of imposition of liability under insider trading regulations can be justified on the two grounds –

    (i.) Mens Rea is in Consonance with the Objectives of PIT Regulations

    Firstly, the purpose with which the PIT Regulations have been enacted is rendered meaningless by the non-inclusion of mens rea. The basic purpose of insider trading regulations is to prevent undue advantage to individuals engaging in trade on the basis of sensitive information. At present, however, the control of SEBI in such cases has been strengthened to a point where the mere possession or communication of UPSI can be considered as a ground for insider trading.

    The legislature has lost sight of its true purpose and engaged itself in policing information and its spread rather than regulating trading done with the intention of acquiring profits. If an insider is penalized for mere communication of information or for trade in securities with no advantage to him over the general investors, the interest of investors remains unharmed. In such a scenario, penalization of such acts becomes meaningless and is clearly beyond the scope of the purpose of the PIT Regulations.

    (ii.) Punishment without Mens Rea is Unjustified

    Secondly, the penalty levied upon an individual for a violation of the PIT Regulations is often exorbitant. Due to the diverse repercussions entailed by the offence, it is of utmost significance that the market regulations take steps towards prosecuting individuals after ascertaining proper cause. This has lead Securities Regulation Agencies in countries like the USA to consider mens rea as a vital element in imposition of liability in order to avoid imposing large penalties in cases of accidental tipping.

    In India, the opinion of the Supreme Court in SEBI v. Shriram Mutual Fund and the legislative notes to Regulation 4 have made it clear that mens rea cannot be considered as an essential element for penalization under the PIT Regulations since it is neither a criminal nor a quasi-criminal offence. Insider trading proceedings pertain to Section 15G of the SEBI Act which are essentially civil proceedings and so the question of proof of mens rea does not arise. However, the Securities Appellate Tribunal has not always subscribed to the same opinion. Previously in Rakesh Agarwal v. SEBI, SAT decided that if an insider deals in securities based on the UPSI for no advantage to him, over others, it is not against the interest of investors and hence should not constitute an offence. It can be similarly inferred that mere communication of information without any advantage to the insider must not be considered an offence. The position adopted by SAT widens the scope of PIT Regulations by correctly interpreting the purpose for which the Regulations were enacted. 

    Mens Rea as a Requirement for Insider Trading in the UK and US

    For the first time in 1984, the US Supreme Court in Dirks v. SEC established that while adjudicating liability in insider trading cases, the mens rea of the tipper must be considered. The Court arrived at its decision by devising a test to decide whether or not breach of a fiduciary duty had been committed by the insider and consequently, whether or not the tippee had committed the offence of insider trading. This was explained by the Court as,

    “The test is whether the insider personally will benefit, directly or indirectly, from his disclosures. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach by the tippee.”

    Hence, post the judgment in Dirks case, the simple test for insider trading violations was whether the insider has communicated sensitive information with the unlawful intention of earning undue personal benefit. If communication of information was done with a guilty intention, the insider had breached his fiduciary duty and would be liable under the regulations. Additionally, the tippee would be considered liable on the basis of his knowledge of the said breach by the tipper.

    The prosecution of individuals was made much more difficult by the Court in the subsequent case of US v. Newman. Here, the Court reinstated its faith in the personal benefit test by clarifying that a mere breach of an insider’s fiduciary duty to not disclose sensitive information is not sufficient to constitute an offence of insider trading, even if the information was communicated to a friend, unless some improper purpose on the part of the insider is demonstrated.

    Similarly, insider trading is illegal under Section 52 of the Criminal Justice Act, 1993 in the UK. Since the offence entails criminal liability under the Act, the requirement for mens rea is indispensible. Section 53 of the Act lays down three defences that can be used by individuals accused of insider trading. To qualify for a defence, the accused must exhibit that, (i) it was not expected at the time of dealing that the transaction would result in a profit; or, (ii) the accused was under the impression that the information is within the public domain; or, (iii) that transaction would have been undertaken even without access to the sensitive information. 

    In a situation entailing an accidental communication of sensitive information where no personal benefit is derived by the tipper, an application of the personal benefit test or the defences enlisted under Section 53 would lead us to the conclusion that there exists no ground for imposing penalty under insider trading regulations.

    Conclusion

    Over the years, the scope of SEBI’s insider trading norms has been widened in order to protect the interests of the investors and to create a healthy environment for trade in the securities. While recent orders in the WhatsApp leak case provide an impression of SEBI’s tireless efforts in curbing insider trading, upon close scrutiny it becomes evident that these orders establish a new threshold of evidence for liability under the existing PIT Regulations. The orders omit discussion on the issue of mens rea and turn a blind eye to a situation where the sharing of the information is accidental and has not resulted in any insider trading or undue benefit. Evidently, at present, the Insider Trading Regulations operating in India are much more rigid and strict than those operating in other countries of the world. It is, thus, proposed that the tipper-tippee test and other principles relating to mens rea prevalent in other jurisdictions should be incorporated in the Indian jurisprudence at the earliest.

