An analysis of the SEBI WhatsApp Orders: Some observations on regulation-making and adjudication

by Rajat Asthana and Renuka Sane and S. Vivek.

The idea of company insiders making huge profits on the basis of non-public information has always elicited a rich discussion on the regulation of insider trading. If the goal of regulation is to craft market participants' behaviour, both, the text of the regulations, and the subsequent enforcement actions of regulators should support this objective. When these are unclear or contradictory, merely having regulations on the book, is unlikely to help. At worst, this may even hinder market efficiency. It is important, therefore, to look at how regulations have been drafted, and to see whether there is a consistent communication of what the regulations mean. This includes questions on the clarity of the regulations, the process of regulation-making, as well as the predictability in enforcement.

In this article we use the example of recent orders in the "WhatsApp case" to demonstrate the problems in: (1) the process of regulation-making, and (2) adjudication, in the context of insider trading regulations. The orders raise several substantive questions. These relate to the scope of the term 'insider', meaning of Unpublished Price Sensitive Information (UPSI), and use of messaging platforms. However, in this article, we mainly focus on the issue of the working of the regulator.

India may have formal provisions against insider trading, and satisfy international standards in that regard. However, the substantive content of the regulations, the rationale for these regulations, the manner of prosecution by the regulator, and the imposition of penalties have all raised concerns on the clarity, consistency and predictability in the regulatory process. This may impose significant costs on regulated entities, and consequently, on cost of capital.

Background: The WhatsApp case

Insider trading in India comprises two types of offences: trading with unpublished price sensitive information ("UPSI") and communication of UPSI (even in the absence of trading). In November 2017, Reuters reported that information about financial results of listed companies was being exchanged on WhatsApp groups, in advance of such results being announced publicly. The news report identified 12 companies where the messages proved to be "prescient" - i.e., they appeared to accurately predict the actual results. Based on this news report, the Securities and Exchange Board of India (SEBI) initiated an investigation into the matter. Basis this investigation, separate showcause notices were issued to certain individuals who are part of the WhatsApp group, and it was alleged that the noticees had communicated UPSI, which even in the absence trading, constituted a violation of provisions of the Securities and Exchange Board of India Act, 1992 (SEBI Act) and the SEBI (Prevention of Insider Trading) Regulations, 2015 (Insider Trading Regulations).

The noticees set up a defense on the basis that the information that they shared on the WhatsApp group was not UPSI. The information had not been sourced from the relevant company or any insider. Further, the messages were not 'price sensitive information' or 'financial results' but in the nature of gossip or 'Heard on the Street'. Additionally, messages were exchanged about several companies - a few of which were consistent with the actual financial results, and many others which were not - and accordingly, the allegations were based on cherry-picked messages. It was also argued that the source of the messages on the WhatsApp group could be analyst reports which had predicted similar results, and therefore should be considered as generally available information (and not UPSI).

The SEBI Adjudicating Officer (AO) dismissed these defenses and held that the messages were UPSI. The AO reasoned that while the source could not be identified because the messages were being shared on WhatsApp, they were UPSI because: (1) the messages were shared just prior to the results being released publicly, and (2) they were so similar to the actual financial results, that it was unlikely to be a coincidence. Further, since the noticees did not clearly establish the analyst reports as the source of the messages, they are not entitled to the 'benefit of doubt' that the messages were in fact sourced from such reports. Accordingly, a penalty of Rs.15 lakh was imposed on the noticees.

On appeal, the Securities Appellate Tribunal (SAT) set aside the SEBI order. It held that SEBI had not given adequate consideration to some of the defences. It also held that for information to be UPSI, the recipient had to know that it was UPSI. The evidence available did not establish the state of mind of the recipients and accordingly, the SEBI order was set aside.

Standard-setting Choices

Standards for insider trading are not uniform across jurisdictions. For example, in the US, liability arises only if the person owes a fiduciary duty to the company or its shareholders or the source of the UPSI. Other jurisdictions such as the UK and Singapore, have adopted the 'parity of information' approach where the emphasis is on the information with the person trading, and not on how it was obtained or whether there was an intention to violate the law (Varottil, 2016).

In India, the language of Regulations 3 and 4 of the Insider Trading Regulations indicates a strict liability regime, where the focus is on the UPSI, and not on the intention behind the trade or the source of the information. Regulation 3(1) prohibits communication of UPSI and Regulation 4 prohibits trading when in possession of UPSI.

Committee reports on insider trading have recommended that communication of UPSI by itself should be an offence. While the offence is drafted broadly, the interpretive note provided in regulations appears to indicate that the emphasis is on the company to ensure that UPSI is not leaked. The High Level Committee to Review the SEBI (Prohibition of Insider Trading), 1992 under the chairmanship of Justice N.K. Sodhi dated December 7, 2013 (Sodhi Committee Report), observed that 'to maintain hygiene' and to 'ensure that UPSI is not handled lightly... and is not communicated except where necessary', communication of UPSI is to be prohibited (Sodhi Committee Report, 2014). The report of the Committee on Fair Market Conduct under the chairmanship of T.K. Viswanathan dated August 8, 2018 (TK Viswanathan Committee Report), observed that UPSI may be communicated for legitimate purposes. The report clarified the meaning of the term 'legitimate purpose', and also recommended maintaining a database of persons to whom such UPSI is being communicated, to prevent misuse.

