Undisputedly, with the ever-going advancement of technology in our society, financial crimes and frauds have often found their way through the loopholes of the law. Hence, in order to tackle such new-age difficulties in the financial markets, legislators and regulators like SEBI have time and again tried to fill the gaps in the law thereby prioritising the interest of investors and various other stakeholders in the market.
The objective of this paper is to analyse and understand the various aspects that led to the proposal of the draft of SEBI (Prohibition of Unexplained Suspicious Trading Activities in the Securities Market) Regulations, 2023 [hereinafter, “PUSTA Regulations” or “Draft”] as released by SEBI in the form of a Consultation Paper. The article goes further to establish how these Regulations are different from the already existing SEBI (Prohibition of Insider Trading) Regulations [hereinafter, “PIT Regulations”] and Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 [hereinafter, “PFUTP Regulations”] andfollowed by a detailed analysis of the problem addressed, penal provisions, the effectiveness of the Regulations, adjudication framework, etc. Towards the end, the article addresses the issues that revolve around the PUSTA Regulations and the recommendations which may cater to the same.
Understanding Insider Trading
Insider Trading, in the simplest words, is the trading in the securities of a company by an Insider. Insider, as we know, is a person who has the access to a privileged piece of information (called Unpublished Price Sensitive Information or UPSI) on the basis of which he/she is at an advantageous position to trade in securities as against those that are not in possession of such UPSI. The PFUTP and PIT Regulations essentially form the major chunk of law which regulates the Insider Trading and other forms of Front Running in the Indian financial market. The rationale behind the existence of such law, not only in the Indian context but every other jurisdiction of the world, is not quite complex to comprehend. Here are some theories that necessitate and justify the existence of PFUTP and PIT norms in the securities market:
- Insider Trading creates a bias in the financial market: The confidential piece of information available to the insiders allows them to reap profits or avoid losses to the disadvantage of those who do not possess such inside information. Hence it is a reprehensible practice as it goes against the rule of equity which puts every investor to an equal pedestal.[1]
- Insider Trading is Unfair: The practice of insider trading is also unfair in a sense that it allows the insiders to use the confidential information to their personal benefit whereas the purpose of such information was not so in the first place.
- Insider Trading is the breach of a fiduciary duty: Any individual holding the position of director, executive officer, or agent of the company is under a fiduciary obligation to refrain from using the company’s confidential or proprietary information for their own benefit.
- Insider Trading Diminishes the Confidence of a Common Investor in Securities Market: The public’s faith in the financial markets suffers as a direct result of insider trading since it makes small investors reluctant to put their money into the market when they believe it is rigged against them. If there are no legal restrictions on insider trading, then it is likely that investors will be hesitant to risk their capital in that market.[2]
The legal standard of proof in accordance with both PIT and PFUTP frameworks is circumstantial evidence, also known as the preponderance of probability, which refers to evidence that suggests a high likelihood of a violation. However, the standard of preponderance of probability is quite extensively discussed by the Courts while dealing with different cases on Insider Trading. For example, in the PC Jeweller case,[3] the Supreme Court ruled that trading patterns alone cannot be used as evidence of insider trading without proof of possession and transfer of non-public price-sensitive information. Another example is the case of Abhijit Rajan,[4] in which it was decided that an insider’s motivation to make money is a necessary requirement for a successful charge of insider trading.
WhatsApp Leak Case: Unveiling of New-Age Difficulties
(A) Facts
The Securities Appellate Tribunal (SAT) recently made a significant ruling in the case of Shruti Vora v. Securities and Exchange Board of India.[5] In this case, SAT overturned the penalty imposed by the Securities and Exchange Board of India (SEBI) under the SEBI (Prohibition of Insider Trading) Regulations, 2015 (PIT Regulations). The penalty amounted to INR 15,00,000/- and was imposed on multiple individuals for the dissemination of unpublished price sensitive information (UPSI) through WhatsApp messages that were shared as forwarded content.
In November 2017, SEBI initiated search and seizure operations on individuals associated with 26 entities who were members of a specific WhatsApp group. This action was taken in response to press reports that suggested the premature circulation of quarterly financial results of various companies within these groups, prior to their official public disclosure. As a result, approximately 190 devices were confiscated. A thorough analysis was conducted on multiple WhatsApp conversations, leading SEBI to assert that confidential financial data pertaining to 12 companies had been compromised.
In order to initiate legal proceedings, SEBI utilised information obtained regarding six companies. This information was obtained after their financial data was leaked shortly after the completion of their financial statements. The leaked data corresponded with the public disclosures made by these companies two weeks later.
