Mr Sandeep Parekh is an Advocate, LL.M. (Securities and Financial Regulations), admitted to the New York bar. Visiting Faculty, Indian Institute of Management, Ahmedabad.
Trading by an insider of a company in the shares of a company is not per se a violation of law. In fact trading by insiders, including directors, officers and employees of the company in the shares of their own company is a positive feature which companies encourage because it aligns its interests with those of the insiders. What is prohibited is the trading by an insider in the stock of the company on the basis of non public information to the exclusion of others. Insider trading thus defined is one of the most violent crimes on the faith of fair dealing in the market.
If insider trading is allowed unchecked in the capital markets, persons with insider information will have a consistent edge in trades executed with such information and those without the information will be consistent losers on the market. The latter category of people, which is of course the vast majority of investors, would slowly realize the loser game they are playing and would believe that all transactions are thus biased against them. Slowly the typical investor would desert the market, leaving important functions of the stock market like capital raising in the dust.
Levels of prohibition in other countries
There have been several argument in favour of allowing insider trading for purposes of efficiency and as a means to reward management and directors of a company.1 Certain countries, like Japan, do not have a prohibition on insider trading. Certain countries, like the US, do not automatically prohibit trading on the basis of possession of inside information. There must be a fiduciary relationship of the insider with the company before the person can be sanctioned. Indian regulations contain more blanket provisions (and cast a wider net) against trading by any insider.
According to the SEBI regulations on Prohibition of Insider Trading, 1992 "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or is deemed to have been connected with the company, and who is reasonably expected to have access, connection, to unpublished price sensitive information in respect of securities of a company, or who has received or has had access to such unpublished price sensitive information;
`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;
No insider shall –
(ii) 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.
Provided that nothing contained above shall be applicable to any communication required in the ordinary course of business or under any law.
Ingredients of violation
For the violation, several requirements are made by the regulations. First, the necessity of being an insider (which now specifically includes a company). Second, the possession of material unpublished price sensitive inside information. And lastly, the factum of dealing (there is another prohibition against disclosing such information) in securities.
An Insider is any person who by virtue of a duty owed to the company is expected to have (or has had) access to unpublished price sensitive information. Thus a taxi driver, who has no connection with the company and overhears two directors discussing unpublished price sensitive information would not fall under the proscriptions of the Act. Every person who chances across inside information is not liable under the regulations.
The possession of material inside information raises the question – what is material and what is an inside unpublished price sensitive fact. What is material is a question of fact and will be depend on a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.1 Unusual trading by insiders could be a good indicator of materiality. Inside unpublished price sensitive fact is inside information which only a select few persons know because of their closeness to the company and which has not been publicly circulated. When does an information enter the public domain? Probably not for at least a few hours after it is intimated to the public (via the stock exchange or the company’s website).
In United States v. Falcone, the court of appeals agreed with the Commission’s amicus brief that a stockbroker who obtained advance notice of the contents of Business Week’s "Inside Wall Street" column through an employee of the magazine’s wholesaler and traded on the information was not too "remote" in the chain of distribution of the magazine to have owed a duty of confidence to Business Week. The court of appeals held that the stockbroker had a duty not to trade on that information because Business Week communicated the need for confidentiality to its distributor, which in turn communicated it to the wholesaler, which accepted and enforced the confidence, and the stockbroker received the information with knowledge that he was getting it in breach of the confidentiality obligation.
The Board may without prejudice to its right to initiate criminal prosecution under section 24 or any action under Chapter VIA of the Act, to protect the interests of investors and in the interests of the securities market and for due compliance with the provisions of the Act, Regulations made thereunder issue any or all of the following order, namely: -
(a) directing the insider or such person as mentioned in clause (i) of sub-section (2) of section 11 of the Act not to deal in securities in any particular manner;
(b) prohibiting the insider or such person as mentioned in clause (i) of sub-section (2) of section 11 of the Act from disposing of any of the securities acquired in violation of these Regulations;
(c) restraining the insider to communicate or counsel any person to deal in securities;
(d) declaring the transaction(s) in securities as null and void;
(e) directing the person who acquired the securities in violation of these regulations to deliver the securities back to the seller;
Provided that in case the buyer is not in a position to deliver such securities, the market price prevailing at the time of issuing of such directions or at the time of transactions whichever is higher, shall be paid to the seller.
