The Sound of SEBI’s Silence Will the Factorial Order Change the Rules of the Game

Last month, the Securities Appellate Tribunal (SAT) passed an order in favour of Factorial Master Fund[1] (Factorial). This overturned the order of the SEBI Whole Time Member who had held that Factorial had contravened the provisions of the SEBI (Prohibition of Insider Trading) Regulations, 2015 (PIT Regulations) by trading in the securities of L&T Finance Holdings Limited (LTFH), while in possession of unpublished price sensitive information (UPSI).

The Factorial Decision

The crux of the issue under consideration before the SAT, was whether Factorial had been privy to UPSI – namely, the fact that the promoters of LTFH were considering an ‘Offer for Sale’ (OFS), and had utilised this information to take short positions on the LTFH securities. Factorial’s key contention remained that they did not have access to any UPSI and the mere fact that they had participated in a market gauging exercise to test investor interest in the potential OFS, could not be held to demonstrate any information asymmetry in their favour. Based on a review of all the information and evidence adduced, the SAT held that Factorial’s discussions in the market sounding process were not tantamount to them receiving UPSI, thereby breaking the chain of circumstantial evidence that SEBI had relied upon, to hold Factorial liable.

At first glance, the SAT ruling is significant since it discusses the circumstances in which UPSI could be said to exist. It also, in its own words, creates a precedent of granting the ‘benefit of doubt’ to the accused if the attendant facts and circumstances demonstrate that the impugned trade could have been motivated by publicly available information. Since insider trading is a strict liability offence, where the burden to prove innocence is usually cast on the accused, this SAT ruling will be a useful reference point, going forward, for persons seeking to demonstrate that their trades were based on commercial factors/ rationale.

However, a closer reading of the SAT order reveals another interesting dimension, which will have an impact on market intermediaries and the manner in which they seek feedback from investors. Para 10 of the SAT Order notes that SEBI should look into the issue of whether investors participating in market gauging exercise should be allowed to trade in the market.

Market Sounding: A Quick Guide

While there is no regulatory definition in India of what constitutes market gauging or market sounding, typically this exercise refers to the practice where intermediaries, such as merchant bankers or brokers, prior to an offer or sale of securities, reach out to sophisticated institutional investors to gauge their interest. The exercise is crucial to obtain investor feedback, which then helps ascertain the market demand and commercial viability of the proposed transaction. This is also relevant for various capital markets transactions, which rely on the market sounding process as a dependable barometer for determining the success or failure of the offer (linked to the specific pricing requirements under law) itself.

Most financial institutions maintain their own, robust in-house protocols that govern the manner in which the market sounding exercise can be conducted and the perimeter within which the relevant individuals must operate. There are restrictions put in place on sharing key data, such as the name of company, proposed pricing band, timing of the transaction, etc., with investor(s) largely limited to discussions on the relevant sector and indicative demand/price, without any further granularity. Other options like wall-crossing, signing non-disclosure agreements etc. , may also be considered, based on individual facts and circumstances.

International Approach

In the international sphere, the most elaborate guidelines around ‘market sounding’ are contained in the European Union Market Abuse Regulations wherein ‘market sounding’ is understood to mean, “The communication of information, prior to the announcement of a transaction, in order to gauge the interest of potential investors in a possible transaction and the conditions relating to it such as its potential size or pricing, to one or more potential investors”.

In terms of these Market Abuse Regulations, inside information is permitted to be shared as part of the market sounding exercise, subject to certain compliances, such as:

(a) The issuer or market intermediary maintaining an audit trail of the information that is shared with the recipient.

(b) Ensuring that any information shared in such market sounding exercise is pursuant to confidentiality obligation being cast on the recipient, in terms of which he is obliged to not disseminate the information.

(c) The recipient being restricted from using such information to trade on its own account or for the benefit of any other person, or even amending/ cancelling existing trade orders which may have been placed earlier, etc.

It is interesting to note that the key principles underlying the safeguards identified in the European Union Regulations already exist, to a large extent, in the PIT Regulations. However, these defences are only available in limited scenarios and do not currently extend to investor feedback exercises. Given that SEBI implicitly acknowledges that NDAs/wall crossing are valid defences in certain cases, it will be interesting to see how these are adapted to comply with the SAT’s directive and what additional checks and balances they may deem fit to be applicable to such situations.

Time to break the Silence?

Interestingly, the SEBI Whole time Member had expressly acknowledged market sounding as an ‘ordinary course of business’ activity in his order, and hence, this lends some credence to the view that such efforts are essential for an investment bank to make an assessment of the commercial feasibility of a potential transaction.

From a policy perspective, though, this will be a great opportunity for SEBI to take guidance from SAT, and introduce and implement practical compliance standards for intermediaries engaging in market sounding exercises.

In doing so, however, it will be critical for SEBI to formulate rules, based on the nature of information being shared in the market gauging process. There has to be a clear demarcation between discussions on a no-names basis, which would not result in any UPSI being shared, and market feedback exercises where transaction specific information is proposed to be shared. Non-disclosure agreements, wall-crossing and standstill obligations can be considered for the latter.

Sophisticated markets require their regulators to acknowledge, understand and legislate on developing business practices and a systematic, well-structured move by SEBI on this issue will certainly be a critical step towards granting regulatory legitimacy to a long-established market practice.

[1] Factorial Master Fund v. SEBI, SAT Order dated June 29, 2018