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Show me a problem, I will write you a law
October, 24th 2011

Whether one can legitimately conduct due diligence into the affairs of an Indian listed company before making a substantial investment in its securities has remained a subject matter of speculation for nearly two decades now. In a recently proposed draft law governing alternate investment funds (not regulations dealing with insider trading) the Securities and Exchange Board of India (SEBI) has feebly acknowledged the problem, with a proposed solution making the medicine appear more painful than the ailment.

Securities regulations dealing with insider trading prohibit dealing in securities when in possession of unpublished price sensitive information.  Unpublished price sensitive information is information about a company that is not published by the company, and which is likely to materially affect the price discovery for securities of the company, when published. If in possession of such information, the prohibition on dealing in securities of such company would get immediately attracted.
Under the listing agreement, every listed company is required to publish information that is likely to affect the price of its securities so that investors in the market make an informed investment decision.  Yet, it is indeed true that making a substantial investment into a listed company without any investigation as to whether publicly available information is indeed true, would be an act of valour.

Insider trading regulations also prohibit communication and counseling of unpublished price sensitive information by an insider. The regulations do not contain well-drafted safe harbour provisions that enable conduct of diligence into the affairs of the company in specific circumstances. Consequently, market players and practitioners have had to tread this area very carefully. The issue is mostly addressed by taking a call that the information reviewed while conducting due diligence is indeed not price-sensitive in nature, or not unique, but just a qualitative validation of what is already publicly known. Another measure adopted by practitioners is to make public findings of due diligence before making the investment, thereby ensuring that the information does not remain unpublished therefore, the person in possession of it is not in possession of unpublished price sensitive information.

The seller of securities, or the issuer of the securities (the listed company), is asked to confirm that the information shared by them does not constitute price-sensitive information. This by itself does not absolve the acquirer from having to ensure that it is not in possession of unpublished price sensitive information, but it helps in building circumstantial support for a defence that information possessed is not price sensitive in nature.

In November 2002, the regulations were amended to provide for ingredients of a valid defence. One loosely drafted defence was that a company could prove that acquisition of shares of a listed company was as per the takeover regulations.

The term as per can be quite meaningless, particularly in view of the plethora of provisions in a self-contained code like the takeover regulations, where requirements range from making disclosures of acquisition to making an open offer to buy shares from public shareholders.

Adopting a purposeful interpretation of the provisions, one would argue that an acquisition that triggers an open offer under the takeover regulations would be a substantial investment. Such an investment also attracts an obligation to write a letter of offer containing all information necessary for the public shareholders to make an informed investment decision on whether or not to sell their shares to the acquirer. Consequently, a transaction that would trigger an open offer would be one where due diligence may be conducted.

Inexplicably, under proposed draft regulations aimed at regulating alternate investment funds, it is contemplated that PIPE Funds, which should invest equity funds exclusively into listed company securities may be given access to non-public information subject to such access being only for the purpose of carrying due diligence and an automatic prohibition on the fund from selling or dealing in securities of the company for five years (no real logic can support such a lock-in, particularly if the information indeed becomes public).

This approach meets the rule: show me a problem, and I will write you a law. There is no logic to provide a special dispensation only to PIPE Funds.

The need to conduct due diligence should be recognised in specific circumstance there is a moral force to this requirement when the investor is an entity that also has investors in it. SEBI should deal with the insider trading regulations head on and provide a structured and well-regulated safe harbour.

A five-year lock-in is not logical if the information gathered during due diligence is in any case made public. This is a matter that needs a more serious approach.

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