  • U.S. Ruling on Disgorgement of Profits: A Model for Indian Securities Market

    U.S. Ruling on Disgorgement of Profits: A Model for Indian Securities Market

    By kartik singh, a second-year STUDENT OF at NLUO, CUttack

    Disgorgement refers to the repayment of unlawful profits earned by an individual arising from unlawful activities. Disgorgement of ill-gotten profits has been a potent tool for global regulatory authorities in preserving the interests of the stakeholders in the securities markets. In spite of having a provision to that effect incorporated under Section 11B of the SEBI Act, 1992, added by an amendment in 2013, the Indian market regulatory authorities have been hesitant in enforcing such powers, primarily due to the lack of clarity in the legislation itself and precedents thereof as to how the amount for disgorgement must be computed. The Indian courts and tribunals, thus, often look to foreign pronouncements on the subject.

    The Indian regulatory law for disgorgement has been inspired by the provisions of the US securities law, therefore, the developments in the US securities market are of considerable importance to the Indian regulatory regime. Recently, the US Supreme Court’s decision in Liu v. SEC has thrown light on the issue of the quantum and computation of disgorgement amount by expounding certain guiding principles for the same. Considering the absence of such a computation mechanism in the Indian securities regulations, the ruling serves as an example for India.

    The Securities and Exchange Commission (‘SEC’) charged Charles Liu and Xin Wang with defrauding Chinese investors of a project that the couple falsely claimed met the requirements of the Immigrant Investment Program, following which they diverted the investment funds to overseas marketers and by paying themselves generous salaries. Proceedings were initiated against them and the matter ultimately reached the US Supreme Court.

    Observations of the US Supreme Court: A guiding example for the Indian Framework

    Firstly, the US Supreme Court categorically observed that the power to order disgorgement must not be viewed as a “punitive remedy”, rather it must be considered as an “equitable remedy” i.e. the same must be meant to remedy the wrong and not to punish the wrongdoer. The amount ordered to be disgorged must not exceed the amount of ill-gains gained by the wrongdoer, the contrary of which would fall within the ambit of a “punitive remedy”. The Securities Appellate Tribunal (‘SAT’) in Gagan Rastogi v. SEBI and Shadilal Chopra v. SEBI had too observed the same principle. The US ruling further exemplifies the principle by providing useful direction to enable the courts and tribunals to differentiate between an equitable order and a punitive order.

    Secondly, the Supreme Court noted that the process of disgorgement must be followed by the restitution of such amount to the victims of the wrongdoing. It is often observed that the regulatory authorities disgorge the amount and then claim to have brought justice to the victims. The US Supreme Court depreciated such practice and observed that the true essence of the disgorgement provision would only prevail if the process of restitution of the disgorged amount is followed. Emphasizing the point that mere collection of the disgorged amount and depositing the same in the government treasury would amount to a penalty, the Supreme Court ordered to follow the principle of restitution. To facilitate this, the regulatory authorities must consider the number of stakeholder/victims of the wrongdoing and pass necessary order to protect their interests. A similar approach has been adopted by SAT in Ram Kishori Gupta v. SEBI, wherein it observed the exclusion of principle of restitution in the disgorgement process to be unacceptable, remarking “disgorgement without restitution does not serve any purpose”. Again, the backing of the US Supreme Court on the aforesaid principle augurs well for the Indian securities framework going forward.

    Thirdly, the US Supreme Court noted that the disgorgement of money must be computed based on the net profits earned by the wrongdoer and not from the money earned from the wrongdoing. It must be taken into account that the wrongdoer may have incurred certain legitimate expenses during the course of wrongdoing. It would be unfair to account and extract such legitimate expenses through the process of disgorgement. Depreciating such practice of the regulatory authorities, the court remarked that there have been instances where they have used disgorgement as a tool to shirk their responsibility of applying their mind in order to compute the “actual” amount for disgorgement i.e. by deducting the legitimate expenses incurred by the wrongdoer.

    In the Indian framework too, it is often seen that the authorities order to disgorge the entire amount in question instead of acknowledging the legitimate expenses of the wrongdoer. The US Supreme Court acknowledging such facet said the same can be done by analysing the facts and circumstances of each case, following which the remedy would be truly equitable in nature.

    Lastly, the court also raised concerns about the repeated use of the “jointly and severally liable” principle by the regulatory authorities. Generally, fraudulent activities are committed by several individuals in connivance of each other. Consequently, authorities punish or impose a penalty on one of the wrongdoers for the acts of others using the ‘jointly and severally liable’ principle. The court was of the opinion that although the use of such principle is justified and may be reasonable in circumstances peculiar to a case, however, in cases of disgorgement authorities must be mindful of the person being asked to disgorge the amount unlawfully gained by the wrongdoers as such person may not actually be in possession of the unlawful gains, thereby impeding his ability to disgorge the amount to the regulatory authorities.

