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.
Showing posts with label Concepts. Show all posts
Showing posts with label Concepts. Show all posts
Tuesday, August 17, 2010
Wednesday, July 14, 2010
The concept of Chinese wall in financial institutions – Part I (origin & mechanisms)
Introduction
Recently, a major brokerage firm in India came out with two different reports on Punj Lloyd Ltd on the same day but with opposite recommendations. In one report, the firm wanted institutional investors to ‘sell’ shares of Punj Lloyd, with a 12-month target price of INR 97 or 29% lower than the then trading price of INR 137 as on 28th May. On the other hand, the second report issued on the same date recommended its private client group to ‘buy’ Punj Lloyd shares with a target price of INR 158. Later the firm stated that its retail and institutional research teams are separated by ‘Chinese walls’ and these groups are distinct and separate. A global investment bank was also in news recently for alleged violations in its Chinese wall policy.
The concept of Chinese wall is very relevant in today’s world of complex financial institutions wearing too many hats at the same time. Chinese walls are widely used by financial conglomerates to manage conflict of interest and to prevent insider trading. Lord Millett has defined Chinese walls as the existence of established organisational arrangements which preclude the passing of information in the possession of one part of the business to other parts of the business.1 Conflicts of interest situations may arise as a result of the different activities/ roles undertaken by a financial institution. For example, if a financial institution extends credit facility to a company while its proprietary trading wing buys and sells securities issued by that company, it will result in a conflict of interest situation. 2 Through a series of posts, I attempt demystify the concept of Chinese walls in financial institutions through an analysis of the origin of the concept, its importance, mechanisms and most importantly the current SEBI rules and regulations in this regard. This post will discuss the origin of the concept of Chinese wall and the major mechanisms used in implementing the Chinese wall.
Origin of the concept of Chinese wall
The use of Chinese wall to guard against the misuse of material, non public information was first endorsed by the Securities and Exchange Commission (SEC) in 1968 in an administrative proceeding involving Merrill Lynch, Pierce, Fenner & Smith, Inc3. Merrill Lynch was the lead underwriter for a potential public offering of debentures by Douglas Aircraft Company and it learned that the company was about to issue a revised estimate of its earnings with substantially lower figures. This information was passed on by the underwriters to the sales department, who in turn told several mutual funds and other large institutional clients. During the three-day period before Douglas publicly disclosed this information, Merrill Lynch and its clients sold the stock to avoid substantial losses. As part of the settlement Merrill Lynch reached with the SEC, the firm adopted a statement of policy that "prohibits disclosure by any member of the underwriting division of material information obtained from a corporation . . . and not disclosed to the investing public." In effect, this statement of policy was the first Chinese wall established in any financial institution in the history of financial institutions. Following this, various brokerage firms voluntarily implemented Chinese wall policy in their institutions. Later various regulators, around the world, felt the need to make Chinese wall policy, a mandatory requirement in every such institution and enacted laws which make it binding for firms to implement it.4
Mechanisms and arrangements under Chinese wall
Basel Committee of Banking Supervision recommended that the policies made by board of directors should ensure that the bank’s business activities that may give rise to conflicts of interest are carried out with a sufficient degree of independence from each other. This independence can be achieved by establishing information barriers between different activities and by providing for separate reporting lines and internal controls.5 Thus the prime objective of Chinese wall policy is to prevent the spill over of confidential information from one department to another. In order to achieve this, the financial institution has to separate departments with access to confidential information from the departments which deal with sale/marketing/investment advise or other departments providing support services. The various steps involved in this process are mentioned below.
Firstly, the institution should identify and designate “Insider Areas” and “Public Areas” in the institution. Insider Areas are those areas/ groups of the institution which routinely have access to confidential information. These areas are also known as “information recipients” as they receive confidential information as a part of conduct of their business. Public Areas are those areas/ groups of the organisation that trade securities or give investment advice or do sale/marketing and they depend on publicly available information for the conduct of their business. These areas are also known as “information processors”. Secondly, the institution should separate the information recipients (Insider Areas) from the others (Public Areas). The institution should also restrict access to confidential information only on a “need to know” basis and thus eliminate access by unauthorized persons.
The UK Law Commission6 defined Chinese wall as the compliance with the following requirements (subsequently approved by Lord Millett in Bolkiah7 and Jacobson J in Australian Securities and Investments Commission v. Citigroup Global Markets Australia Pty Limited8): -
• The physical separation of departments to insulate them from each other;
• An educational programme, normally recurring, to emphasize the importance of not improperly or inadvertently divulging confidential information;
• Strict and carefully defined procedures for dealing with situations where it is thought the wall should be crossed, and the maintaining of proper records where this occurs;
• Monitoring by compliance officers of the effectiveness of the Chinese wall; and
• Disciplinary sanctions where there has been a breach of the wall.
In the next post, I will discuss the requirements of Chinese wall under the SEBI rules and regulations.
Notes
1. Prince Jefri Bolkiah v. KPMG(A firm), [1998] UKHL 52; [1999] 2 AC 222.
2. Basel Committee of Banking Supervision, Enhancing Corporate Governance for Banking Organizations, Feb. 2006 (new version, first published 1999), Para. 27.
3. In re Merrill Lynch, Pierce, Fenner & Smith, Inc., SEC Rel. No. 34-8459.
4. Section 15(f) and Section 204A of the Investment Advisers Act, 1940 and Section 15D of the Securities Exchange Act of 1934 in USA, Section 1043F of the Corporations Act, 2001 in Australia, Regulation 3B (1) of SEBI (Prohibition of Insider Trading) Regulations, 1992 in India etc.
5. Supra n.2
6. Law Commission, United Kingdom, Fiduciary Duties and Regulatory Rules, Consultation Paper No 124 (1992) at [4.5]. The final report is Report No 236 (1995).
