Sunday, April 27, 2014



By K P C Rao.,
Practicing Company Secretary

"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[1]."
-U S Supreme Court

Insider trading is the trading of a 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 corporate 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. However, the term is frequently used to refer to a practice in which an insider or a related party trades based on material non-public information obtained during the performance of the insider's duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company[2].

It was only about three decades back that insider trading was recognized in many developed countries as what it was - an injustice; in fact, a crime against shareholders and markets in general. At one time, not so far in the past, inside information and its use for personal profits was regarded as a perk of office and a benefit of having reached a high stage in life.

In the United States and Germany, 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 fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has undertaken a legal obligation to 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 obligation to the shareholders.

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

In the United States and many other jurisdictions, however, "insiders" are not just limited to corporate officials and major shareholders where illegal insider trading is concerned, but can include any individual who trades shares based on material non-public information in violation of some duty of trust. This duty may be imputed; for example, in many jurisdictions, in cases of where a corporate insider "tips" a friend about non-public information likely to have an effect on the company's share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if he or she trades on the basis of this information.

It was the Sunday Times of UK that coined the classic phrase in 1973 to describe this sentiment - "the crime of being something in the city", meaning that insider trading was believed as legitimate at one time and a law against insider trading was like a law against high achievement. It is the trading that takes place when those privileged with confidential information about important events use the special advantage of that knowledge to reap profits or avoid losses on the stock market, to the detriment of the source of the information and to the typical investors who buy or sell their stock without the advantage of "inside" information. Almost eight years ago, India's capital markets watchdog – the Securities and Exchange Board of India organised an international seminar on capital market regulations. Among others issues, it had invited senior officials of the Securities and Exchange Commission to tell us how it tackled the ‘menace of insider trading’.

In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders[3] must be reported to the Regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While "legal" insider trading cannot be based on material non-public information, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation and that their trades otherwise convey important information.

But one of the main reasons that capital is available in such quantities in the markets is basically that the investor trusts the markets to be fair. Fairness is a major issue. Even though it sounds simplistic, it is a critical factor and one that is absent, really to a surprising degree in many of the sophisticated foreign markets. The common belief in Europe that certain investors have access to confidential information and regularly profit from that information may be the major reason why comparatively few Europeans actually own stock. Indeed, the European Economic Community has formally recognized the importance of insider trading prohibitions by passing a directive requiring its members to adopt insider trading legislation. The preamble to the directive stresses the economic importance of a healthy securities market, recognizes that maintaining healthy markets requires investor confidence and acknowledges that investor confidence depends on the "assurance afforded to investors that they are placed on an equal footing and that they will be protected against the improper use of inside information." These precepts echo around the world as reports of increased insider trading regulation and enforcement efforts are daily news.[4]

What Constitutes ‘The Insider Trading’ – A Debatable Issue

“Insider trading" term is a subject to many definitions and connotations and it encompasses both legal and prohibited activity. It is an offence on which there is a huge public debate. 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.

The American notion that insider trading is wrong, was well-established long before the passage of the federal securities laws. In 1909, the United States Supreme Court held that a director of a corporation who knew that the value of the stock of his company was about to skyrocket committed fraud when he bought company stock from an outsider without disclosing what he knew.[5] But this condemnation is not universal, even in the United States.

Those who oppose prohibiting insider trading advance many arguments, most of which fall on their own weight.

1)     Some argue that insider trading is a legitimate form of compensation for corporate employees, permitting lower salaries that, in turn, and benefits shareholders. It provides an incentive to innovation, some argue, by promising huge rewards for developing a plan or product that will lead to a precipitous rise in the stock.[6] This argument, however, fails to address the real and significant hazard of creating an incentive for corporate insiders to enter into risky or ill-advised ventures for short term personal gain, as well as to put off the public release of important corporate information so that they can capture the economic fruits at the expense of shareholders.

2)     Others have argued that reliance on several antifraud provisions, and the absence of a statutory definition of insider trading, may lead to unfairly penalizing traders whose conduct comes close to the line. This seems an illusory concern. There are at least two compelling reasons for this. First, scanter, a fraudulent intent is an element that must be proven.[7] Second, given the inherent difficulties in investigating and proving insider trading cases, the reality is that there is a significant amount of clearly illegal activity that goes undetected or unpunished. As SEC Chairman observed, "It's not as if insider traders wander innocently into the gray areas near the boundaries of legality. They willfully stride across the bright line of the law."