The Securities and Exchange Board of India (SEBI) concluded that the individuals in question, who were either employees of the listed entities or engaged in the securities market, were not obligated to disseminate such messages to any individuals or clients. SEBI determined that the information in question constituted Unpublished Price Sensitive Information (UPSI) and was circulated in violation of the Prohibition of Insider Trading (PIT) Regulations. The Securities and Exchange Board of India (SEBI) stated that it had taken into account the potential existence of the information prior to its order imposing a penalty. The decision was based on the close timing between the circulation of the WhatsApp messages and the publication of financial results, as well as the significant similarities between the figures shared and the actual results declared by the companies involved.
(B) Appellant’s Arguments
The appellants presented their argument that the Securities and Exchange Board of India (SEBI) had conducted an investigation into the financial results preparation process of the mentioned companies, including the individuals involved, including former employees who were involved in the process. The appellants stated that SEBI did not find any evidence of information leakage during this investigation. Additionally, the messages obtained by SEBI indicate that the appellants were not the creators of the messages, but rather forwarded them as they were received from another source. The inability to trace the source(s) of these messages was due to the passage of time and WhatsApp’s implementation of end-to-end encryption policy. The appellants further contended that SEBI selectively chose information and disregarded multiple messages containing inaccurate financial information pertaining to the quarterly results of certain listed companies.
The appellants also referenced the common market practise of estimating financial results of listed entities before their disclosure. They also mentioned the market concept known as “Heard on the Street”, which is popular among traders, market analysts, and others. This concept involves the sharing of unsubstantiated information, including by news agencies such as CNBC, Reuters, and Bloomberg. The appellants also highlighted that reputable market publications, such as the Wall Street Journal, operated dedicated Twitter accounts for the dissemination of such information.
(C) Respondent’s Arguments
The Securities and Exchange Board of India (SEBI) justified its actions by stating that specific financial information shared on the messaging platform WhatsApp was found to be identical to the officially published results. Hence, it was not necessary to provide evidence of leakage or identify the source of the information in order to establish that the information contained in the WhatsApp messages was Unpublished Price Sensitive Information (UPSI).
Additionally, SEBI aimed to distinguish between the estimates presented on Bloomberg and other agencies and the information conveyed through WhatsApp messages. This differentiation was based on the fact that the estimates were disclosed before the companies finalised their financial results, resulting in variations in the figures.
(D) Observations of SAT
The Securities Appellate Tribunal (SAT) observed that the Securities and Exchange Board of India (SEBI) had not adequately acknowledged the possibility that the WhatsApp messages may have originated from brokerage houses or from publicly available estimates on Bloomberg. As such, this information could not be considered as unpublished price sensitive information (UPSI). The Securities Appellate Tribunal (SAT) also acknowledged the appellants’ argument that the Securities and Exchange Board of India (SEBI) had neglected to take into account additional messages received and forwarded by the appellants that did not align with the publicly disclosed financial results.
Based on the ruling in the case of Samir Arora v. SEBI,[6] the Securities Appellate Tribunal (SAT) also dismissed SEBI’s argument that it was unnecessary to establish a connection between the potential source of the Unpublished Price Sensitive Information (UPSI) and the individual accused of possessing said UPSI.
The Securities Appellate Tribunal (SAT) has also determined that according to the Prohibition of Insider Trading (PIT) Regulations, information is classified as Unpublished Price Sensitive Information (UPSI) only when the recipient of the information was aware that it qualified as UPSI. The validity of this knowledge can be established through the principle of preponderance of probabilities, which relies on evidence derived from relevant circumstances that were absent in the current case. According to the current findings, the Securities and Exchange Board of India (SEBI) was unable to provide sufficient evidence to demonstrate that the WhatsApp messages constituted unpublished price sensitive information (UPSI). Furthermore, SEBI did not establish that the individuals in question were aware that the information in question was UPSI, and subsequently shared it with other parties.
(E) Appeal
The SEBI preferred an appeal against the order under section 15Z[7] of the SEBI Act, 1992 before the Supreme Court. The Apex Court dismissed the appeal in light of the facts and circumstances of the case.
Overview of SEBI PUSTA Regulations
(A) What Led to the Introduction of the PUSTA framework?
The proposed framework by the market regulator is a response to various judicial pronouncements, including the PC Jeweller Case (supra), Abhijit Rajan’s Case (supra), and the WhatsApp leak Case (supra). Reference can also be made to the Delhi High Court judgment in the case of Karmanya Singh Sareen & Anr. v. Union of India,[8] where the WhatsApp was prohibited from disclosing the information of its users to Facebook or any affiliated entities. These cases, along with the government’s hesitance to grant SEBI the authority to decrypt electronic communications, have prompted the regulator to put forth this new framework called SEBI (Prohibition of Unexplained Suspicious Trading Activities in the Securities Market) Regulations, 2023 [hereinafter, “PUSTA Regulations”].
