Insider Trading: What must the Regulator Prove? Balram Garg v. SEBI: A case comment

The Supreme Court of India in Balram Garg v. SEBI,¹ had the occasion to consider the burden of proof that the Securities and Exchange Board of India (SEBI) should discharge to establish a charge of insider trading. The substance of SEBI’s case is that three close relatives (hereinafter “relatives”) of the Chairman and the Managing Director of a listed company traded the shares of the company based on some unpublished price sensitive information (UPSI) they received from the Chairman and the Managing Director. According to SEBI, the Chairman and the Managing Director communicated the UPSI violating the prohibition in the SEBI Act and SEBI (Prohibition of Insider Trading) Regulations, 2015². Similarly, their relatives violated the Act and Regulations by trading while in possession of that information.

Insider trading the legal framework

The SEBI Act, Section 12-A(e)³ and the SEBI (Prohibition of Insider Trading) Regulations, 2015 prohibit an insider from dealing with securities while they are in possession of material non-public price-sensitive information/unpublished price sensitive information (UPSI).⁴ Nor shall an insider in possession of such information communicate that information to anyone else.⁵ A person becomes an insider in two ways. Firstly, if a person is a connected person,⁶ he is an insider. A connected person is one who is associated with the company in a manner that allows him to access UPSI. Secondly, a person in possession of or having access to UPSI is also an insider.⁷ The distinction between the two, relevant for our discussion is that connected persons are presumed to be in possession of the UPSI; but in the case of others, SEBI has to prove that such persons were in possession of the UPSI.

The Chairman and the Managing Director are clearly connected persons to the company and hence they are insiders. They are presumed to be in possession of UPSI. They can neither trade based on UPSI nor disclose UPSI to others. The allegation is that the Chairman and the Managing Director communicated the UPSI to their close relatives violating the Prohibition of Insider Trading Regulations. As far as the relatives are concerned one has to determine whether they are immediate relatives within the meaning of the Regulations. A connected person’s spouse, parents, siblings, and children are also treated as immediate relatives if they are financially dependent on or consult connected persons for trading in securities.⁸ Immediate relatives are treated as connected persons.⁹ Therefore, immediate relatives are also presumed to possess UPSI. Secondly, a relative becomes an insider (like anyone else) if they are in possession of UPSI, even when they do not qualify as immediate relatives.

What did the Court hold?

In the backdrop of the provisions described above, SEBI had to prove against the Chairman and the Managing Director that they communicated UPSI to their relatives. As far as the relatives are concerned, SEBI had to prove either that the relatives were immediate relatives or that they traded while in possession of the UPSI. In other words, even if there was no evidence that the relatives had received any UPSI, SEBI could still succeed against the relatives if SEBI could show that they were immediate relatives of the connected persons. On the other hand, the Chairman and the Managing Director would try to demonstrate that they did not communicate any UPSI to the relatives. Similarly, the relatives would try to demonstrate that they were not immediate relatives and there was no evidence to show that they were in possession of UPSI.

In this case, two pieces of information qualify to be UPSI. The first one is the company’s decision to buy back its shares. The second UPSI is the withdrawal of the buy-back offer on account of the non-receipt of the no-objection certificate from the lead bank. The allegation was that the relatives or their associates traded in the share of the company while they were in possession of UPSI. The allegations were based on the trading pattern and time of the relatives. One of the relatives had been selling the company’s shares before the announcement of the buy-back at a lower price. But she stopped selling the shares before the announcement of the buy-back offer and avoided losses. She again sold her shares before the withdrawal of the buy-back offer and avoided loss. Further, a company that is fully owned by two of the relatives took a short position with respect to the shares of the company immediately before the withdrawal of the buy-back offer to gain from the fall in share price after the withdrawal. But apart from these circumstances, SEBI did not have any letters, e-mails, or witnesses to prove that the connected persons communicated UPSI to their relatives.

The Court held that the above circumstances fall short of proving the allegations. The burden of proof was on SEBI to show that the Chairman and the Managing Director communicated frequently with the relatives and that the relatives were in actual possession of the UPSI. Mere circumstantial evidence such as the trading pattern and timing was not sufficient to hold them guilty. It was necessary for SEBI to establish the communication and possession of UPSI through cogent evidence like letters, e-mails, or witnesses. As far as the relatives in question are concerned, they do not qualify as immediate relatives. The Court found that the Chairman and the Managing Director, and the relatives were estranged. Moreover, the relatives had resigned from the positions they held in the company. The relatives were financially independent and did not consult the Chairman and the Managing Director to make their decisions. For these reasons, relatives do not qualify as immediate relatives (and hence they themselves are not connected persons). Hence, they cannot be presumed to be in possession of the UPSI. The SEBI must have established through cogent evidence that they had been in possession of UPSI when they traded.

Going forward what does the judgment mean?

A recent blog post argued that this case marks the evolution of a “new standard of proof” in insider trading matters.¹⁰ It is not wholly unreasonable for the court to expect that mere circumstances are not sufficient to hold one guilty of insider trading. The decision will have no application to the standard of proof applicable in the case of immediate relatives. They will be treated on par with connected persons and will be presumed to be in possession of UPSI. But as far as others are concerned mere trading patterns and timing are not sufficient proof of possession of UPSI. The charge of communicating UPSI against the connected persons will not be sustained unless there is evidence to show the actual communication of the UPSI.

But the question is if not the circumstantial evidence of trade timing and pattern, what other material could SEBI find out in an insider trading? If the court is looking for material evidence such as written communication or witnesses directly proving communication of UPSI, it will not be hard for the violators to ensure that there is no such material or witness. When the tipper and tippee are intimate, it would be even more challenging to find such material evidence to prove the actual communication of UPSI.¹¹ The doubt that remains is whether SEBI has the wherewithal and power to gather the kind of evidence required.