Ashish Gupta asked:


Insider Trading

Introduction – Insider trading is a term subject to many definitions and connotations and it encompasses both legal and prohibited activity. Insider trading takes place legally every day, when corporate insiders – officers, directors or employees – buy or sell stock in their own companies within the confines of company policy and the regulations governing this trading. In simple terms ‘insider trading’ buying or selling a security, in breach of a fiduciary duty or other relationship of trust, and confidence, while in possession of material, non-public information about the security

Thus , in nutshell , insider trading is the buying , selling or dealing in securities of a listed company by a director , member of management , employee of the company , or by any other person such as internal auditor , advisor , consultant , analyst etc, who has knowledge of material inside information which is not available to general public

Examples of insider trading -



Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;

Government employees who learned of such information because of their employment by the government; and

Other persons who misappropriated, and took advantage of, confidential information from their employers.



Other persons who misappropriated, and took advantage of, confidential information from their employers.

Therefore, preventing such transactions is an important obligation for any capital market regulatory system, because insider trading undermines investor confidence in the fairness and integrity of the securities markets.

For instance, prior knowledge of a bonus issue would result in the insider acquiring a significant exposure in particular scrip, knowing that his holding would increase significantly after the bonus is announced.

The first country to tackle insider trading effectively however was the United States. In the USA, the Securities and Exchange Commission is empowered under the Insider Trading Sanctions Act, 1984 to impose civil penalties in addition to criminal proceedings. Most countries have in place suitable legislation to curb the menace of insider trading.

In India, SEBI (Insider Trading) Regulations 1992, framed under Section 11 of the SEBI Act, 1992, are intended to prevent and curb the menace of insider trading in Securities. Now SEBI has with effect from 20th February 2002 amended these Regulations and rechristened them as SEBI 9 Prohibition of Insider Trading Regulation, 1992. These Regulation have been further amended in November 2002

Rational Behind Prohibition of Insider Trading

The smooth operation of the securities market and its healthy growth and development depends on a large extend on the quality and integrity of the market .Such a market can alone inspire confidence in investors

Insider trading leads to loose of confidence of investors in securities market as they feel that market is rigged and only the few, who have inside information get benefit and make profits from their investments. Thus, process of insider trading corrupts the ‘level playing field’

Hence the practice of insider trading is intended to be prohibited in order to sustain the investor’s confidence in the integrity of the security market.

In Samir C Arora Vs. SEBI

It was observed that activities like insider trading fraudulent trade practices and professional misconduct are absolutely detrimental to the interests of ordinary investors and are strongly deprecated under the SEBI Act, 1992 and the Regulations made there under. No punishment is too severe for those indulging such activities.

The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, does not directly define the term “insider trading”. But it defines the terms-

. insider” or who is an “insider;

. who is a “connected person

. What are “price sensitive information”.

Insider -According to the Regulations “insider” means any person who, is or was connected with the company or is deemed to have been connected with the company, and who is reasonably expected to have access, connection, to unpublished price sensitive information in respect of securities of a company, or who has received or has had access to such unpublished price sensitive information;

Connected person – The Regulation defines that a “connected person” means any person who- (i) is a director, as defined in clause (13) of section 2 of the Companies Act, 1956 (1 of 1956) of a company, or is deemed to be a director of that company by virtue of sub-clause (10) of section 307 of that Act or (ii) occupies the position as an officer or an employee of the company or holds a position involving a professional or business relationship between himself and the company whether temporary or permanent and who may reasonably be expected to have an access to unpublished price sensitive information in relation to that company;

Price Sensitive Information means any information, which relates directly or indirectly to a company and which if published, is likely to materially affect the price of securities of company.

American insider trading law

The United States has been the leading country in prohibiting insider trading and the first country to tackle insider trading effectively. Thus it is important to discuss insider trading in American perspective. While Congress gave us the mandate to protect investors and keep our markets free from fraud, it has been our jurists, albeit at the urging of the Commission and the United States Department of Justice, who have played the largest role in defining the law of insider trading.

