De-regulating Insider Trading
Wednesday, August 13th, 2008
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 What is illegal is the trading by an insider on the basis of unpublished price-sensitive information.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“insider” is any person who, is or was connected with the company, and who is reasonably expected to have access to unpublished price-sensitive information about the stock of that particular company, or who has access to such unpublished price sensitive information.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
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