Tuesday, August 17, 2010

The concept of Chinese wall in financial institutions – Part II (SEBI regulations)

The Chinese wall policy, in the context of financial institutions, was introduced in India by the Securities and Exchange Board of India (Insider Trading) (Amendment) Regulations, 2002. These regulations made it mandatory for (i) all listed companies and (ii) other organizations associated with securities markets (financial institutions), to have a Chinese wall policy as a part of their code of internal procedures and conduct (“Internal Code”). It also recognized implementation of a Chinese wall policy as a valid defense against insider trading allegations.

Chinese wall policy as a part of Internal Code

Financial institutions, by virtue of being organizations associated with securities market (broker/ sub-broker, depository participant, clearing/ trading member, merchant banker, custodian etc.) are under an obligation to implement an Internal Code which contains provisions of Chinese wall framework. Regulation 12 of the SEBI (Prohibition of Insider Trading) Regulations, 1992 (“Regulations”) requires such organizations to frame an Internal Code in accordance with the ‘model code’ specified in Schedule I of the Regulations (“Model Code”). The Internal Code should be framed ‘without diluting’ the Model Code prescribed by SEBI and the organizations should adopt appropriate mechanisms and procedure to enforce such Internal Code. Apart from the entities mentioned above, other entities like public financial institutions, all intermediaries registered with SEBI, asset management companies, trustees of mutual fund, self regulatory organizations, stock exchanges and professional firms who assist or advise listed companies are also under the obligation to frame such Internal Code.

The Model Code acts as the basic framework of Chinese wall policy in India, in the context of financial institutions. It contains two parts namely, (i) Part A which contains the model code for listed companies (the title reads as ‘Model code of conduct for prevention of insider trading for listed companies’) and (ii) Part B which contains the model code for organizations associated with securities markets (the title reads as ‘Model code of conduct for prevention of insider trading for other entities’). It appears from the Regulations that if the entity is associated with securities market and is listed, such an entity should implement an Internal Code which is a combination of Part A and Part B.

Part A (Model Code for listed companies)

Clause 2.1 of the Model Code (Part A) for listed companies requires the employees/ directors of such organisations to maintain confidentiality of all price sensitive information. They are prohibited from passing on such information to any person directly or indirectly by way of making a recommendation for the purchase or sale of securities. Clause 2.2.1 states that price sensitive information should be handled on a “need to know” basis. This means that such information should be disclosed only to those within the company who need the information to discharge their duty. Clause 2.3.1 mandates that the files containing confidential information should be kept secure and should have adequate security of login and pass word etc.

Part B (Model Code for other entities)

The Model Code for other entities (Part B) contains, in addition to the above mentioned restrictions under Part A, certain other requirements which details out Chinese wall policy, in further. Clause 2.4 and 4 require the organisation to adopt a "Chinese Wall" policy which separates “inside areas” from “public areas” for preventing the misuse of confidential information. The “inside areas” are defined as those areas of the organization which routinely have access to confidential information and “public areas” are defined as those areas which deal with sales, marketing, investment advise or other departments providing support services. The Regulations stipulates the following measures to be adopted by organizations for separating “inside areas” from “public areas”.

• The employees in the “inside area” should not communicate any price sensitive information to anyone in “public area”.
• The employees in “inside area” may be physically segregated from employees in “public area”.
• Demarcation of the various departments as “inside areas
• Only in exceptional circumstances, employees from the public areas may be brought "over the wall" and be given access to confidential information on the basis of "need to know" criteria.

The Model Code for other entities (Part B) also requires that securities or shares of a listed company should be put on a “restricted/grey list” while the organization is handling any assignment for such listed company or while preparing appraisal report or while handling credit rating assignments and is privy to price sensitive information. Additionally, any security which is being purchased or sold or is being considered for purchase or sale by the organisation on behalf of its clients/schemes of mutual funds, etc. should also be put on the “restricted / grey list”. The effect of putting/ adding a security on the “restricted / grey list”’ is that any trading in such securities by employees/directors/partners of the organization would require the pre-clearance of trade by compliance officer. As a result of this, trading in these securities may be blocked or may be disallowed at the time of pre-clearance by the compliance officer after taking into account, all the relevant circumstances. This can be explained by way of simple example. If ‘Company A’ (a listed company), appoints ‘Only profit’ (an investment banker/ merchant banker) to find out an investor in ‘Company A’ to fund its new projects. This would be followed by ‘Company A’ sharing confidential information (which may be price sensitive) with ‘Only profit’ for preperation of IM, financial projections etc. In such a case ‘Company A’ would be added to the “restricted/grey list” maintained by the compliance officer of ‘Only profit’ and henceforth any trade made by employees/directors/partners of ‘Only profit’ would require pre-clearance of such trade by compliance officer of ‘Only profit’. The compliance officer would also have the option to restrict such trades, taking into account ‘relevant circumstances’.

In the next post, I will discuss the scope of “Chinese wall policy” as a defense to insider trading.

“The concept of Chinese wall in financial institutions – Part I (origin & mechanisms)” is available here.

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