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Does India need an independent regulator of audit firms?
June, 02nd 2008

In any crime proving, motive is important while prosecuting. The same quite logically applies to financial crimes like insider trading. But some of our experts believe that the insider trading laws in India place an unreasonable emphasis on motive instead of taking into account things like realized gains.

 There are 2805 listed companies and exchange worth USD 27 trillion dollars is done in India. India has some of the most stringent securities laws in the world. But, when it comes to insider trading cases, the United States has a different story to tell. In US, less than 100 such cases have been tried ever since the liability for insider trading was introduced in the SEC Act in 1964. But if trading on the basis of inside information is tough to prove in the US, it seems it is even tougher to prove in India where only about four major cases have been tried so far.

 C Achuthan, Former Presiding Officer said, the law came into force in 1992, in fact Insider Trading Regulation was the second regulation notified by SEBI in sequence. First was the stockbroker regulation, so that shows the priority. The first case was decided in 1998 that was Hindustan Lever. It took another four years for the Rajesh Agarwal then another two years for Samir Arora, he added.

 The most recent example is the case of Rajiv Gandhi, CFO of a pharmaceutial company Wockhardt. On May 9, 2008, Gandhi, his wife and his sister were upheld as guilty of Insider Trading by the Securities Appellate Tribunal or SAT. The charges were that the Gandhis were all designated insiders as per SEBI's Insider Trading Regulations. They violated SEBI's rules, which states that no insider can deal in shares on the basis of any unpublished price sensitive information.

 Between January and October 1999, Sandhya Gandhi and her sister-in-law Amishi bought and sold Wockhardt shares close to the occurrence of important financial events in the company. For instance, on January 21, Amishi and Sandhya Gandhi sold Wockhardt shares only a few hours before a crucial company board meeting and then again a few minutes before results were disclosed to the stock exchanges the next day.

 On April 22, Amishi Gandhi sold shares before a board meeting in which the demerger of Wockhardts businesses was announced and later purchased shares the next day after the meeting when the price had dramatically dropped.

 On this case, Ravi Kulkarni, Partner, Khaitan & Co said, Who is the person who is trading, he is not some ordinary person, he is the CFO of the company and his wife and his sister traded in large quantities. So, there is absolutely a prima facie presumption that all this was being done on the basis of some previous knowledge.

 The Gandhis do not deny being insiders or having inside information but they do deny having traded on the basis of that information. They claimed that many of their trades resulted in losses.

 SATs decision reiterates the law that states, The onus would be on the insider to show that he did not trade on the basis of price sensitive information and that he traded on some other basis. He shall have to furnish some reasonable or plausible explanation of the basis on which he traded.

 Now a reasonable explanation could include personal or family emergency that probably compel the trade, but Gandhis lawyer says that the law must discern the crime not the motive.

 Somasekhar Sunderesan, Partner, J Sagar Associates is of the view that the point is did you trade on the basis of the information that was with you or did you trade despite the information that was available with you. He said, Did you sell despite having positive information or did you buy despite having adverse information. These two can demonstrate whether the information with you was the basis of the trading or not? You cannot confuse that with whether you needed to trade to fund a bypass surgery or to fund an exigency in the family.

 Sandeep Parekh, Former Executive Director, SEBI said, Criminal Law motive is not important. You can be Robin Hood, but again you are doing robbery and that is not allowed.  But intention is very important.

 Therefore, the motive seems to be the deciding factor in being held guilty or innocent of Insider Trading. If we rewind to 1996, the SAT dismissed the charges of insider trading against Rakesh Agarwal, the MD of ABS Industries. In the midst of joint venture talks with Bayer Industries, Agarwal had indirectly purchased over one lakh, 82 thousand shares from the open market to sell to Bayer. This was to ensure that Bayer receive the 51% stake of ABS that was needed to conclude the deal. SEBI branded this an inside trade on the basis of unpublished price sensitive information since discussions with Bayer were not in the public domain. But the Tribunals presiding officer for the case Mr C Achuthan dismissed those charges.

 Achuthan believes that if you go by the procession theory then Rakesh Agarwal is guilty because he was in the procession of the entry of the bear. Still you know the Tribunal had taken a view that he is not guilty because he was acting in his capacity and his dealing in shares was for the betterment of the companys business, he said.

 Agarwals was the first case to introduce the concept of deliberate fraud versus unintended violation into the system. But, these concepts have not yet been incorporated within the law itself. Unlike the United States, SEC regulations, which state under rule 10b5-1, that a person trades on the basis of material nonpublic information if a trader is aware of the material nonpublic information when making the purchase or sale.

 In this case, the trader is excused only if the trade is pursuant to a free existing plan contract or instruction that was made in good faith. Starting January this year, SEBI has proposed amendments to the Insider Trading Regulations. The amendments include the removal of bonus rights and shares as prohibited items within trading windows more frequent disclosures by officers, directors and substantial shareholders at certain events or at certain intervals and the harmonizing of disclosures between the takeover code and the Insider Trading regulations.

