Insider Trading and the Chinese Wall Defense
By Tanaya Sanyal July 18, 2016
By Tanaya Sanyal, 5th Year, WBNUJS, Kolkata
The concept of a Chinese Wall has been a widely acknowledged method of preventing conflict of interests in financial institutions for a considerable period of time. The House of Lords recognised this principle when they defined a Chinese Wall 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” in Bolkiah v. KPMG.  Such an arrangement is usually characterised by a physical separation of various departments to prevent leakage of information, an informative and ethics based programme to sensitise the employees of the need to prevent divulging of information, clearly defined situations in which the separation can be compromised and guidelines to regulate such exchange, constant monitoring of compliance with the wall and finally imposition of sanctions in the event of an unauthorised contravention. 
The use of The Chinese Wall is not only limited to rein insider trading activities, but has also found widespread application in protecting the integrity of research reports prepared by analysts in mammoth investment concerns. It attempts to insulate the analysts from the banking wing of the organisation, to ensure independence in the research reports based on which investors weigh their options. In this blog post, I shall only be examining the Chinese Wall as a defence to insider trading in the Indian regulatory framework and its viability.
1. Regulatory framework in India
Regulation 12 of the Insider Trading Regulations mandates all listed companies and organisations associated with the securities market to frame and adopt a code of internal procedures. This Code must comply with the terms of the Model Code of Conduct which is also annexed to the Regulations. The conditions in the Code can be in addition to what has been suggested in the Model Code but shall not dilute the terms laid down in it. The Model of Code Conduct is divided into two parts: Part A prescribes conditions for the listed companies while Part B lays down conditions for operation of residuary entities such as intermediaries, professional firms and any other entity associated with the securities market.
2. Statutory recognition of the “Chinese Wall” principle
As part of the obligations under Part B of Schedule I of the Regulations, entities associated with the securities market shall be required to follow a Chinese Wall policy. The Code speaks of creation of ‘insider areas’ and ‘public areas’ within the organisation, for the purpose of segregation of the two zones. Access to insider areas (zones of confidential information) shall be restricted and segregated from public areas and accordingly, employees engaged in the former shall not communicate price sensitive information to the latter. If in any exceptional circumstance, the employees of the public area have to be given confidential information, it shall be on a ‘need to know’ basis and shall take place within the insider area. Such exchange must be cleared by the compliance officer.
3. Enforcement of the principle
It is not feasible to physically segregate the departments of an organisation handling confidential information and those dealing with sales or investment. If the organisation is allowed to trade in client securities, based on the information it has been privy to on account of close association or interaction with any of its client it would be considered as a violation of the Regulations. It is for this purpose that ‘restrictive or grey lists’ have been mandated under the Regulations.  For instance, if an organisation by virtue of preparing an appraisal report, credit rating or handling any assignment for a company is privy to price sensitive information, the securities of the company shall be put in a ‘restricted/grey’ list and trading shall be restricted in such securities. The rationale behind such lists is to ensure compliance with the Chinese Wall principle and ensure that the interests of clients of an organisation are not compromised with. To quote a live example, Merrill Lynch, a consultancy firm, was alleged to have engaged in practices that compromised its client, the Douglas Aircraft Co. Merill Lynch was the underwriters working on a public offering by the client. When the underwriters became aware of the fact that the client was going to re-issue a revised estimate of their earnings which was lower than the previous projections, they passed on the information to the sales wing of the firm which subsequently fed the news to many of its other institutional clients. Before the revised estimate was to be published, Merill Lynch, along with its other clients, had dumped large number of shares belonging to the Co. in order to minimise losses. Such examples underscore the need for a restriction on trading in the securities of the client during an ongoing assignment due to the organisation’s knowledge of price sensitive information.
A question thus arises as to why even with the existence of rigid Chinese Wall policies do price sensitive information get abused? Is the policy deficient to address concerns of insider trading.?
4.Inadequacies of the Chinese Wall.
It has been averred that the above policy is only equipped to impede accidental exchange of information among the departments of an organisation. It cannot curb those situations when there is a deliberate disclosure of information by the investment advisors to clients as in the case of “givingtips”.
However, at times the firm’s compliance with the Chinese Wall policy can also be counterproductive in light of the duty it owes to its customers. It is an uphill task to strike a balance between the duty to maintain confidentiality of information obtained from its corporate clients and its duty of providing accurate information of all material facts and circumstances to its customers. This is exactly what happened in Slade v. Shearson, Hammill & Co, where Slade did not act on the adverse information of a company’s financial stability that its underwriting department was privy to and continued to recommend stock to its clients. As a result, it was sued –by its clients. The defense of a Chinese Wall did not hold good in court as it was of the opinion that the firm was unable to recognise its ‘conflicting fiduciary relationships’ and its duty not to recommend the said stock which it failed to fulfil.  Hence, compliance with the Chinese Wall policy can often conflict with other fiduciary duties in securities trade, producing adverse consequences.
Hence, from an above analysis, it is clear that the concept of Chinese Walls as existing is not self-sufficient in checking the flow of price sensitive information. It often discourages the traders to comply with the regulations since they cannot perform their duties towards clients with the most updated information available. Also, it discourages collective pooling of resources within an organisation due to watertight compartmentalisation of the various wings. Hence it is argued that the Chinese Wall defense itself will not be a sufficient defence to insider trading. It must be coupled with other defences for the organisation to immunise itself from claims of insider trading. To this end, the additional defences suggested in the J. Sondhi Committee Report may provide useful guidance.
  UKHL 52, Lord Millet.
 Christopher M Gorman, Are Chinese Walls the Best Solution to the Problems of Insider Trading and Conflicts of Interest in Broker-Dealers?, available at http://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=1169&context=jcfl (Last visited on March 27, 2014). Hereinafter ‘Regulations’.
 Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992.
Hereinafter ‘Code of Conduct.’
 Regulations, Schedule 1, Part A & B.
 Regulations, Reg. 12(1): “. (1) All listed companies and organisations associated with securities markets including : (a) the intermediaries as mentioned in section 12 of the Act, asset management company and trustees of mutual funds ; (b) the self-regulatory organisations recognised or authorised by the Board; (c) the recognised stock exchanges and clearing house or corporations; (d) the public financial institutions as defined in section 4A of the Companies Act, 1956; and (e) the professional firms such as auditors, accountancy firms, law firms, analysts, consultants, etc., assisting or advising listed companies, shall frame a code of internal procedures and conduct as near thereto the Model Code specified in Schedule I of these Regulations 45[without diluting it in any manner and ensure compliance of the same].”
 Regulations, Schedule I, Part B, ¶2.4.
Ibid., ¶ 2.4.5.
 Ibid., ¶ 4.2.
Supra note 3, at 483.
 517 F.2d 398, 400 (2d Cir. 1974).
Supra note 3, at 491-92.
 SEBI, Report of the High Level Committee to Review The Sebi (Prohibition of Insider Trading) Regulations, 1992, December 7, 2013, available at http://www.sebi.gov.in/cms/sebi_data/attachdocs/1386758945803.pdf (Last visited on March 25, 2014).
Insider Trading , Chinese Wall Defense , Bolkiah v. KPMG , Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations , 1992 , Regulation 12 , restricted list , grey list , Slade v. Shearson , Hammill & Co
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