The market crash in 1929 due to prolonged lack of investors confidence in the securities market followed by Great Depression of US Economy , led to the enactment of Securities Act of 1933 in which Section 17 of the contained prohibitions of fraud in the sale of securities which were greatly strengthened by the Securities Exchange Act of 1934The 1934 Act addressed insider trading directly through Section 16(b) and indirectly through Section 10(b).Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5 prohibits fraud related to securities trading. Further the Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading. Much of the development of insider trading law has resulted from court decisions. In SEC v. Texas Gulf Sulphur Co, a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading. (1966)

In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. (Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.)

The Dirks case also defined the concept of “constructive insiders,” who are lawyers, investment bankers and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider.

In United States v. Carpenter (1986) the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted.

“It is well established, as a general proposition that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived there from.” However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.

In 1997 the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O’Hagan, 521 U.S. 642, 655 (1997),. O’Hagan was a partner in a law firm representing Grand Met, while it was considering a tender offer for Pillsbury Co. O’Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O’Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options.

The Court rejected O’Hagan’s arguments and upheld his conviction. The “misappropriation theory” holds that a person commits fraud “in connection with” a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.

The Court specifically recognized that a corporation’s information is its property: “A company’s confidential information…qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty…constitutes fraud akin to embezzlement – the fraudulent appropriation to one’s own use of the money or goods entrusted to one’s care by another.”

In 2000, the SEC enacted Rule 10b5-1, which defined trading “on the basis of” inside information as any time a person trades while aware of material nonpublic information — so that it is no defense for one to say that she would have made the trade anyway. This rule also created an affirmative defense for pre-planned trades.

In May of 2007, representatives Brian Baird and Louise Slaughter introduced a bill entitled the “Stop Trading on Congressional Knowledge Act, or STOCK Act.” that would hold congressional and federal employees liable for stock trades they made using information they gained through their jobs. The bill would also seek to regulate so called “Political Intelligence” firms that research government activities and sell the information to financial managers.

Insider trading in India

In India Regulation 3 of the SEBI Regulations seeks to prohibit dealing, communication and counseling on matters relating to, insider trading. Regulation 3 provides that no insider shall either on his own behalf of any other person deal in securities of a company when in possession of any unpublished price sensitive information on communicate, counsel or procure, directly or indirectly any unpublished price sensitive information to any person, who while in possession of such unpublished price sensitive information shall not deal in securities. However, these restrictions are not applicable to any communication required ordinary, course of business or profession or employment or any law.

Further 3 A prohibits any company from dealing in the securities of another company or associate of that other company while in possession of any unpublished price sensitive information.

Insider Trading Regulations have been tightened by SEBI during February 2002. New rules cover ‘temporary insiders’ like lawyers, accountants, investment bankers etc.

Directors and substantial shareholders have to disclose their holding to the company periodically. The New Regulations have added relatives of connected persons, as well as, the companies, firms, trust, etc. in which relatives of connected persons, bankers of the company and of persons deemed to be connected persons hold more than 10% .The definition of relative, under the New regulations is in line with that of the Companies Act, 1956, which ranges from parents and siblings to spouses of siblings and grandchildren. The term “connected person” is defined to mean either i) a director or deemed to be a director, ii) occupies the position as an officer or an employee or having professional or business relationship whether temporary or permanent, with the company. Thus, there are two categories of insiders:

Primary insiders, who are directly connected with the company and secondary insiders who are deemed to be connected with the company since they are expected to have access to unpublished price sensitive information. The jurisprudential basis for the ‘person-connected’ approach seems to be founded in the equitable notions of fiduciary duty.