(f) directing the person who has dealt in securities in violation of these regulations to transfer an amount or proceeds equivalent to the cost price or market price of securities, whichever is higher to the investor protection fund of a Recognised Stock Exchange.
Means of controlling insider trading
One way of dealing with insider trading is by passing regulations prohibiting such trades, making them penal and enforcing civil and criminal regulations against violators. However, experience has shown us that this method provides only a small amount of relief even in more heavily regulated countries. For instance the Securities and Exchange Commission of the United States brought only 47 cases of insider trading in the year 20012.
The other way of attacking the problem is by encouraging the companies to practice self regulation and taking preventive action. This is inherently connected to the field of corporate governance. It is a means by which the company signals to the market that effective self regulation is in place and that investors are safe to invest in their securities. In addition to prohibiting inappropriate actions (which might not necessarily be prohibited), self regulation is also considered an effective means of creating shareholder value. Companies can always regulate their directors/officers beyond what is prohibited by the law and signal the fact to their shareholders.
Are insider laws in India effective
Insider trading has rightly been seen as amongst the most violent crimes on an efficient and integral capital market. It reduces the confidence of the investor in the market and hinders capital flow. The insider trading law of India is far better codified than many of the western countries laws, particularly the American law which has primarily been developed by case law and is quite unsettled in various respects (in part because the American legislature refuses to define insider trading). The American case law, which nonetheless is highly developed, is based on the general antifraud provisions of the Securities and Exchange Act3
However where India misses out is specifying effective civil consequences of insider trading. Regulation 11 of the Insider trading regulations offer rescissionary rights to SEBI against insiders. SEBI can annul the trades entered into by an insider. However such rescission is more in terms of returning stolen property. There is no monetary penalty imposed – there is no economic burden imposed on the insider. There is no regulatory signaling to the market that insider trading is not economically efficient for the insider.
S.15G of the SEBI Act specifies the penalty for insider trading: "shall be liable to a penalty not exceeding five lakh rupees". Section 24 is an omnibus criminal provision relating to prosecution for violation of any part of the Act, or any rules and regulations under the Act.
These penal monetary consequences are without reference to the degree of economic offense perpetrated. Thus a person who has gained a crore from an illegal insider transaction is liable to pay only Rs. Five lakhs as monetary penalty. The amount of penalty remains a constant even if the violation exceeds tens or even hundreds of crores.
There is need to add heavy civil consequences on the insider trader. According to SEBI, it does not have the power to impose civil penalties on the violator. Merely because specific powers have not been given to SEBI under the statute does not suggest that it does not have those powers. SEBI could seek civil powers over violators with assistance from civil courts.
S. 11 of the SEBI Act gives the Board broad discretionary powers to issue appropriate remedies. To quote "Subject to the provisions of this Act, it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit". It also has the powers to issue to any person connected to the securities market such directions "as may be appropriate in the interests of the investors in securities". SEBI has, like Harry Potter, powers it does not know of.
Of course there is the usual threat of a jail sentence for the offender under S.24 above. The section is more of a paper tiger. Though the jail sentence may look good on the statute, history bears out the difficulty in enforcing criminal prosecution against an economic offender. The burden of proof of proving a criminal charge is so onerous that a matter lies in the courts to unravel the complicated issues of facts of illegal transactions consummated over a period of time. For instance the only case of insider trading prosecuted by Dutch authorities in ten years failed on lack of proof. Similarly the US SEC referred fewer than 5 insider trading cases for criminal prosecution - many of which would end up with unsuccessful results.
With a conviction rate of less than 3% in India, SEBI should really concentrate on efforts to economically paralyze insider traders instead of the more high profile and far less successful criminal sanctions. The not so recent action against the directors of Hindustan Lever Limited is a case in point. Two years after a weak case in their hands, the regulator is now getting the case to start criminally. It is still not clear how an officer of a company is criminally liable for the actions he took for the benefit of the company. However, that is the subject of another paper.