However, neither the Insider Trading Regulations nor the committee reports distinguish between persons who have a duty to keep the information confidential (such as directors and officers of the company), and outsiders who may chance upon this information but do not have any such obligation. In Singapore, for example, it is presumed that connected persons were aware that the information is UPSI; however, this presumption is not 'available' for others including tippees. In the absence of such guiding principles or specific rules, these critical questions are left entirely to the AO's discretion.

Further, the SEBI Board made certain modifications to the draft regulations suggested by the Sodhi Committee Report, but the reasons for such modifications are not available publicly. One of the changes was to delete the clear language in the draft regulations that research reports should be considered as generally available information. While there may be good reasons for the SEBI Board to have made this modification, the absence of reasons for this choice leads to confusion about how information in research reports should treated. For example, if it were clear that information in research reports is generally available information, then similar numbers appearing in a Whastsapp group should not have raised UPSI concerns.

Lack of clarity on reasons for specific legislative choices could also lead to different views being taken by various adjudication officers and the appellate tribunal.

Adjudicatory Discipline

There will always be some uncertainty inherent in legal rules, despite best efforts during the standard-setting process. Disagreement among judicial officers on the interpretation of the law is expected to be settled by appeals to higher tribunals/courts. However, for this process to work, judicial officers will have to look to previous interpretations and record reasons if a new interpretation is preferred in a specific case, especially if a higher tribunal has already indicated a particular interpretation. How has uncertainty been resolved in the WhatsApp orders?

The SEBI AO order states that it was not possible to identify the original source of the messages shared on the Whastapp group. Inquiries with the relevant companies also did not establish any leak of the financial information. The noticees were not clear as to how they received the messages, but they suggested that the messages could have been sourced from analyst reports. How should information in the hands of unconnected third parties be evaluated?

The committee reports do not provide an answer in the context of the communication offence. However, in the context of the trading offence, the Sodhi Committee Report states that SEBI will be required to demonstrate that: (1) trading took place, and (2) that there can be a reasonable inference of the person being in possession of UPSI at the time of execution of the trade. If the trade is by an 'outsider' i.e. a person not connected to the company, then SEBI has to further demonstrate a prima facie case that the noticee was in possession of UPSI at the time of trading (Sodhi Committee Report).

The AO order states that since the information is closely aligned to the actual results, and the noticees have not been able to demonstrate how they came to be in possession of the information, it is to be presumed that the information is UPSI. Further, while the source of the information could not be traced, the noticeees cannot be given the 'benefit of doubt' given the 'gravity of consequences' resulting from the sharing of such information.

In terms of the AO's interpretation, the Insider Trading Regulations do not require the source of the information to be identified for a violation to be established. However, this issue has been considered earlier by both - SEBI and the SAT. The SAT has held that the source of the information is an important element in establishing UPSI (Samir Arora v. SEBI). The AO orders have neither accepted that principle nor sought to distinguish that precedent based on specific facts. Further, while there are references in the AO orders to judicial decisions on circumstantial evidence being sufficient in certain cases, this issue was not in dispute. The AO orders do not cite any precedent to justify how mere similarity of some information with the actual results is sufficient for it to be classified as UPSI. Further, while the AO order cites various extracts from the Sodhi Committee Report, there is no reference to the portion, which states (albeit in the context of trading), that it is SEBI's obligation, to prima facie show how an unconnected person was in possession of UPSI.

Additionally, it is worth noting the approach in some other SEBI orders on insider trading issued around the same time: One held that the noticee was not liable for insider trading (even though the noticee had UPSI and had traded) since the intention behind the Insider Trading Regulations is that the person in possession of UPSI should not benefit compared to the general investor. In another, even though a director had access to UPSI and benefited from trading, it was held that although price sensitive, the information was wrongly disclosed by the company and therefore was not UPSI; and that the director's conduct did not indicate that he intended to maximise profits (a defense that the SEBI Board expressly rejected while adopting the other recommendations of the Sodhi Committee Report). In a third case, a company official had traded when the trading window was closed, but it was held not to be in violation of the Insider Trading Regulations as there was no material to show that the trading was on the basis of the UPSI (although this is not the requirement under the Insider Trading Regulations). If any one of these principles had been applied in the WhatsApp orders, the result could have been different.

Further, while the SAT records its earlier judgment emphasizing the importance of the source of UPSI, it sets out a new test for subjective knowledge of the recipient. Again, there is no reference to precedent or to the background reports for setting out this new test. Indeed, the SAT could have set aside the SEBI order by merely reiterating the principle in its earlier judgment and avoided setting out a new test.