The secondary insider, who would have traded with an unfair informational advantage, may escape from being caught simply because there can be no trace of how he derived this information in the first place. Insider by reason of his connection with the company. In reality, much of the flow of the price-sensitive information often does not operate by way of such established networks of relational links between individuals. Very often, such price-sensitive information is communicated and spread out through very loosely connected and informal networks of brokers, clients and even between friends and through electronic networks etc. or an elaborate nexus of company official, brokers, traders. These individuals are very often privy to strategic policy decisions or developments that may influence the valuation of a company’s scrip on the bourses

Duties/ Obligations Of the listed company under the SEBI (Prohibition of Insider Trading) Regulations, 1992



To appoint a senior level employee generally the Company Secretary , as the Compliance Officers;

To set up an appropriate mechanism and to frame and enforce a code of conduct for internal procedures,

To abide by the Code of Corporate Disclosure practices as specified in Schedule ii to the SEBI (Prohibition of Insider Trading)Regulations , 1992

To initiate the information received under the initial and continual disclosures to the Stock Exchange within 5 days of their receipts;

To specify the close period;

To identify the Price Sensitive Information

To ensure adequate data security of confidential information stored on the computer;



To prescribe the procedure for the pre- clearance of trade and entrusted the Compliance Officers with the responsibility of strict adherence of the same

The penalties /punishments can be imposed in case of violation of SEBI (Prohibition of Insider Trading) Regulations, 1992

1. SEBI may impose a penalty of not more than Rs 25 Crores or three times the amount of profit made out of insider trading; whichever is higher; or

2. SEBI may initiate criminal prosecution; or

3. SEBI may issue orders declaring transactions in securities based on unpublished price sensitive information; or

4. SEBI may issue orders prohibiting an insider or refraining an insider from dealing in the securities of the company

Conclusion -The new 2002 regulations in India have further fortified the 1992 regulations and have increased the list of persons that are deemed to be connected to Insiders. Listed companies and other entities are now required to frame internal policies and guidelines to preclude insider trading by directors, employees, partners, etc. In the past, it has been observed that insider trading legislation is ineffective and difficult to enforce and has little impact on securities markets. Low enforcement rates and few convictions against insiders have been cited as evidence of this ineffectiveness. Irrespective of whether or not the SEBI was bestowed with wide ranging powers, it has been a clear failure when it came to the task of administering the law.

The importance of policing insider trading has also assumed international significance as overseas regulators attempt to boost the confidence of domestic investors and attract the international investment community. So, SEBI now should take the role of a regulator only. Special Courts could be set up for faster and efficacious disposal of cases.

 



Alice

Partha Pati asked:


Submitted by: PARTHA PATI

Class: BBA.LLB, Vth Year

Symbiosis Law School, Pune

 

 

DE_REGULATING INSIDER TRADING

 

Introduction:

Insider trading is a trading of corporation’s stock or other securities (e.g. bonds or stock options) by individuals with potential access to non-public information about the company. In most countries trading by insiders such as officers, key employees, directors, and large shareholders may be legal, if this trading is done in a way that does not take advantage of non-public information. What is illegal is the trading by an insider on the basis of unpublished price-sensitive information. The prevention of insider trading is widely treated as an important function of securities regulation. In the United States, which has the most–studied financial markets of the world, regulators appear to devote significant resources to combat insider trading. This has led many observers in India to mechanically accept the notion that the prohibition of insider trading is an important function of SEBI. In most countries other than the US, government actions against insider trading are much more limited. Many countries pay lip service to the idea that insider trading must be prevented, while doing little by way of enforcement.

Objective:

The article intends to put forth the futility of regulating insider trading in the light of lack of enforceability and market efficiency. Insider trading is an extremely difficult crime to prove. The underlying act of buying and selling of securities is a perfectly legal activity  It is only the malafide intention of the trader which can make this act a crime. Moreover the primary function of the regulation and policy is to foster market efficiency. The article will also analyse the possible effect of de-regulation.

Main Text:

Who is an insider?

The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, say, “insider” is any person who, is or was connected with the company, and who is reasonably expected to have access to unpublished price-sensitive information about the stock of that particular company, or who has access to such unpublished price sensitive information.

In the United States, for mandatory reporting purposes, corporate insiders are defined as a company’s officers, directors and any beneficial owners of more than ten percent of a class of the company’s equity securities. Trades made by these types of insiders in the company’s own stock, based on material non-public information, are considered to be fraudulent since the insiders are violating the trust or the fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has made a contract with the shareholders to put the shareholders’ interests before their own, in matters related to the corporation. When the insider buys or sells based upon company owned information, he is violating his contract with the shareholders.

