There is no uniform or consistent definition of an 'insider' among the securities regulatory authorities of the world's major financial economies. An insider (in context of insider trading in securities) is anyone who has privileged access to material price sensitive non-public information of the company due to some special relationship, and could be the director, corporate executive, lawyer, banker, accountant or a major shareholder.
Insider Trading may be perfectly legal, but this term is today used to denote an illegal practice, which is said to occur when a person who misappropriates, or comes in possession of price-sensitive information about a company during the performance of insider duties at the corporation, buys or sells securities in that company and so obtains better terms in the contract of sale than would have been the case had the counterparty been aware of the information in question.
This article analyses the penal provisions of the legal framework to check insider trading in the United States of America and India. These particular regimes have been selected because United States, being one of the largest financial markets of the world can act as a guide to the securities market of India, one of the fastest emerging economies of the world. In order to retain the confidence of the investors, India needs to have effective penal provisions at par with the securities market of developed economies and centred around the preponderance of criminal intent to protect innocent traders from being victimized.
ROLE OF MENS REAS IN PENALISING INSIDER TRADING IN THE UNITED STATES
Until the Great Depression and corresponding stock market crash of 1929, the securities market in the United States was largely unregulated, and this resulted in several corporate frauds and mismanagement. For the very first time in an attempt to regulate the capital market, the Securities Act and the Securities Exchange Act were enacted in 1933 and 1934 respectively. The latter provided that, to be held criminally liable for violation of Section 10(b) of the said Act prohibiting insider trading, the defendant's action must be expressly considered to constitute a "wilful" violation of the securities crimes under Section 32(a) of the Act, thereby implicitly recognising the principle of mens rea or criminal intent. Subsequently, the Securities and Exchange Commission (hereinafter, the "SEC") adopted Rule 10b-5,1 which made it unlawful to engage in fraud or misrepresentation in connection with the purchase or sale of securities and imposed criminal liability for wilful violation thereof.
The U.S. federal courts have also played an important role in crystallising the role of the mental element for attracting liability for insider trading. Since the United States often serves as the "gold standard" for many emerging markets there is a need to understand what constitutes mens rea so as to attract criminal liability for insider trading violations within the jurisdiction of the United States. As early as in 1933, the U.S. Supreme Court, in the case of U.S. v. Murdock, interpreted the meaning of "wilfulness" as "an act which is intentional, or knowing, or voluntary, as distinguished from accidental" and "when used in a criminal statute it generally means an act done with a bad purpose" and "without justifiable excuse."2 In United States v. Dixon, Judge Friendly held that an act is done wilfully "if done intentionally and deliberately" and excluded an "innocent mistake, negligence or inadvertence" from "wilfulness."3 In the aforesaid case, the court further held that an actor who disregards or disobeys securities regulations and is aware of the significant risk to violate the law fulfils the standard of "wilfulness."
In United States v Chiarella4 the importance of mens rea was recognised by way of the misappropriation theory propounded for the very first time, which was explained by Professor Bainbridge as a theory requiring a breach of fiduciary duty before trading on inside information becomes unlawful'.5 The Supreme Court declared that trading on material, non-public information in itself was not enough to trigger liability in the absence of breach of fiduciary duty.6 'In Dirks v. SEC,7 in footnote no.14, Justice Powell formulated the concept of "constructive insiders" – outside lawyers, consultants, investment bankers or others – who legitimately receive confidential information from a corporation in the course of providing services to the corporation. The Supreme Court held that these constructive insiders acquire the fiduciary duties of a true insider, provided the corporation expected the constructive insider to keep the information confidential. This rule came to be popularly known as "Dirks footnote 14."
In United States v o' Hogan, taking the constructive insiders principle forward, liability was imposed for people who owed no duty to the company in which stock was traded by extending the fiduciary duty owed to one's own company in the "traditional" case to a fiduciary duty owed to "the source of information" in a "misappropriation" case and held that to qualify for a criminal penalty over civil penalty, the defendant's action must be expressly considered to constitute a "wilful" violation of the securities crimes.8" Although the Supreme Court accepted the misappropriation theory in the O'Hagan case, it remanded the case to the Eighth Circuit because the charges against "O'Hagan under the misappropriation theory were too indefinite to permit the imposition of criminal liability."9 The Eighth Circuit upheld the conviction by loosely interpreting the requirement of wilfulness and precluding reckless or negligent violation of securities law from criminal liability".10
Judge William B. Herlands, in his article 'Criminal Law Aspects of the Securities Exchange Act of 1934' had attempted to throw light on the meaning of the term "wilfulness" and in this regard excluded the requirement of prior knowledge of the particular statute or rule by the defendant and instead propounded that the prosecution must establish a "realization on the defendant's part that he was doing a wrongful act."11 This opinion has been widely followed by the Ninth Circuit in cases involving securities fraud.12
Thus, as a result of regulations against insider trading and a robust and dynamic role played by the U.S. judicial system, there exists a stringent framework in place to safeguard the market against the evils of insider trading and to penalize insider trading on the basis of the existence of a profit motive.