Penalty

The AO's order on penalty also demonstrates that when there are gaps in the law, officials use their discretion completely. Section 15J of the SEBI Act sets out the factors which are to be considered when an AO imposes penalties:

1. Amount of disproportionate gain or unfair advantage, where quantifiable, as a result of the default;

2. Amount of loss caused to investors as a result of the default; and

3. Repetitive nature of the default.

In imposing a penalty on the noticees, the AO is forced to concede that none of these factors apply in this case. By merely communicating UPSI, no loss or advantage had been caused to anyone. The AO then proceeds to impose a penalty of Rs. 15 lakh, as such acts may compromise the confidence of investors in the market.

Evidently, the considerations for imposing the penalty do not relate to the different types of offences. In Adjudicating Officer, SEBI v. Bhavesh Pabari, the Supreme Court held that the factors set out in Section 15J are not exhaustive, particularly in the context of offences such as failure to furnish information and returns, which will typically not involve the factors set out above. It is arguable if this holding entirely applies in the context of insider trading where these factors are typically relevant. In any event, even if these factors do not apply, the order should state what other factors outside of Section 15J have been considered relevant. Without these reasons, it is not clear how the penalty amount of Rs. 15 lakh was calculated. These are concerns not specific to the individual penalty imposed in this case but for the overall design of the regulations.

Implications for the design of the legal framework

The learnings from the WhatsApp case has implications for the design of the insider trading framework in India:

1. Standard-setting: Lack of clarity on why certain choices were made at the time of standard-setting makes it challenging to interpret the principles inherent in the regulations. Further, even where the SEBI Board has deviated from some recommendations of the expert committee, the reasons for such deviation have not been disclosed. This information is critical, not only from the perspective of transparency, but also as a guide to officials as to the purpose of creating an offence, when they adjudicate cases in connection with such matters.

2. Adjudicatory process: While the common law judicial tradition is well suited to clarify existing principles in light of changes in technology and markets (Report of the Financial Sector Legislative Reforms Commission), this requires officials to record their interpretation of law and explain if that is different from an earlier interpretation. Similarly, while imposing penalties, the factors considered should be made explicit to ensure clear communication to stakeholders and consistency among orders.

3. Taking stock: More than five years have passed since this iteration of the Insider Trading Regulations were issued. It is not possible to think of every situation at the drafting stage, particularly for an area that is constantly changing. Further, there have been changes to some portions of the regulations pursuant to the TK Viswanathan Committee Report. However, a comprehensive review of the effectiveness of the regulations, and a transparent discussion of the various choices made in framing the regulations, will benefit all stakeholders.

Conclusion

The problems of the insider trading legal framework discussed in this article connect to an emerging literature on the problems of regulatory governance in India. For example, Burman and Zaveri (2018) study the process of public consultation in regulation making across three regulators in India and find that much more needs to bedone. Others have argued that there is little guidance given to regulators on how to translate the principles of law into practice (Burman & Krishnan, 2019; Sundaresan, 2018; Goyal and Sane, 2021). This leads to a situation of weak state capacity in India (Roy et. al., 2019).

Ultimately, if the goal of regulation is to (dis)incentivise market participants from (not) behaving in a particular manner, then the text of the regulations, and subsequent actions of regulators should support such an objective. If the text and the subsequent actions of the legal regime are weak, unclear, confusing, or inconsistent, then the mere existence of a legal framework may at best not help, and at worst, actually hinder the working of the market. It is also important to study how the text of the law was arrived at - whether there is adequate rationale provided on the choices made, whether public consultations have been undertaken, and whether sufficient guidance is provided to both; the regulator, and the regulated entities, so that there is a shared understanding of the objective, and the process of the legal framework. It is also critical to ensure that the regulator moves towards a consistent interpretation of the regulations that allows for predictability, instead of each order interpreting the regulations in their own way.

References

Burman, A., & Krishnan, K. (2019). Statutory regulatory authorities: Evolution and impact.

Burman, A., & Zaveri, B. (2018). [https://bit.ly/32eDCdX]Regulatory responsiveness in India: A normative and empirical framework for assessment. William & Mary Policy Review, 9 (2), 1-26.

Roy, S., Shah, A., Srikrishna, B. N., & Sundaresan, S. (2019). Building state capacity for regulation in India. Devesh Kapur and Madhav Khosla (eds.), Regulation in India: Design, Capacity, Performance, Oxford: Hart Publishing.

Samir Arora v. SEBI, (2004) SCC Online 90.

Sodhi Committee report - Part II, paragraph 43, page 27; SEBI Board Agenda dated November 14, 2014 - paragraph 2.2.

Sundaresan, S. (2018). Capacity building is imperative. Column titled Without Contempt in the editions of Business Standard dated August 2, 2018.

Varottil, U. (2016), "Due Diligence in Share Acquisitions: Navigating the Insider Trading Regime", NUS working paper at page 9 (April 2016).

Rajat Asthana and S. Vivek are researchers with the Regulatory Governance Project at the National Law School of India University, Bengaluru. Renuka Sane is a researcher at NIPFP. Author names are in alphabetical order. We thank two referees for useful comments. Views are personal.