For example, illegal insider trading would occur if the Chief executive officer of Company A learned (prior to a public announcement) that Company A will be taken over, and bought shares in Company A knowing that the share price would likely rise.

Information that could be price sensitive includes periodical financial results of a company, intended declaration of dividend, issue or buyback of securities, any major expansion plans or execution of new projects, amalgamation, merger, takeovers, disposal of the whole or substantial part of the undertaking and any other significant changes in policies, plans or operations of the company.

How does insider trading work?

An insider buys the stock (he might also already own it). He then releases price-sensitive information to a small group of people close to him, who buy the stock based on it, and spread the information further. This results in an increase in volumes and prices of the stock. The inside information has now become known to a larger group of people which further pushes up volumes and prices of the stock.

After a certain price has been reached, which the insider knows about, he exits, as do the ones close to him, and the stock’s price falls. Those who had inside information are safe while the ordinary retail investor is stuck holding a white elephant as, in many cases, the ‘tip’ reaches him only when the stock is already on a boil.

The regular investor gets on the bandwagon rather late in the day as he is away from the buzz with no direct connection to the ‘real’ source. He buys the overvalued stock due to imbalance in the information flow.

In 2001, Sam Waksal,CEO of ImClone Systems,USA was sentenced to seven years and three months for breaking insider trading laws.He had learnt from his brother, the COO of ImClone that the FDA would reject an application for the company’s leading drug, and acted upon it.

 

In April this year, 2 Goldman Sachs employees made more than $6.7 million through insider trading by enlisting an analyst who provided information on Wall Street deals and a forklift driver who leaked copies of a market-moving magazine. SEC indicted 13 persons for insider trading.

 

SEC has brought about merely 200 charges for insider trading in the last five years.

In India only 14 cases have been taken up by SEBI for insider trading in 2003-04, which went down to only 7 in 2004-05, This clearly reflects our regulating authority’s dismal performance over the years.

Difficult to prove

While it’s common knowledge that insider trading takes place, it is very difficult to prove. Insiders may not trade on their own account. Flow of information is another important factor, but difficult to track. Regulations are in place to prevent this, but the stock price of a company invariably tends to move up or down at least a couple of weeks ahead of any price-sensitive announcement.

Take the case of IFCI. The stock has been on fire since early January 2007. It gained almost 53 per cent in eight trading sessions from Rs 13.45 before the announcement of its 7-per cent stake sale in NSE was made in January 2007.

The stock also gained 30 per cent in 12 sessions before the announcement to appoint Ernst & Young for advising the company on induction of a strategic investor in the company was made in March 2007. From this level, the run up in the stock has been over 210 per cent.

While it is not possible to say that insider trading took place in this case, little else explains the share price movement.

The expected strategic sale was called off in December 2007, and the stock shed almost 23 per cent in one session. Investors who got on the bandwagon at around Rs 70-74 in early September 2007 and did not sell by this time, would have lost all their gains.

Innocent till proven guilty. Considering the sensitivity of the subject and the evidence required to allege and prove it, the instances of insider trading that get reported are far and few. Says Bhavesh Shah, vice-president (research), Asit C Mehta Investment Intermediates: “Majority of the cases that have been reported and acted upon by the exchange and the Sebi have been too few and the action too late. A study of the reported cases on insider trading in Securities Appellate Tribunal (SAT) very clearly reflects a complex web of transactions of unusual nature put through for extraordinary gains by few interested parties. However, in almost all cases the Sebi has not managed to bring the culprit to book for one or the other reason.”

Samir Arora, the erstwhile fund manager of Alliance Capital Mutual Fund, was probed for professional misconduct, fraudulent and unfair trade practices and insider trading. SAT dismissed the charges against Arora on the premise that there was no violation and for want of evidence. Recently, the Sebi has initiated an investigation into sale of 4.01 per cent in Reliance Petroleum by Reliance Industries.

Arguments in favour of legalizing insider trading:

In order to make sense of insider trading, we must go back to a basic understanding of markets, prices and the role of markets in the economy. The ideal securities market is one which does a good job of allocating capital in the economy. This function is enabled by “market efficiency”, the situation where the market price of each security accurately reflects the risk and return in its future. The primary function of regulation and policy is to foster market efficiency, hence we must evaluate the impact of insider trading upon market efficiency.