LEGAL SYSTEM GOVERNING INSIDER TRADING IN INDIA
Any insider having deep insight into the affairs of the company may hold knowledge about price sensitive information relating to the performance of the company that could have a decided impact on the movement of the price of its equity. Such an insider may utilise this information asymmetry to his special advantage, to reap profits and avoid losses in the stock market, to the detriment of investors not being privy to such "inside" information. An insider or a related party is not permitted to trade on such information obtained during the performance of insider's duties as it is a breach of fiduciary relationship. Thus the main reason of passing insider trading laws is that the government wants to secure the interests of all the investors in the stock market and ensure that any information available to one active participant in the market is available to all participants. Towards this end, the SEBI attempts to exercise control over the trading behaviour of the insiders.
Until late 1992, there existed no legal sanction to deal with the various offences related to the financial market that arose post liberalisation. This led to the enactment of the Securities and Exchange Board of India Act 1992, (hereinafter, the "SEBI Act") which outlawed insider trading and conferred upon the Securities and Exchange Board of India (hereinafter, "SEBI") the authority to investigate instances of alleged insider trading. Section 12A (d) and Section 12A (e) of the SEBI Act specifically prohibit insider trading. The SEBI further adopted the SEBI (Insider Trading) Regulations in 1992 that prohibited the practice of insider trading. However, the prosecution for the offences under the aforesaid Regulations was very unsatisfactory. This, along with the final recommendations of the SEBI Insider Group headed by Mr. Kumarmangalam Birla13 on March 31, 2001, that were approved by the SEBI on May 14, 2001, formed the basis in 2002 for the drastically amended and renamed SEBI (Prohibition of Insider Trading) Regulations, 1992. Subsequently, the SEBI replaced the two-decade old framework with the SEBI (Prohibition of Insider Trading) Regulations, 2015 (hereinafter, "SEBI Regulations"), to come into force in May 2015.14 The legislative intent behind the SEBI Regulations is to prevent any insider trading that would earn the insider an unjustified benefit and operate to the disadvantage of the bonafide shareholders. These regulations, applicable to listed companies or those that are proposed to be listed on a stock exchange, seek to enhance transparency in security dealings by mandating disclosures and also prescribe minimum standards to prevent insider trading.
Regulation 4 of the SEBI Regulations15 prohibits insider trading by all insiders in general, including companies. The SEBI Regulations do not define the term "insider trading". But it defines an "insider" to mean any person who,
- is a connected person, or
- is in possession of or having access to unpublished price sensitive information.16
A "connected person" is defined to mean any person who is or, during the six months prior to the concerned act, has been associated with a company, directly or indirectly, in any capacity including by reason of (i) frequent communication with its officers; (ii) by being in any contractual, fiduciary or employment relationship; (iii) by being a director, officer or an employee of the company; or (iv) holding any position including a professional or business relationship between himself and the company whether temporary or permanent; that allows such person, directly or indirectly, access to unpublished price sensitive information or is reasonably expected to allow such access.17 The SEBI Regulations further list a set of persons who shall be deemed to be connected persons, unless the contrary is established.18 The SEBI Regulations also define "unpublished price sensitive information" as any information, relating to a company or its securities, directly or indirectly, that is not generally available which upon becoming generally available, is likely to materially affect the price of the securities.19 Financial results of the company, dividends, change in capital structure, mergers, de-mergers, acquisitions or business expansion and changes in key managerial personnel, among others, are considered to be unpublished price sensitive information under the SEBI Regulations.