(B) Idea Behind the Regulations
According to the proposed framework, if an individual or a group engages in repetitive abnormal trading patterns that result in significant changes in risk, specifically related to the presence of Material Non-Public Information (MNPI), it will be classified as Suspicious Trading Activity (STA). Consequently, such behaviour will be deemed a violation of securities laws. If an individual or individuals fail to provide compelling counterarguments, it will be referred to as Unexplained STA and a decision may be rendered. Material non-public information (MNPI) is defined as information that is not widely available but, upon becoming so, could reasonably affect the price of a company’s securities. This definition is similar to that of undisclosed price-sensitive information (UPSI) in insider trading laws. MNPI can include details about an upcoming order that would reasonably impact the security’s price upon execution, as well as information about an impending recommendation in a security by an influential individual. As an illustration, if a trader consistently executes substantial orders and profits from such trades (utilising non-public information) immediately prior to the release of a company’s quarterly results (material non-public information), this would be considered a presumed violation (subject to regulatory scrutiny).
(C) Penal Provisions
Regulation 3(2) of the Draft stipulates that any violation is subject to penal action by the SEBI under the SEBI Act and the rules and regulations made thereunder.
Furthermore, Regulation 4 of the Draft puts an obligation on every Recognised Stock Exchange (RSE) and every intermediary registered with SEBI under Section 12 of SEBI Act 1992 to report to SEBI on immediate basis of any STA that has either been noticed by them suo moto or brought to their notice in the course of their business.
The Board has been granted discretionary power to initiate investigation against any person or group of connected persons if it has a reasonable ground in respect of the same.
(D) Adjudication Framework
In order for the Securities and Exchange Board of India (SEBI) to issue orders against an entity, it is necessary to have circumstantial evidence and a preponderance of probability. In contrast to the standard of proof beyond a reasonable doubt, the preponderance of probability standard necessitates that a fact be sufficiently likely when considering multiple probabilities. The Securities and Exchange Board of India (SEBI) has encountered challenges in accumulating sufficient evidence to establish a preponderance of evidence in its favour. The utilisation of innovative encrypted methods for transmitting confidential information and conducting trades has resulted in limited success when attempting to collect evidence through conventional means such as call data records. This led to the development of the proposed regulation, which completely disregards the need to collect evidence and establish the occurrence of any violation in the initial stages. Sebi is now required to provide evidence of the existence of material non-public information (MNPI) and the occurrence of trading activities during that specific period. There is no necessity to establish a connection between the trader and their knowledge or access to Material Non-public Information (MNPI), as is customary in cases involving insider trading.
(E) Issues Involved
The importance of a proposal to amend the existing framework in order to ensure conviction cannot be emphasised enough. However, it is important to note that the current approach is riddled with concerns.
- The Constitutionality of Presumption of Guilt Provision is questionable: In case of Seema Silk & Sarees v. Directorate of Enforcement,[9] the Apex Court held that “reverse burden as a statutory presumption is permitted, but it can be raised only when certain foundational facts are established by the prosecution.” The Court referred to statutes such as the Negotiable Instruments Act and the Prevention of Corruption Act to support its assertion that the imposition of a reverse burden alone does not necessarily make a statute unconstitutional.
However, the practise of shifting the burden of proof and presuming guilt based solely on suspicion can be seen as contradictory to the fundamental principles of fairness and justice. The Securities and Exchange Board of India (SEBI) utilises the Supreme Court’s observations in multiple cases to highlight that the notion of ‘unfair trade practise’ can be interpreted expansively.[10] As a regulatory authority, SEBI is responsible for establishing a fair and equitable market environment.
- The Approach provided in the framework is Broad and Ambiguous: Employing a broad approach to apprehend perpetrators is likely to cause inconvenience for all individuals involved. Legitimate traders may find themselves unjustly trapped in the overwhelming influx of ‘show cause’ notices. Although some legitimate traders may be able to challenge the assumption, it can potentially result in unnecessary time loss and higher litigation expenses. Moreover, considering the inherent subjectivity of rebuttals, it is possible for legitimate traders to have orders passed against them, resulting in a detrimental impact on their reputation. For instance, a prudent trader will carefully consider their positions prior to the release of a company’s quarterly results. This is because consistently profiting from trades in anticipation of positive results could potentially attract scrutiny and result in a formal inquiry, despite the financial gains. A professional algorithmic trader may exercise caution when executing trades, as they may have concerns regarding the potential existence of material non-public information (MNPI) that they were not previously aware of. The mere act of assuming guilt should not be based solely on the willingness to take on additional risk in pursuit of high rewards. It would be beneficial to consider making certain modifications to the proposal in order to mitigate any potential impact on legitimate traders.