3)     Another argument advanced by critics is that strict insider trading regulation may have a chilling effect on the work of securities analysts, prohibiting "sensible dialogue" between company officials and analysts. The empirical evidence is to the contrary. Thousands of analysts ply their important trade diligently, effectively and within the law.[8] Currently, this is an area of special concern to the Regulator because in several cases of unusual trading in the interval between a company's disclosure of price sensitive information to analysts and disclosure of the information to the public. "Legally, you can split hairs all you want. But, ethically, it’s very clear: If analysts or their firms are trading – knowing this information and prior to public release – it's just as wrong as if corporate insiders did it."

4)     Finally, there are those who argue that insider trading is a victimless offense and that enforcing insider trading prohibitions is simply not cost effective; the amount of money recovered does not justify the money and human capital spent on investigating and prosecuting insider traders. With respect to equities trading, it may well be true that public shareholders' transactions would have taken place whether or not an insider was unlawfully in the market. But the options market presents a different story. Professional option writers write options only in response to a particular demand. Where that demand comes from an insider possessing material non-public information, the option writer suffers a loss that would not otherwise have occurred. Additionally, this penny-wise, pound-foolish argument neglects the external costs that result from a perception that insider trading is unchecked. In fact, as regulators throughout the world are discovering, governments cannot afford to turn a blind eye to insider trading if they hope to promote an active securities market and attract international investment.

Insider Trading Law in the US

The word Insider Trading is always misunderstood as an illegal activity. In fact, only a fraction of total insider trading is illegal. Everyday promoters, directors, managers and other employees buy or sell securities of their company worth millions of dollars; all these trades are not illegal. The regulation on insider trading does not stop anybody from buying or selling of securities of any company in the stock market. The trading is illegal when an Insider or deemed to be insider of public limited company trade in the securities of their company on the basis of unpublished price sensitive information for the intention of making profit or avoiding loss. Cases of insider trading have increased in recent past. The Securities and Exchange Commission (SEC) of US has awarded $ 34 million fine to Mr. Deep Shah. His ally Mr. Raj Rajarathanam is imprisoned for 11 years. Both of them were not directly connected to any company. Mr. Deep Shah was an employee of Moody’s credit rating agency and Mr. Raj Rajarathanam was a founder member and head of Galleon hedge funds. The main cause of worry is, deemed to be insiders have been more active in this illegal trading than the directly connected insiders of the company.
Rooted in the common law tradition of England, the US legal system has relied largely on the courts to develop the law prohibiting insider trading. The United States Department of Justice has played the largest role in defining the law of insider trading.
After the United States stock market crash of 1929, Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934, aimed at controlling the abuses believed to have contributed to the crash. The 1934 Act addressed insider trading directly through Section 16(b) and indirectly through Section 10(b).
Section 16(b) prohibits short-swing profits (profits realized in any period less than six months) by corporate insiders in their own corporation's stock, except in very limited circumstance. It applies only to directors or officers of the corporation and those holding greater than 10% of the stock and is designed to prevent insider trading by those most likely to be privy to important corporate information.

Section 10(b) of the Securities and Exchange Act of 1934 makes it unlawful for any person "to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." To implement Section 10(b), the SEC adopted Rule 10b-5, which provides, in relevant part:

It shall be unlawful for any person, directly or indirectly . . .,
(a)  to employ any device, scheme, or artifice to defraud,
(b)  to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
(c)  to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of a security.

 Insider Trading Law-Court Decisions

In U S the development of insider trading law has resulted from court decisions. These broad anti-fraud provisions make it unlawful to engage in fraud or misrepresentation in connection with the purchase or sale of a security. While they do not speak expressly to insider trading, here is where the courts have exercised the authority that has led to the most important developments in insider trading law in the United States.
The breadth of the anti-fraud provisions leaves much room for interpretation and the flexibility to meet new schemes and contrivances head on. Moral imperatives have driven the development of insider trading law in the United States. And the development of insider trading law has not progressed with logical precision as the reach of the anti-fraud provisions to cover insider trading has expanded and contracted over time.
The anti-fraud provisions were relatively easy to apply to the corporate insider who secretly traded in his own company's stock while in possession of inside information because such behavior fit within traditional notions of fraud. Far less clear was whether Section 10(b) and Rule 10b-5 prohibited insider trading by a corporate "outsider." In 1961, in the case of In re Cady Roberts & Co[9], the Securities and Exchange Commission, applying a broad construction of the provisions, held that they do. The Commission held that the duty or obligations of the corporate insider could attach to those outside the insiders' realm in certain circumstances. The Commission reasoned in language worth quoting:

