Critique on Unpublished Price Sensitive Information- Kotak Committee report on Corporate Governance

A committee has been constituted by SEBI under the Chairmanship of Mr. Uday Kotak (“Kotak Committee”), whereby certain amendments have been proposed to the Indian legislations for listed companies. After careful deliberations, a report has been submitted by the Kotak Committee on Corporate Governance dated October 5, 2017 (“Report”). The purpose of the Report is to improve the standards of corporate governance of listed companies in India.

The critique of the Report is based on sharing of unpublished price sensitive information (“UPSI”) with promoters/ controlling shareholders and the consequent effect of such sharing of information with the specified persons.

The amendments have been proposed to the following legislations:

(a) Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”) by way of insertion of a new chapter IV-A; and

(b) Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015 (“Insider Trading Regulations”), by way of insertion of a new sub-regulation (2A) under Regulation 3 of the Insider Trading Regulations.

Set out below is a key analysis of the proposals laid out by the Kotak Committee in relation to sharing of UPSI.

1. UPSI – sharing with Specified Persons

(a) By way of an amendment to the LODR Regulations, the Report proposes 3 (three) classes of persons (“Specified Persons”) to whom a listed entity may provide access to material information (including UPSI), namely, any person who:

(i) qualifies as promoter of the listed entity and holds, by itself or together with the members of the promoter group, shareholding of more than 25% in the listed entity;
(ii) is in direct or indirect control of the person specified in point (i) above; or
(iii) has nominated a director on the board of directors of the listed entity.

(b) As a corollary to the proposed amendment to the LODR Regulations, the Report proposes an amendment to Regulation 3 of the Insider Trading Regulations, pursuant to which it will be deemed that any information communicated to/ procured by Specified Persons in accordance with the relevant LODR Regulations is in furtherance of legitimate purposes.

In the present scenario, for sharing of UPSI, a listed entity is required to meet the ‘legitimate purpose’ test, which is subjective and determined on a case to case basis. Pursuant to the deeming fiction proposed in Regulation 3 of the Insider Trading Regulations, the legitimacy of the purpose for sharing UPSI with the Specified Person will not be required to be tested. This will reduce the risk of regulatory scrutiny on the listed entity and the insider.

2. Terms of sharing of UPSI

(a) The Report proposes certain conditions/ procedures pursuant to which UPSI may be communicated to/ procured by Specified Persons. A majority of the terms and conditions would be required to be incorporated in the Agreement (provided below).

Some of the key conditions are:

(i) Execution of an ‘Access to Information Agreement’ (“Agreement”) between the listed entity and the Specified Person, in relation to provision of access to material information (including UPSI). Such Agreement is required to be for a period of not less than one year at a time.

(ii) A promoter of the listed entity which meets the 25% shareholding and a person in control of such promoter (i.e. persons mentioned in points (i) and (ii) of Paragraph (a)) may be provided access to any material information (including UPSI) (in accordance with the terms of the Agreement). However, a person who has nominated a director on the board of the listed entity (i.e. a person mentioned in point (iii) of Paragraph ((a) ) may be provided only such material information (including UPSI) as is shared with the nominee director in the normal course, by virtue of his directorship in the listed entity.

(iii) Automatic termination of the Agreement if the Specified Persons ceases to be eligible in the category of a Specified Person.

(iv) Onward communication of UPSI by the Specified Person to be in compliance with Insider Trading Regulations.

(v) An undertaking by the Specified Person in favour of the listed entity, that the access to information provided does not undermine the independence and autonomy of the board of directors of the listed entity in any manner.

(vi) Unilateral right of the listed entity to terminate the Agreement, with the consent of majority of directors of the listed entity representing three-fourths in number.

As per the present Insider Trading Regulations, since UPSI is not allowed to be communicated to Specified Persons, it forbids the requirement to execute an ‘access to information’ agreement. Currently, the recommendations proposed in the Kotak Committee serve for guidance purposes, however, once adopted and mandated as law then the communication between the Specified Persons would be contractually binding and subject to the terms of the agreement stated above. While it is difficult to principally controvert the access to the agreement point, practically it could provide an ammunition to the board against an activist shareholder action by the promoter.

3. Designated Persons

(a) Pursuant to the extant Insider Trading Regulations, ‘Designated Persons’ are (a) employees; and (b) connected persons (as defined under the Insider Trading Regulations), designated on the basis of their functional role in the organisation. Accordingly, the board of directors of the listed entity (in consultation with the compliance officer) has the discretion to specify the designated persons based on seniority, designation and access that the role and function of such person would provide to UPSI.

(b) Pursuant to the Report, it is proposed that (a) any individual representative of a Specified Person who is a recipient of UPSI will be categorised as a ‘Designated Person’; and (b) the Specified Person itself, may be categorised by the listed entity as a ‘Designated Person’. Such categorisation by the listed entity would be pursuant to an assessment by its board of directors (in consultation with the compliance officer), on the basis of the extent of information access provided or proposed to be provided to the Specified Person.

(c) It is pertinent to note that Designated Persons are subject to greater checks and compliances while trading in securities of the listed entity.

In light of the nature of the relationship of the Specified Person with the listed entity and the enabling provisions for sharing of UPSI as proposed in the Report, it is likely that the Specified Person shall always be in possession of UPSI. Categorisation of the Specified Person as a ‘designated person’ may therefore prove to be cumbersome and impose a compliance burden on the Specified Person.

