The efficiency of the securities market depends on equal access to information and ensuring information symmetry for all stakeholders. Many Indian listed entities have significant promoter/ promoter group shareholding, which gives them the advantage of asymmetrical access to unpublished information. For free and fair trade in the financial market, a level-playing field between the promoter/ promoter group and retail shareholders is crucial. This is why there is prohibition on communication of Unpublished Price Sensitive Information (“UPSI”) and insider trading.
The Securities and Exchange of Board of India (“SEBI”) introduced the SEBI Prohibition of Insider Trading Regulations, 2015 (“PIT Regulations”), to prevent misuse of confidential information that parties involved in ‘trading’ of securities may possess.
‘Trading’ is defined under Regulation 2(l) of the PIT Regulations, which includes ‘any dealing in securities’. Under the erstwhile PIT Regulations, 1992, ‘dealing’ in securities was prohibited. The High-Level Committee to Review the SEBI (Prohibition of Insider Trading) Regulations, headed by NK Sodhi (“Sodhi Committee Report”), suggested that the term ‘trading’ should be adopted instead of ‘dealing’, since the more appropriate term for imposing prohibition under the regulations would be ‘trading’. However, while SEBI decided to use the nomenclature of ‘trading’, it retained the reference to ‘dealing’ within its definition and did not restrict it to mere buying and selling of securities.
Pledging a part of dealing
Pledges are security created over the shares of a Company, which, in the event of a default, can be invoked by a lender and enforced by way of transfer of sale to a third party. A pledge is created as security against a loan. Mere creation and invocation of a pledge should not per se have attracted the provisions of PIT Regulations because the pledgor is typically not relying on inside information nor is getting undue benefit from such information while creating the pledge. The pledgor is creating the pledge because the terms of the loan/ debt require the same.
However, PIT regulations restrict an insider from ‘dealing’ in shares while in possession of insider information. Hence, pledges created by promoters or other insiders are covered under the restrictions provided for in the PIT regulations, because it constitutes ‘dealing’ in shares.
The Sodhi Committee Report had recognised this issue and stated that “such encumbrances are but provisions of security for loans advanced and as such cannot be justified as being the mischief sought to be suppressed by these regulations. If dealing in securities were to be prohibited when in possession of UPSI, all such acts of providing security would become illegal.”
However, SEBI was of the view that not including ‘dealing’ in the definition of trading would contradict the parliamentary mandate laid down in Section 12A(e) and 15G of the SEBI Act, 1992. Therefore, not only was ‘dealing’ included in the definition of ‘trading’, but also pledging was described as one of the modes of dealing in PIT Regulations.
Nonetheless, SEBI vide FAQ 13 of the frequently asked questions on PIT Regulations (“PIT FAQs”) clarified that the pledgor or pledgee may demonstrate that the creation/ revocation of pledge or invocation of pledge was bona fide and prove their innocence under proviso to sub-regulation (1) of regulation 4 of the PIT Regulations.
While this clarification provides some respite, if an insider proposes to create a pledge during the trading window closure, the insider requires approval from the compliance officer of the listed company. However, compliance officers are accountable to the regulator, and hence may hesitate to give such approvals easily.
Therefore, while pledges should not have ordinarily fallen within the mischief of the PIT Regulations, given the wide nature of the definition of ‘trading’, pledges must follow the same rigour as selling shares vis-a-vis the PIT Regulations.
Contra Trade under PIT Regulations and Top-ups
Margin loans usually require borrowers to maintain a minimum collateral value as agreed between parties. If the value of the shares falls below the minimum collateral value, borrowers must pledge additional shares or maintain cash margin. Thereafter, if the value of shares rises again, it would result in de-pledging of shares by the borrowers. This pledging and de-pledging could happen within a span of six months solely due to market fluctuations. While such pledges should have been par for the course, there is a view that these attract contra-trade restrictions.
Contra trades or swing trades are trades or transactions that typically involve buying or selling any number of shares of a company and effecting an opposite transaction by selling or buying the securities within six months of making the initial trade.
The PIT Regulations prohibit ‘contra trade’, while in possession of and relating to UPSI. As stated above, since the definition of trading is wide enough to bring within its ambit ‘dealing’ in shares, it implies that if a designated person pledges his/ her shares, he/ she can neither de-pledge shares nor change the banker with whom such shares are pledged in the following six months, as per PIT Regulations.
This restriction seems unreasonable for pledging shares as a collateral for availing loans and credit facilities as borrowers or security providers will be under contractual obligation to pledge/ de-pledge shares to match the minimum collateral value, in case of market fluctuations. If contra trade restrictions were to apply on pledge of shares, it would impede a routine activity in the banking and finance industry. It is also relevant to note that in offshore jurisdictions, contra trade applies to sale and purchase of shares and not for pledges.
In this regard, SEBI in its Informal Guidance to Geetanjali Trading and Investments Pvt. Ltd. (“GTIPL”), dated November 9, 2015 (“Informal Guidance”), clarified that creation, release and further creation of pledges during the six-months period is permissible, provided such transactions are carried out within the spirit of the PIT Regulations. Also, the onus to demonstrate the same will lie with the pledgor/ pledgee. SEBI also referred to facts and presumed that pledging was for genuine business purposes and stated that the defence provided in regulation 4(1) of the PIT Regulations will be available to GTIPL.
In this case, GTIPL, along with some of its associate companies, was borrowing from financial institutions on an ongoing basis. The amount borrowed was secured by pledging the shares of Asian Paints Limited (“APL”) in favour of the lenders.
- At the end of the tenure, the loans were either rolled over to the same lender or shifted to other lenders. GTIPL, with associate companies, was part of the promoter and promoter group of APL.
- At the time of maturity of loans, the above entities had to pledge and ‘de-pledge’ APL shares in favour of the lenders as per the loan agreements. This resulted in pledging and simultaneously ‘de-pledging’ of APL shares within a period of six months, resulting in a ‘contra trade’.
It is apparent from the SEBI’s view in this Informal Guidance that executing pledges/ releasing pledges, etc., in the six-months period is permissible, provided that it is bona fide and for genuine business purposes.
Conclusion
The broad definition of trading may have been guided by the SEBI’s intent to safeguard the interests of investors in the securities market. Though SEBI has, time and again, clarified that bona fide trades are permissible, creation of a pledge can be a challenge when the trading window is closed. A similar challenge arises when a top up pledge is required to be created, within a period of six months after ‘de-pledging’ the shares. The SEBI informal guidance, as stated above, demonstrates its perspective. While considering these issues, it is necessary to identify SEBI’s intent behind introducing such provisions and identifying the ‘right evil’ that the regulator intends to curb. A contrary view could adversely impact the banking and finance industry where creation/ invocation/ revocation of pledges is a frequent activity. It may also help if the regulator made an exception from the PIT Regulations for pledges made in favour of banks (onshore and offshore), financial institutions and/or capital market investors.