7. Supra n.1
8. [2007] FCA 963
Recently, a major brokerage firm in India came out with two different reports on Punj Lloyd Ltd on the same day but with opposite recommendations. In one report, the firm wanted institutional investors to ‘sell’ shares of Punj Lloyd, with a 12-month target price of INR 97 or 29% lower than the then trading price of INR 137 as on 28th May. On the other hand, the second report issued on the same date recommended its private client group to ‘buy’ Punj Lloyd shares with a target price of INR 158. Later the firm stated that its retail and institutional research teams are separated by ‘Chinese walls’ and these groups are distinct and separate. A global investment bank was also in news recently for alleged violations in its Chinese wall policy.
The concept of Chinese wall is very relevant in today’s world of complex financial institutions wearing too many hats at the same time. Chinese walls are widely used by financial conglomerates to manage conflict of interest and to prevent insider trading. Lord Millett has defined Chinese walls as the existence of established organisational arrangements which preclude the passing of information in the possession of one part of the business to other parts of the business.1 Conflicts of interest situations may arise as a result of the different activities/ roles undertaken by a financial institution. For example, if a financial institution extends credit facility to a company while its proprietary trading wing buys and sells securities issued by that company, it will result in a conflict of interest situation. 2 Through a series of posts, I attempt demystify the concept of Chinese walls in financial institutions through an analysis of the origin of the concept, its importance, mechanisms and most importantly the current SEBI rules and regulations in this regard. This post will discuss the origin of the concept of Chinese wall and the major mechanisms used in implementing the Chinese wall.
Origin of the concept of Chinese wall
The use of Chinese wall to guard against the misuse of material, non public information was first endorsed by the Securities and Exchange Commission (SEC) in 1968 in an administrative proceeding involving Merrill Lynch, Pierce, Fenner & Smith, Inc3. Merrill Lynch was the lead underwriter for a potential public offering of debentures by Douglas Aircraft Company and it learned that the company was about to issue a revised estimate of its earnings with substantially lower figures. This information was passed on by the underwriters to the sales department, who in turn told several mutual funds and other large institutional clients. During the three-day period before Douglas publicly disclosed this information, Merrill Lynch and its clients sold the stock to avoid substantial losses. As part of the settlement Merrill Lynch reached with the SEC, the firm adopted a statement of policy that "prohibits disclosure by any member of the underwriting division of material information obtained from a corporation . . . and not disclosed to the investing public." In effect, this statement of policy was the first Chinese wall established in any financial institution in the history of financial institutions. Following this, various brokerage firms voluntarily implemented Chinese wall policy in their institutions. Later various regulators, around the world, felt the need to make Chinese wall policy, a mandatory requirement in every such institution and enacted laws which make it binding for firms to implement it.4
Mechanisms and arrangements under Chinese wall
Basel Committee of Banking Supervision recommended that the policies made by board of directors should ensure that the bank’s business activities that may give rise to conflicts of interest are carried out with a sufficient degree of independence from each other. This independence can be achieved by establishing information barriers between different activities and by providing for separate reporting lines and internal controls.5 Thus the prime objective of Chinese wall policy is to prevent the spill over of confidential information from one department to another. In order to achieve this, the financial institution has to separate departments with access to confidential information from the departments which deal with sale/marketing/investment advise or other departments providing support services. The various steps involved in this process are mentioned below.
Firstly, the institution should identify and designate “Insider Areas” and “Public Areas” in the institution. Insider Areas are those areas/ groups of the institution which routinely have access to confidential information. These areas are also known as “information recipients” as they receive confidential information as a part of conduct of their business. Public Areas are those areas/ groups of the organisation that trade securities or give investment advice or do sale/marketing and they depend on publicly available information for the conduct of their business. These areas are also known as “information processors”. Secondly, the institution should separate the information recipients (Insider Areas) from the others (Public Areas). The institution should also restrict access to confidential information only on a “need to know” basis and thus eliminate access by unauthorized persons.
The UK Law Commission6 defined Chinese wall as the compliance with the following requirements (subsequently approved by Lord Millett in Bolkiah7 and Jacobson J in Australian Securities and Investments Commission v. Citigroup Global Markets Australia Pty Limited8): -
• The physical separation of departments to insulate them from each other;
• An educational programme, normally recurring, to emphasize the importance of not improperly or inadvertently divulging confidential information;
• Strict and carefully defined procedures for dealing with situations where it is thought the wall should be crossed, and the maintaining of proper records where this occurs;
• Monitoring by compliance officers of the effectiveness of the Chinese wall; and
• Disciplinary sanctions where there has been a breach of the wall.
In the next post, I will discuss the requirements of Chinese wall under the SEBI rules and regulations.
Notes
1. Prince Jefri Bolkiah v. KPMG(A firm), [1998] UKHL 52; [1999] 2 AC 222.
2. Basel Committee of Banking Supervision, Enhancing Corporate Governance for Banking Organizations, Feb. 2006 (new version, first published 1999), Para. 27.
3. In re Merrill Lynch, Pierce, Fenner & Smith, Inc., SEC Rel. No. 34-8459.
4. Section 15(f) and Section 204A of the Investment Advisers Act, 1940 and Section 15D of the Securities Exchange Act of 1934 in USA, Section 1043F of the Corporations Act, 2001 in Australia, Regulation 3B (1) of SEBI (Prohibition of Insider Trading) Regulations, 1992 in India etc.
5. Supra n.2
6. Law Commission, United Kingdom, Fiduciary Duties and Regulatory Rules, Consultation Paper No 124 (1992) at [4.5]. The final report is Report No 236 (1995).
7. Supra n.1
8. [2007] FCA 963
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