4. Nature and purpose of sharing UPSI

(a) Pursuant to the extant Insider Trading Regulations, communication, provision, allowance of access to and procurement of UPSI is strictly prohibited, except in furtherance of legitimate purpose, performance of duties or discharge of legal obligations. Accordingly, in the event of regulatory scrutiny, parties sharing or procuring UPSI are required to demonstrate that such communication was ‘in furtherance of legitimate purpose’, which is determined on a subjective/ case to case basis.

(b) As stated in paragraph 1 (b) above, a deeming fiction has been proposed, pursuant to which any UPSI communicated or procured in accordance with the proposed Chapter IV-A of the LODR Regulations will be deemed to be communication or procurement of UPSI “in furtherance of legitimate purposes”.

(c) The proposed Chapter IV-A does not contain conditions/ restrictions in relation to the nature of UPSI which may be shared by a listed entity. In fact, it provides that (a) a promoter of the listed entity which meets the 25% shareholding; and (b) a person in control of such person mentioned in point (a), may be provided access to any material information (including UPSI) (in accordance with the terms of the Agreement).

(d) The proposed Chapter IV-A is silent on the use of UPSI by a Specified Person. It is not clear whether such use is required to be for the benefit of the listed entity.

(e) Excerpts from the rationale provided in the Report indicate scenarios envisaged by the Kotak Committee for the purpose of communicating UPSI by a listed entity and using UPSI by a Specified Person:

• (In the context of Indian companies)…“Information flow occurs through informal channels, matrix structures and through nominees. Generally, these may be for genuine business reasons, such as strategic transactions, including acquisitions, mergers, divestments, financing, etc., which often require the support of the promoter to be successful.”

• “Given the absence of a formal green channel on information access and an explicit framework recognizing a legitimate right to information of promoters and significant shareholders, all communication of UPSI to promoters and significant shareholders (including those for legitimate purposes and on a need-to-know basis) are open to regulatory scrutiny on a post facto basis.”

• … “this regulatory white space has so far possibly been filled in by virtue of legal interpretation (of terms such as “legitimate purpose”, “need to know”, etc.), market practice and pragmatism. Whilst derivative economic interest may suffice for some entities to constitute legitimate purpose, other companies may need clarity on each issue.”

(f) Proposals in the Report in relation to withholding of information by the board of directors of the listed entity may also be relied on to assess whether only UPSI which is beneficial to the listed entity may be disclosed.

In light of the deeming fiction proposed in relation to disclosure of UPSI to Specified Persons, it may be construed that there is no requirement to demonstrate meeting the ‘furtherance of legitimate purpose’ test. Further, it is proposed that a listed entity may provide access to “any material information” to a Specified Person. Therefore, it can be said that it is not entirely clear whether such UPSI which is communicated should be only that which will be in the interest of the listed entity.

It is pertinent to note that the proposals in the Report do not contain any restrictions on the use of the UPSI by the Specified Person for the benefit of the listed entity.

However, from the deliberations of the Kotak Committee, it appears that the nature of ‘legitimate purpose’ may have been envisaged to be communication of information on a ‘need to know’ basis, in furtherance of ‘strategic transactions’ or having a ‘derivative economic interest’. Taking of such a position by the regulator cannot be ruled out.

5. Trading by an insider

(a) Despite the proposed amendment in relation to procurement of UPSI by Specified Persons, the prohibition on trading by an insider while in possession of UPSI – the defences available to insiders for trading while in possession of UPSI, as contained in Regulation 4 of the Insider Trading Regulations, have not been proposed to be amended.

6. Board right to withhold information

(a) Pursuant to the Report, it has been proposed that notwithstanding the Agreement, a listed entity shall have the right to withhold communication/ access to material information in the event the board of directors of the listed entity determines that:

(i) providing access to the material information to the Specified Person is not in the interest of the listed entity;

(ii) there is a conflict of interest in the listed entity sharing the material information with the Specified Person; or

(iii) there has been a breach of the agreement by the Specified Person and the same has been established by the board of directors of the listed entity or its committee pursuant to an investigation.

(b) Notwithstanding that the proposal has been set as a board’s right, it may be construed to be the board’s duty to determine whether the material information to be provided to the Specified Person is in the interest of the listed entity/ that there is no conflict of interest.

(c) As a corollary to the board’s right to withhold certain information elaborated above, it may be interpreted that the only information which may be shared by the listed entity is that which is in the interest of the listed entity.

Owing to the nature of relationship between the Specified Persons and the listed entity, sharing of material information would be on a continuous basis. It is not clear whether it is the intention that the board of directors of the listed entity evaluate such information on a continuous basis. Since it is not feasible to do, the board of directors of the listed entity may consider issuing internal guidelines in relation to sharing of material information with Specified Persons. Such guidelines may specify the nature of information that would (a) typically not be in the interest of the listed entity; and (b) typically conflict with the interest of the listed entity In the event a more subjective test is required, the guidelines may designate a member of management of the listed entity who is responsible for determining the nature of the material information.

However, it is clear that the board of directors of the listed entity will have the discretion to withhold material information, if it determines that it is not in the interest of the listed entity to disclose it. Conversely, whether only information which is beneficial to the interest of the listed entity may be disclosed is not clear.

7. Autonomy of the Board

(a) As stated above, one of the conditions proposed for communication/ procurement of UPSI, is furnishing an undertaking by a Specified Person that the access to information does not “undermine the independence and autonomy of the board of directors” of the listed entity in any manner.

This proposal appears to be protective in nature, in order to prevent a Specified Person from dictating terms to the board of directors of a listed entity. It must be ensured that the interactions of the Specified Person with the listed entity are advisory/ consultative in nature.