While Regulation 4(1)(i) of the SEBI Regulations20 provides the defence that could be adopted by an individual to prove his innocence against a charge of insider trading, Regulation 4(1)(ii)21 is a specific list of defences available to companies against a charge of insider trading. However, the note attached to Regulation 4 of the SEBI Regulations clearly stipulates the intent of the regulations to disregard mens rea or motive as a relevant criteria for attributing liability for insider trading, and is reproduced hereunder:
"When a person who has traded in securities has been in possession of unpublished price sensitive information, his trades would be presumed to have been motivated by the knowledge and awareness of such information in his possession. The reasons for which he trades or the purposes to which he applies the proceeds of the transactions are not intended to be relevant for determining whether a person has violated the regulation. He traded when in possession of unpublished price sensitive information is what would need to be demonstrated at the outset to bring a charge. Once this is established, it would be open to the insider to prove his innocence by demonstrating the circumstances mentioned in the proviso, failing which he would have violated the prohibition."
The Consultative Paper issued by SEBI in 2008, prior to the amendment of the SEBI Regulations to introduce short swing profits, also opined as follows, which implies that 'intent' was not considered a critical element to determine liability for insider trading.
"Liability will be imposed without any necessity for guilt or wrongfulness and conversely a direction to surrender profits made in a short swing transaction shall not necessarily imply any form of guilt. The surrender of profits made in such short swing transactions shall be automatically imposed as a part of good corporate governance requirement. The short swing rule will get automatically attracted as soon as two things are established. First is the fact of being an insider or a "designated insider" (which is elaborated below). And second, the fact that the same securities were bought and sold within six months of each other. In such a regulation, the intent of the person shall be immaterial. Merely the fact of the trade will be sufficient to take action i.e. direction to make over such profits to the company."
ABSENCE OF MENS REA AS A CRITERION FOR PENALISING INSIDER TRADING IN INDIA
Traditionally, criminal law required the existence of mens rea (Latin term meaning 'guilty mind') for a person to be convicted of an offense. The mens rea requirement of the criminal law embodies the fundamental principle that punishment requires personal fault.22
Section 15G under Chapter VIA of the SEBI Act lays down the penalty in the case of insider trading in contravention of the SEBI Act and the SEBI Regulations passed there under. Securities Appellate Tribunal (hereinafter, "SAT") has observed in Rakesh Agrawal v. SEBI23 that no other provision of the SEBI Act authorizes SEBI to impose pecuniary burden in the form of monetary penalty in a case of insider trading except Section 15G.
Under the SEBI Act it is not necessary to prove that the insider knowingly indulged in insider trading. This prima facie means that mens rea is not an essential ingredient of the offence of insider trading. Consequently, a person may be convicted of the offence regardless of whether he has committed it knowingly, deliberately or intentionally. Similarly, the SEBI Regulations also do not contain the requirement of motive, knowledge or intention for conviction of insider trading.24 One significant case, in this regard, is that of Hindustan Level Limited v. SEBI25 (hereinafter, the "HLL"). Shortly before HLL announced that it was merging with Brooke Bond Lipton Limited, HLL purchased eight hundred thousand shares of the latter company from Unit Trust of India (UTI). It was argued that for insider trading it is essential to prove the misuse of fiduciary position and that the transaction was undertaken to make a gain, profit or to avoid a loss. These contentions were negated by the SAT and this case was held to be that of insider dealing.
Contrarily, in Rakesh Agarwal v. SEBI, the SAT held that intention /motive of the insider has to be taken cognizance of even though the SEBI Regulations do not specifically bring in mens rea as an ingredient of insider trading.26 SEBI had ruled against the appellant on the premise that mens rea was not essential to constitute the offence of insider trading, based on a literal interpretation of Regulation 3 of the SEBI Regulations, which prohibits dealing in securities when in possession of price-sensitive information and does not take into account the existence of any intention to make gains. SAT on appeal held this interpretation by SEBI to be contrary to the objective, purpose and spirit of the SEBI Regulations.