    Conclusion

    The US ruling has certainly paved the way for developing a mechanism to ascertain the disgorgement amount from the wrongdoer. While it may be argued that the securities market of the US is different than that of the Indian market, the principles enunciated by the court form the basic structure and the essence as to the computation for disgorgement. Disgorgement differs from a claim of damages, the former being a right in rem and the latter being a right in personam, thus, the method developed by the courts over the years in computing claims for damages must not be applied for the purpose of disgorgement.

    Further, disgorgement, especially in the Indian context, allows the regulators to be more liberal in deciding the quantum since they are themselves the court of first instance. The concept of disgorgement is still at a nascent stage and it is expected that the US ruling would guide the development of the subject in India.

  • SEBI’s Approved Framework for Regulatory Sandboxes: Going the Right Direction?

    SEBI’s Approved Framework for Regulatory Sandboxes: Going the Right Direction?

    by aabha dixit, a fourth-year student at hnlu, raipur

    On June 5, 2020, the Securities Exchange Board of India (“SEBI”) rolled out the final framework enabling regulatory sandboxes for FinTech companies, after introducing draft mechanisms earlier last year – ‘Framework for Innovation Sandbox’ issued on 20 May, 2019 and the ‘Discussion Paper on Framework for Regulatory Sandbox’ issued on 28 May, 2019 (“Discussion Paper”). The framework is expected to provide a time-bound structure to mitigate regulatory uncertainty around new FinTech products.

    The concept of a regulatory sandbox

    The concept of a regulatory sandbox is a close-ended idea that allows FinTech companies to test disruptive technological products in a closed and controlled environment with limited regulatory relaxations. The need for such experimentation seems to arise from two evident challenges – firstly, the lack of regulations or inapplicability of existing regulations to the innovation and secondly, the trust deficit in the market to depend upon experimental FinTech products. The creation of a regulatory sandbox allows testing on innovative FinTech products in a strictly controlled environment.  Globally, over 20 other jurisdictions have successfully introduced sandboxes as a way of gradually integrating new financial innovations into the mainstream market, including the UK, Australia, Singapore etc. In the Indian scenario, the Reserve Bank of India (“RBI”) and the Insurance Regulatory and Development Authority of India (“IRDAI”) have both released guidelines for enabling regulatory sandboxes.

    SEBI’s framework for Regulatory Sandboxes

    SEBI’s framework for Regulatory Sandboxes (“Framework”) has strict eligibility criteria requiring genuineness of innovation, the need for live testing on real customers and relaxation of existing regulations. It also requires the participants to outline benefits for investors and/or the securities market and provide for a risk management system to control any potential threats to users. Further, the Framework mandates data privacy and disclosure of all possible risks to participating consumers along with setting up of a complaint redressal mechanism.

    Changes in the final Framework on Regulatory Sandboxes vis-à-vis the Discussion Paper

    The Framework extends eligibility for testing in the regulatory sandbox to all entities registered under Section 12 of the SEBI Act, 1992 either on its own or through a FinTech firm. While the Discussion Paper included the scope for SEBI to consider admitting FinTech start-ups, firms and other entities not regulated by it to the sandbox process independently, the same has not been adopted in the Framework. While this limits participation to regulatory sandboxes, the SEBI may reconsider the same based on testing results and market response.

    Further, registration granted under Section 12 is based on the nature of the specific activity undertaken by an applicant entity. To widen the ambit of products that can be tested by a participant beyond its registered category, SEBI has incorporated a cross-domain approach in the Framework. This is facilitated by a limited registration certificate issued to the entity which will allow it to operate in a regulatory sandbox without being subjected to the entire set of regulatory requirements to carry out that activity. Cross-domain testing adds to the flexibility of process and will encourage participants to venture into new product categories without excessive regulatory hindrances. 

    The chink in the armour

    Post publication of the Discussion Paper, SEBI has addressed and made necessary provisions for complaint redressal for consumers in the Framework by mandating participants to set up grievance redressal mechanisms. However, no mechanism for grievance redressal of participants has been provided by SEBI. Further, while the RBI Regulatory Framework includes clear safeguards for exercising intellectual property rights, the same are missing in SEBI’s Framework. 

    Since FinTech products may be governed by both the RBI and SEBI (and the IRDAI for products involving insurance-related solutions), the Framework needs to provide for coordination between the regulators to avoid replication of the processes and wastage of resources. For products that provide multiple solutions on the same technological platform, providing a unified channel for different regulators will simplify the compliance process. Additionally, post-testing, it is important that SEBI gives weightage to consumer feedback and complaints while drafting regulations for the new product. An inclusive and transparent approach by SEBI in this regard will benefit all stakeholders in the long run.   

    In conclusion, while the Framework seems structurally sound, it is imperative that SEBI conducts frequent evaluations of the actual outcomes as well as market responses and amends the regulations flexibly to uplift the FinTech sector through regulatory sandboxes.