Prophylactics and corporate good governance
The 2002 amendments to the Regulations provide extensive suggestions and also extensive regulations couched in the language of corporate good governance. Most of the good governance provisions are provided for as mandatory provisions. Corporate good governance has been married to the penal provisions of the regulations to create a smothering framework of regulations, which for instance provide that certain meetings should be recorded and should be made only in the presence of two company officers4. Of course there is no denying that the regulations create a fair market and create a framework which more and more western countries are moving towards. See the Sarbanes Oxley Act passed a few weeks back in the US - discussed below.
Briefly, the good governance regulations provide for
a) Officer, director and substantial shareholder to disclose their holding on certain events or at certain intervals.
b) Appointment of a compliance officer.
c) Setting forth policies and procedure to restrict the possibility of abuse of insider trading.
d) Monitoring and pre-clearance of trades by the designated persons.
e) Restrict trading by such insiders within a certain period of time i.e. before corporate announcements, buybacks etc. are made.
f) The company has to convey all the significant insider activity and corporate disclosure in a uniform publicly accessible means to the public – and to the stock exchange.
g) Chinese walls within a firm to prevent one part of the firm which deals in sensitive information from going to other parts of the firm which have an inherent conflict of interest with such other parts.
h) Minimum holding period of securities by insiders.
i) No selective disclosure to analysts. Wide dissemination of information.
The US legislature, witness to an unending line of scandals, recently passed amendments to the securities/disclosure laws of the country – in effect codifying into law several corporate governance suggestions made on previous occasions. The Sarbanes-Oxley Act of 2002 requires:
- directors, executive officers and large shareholders of public issuers to report transactions in the issuer’s equity securities within two business days of a transaction.
- pre-clearance procedures for transactions in the issuer’s equity securities;
- the responsibilities the company will take for completing filings;
- the requirement (or encouragement) to use a specified broker for transactions in the issuer’s securities, or the certifications required from brokers if no specific broker is required;
- the applicability of the rules to persons with business or family relations to the insider; and
- sanctions for failure to make timely filings.
Some possible additions to the regulations
There are a few further provisions the Indian legislators should consider to reduce the occurrence of insider trading.
Short swing profits
There should be a regulation introduced in the Insider Trading regulations which compel an insider to disgorge or turn in profits made by insiders to the company for any transaction in equity based securities in the company’s securities (including it’s parents or subsidiary’s shares) if both the buy and sell side of the transaction is entered into within six months of the other.
Such a liability should be imposed without any necessity for guilt or wrongfulness. This would be a provision which would get automatically attracted as soon as two things are established. First, the fact of being a designated insider. And second, the fact that the same securities were bought and sold within six months of each other.
Designated or qualified brokers.
To facilitate compliance with the new reporting of transactions, issuers should either designate a single broker through whom all transactions in issuer stock by insiders must be completed or require insiders to use only brokers who will agree to the procedures set out by the company. A designated broker can help ensure compliance with the company’s pre-clearance procedures and reporting obligations by monitoring all transactions and reporting them promptly to the issuer. If designating a single broker is not feasible, issuers should require insiders to obtain a certification from their broker that the broker will:
- Verify with the issuer that each transaction entered on behalf of the insider was precleared; and
- Report immediately to the issuer the details of each of the insider’s transactions in the issuer’s securities.
Parts of the regulations refer to ‘shares’ for the purpose of proscription while they should prohibit "securities" trading. For instance, one could, using derivatives, economically sell the shares without physically trading in those shares.5 Similarly, one can easily create synthetic securities with the same economic impact as an equity share of a company. By reclassifying shares into securities, one can eliminate the problem because securities are defined to include equity, quasi-equity, derivatives and any combination of the three. Pure debt instruments can be excluded specifically from the regulations.
Similarly, under Regulation 13 the disclosure requirements should refer to not merely a 5% stake in the equity but also to a minimum stake in derivatives of the company’s securities. The minimum can be a rupee amount of the market value of the derivative (since calculating 5% of the derivatives market is neither possible and if possible not meaningful)
SEBI should be specifically provided with powers to charge several times the profit made (or loss avoided) and provide an economic blow to an economic offence. People trading in the market (not just counterparties to the insider) should also have specific powers to rescind trades and charge damages to the insiders during the period when they traded.