However, in SEBI v. Cabot International Capital Corporation27, it was held by the Bombay High Court that the scheme of penalty prescribed under the SEBI Act and the SEBI Regulations is penalty for failure of statutory obligation or breach of civil obligation. There is no element of any criminal offence as contemplated under criminal proceedings and hence mens rea is not an essential element for imposing penalty under the SEBI Act and SEBI Regulations. This view was upheld by the Supreme Court which stated that Section 15G of the SEBI Act deals with defaults or failure of statutory civil obligations under the SEBI Act and SEBI Regulations, while Section 24 of the SEBI Act deals with criminal offences under the said Act and its punishment. Since the proceedings pertaining to Section 15G are neither criminal nor quasi-criminal, there is no question of proof of mens rea as an essential element for imposition of penalty and that the penalty is attracted once the contravention of statutory obligations under the SEBI Act and Regulations is established regardless of the intention of the parties, and the 'no mens rea, no penalty' principle is erroneous.28 The SAT was also of the view that making mens rea an essential requirement for the charge of insider trading under the SEBI Act sets the stage for various market players to violate statutory regulations with impunity and subsequently plead ignorance of law or lack of mens rea, which frustrates the object of Section 15G, that is to give teeth to SEBI to ensure strict compliance of the SEBI Act and SEBI Regulations.29 These judgments have been subsequently approved by a three-judge bench of the Supreme Court.30
In view of the aforesaid judgments by the Supreme Court and the SAT subsequently, the views indicated by SAT in Rakesh Agarwal v. SEBI,31 regarding mens rea being essential for imposition of penalty have been impliedly overruled.
The recently enacted Companies Act, 2013,32 also includes prohibition on insider trading of securities by directors and key managerial personnel within its fold by capturing the essence of SEBI Regulations on insider trading and extending its applicability prima facie to public unlisted companies and private companies. Insider trading has been defined therein as (i) an act of subscribing, buying, selling, dealing or agreeing to subscribe, buy, sell or deal in any securities by any director or key managerial personnel or any other officer of a company either as principal or agent if such director or key managerial personnel or any other officer of the company is reasonably expected to have access to any non-public price sensitive information in respect of securities of company; or (ii) an act of counselling about procuring or communicating directly or indirectly any non-public price-sensitive information to any person.33 However, Section 19534 of the Companies Act, 2013 which penalizes any director or key managerial personnel who enters into insider trading with imprisonment or with fine or with both, also does not make mens rea a criterion for liability.
The existing statutes make it apparent that motive is not integral and insider trading is punishable without establishing mens rea. This defeats the purpose of penalising insider trading as a device to obtain unfair advantage on the basis of price-sensitive information. Mere possession of unpublished price-sensitive information should not be considered sufficient ground to constitute insider trading, given that most directors and key managerial personnel of a company would have access to such information.35 This may also act as a deterrent to investors investing into the Company and participating in the operation and management of the Company.
Mens rea must hence be the deciding factor for imposing liability for insider trading. Further the mens rea element for insider trading must require a high standard, and the onus should be on the prosecution to establish that the defendant acted knowingly in committing insider trading and that he knew his action was not allowed by law. The view largely adopted by the Indian judiciary and regulatory authorities is therefore incorrect.
Laws prohibiting and penalising insider trading seek to curb the disparity in information, non-transparency in dealings, and erosion of investor confidence, while increasing market efficiency.36 Over the decades, SEBI has done a commendable job in strengthening its control over insider trading practices in India by formulating stringent regulations. However, as a result of creating offenses that explicitly dispense with mens rea, the Indian regulatory framework to address insider trading practices is so broad that citizens can never be sure when they have violated the law. A just legal system demands does not permit punishment without fault. Hence, justice demands the reinvigoration and preservation of the mens rea requirement for criminal punishment in the Indian legal system. In current times of commingling of financial markets, to enjoy the benefits of globalisation, it is hoped that the precedent set by the SEC and the courts in the United States of criminalizing insider trading on the basis of mens rea, shall continue to act as a guiding factor for other developing economies like India.
It is therefore advocated that we establish a coherent standard based on mens rea, by way of statutory provisions or judicial precedents, to give the market a clear idea about what conduct attracts criminal liability and to avoid any wrong-doer from escaping liability on the ground of ambiguity, thereby acting as a deterrent. This will instil confidence in both domestic and foreign investors, which comes from investing in a fair and transparent securities market.
1. 17 C.F.R. §240.10b-5. Adopted pursuant to the authority provided to SEC under Securities Exchange Act, 1934, §10(b).
2. U.S. v. Murdock, 290 U.S. 389, 394 (1933).
3. U.S. v. Dixon, 536 F.2d 1388, 1397 (2d Cir. 1976).
4. United States v Vincent F. Chiarella, 445 U.S. 222 (1980).
5. STEPHEN M. BAINBRIDGE, SECURITIES LAW: INSIDER TRADING 164-169 (1999).
6. United States v Vincent F. Chiarella, 445 U.S. 222 (1980) at 233-34.
7. 463 U.S. 646 (1983).