“Analytically, the obligation [not to engage in insider trading] rests on two principal elements: first, the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing. In considering these elements under the broad language of the anti-fraud provisions we are not to be circumscribed by fine distinctions and rigid classifications. Thus, it is our task here to identify those persons who are in a special relationship with a company and privy to its internal affairs, and thereby suffer correlative duties in trading in its securities. Intimacy demands restraint lest the uninformed be exploited”.
Based on this reasoning, the Commission held that a broker who traded while in possession of nonpublic information he received from a company director violated Rule 10b-5. The Commission adopted the "disclose or abstain rule": insiders, and those who would come to be known as "temporary" or "constructive" insiders, who possess material nonpublic information, must disclose it before trading or abstain from trading until the information is publicly disseminated.
Several years later in the case of SEC v. Texas Gulf Sulphur Co[10], a federal circuit court supported the Commission's ruling in Cady (referred supra), stating that anyone in possession of inside information is required either to disclose the information publicly or refrain from trading. The court expressed the view that no one should be allowed to trade with the benefit of inside information because it operates as a fraud all other buyers and sellers in the market. This was the broadest formulation of prohibited insider trading.
In Strong v. Repide[11], the Supreme Court of the United States ruled that a director upon whose action the value of the shares depends cannot avail of his knowledge of what his own action will be to acquire shares from those whom he intentionally keeps in ignorance of his expected action and the resulting value of the shares. Even though in general, ordinary relations between directors and shareholders in a business corporation are not of such a fiduciary nature as to make it the duty of a director to disclose to a shareholder the general knowledge which he may possess regarding the value of the shares of the company before he purchases any from a shareholder, yet there are cases where, by reason of the special facts, such duty exists.

In the case of Dirks v. SEC [12], the Supreme Court of the United States ruled that tippers (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 [13]  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, on the grounds that he had misappropriated information belonging to his employer, the Wall Street Journal. In that widely publicized case, Winans traded in advance of "Heard on the Street" columns appearing in the Journal.

The court ruled in Carpenter: "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 principal for any profits derived therefrom."

However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.

In United States v. O'Haga[14], the U.S. Supreme Court adopted the misappropriation theory of insider trading. O'Hagan was a partner in a law firm representing Grand Metropolitan, 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 and held:

"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 at any time a person trades while aware of material nonpublic information – so that it is no defense for one to say that he would have made the trade anyway. This rule also created an affirmative defense for pre-planned trades.

Illegal insider trading is believed to raise the cost of capital for ‘Securities Issuers’ thus decreasing overall economic growth.

SEC regulations

SEC regulation FD ("Fair Disclosure") requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large. In the case of an unintentional disclosure of material non-public information to one person, the company must make a public disclosure "promptly." Insider trading, or similar practices, are also regulated by the SEC under its rules on takeovers and tender offers under the Williams Act[15].

Security analysis and insider trading

Security analysts gather and compile information, talk to corporate officers and other insiders, and issue recommendations to traders. Thus their activities may easily cross legal lines if they are not especially careful. The CFA Institute in its code of ethics states that analysts should make every effort to make all reports available to all the broker's clients on a timely basis. Analysts should never report material nonpublic information, except in an effort to make that information available to the general public. Nevertheless, analysts' reports may contain a variety of information that is "pieced together" without violating insider trading laws, under the ‘mosaic theory [16]. This information may include non-material nonpublic information as well as material public information, which may increase in value when properly compiled and documented.

Liability for insider trading

Liability for insider trading violations cannot be avoided by passing on the information in an "I scratch your back, you scratch mine" or quid pro quo arrangement, as long as the person receiving the information knew or should have known that the information was company’s property. It should be noted that when allegations of a potential inside deal occur, all parties that may have been involved are at risk of being found guilty.

For example, if Company A's CEO did not trade on the undisclosed takeover news, but instead passed the information on to his brother-in-law who traded on it, illegal insider trading would still have occurred.

Operation Perfect Hedge[17]

Recently, US has come up with a strategy known as “Operation Perfect Hedge” to cleanse wall street of insider trading and make it ‘clean and green’. It commenced in the year 2008. It has resulted in some marquee insider trading cases being judged and some high-profile people being proved guilty of the offence — Raj Rajaratnam and Rajat Gupta being illustrative examples.