 Vineet Aneja, Partner, FoxMandal Little said, It is very difficult to have disclosures in extent that each and every transaction which maybe emanate from insider trading is captured. But, if disclosures are broadened to include an individual and a connected person, it would cover a greater ambit of the transactions, which do take place.

 The 2008 amendments also proposed short swing profit regulations akin to American rules where profits accumulated by 10% owners; directors or officers by buying or selling company shares within six months must be surrendered to the company.

 Sunderan said, "If people take a permission to trade, it is one thing that the compliance officer will have to pre-clear it and they will trade only if they are not violating the Insider Trading Regulations. This takes out the commercial sting of the need to trade.

 That is not the only loophole, it seems that there is no clarity on safe hours for insiders or for investors when it comes to due diligence in a target company. Having done due diligence and thereby getting an access to unpublished information then will buying a stake be considered insider trading? It is considered as insider trading as per current laws.

 On this Aneja said, In case of a subscription of shares, the benefit of contribution by an investor is directly realized by the company itself. However, when it comes to transfer of shares, the benefit is really being realized by the promoters or selling shareholders. So, a due diligence in case of a sell between two shareholders may not be allowed. But, where there is subscription and contribution been happening directly to the company where the company is actually going to benefit from the investment due diligence should be allowed in that.

 Isha Dalal said, What these amendments do not address is the nuances of law that have emerged in cases like Rakesh Agarwal and Rajiv Gandhi. Should motive be taken into consideration, is there such a thing as a reasonable motive, should intent be introduced into the law or should realized gain be a criteria of a judgment? So, the legal community and India Inc can only hope that these questions will be answered through precedents.

 The Enron fiasco at the turn of the century gave birth to a landmark Governance Act in the US, the Sarbanes-Oxley Act of 2002. That in turn created the Public Company Accounting Oversight Board or the PCAOB, a private sector nonprofit cooperation that oversees auditors of public companies in order to protect the interests of American investors.

 Isnt it time for countries like India to think of adopting this best practice and instituting an independent super regulator for the audit fraternity? In India, The Institute of Chartered Accountants of India sets the ICAI audits standards. A statutory body, the ICAI, was set up in 1949 and its primary function is to regulate the profession of Chartered Accountants and then prescribe accounting standards. An elected council of Chartered Accountants runs the ICAI. Only ICAI registered accountants are allowed to audit Indian firms.

So does India need an independent regulator of audit firms?

 On this, Ved Jain, President, ICAI said, There is no need because we have a body better than PCAOB at one stage. We as an institute regulate the profession, we are overseeing it then we have a Quality Review Board, we are overseeing it, we have a Peer Review Board and then we have on top of it Financial Reporting Review Board where we review the balance sheet and financial statement of all the corporates.

 Rajesh Kapadia, Partner, GM Kapadia & Co said, If we have not been subjected to a Peer Review, it would automatically become a disqualification and in fact all your prescriptions, which are there under the PCAOB or under the Sarbanes-Oxley Act find place at some place or the other in all the regulations that I have mentioned here.

 Natrajan Ramkrishna, Partner, Audit, BSR & Co said, There is a very significant difference between what the PCAOB does and what the institute does. For example, the institute typically looks at financial statements and looks out for deviations whereas the PCAOB will visit your accountants office, the chartered accountants office and carry out extremely detailed review of files for extended periods of time to ensure that the chartered accountant has complied with the documentation standards and other auditing and accounting standards prescribed by various accounting bodies. So to that extent, it is a far more effective process.

 On the other hand, HP Ranina, Tax Advocate said, Certainly it would add value in that sense there is no doubt about it and whether it is a large firm, the middle sized firm, small firm all the auditors who certify these type of accounts would have to make sure that the guidelines laid down by this body are met with. So, any regulatory authority is good but at the same time one must keep in mind that there cannot be overlapping.

 Kapadia feels that it would only mean an additional level of compliance, which will be there. Whereas, Rahul Roy, Director, Ernst & Young said, What does the layman who is not an auditor, who is not a company perceive? He perceives the institute, which is educating its members, disciplining its members, and setting up standards.

 So, should there not be an independent oversight body as there is in other countries. For example, PCAOB in USA is there though the AICPA institute runs the profession. ICAI has been handling things wonderfully. However, perhaps increasingly that is inevitable from a perception point of view.

 On this Ramkrishna said, It is not necessary that all this sort of autonomy and control would lead to better quality of work and better corporate governance. The subprime crisis, the number of deviation that we observe in the USA is sufficient proof of the fact that all these controls at the end of the day have limited applications and what is important is an effort on the part of the institute to genuinely improve quality of work.

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