8. 521 U.S. 642, 665-66 (1997).
9. Id. at 666.
10. U.S. v. O'Hagan, 139 F.3d 641, 647 (8th Cir. 1998).
11. William B. Herlands, Criminal Law Aspects of the Securities Exchange Act of 1934, 21 VA. L. REV. 139, 147-48 (1934).
12. See U.S. v. Tarallo, 380 F.3d 1174 (9th Cir. 2004).
13. SEBI Committee on Corporate Governance, 1992.
14. Framed under §11(2) (g) of the SEBI Act 1992 and published in the Gazette of India on Jan. 15, 2015, vide No. LAD-NRO/GN/2014-15/21/85.
15. Rule 4(1) of the SEBI (Prohibition of Insider Trading) Regulations, 2015: "No insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information."
16. Rule 2(1)(g) of the SEBI (Prohibition of Insider Trading) Regulations, 2015.
17. Rule 2(1)(d) of the SEBI (Prohibition of Insider Trading) Regulations, 2015.
18. After the famous case of Hindustan Level Limited v. SEBI, (1998) 18 SCL 311 (AA), the concept of deemed connected person was introduced to include a person who "who would have access to or could access to such unpublished price sensitive information", and not just a person who is or was connected with the company.
19. Rule 2(1)(n) of the SEBI (Prohibition of Insider Trading) Regulations, 2015.
20. Rule 4(1)(i) of the SEBI (Prohibition of Insider Trading) Regulations, 2015: "Provided that the insider may prove his innocence by demonstrating the circumstances including the following : – (i) the transaction is an off-market inter-se transfer between promoters who were in possession of the same unpublished price sensitive information without being in breach of regulation 3 and both parties had made a conscious and informed trade decision."
21. Rule 4(1)(ii) of the SEBI (Prohibition of Insider Trading) Regulations, 2015: "Provided that the insider may prove his innocence by demonstrating the circumstances including the following : – (ii) in the case of non-individual insiders: – (a) the individuals who were in possession of such unpublished price sensitive information were different from the individuals taking trading decisions and such decision-making individuals were not in possession of such unpublished price sensitive information when they took the decision to trade; and (b) appropriate and adequate arrangements were in place to ensure that these regulations are not violated and no unpublished price sensitive information was communicated by the individuals possessing the information to the individuals taking trading decisions and there is no evidence of such arrangements having been breached; (iii) the trades were pursuant to a trading plan set up in accordance with regulation 5."
22. John Hasnas, Mens Rea Requirement: A critical casualty of overcriminalization, Washington Legal Foundation Vol.18 No.27 (Dec. 12, 2008), http://www.wlf.org/upload/12-12-08_Hasnas_LegalOpinionLetter.pdf (last visited on Sep.6, 2013).
23. (2004) 49 SCL 351 (SAT).
24. Manthan Saksena, Insider Trading, http://www.legalindia.in/insider-trading-2 (last visited on Sep.6, 2013).
25. (1998) 18 SCL 311 (AA).
26. (2004) 49 SCL 351 (SAT). See also, Samrat Holding Limited v. SEBI, Appeal No. 23/2000, SAT Order dated Jan. 25, 2001; Swedish Match v. SEBI, AIR 2004 SC 4219.
27. (2004) 51 SCL 307 (Bom).
28. SEBI v. Shriram Mutual Fund, AIR 2006 SC 2287.
29. Rajiv B. Gandhi and Others v. SEBI, Appeal No. 50/2007, SAT Order dated May 9, 2008.
30. Union of India v. Dharmendra Textiles Processors and others (2008) 2008 SCC (13) 369. See also, Kanbay Software India Pvt. Ltd. v. Dy. CIT (2009) 122 TTJ (Pune) 721.
31. Rakesh Agarwal v. SEBI, (2004) 49 SCL 351 (SAT).
32. No.18 of 2013.
33. Companies Act, 2013, §195.
34. See, Companies Act, 2013, http://egazette.nic.in/WriteReadData/2013/E_27_2013_425.pdf (last visited on Sep.4, 2013).
35. N. Jain, Significance of mens rea in insider trading, 25 Co Law 132 (2004).
36. SUMIT AGRAWAL AND ROBIN JOSEPH BABY, SEBI ACT (Amit Agrawal ed., Taxmann Publications, 2011).
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