Contra trade restriction

Pre-clearance checks one moment in time. A designated person can hold no price sensitive information on Monday, buy legitimately, learn something on Wednesday and sell on Friday — and each leg, taken alone, looks defensible.

The contra trade restriction removes that possibility by removing the short horizon. Once a designated person has been permitted to trade, the opposite transaction is barred for a minimum period, so a position taken has to be lived with rather than flipped. A purchase cannot be reversed by a sale, and a sale cannot be reversed by a purchase, inside the window the code specifies.

The code of conduct must specify the period, and the regulations set the floor:

• Not less than six months for a designated person permitted to trade in securities. In Schedule C the clause is framed for a designated person who is a connected person of the listed company and is permitted to trade in that company's securities.
• Not less than two months for dealing in units of mutual funds, where the designated person is a connected person of the mutual fund, the asset management company or the trustees.

The compliance officer may grant relaxation from strict application of the restriction, but only for reasons recorded in writing, and only where the relaxation does not itself violate the regulations.

The consequence of breach is unusual, and it is the part that gets examined. If a contra trade is executed inadvertently or otherwise in violation of the restriction, the profits from that trade are liable to be disgorged for remittance to SEBI, for credit to the Investor Protection and Education Fund administered by SEBI under the Act. The employer does not keep the money, and "I did not realise" is not a defence.

One carve-out: the restriction does not apply to trades pursuant to the exercise of stock options.

Ms Sharma is a designated person at Deccan Chemicals Ltd. On 10 June, with the window open, she is pre-cleared and buys 20,000 shares at Rs 480 — an outlay of Rs 96 lakh.

On 5 November the stock is at Rs 610 and she sells the lot for Rs 1.22 crore, a gain of Rs 26 lakh.

Deccan's code specifies the statutory minimum of six months. The sale falls on day 148 — inside the period — so it is a contra trade even though the window was open, even though she obtained pre-clearance for the sale, and even though she genuinely held no UPSI. The Rs 26 lakh of profit is liable to be disgorged and remitted to SEBI for credit to the Investor Protection and Education Fund. She keeps her original capital; she does not keep the gain.

Had she waited until 11 December, the trade would have been outside the six months and the profit hers.

Now change the instrument. Ms Sharma is also a designated person at the AMC managing Deccan Mutual Fund. She buys units of one of its schemes worth Rs 8 lakh on 1 August and redeems on 20 September — day 50. For units of mutual funds the floor is two months, so this too is a contra trade, and the gain is disgorged on the same footing.

Chapter 7, Schedules B and C. Questions test three things: the six-month floor, the two-month floor for mutual fund units, and where the disgorged profits go — the answer is SEBI, for credit to the Investor Protection and Education Fund, not the company, not the exchange and not the investor protection fund of the exchange. The stock option carve-out is the standard "which of the following is excluded" option.

• Six months is a minimum, not a fixed period. A company's code may specify longer, and the question may say so.
• The two-month period is specific to units of mutual funds, and applies to a designated person connected with the mutual fund, AMC or trustees — do not apply it to shares.
• Disgorged profits go to the Investor Protection and Education Fund administered by SEBI. This is a different fund from the exchange-administered Investor Protection Fund that compensates clients of a defaulting broker.
• "Inadvertently or otherwise" is in the text: an accidental contra trade is still a contra trade and the profits still go.
• The compliance officer can relax the restriction, but needs reasons recorded in writing, and cannot relax it into a breach of the regulations themselves.
• Trades pursuant to the exercise of stock options are outside the restriction — but the shares received on exercise are not thereafter free of the trading window.