- Certain definitions under the framework are either absent or not clear: Additionally, the existing proposal contains unspecified terms that could introduce inconsistency and subjectivity into the adjudication process. The Securities and Exchange Board of India (SEBI) has not provided clear definitions for terms such as ‘repetitive pattern of trading activity’, ‘short period of time’, and ‘abnormal profits/losses’ in its definition of Unfair Trade Practises (UTP). Additionally, the assessment of a ‘change in risk taken’ is subjective and lacks objective criteria. This approach would enable a significant level of discretion for the adjudicator, potentially resulting in ambiguous rulings and prolonged legal disputes. It is advisable for the Securities and Exchange Board of India (SEBI) to establish clear definitions for these terms or offer specific examples within the existing framework.
- The Counterarguments as suggested by SEBI are also problematic: The presumption of guilt is a rebuttable presumption. Upon reviewing several counterarguments presented in the consultation paper, it becomes evident that alleged offenders face a formidable challenge.
- One of the counterarguments is that the data upon which the trades are purportedly founded is not material, or that said information was already available to the public. Consequently, it can be argued that the information does not qualify as material non-public information (MNPI). Within the proposed framework, Sebi provides notification to the accused party regarding what it deems to be Material Non-Public Information (MNPI). However, there is no assessment conducted to determine whether the accused party had a reasonable basis to possess or establish a connection with said information. It could pose a challenge for an accused party to impartially assert that certain information is immaterial, particularly considering that Sebi would have already examined the same before issuing the show cause notice. In the majority of instances, the determination of whether certain information qualifies as Unpublished Price Sensitive Information (UPSI) is typically established, even in situations involving insider trading. The crux of the defence primarily hinges on whether or not they possessed access to said information.
- Another counterargument is that the trading pattern does not exhibit repetitiveness. By maintaining a level of subjectivity in certain aspects of the presumptive deeming provision, Sebi is implementing a stringent approach that could potentially affect legitimate traders. Additionally, it is necessary for the accused individual to provide comprehensive documentary evidence in order to support any assertions made. In certain cases, a modification in trading pattern may involve a deliberate choice to assume additional risk with the expectation of achieving greater rewards. The task of maintaining records to provide evidence for every decision can be burdensome and occasionally unfeasible. It is imperative to maintain high thresholds of suspicion in order to minimise errors in reasoning and to safeguard against wrongful convictions of innocent individuals.
- The Parent Act does not provide sufficient authority: In addition, SEBI has argued in the Consultation Paper that its proposed presumption of guilt approach is identical to that which is provided by income tax law with respect to unexplained cash credits. While the provision pertaining to income tax, as well as similar provisions found in other laws, are included within the parent legislation, there is no provision within the SEBI Act itself that addresses this matter.
Recommendations
- It is pertinent to establish well-defined standards that would necessitate the shifting of the burden of proof on the accused.
- The definitions clause must be unambiguous and clear for the other provisions to have the desired impact and results.
- There can be use of technology in detecting Suspicious and Unusual Trading Activities, however, even then it must not solely constitute as a ground to initiate adjudication proceedings.
Conclusion
Given the nature of the violations and the challenges faced by Sebi in obtaining evidence, it may be necessary to consider a presumption of guilt. However, it is even more important to exercise caution in order to prevent any undue impact on legitimate market participants as a result of this new framework. Adopting a well-rounded approach is the recommended course of action.
[1] A.M. Louis The Unwinnable war on insider trading. (1981)
[2] ICSI, Guidance Notes On Prevention of Insider Trading (Revised Edition), 2022
[3] Balram Garg v. SEBI along with Shivani Gupta & Ors. v. SEBI (2022) 9 Supreme Court Cases 425
[4] SEBI v. Abhijit Rajan, 2022 SCC OnLine SC 1241.
[5] Shruti Vora v. Securities and Exchange Board of India, [2021] 126 taxmann.com 38 (SAT – Mumbai).
[6] Samir Arora v. SEBI, (2004) SCC Online SAT 90.
[7] Securities and Exchange Board of India Act, 1992, §15Z, No. 15, Acts of Parliament, 1992 (India).
[8] Karmanya Singh Sareen & Anr. v. Union of India, (2016) 233 DLT 436 (DB).
[9] Seema Silk & Sarees v. Directorate of Enforcement, (2008) 5 SCC 580.
[10] Vini Gupta, The Indian Stock Market Saga, SCCOnline (2020). https://www.scconline.com/blog/post/2020/07/08/the-indian-stock-market-saga/
Author: Ishita Chawla
Juris Centre 