It is not hard to see that when company insiders trade on the secondary market, they speed up the flow of information and forecasts into prices. Company insiders are in a unique position to make forecasts about the future risk and return of the shares and bonds of their company, hence they might often correctly perceive market prices to be “too low” or “too high”. When they trade on the secondary market, they serve to feed their knowledge into prices, thus making markets more efficient.

Insider trading is often equated with market manipulation, yet the two phenomena are completely different. Manipulation is intrinsically about making market prices move away from their fair values; manipulators reduce market efficiency. Insider trading brings prices closer to their fair values; insiders enhance market efficiency.

Some economists and legal scholars (e.g. Henry Manne, Milton Friedman, Thomas Sowell, Daniel Fischel, Frank H. Easterbook) argue that laws making insider trading illegal should be revoked. They claim that insider trading based on material nonpublic information benefits investors, in general, by more quickly introducing new information into the market.

Milton Friedman, laureate of the Nobel Memorial Prize in Economics, said: “You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that.” Friedman did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.

Other critics argue that insider trading is a victimless act: A willing buyer and a willing seller agree to trade property which the seller rightfully owns, with no prior contract (according to this view) having been made between the parties to refrain from trading if there is aymmetric information.

Legalization advocates also question why activity that is similar to insider trading is legal in other markets, such as real estate, but not in the stock market. For example, if a geologist knows there is a high likelihood of the discovery of petroleum under Farmer Smith’s land, he may be entitled to make Smith an offer for the land, and buy it, without first telling Farmer Smith of the geological data. Nevertheless, circumstances can occur when the geologist would be committing fraud if he did not disclose the information, e.g. when he had been hired by Farmer Smith to assess the geology of the farm.

Advocates of legalization make free speech arguments. Punishment for communicating about a development pertinent to the next day’s stock price might seem to be an act of censorship. If the information being conveyed is proprietary information and the corporate insider has contracted to not expose it, he has no more right to communicate it than he would to tell others about the company’s confidential new product designs, formulas, or bank account passwords,

This is one of the situations where the insights of modern economics contradict common intuition. The fact that securities regulation in the US is primarily the creation of lawyers is not unrelated of the fact that the US is unique in emphasising restrictions on insider trading.

Insider trading appears unfair, especially to speculators outside a company who face difficult competition in the form of inside traders. Individual speculators and fund managers alike face inferior returns when markets are more efficient owing to the actions of inside traders. This does not, in itself, imply that insider trading is harmful. Insider trading clearly hurts individual and institutional speculators, but the interests of the economy and the interests of these professional traders are not congruent. Indeed, inside traders competing with professional traders is not unlike foreign goods competing on the domestic market — the economy at large benefits even though one class of economic agents suffers.

Once again, a mechanical adoption of regulation from the US is inappropriate. Given the higher degree of automation of the Indian markets, it is not difficult to imagine a situation where trades by insiders are disclosed to the market within five minutes of the trade being matched by the computer. Such a reporting requirement would harness the informational potential of insider trading, and enhance market efficiency by speeding up the full impact of the trade upon market prices

Conclusion:

Even if restrictions on insider trading were considered desirable, their sound implementation is extremely expensive. A wide variety of individuals can be classed as insiders by virtue of possessing information material to securities prices — top management, upstream and downstream producers, regulatory and enforcement authorities, professional advisors, etc. Further, the universe of associates through whom insiders could route their trades is very large — family, friends, business associates who are “paid” in information, etc. Enforcement of restrictions upon insider trading runs the risk of either being ineffective or being a witch hunt. Even if there are pockets of high quality enforcement, they would not appear fair in an environment where insider trading is otherwise rampant. Even in the US, where significant resources have been expended on deterring insider trading, there is anecdotal evidence that a great deal of successful speculation continues based on insider trading.

Hence, if we view securities regulation in terms of maximising the impact upon market efficiency given a scarce supply of regulation and supervision, then insider trading would be a low priority.

 



Jon