A recent US case is illustrative of a typical civil penalty charged by the Securities and Exchange Commission. In SEC v. Steve Madden, the Commission filed a settled injunctive action against shoe designer Steve Madden alleging that he engaged in insider trading. The complaint alleged that after Madden learned from the criminal authorities that he was the target of a criminal investigation and would be indicted or otherwise charged for securities fraud, he sold 100,000 shares of common stock in his company, Steven Madden Ltd. Madden sold this stock without disclosing to the public the information he had learned regarding the criminal investigation. After Madden was arrested, the company’s stock price sank and Madden avoided losses of $784,000. Madden consented to an order of permanent injunction and agreed to disgorge $784,000 of illegally avoided losses, plus prejudgment interest, and to pay $784,000 in civil penalties.
Proactive Stock Exchanges
The stock exchanges should take up at least a substantial burden of filing action against persons violating the regulations. Since the Rules and regulations of the stock exchanges are tabled in parliament, and court judgments have found the regulations having the force of law – they could easily enforce the requirements of the listing terms or the rules and regulations by seeking civil action in courts against persons or companies who violate such regulations. The exchanges should also better coordinate monitoring and surveillance of listed companies to track unusual activity in the stock of a company across markets for traces of insider dealings or manipulation.
One author has suggested that a contract of sale or purchase by an insider be declared void by the counterparty to a trade under the Indian Contract Act (this is besides the powers SEBI has to annul the trade under Regulation 11). Though legally feasible, it raises impossible burdens in today’s virtually anonymous capital markets. For instance if an investor had bought 100 shares of the company during the period when the insider trading took place, it would be difficult to determine the counterparty to the insider. And in any case even if the counterparty to the trade is identified, the insider has not only hurt his trade counterparty but also the market as a whole.6 By buying (or selling) shares the insider would have raised (or lowered) the price of the shares so bought (or sold) and thus would affect the rights of every person who bought or sold contemporaneously.
The regulations prohibit persons from tipping people about inside information by insiders i.e. the tipper. However, there seems to be no liability for a person who improperly receives a tip i.e. a tippee from trading. There is a vague prohibition against ‘procurement’ of information. However, it does not clearly prohibit a tippee from trading.
Disgorgement orders could be obtained by SEBI from courts so that the ill gotten gains or the losses avoided can be taken away from the offender. A 5 times penalty or a ten times the gains made or loss avoided penalty besides disgorgement obtained from a civil court would be a more effective remedy than imprisonment under S. 24 of the SEBI Act (the courts are lenient in giving prison terms to economic offenders in any case). Disgorgement could be assessed even against non-violators if they knew of the violation and are currently in possession of the money (would include family members). The SEBI should also seek asset freeze of bank accounts to catch insider trading funds from flying away and other ancillary reliefs (like restitution, forfeiture of ill gotten gains when they cannot be returned to the rightful owner). SEBI has additional powers over brokers and other securities professionals who could be censured, or whose license or registration could be suspended/revoked without going to courts.
The core of securities regulations is the implementation of the purpose that all investors should have equal access to the rewards of participation in securities transactions. In other words all members of the investing public should be subject to identical market risks. Inequities based upon unequal access to knowledge should not be shrugged off as inevitable in our way of life.
The author is an Advocate based in New Delhi.
1 Other arguments in favour of allowing insider trading are that in light of trading volume insider trading has no material impact on other investors. Besides it is argued that victims are selected randomly because of the now faceless market. See. Henry G. Manne, Insider Trading and the Stock Market (1966).
2 TSC Industries v. Northway 426 US 438.
3 SEC Annual Report, 2001
4 The ubiquitous Rule 10b-5 of the regulations passed under the Act which prohibits fraud in connection with the purchase and sale of securities.
5 Schedule II, Rule 6.0
6 By selling futures in the derivatives market of the exchange.
7 See Basic v. Levinson 485 US 224, where the US court found that under the economic principle of "Efficient Capital Markets Hypothesis" a person trading on unpublished information is hurting the entire market and all contemporaneous people who traded that security during that period may rely on the implied misrepresentation made to the entire market.
This article is for general informational purposes only and does not represent our legal advice as to any particular set of facts.