An expanding US investigation into insider trading reached the inner circle of a hedge fund — SAC Capital — when authorities charged Michael Steinberg, a 17-year veteran of the firm, with trading in advance of Dell and Nvidia earnings. He is the eighth employee of SAC, a $15-billion hedge fund, to be convicted in the six years since the FBI launched Operation Perfect Hedge. Civil charges brought by the Securities and Exchange Commission implicated an additional portfolio manager who also allegedly traded shares of Dell. The SEC alleges SAC and Sigma, an affiliate, made profits and avoided losses totalling $6.4 million.

The modus operandi appears to be simple — an analyst at Sigma passes on information that Dell earnings are going to be weak to Steinberg. The e-mail mentions the fact that the information is sensitive. Another Sigma trader corresponds with Steinberg with a positive view of Dell and Steinberg asks him to compare notes with the other trader who had an opposite view. Twenty four minutes after the notes were exchanged; the second trader began selling shares of Dell, thereby avoiding loss of $2 million. A similar strategy appears to have followed in the case of Nvida shares too.

Position in India

In India, first attempt to curb insider trading was made in 1948 by appointing Thomas committee. Recommendation of the committee was incorporated in the Section 307 and 308 of Companies Act 1956. This section emphasized on various disclosures by directors and managers. The Companies Act was not much effective to stop insiders trading. Subsequently Sachar committee and Patel committee was set up in 1977 and 1986. Along with other recommendations, both the committees recommended formation of separate Statute for curbing insider trading. Another Abid Hussain committee in 1989 recommended that the person should be penalized by both civil and criminal proceeding for insider trading. On the basis of the recommendations by these committees, a comprehensive legislation “SEBI (Insider Trading) Regulations 1992” was brought in force. Subsequently the policy was amended in 2002 and renamed as SEBI (Prohibition of Insider Trading) Regulations 1992. The regulation was further amended in 2008 and 2011 to make the regulation more stringent, more disclosure was made mandatory by the shareholders/insiders. To curb the menace of insider trading, recently the SEBI has set up a new committee headed by former chief justice of Karnataka High Court Justice N. K. Sodhi to review insider trading norms.

According to Regulation 2 (e) of the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992[18]  ‘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 to unpublished price sensitive information in respect of securities, or who has received or has had access to such unpublished price sensitive information. The following persons may be considered as Insiders of the company:-
(1)  Directors/CEOs/Large shareholders/managers/workers
(2)  Independent non-executive directors, it includes a person who is a connected person six months prior to an act of insider trading
(3)  Share Transfer Agents/Registrar to an issue,
(4)  Investment company/trustee company,
(5)  Subsidiary of a company and relatives of connected persons,
(6)  Asset management company,
(7)  Merchant banker/Debenture Trustee/ Broker/Sub-broker,
(8)  Portfolio manager/Investment adviser/analysts
(9)  Accountancy firms, law firms/Consultants Or an employee thereof

Price Sensitive Information

It is the information which is in the hand of insiders and has not been made public. This information can influence market price of the security and generally comes through internal corporate sources. It may affect assets and earnings. On the other hand market information comes from outsiders that may affects price but not assets and earnings. According to Regulation 2 (ha) of the Regulations, “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.

According to the Explanation given in this Regulation — the following shall be deemed to be price sensitive information:—

(i)       Periodical financial results of the company;
(ii)    Intended declaration of dividends (both interim and final);
(iii)  Issue of securities or buy-back of securities;
(iv)   Any major expansion plans or execution of new projects;
(v)     Amalgamation, mergers or takeovers;
(vi)      Disposal of the whole or substantial part of the undertaking; and
(vii)   Any significant changes in policies, plans or operations of the company.

The Trading Windows will be closed if any of the above quoted corporate action is to be announced. Insiders cannot deal in securities of the company during this period.

Prohibition on dealing, communicating or counseling on matters relating to insider trading.  (R.3& 3A)

The regulations state that to prevent the misuse of confidential information, the organisation/firm shall adopt a “Chinese Wall” policy which separates those areas of the organisation/firm which routinely have access to confidential information, considered “inside areas”, from those areas which deal with sale/marketing/investment advise or other departments providing support services, considered public areas.

According to these regulations, no insider shall:-

(i) either on his own behalf or on behalf of any other person, deal in securities of a company listed on any stock exchange [19][when in possession of] any unpublished price sensitive information; or

[[20](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 [21][or profession or employment] or under any law.]

No company shall deal in the securities of another company or associate of that other company while in possession of any unpublished price sensitive information.

Violation of provisions relating to insider trading. (R.4)

Price-sensitive information is to be handled on a “need to know” basis, that is, it should be disclosed only to those within the company who need the information to discharge their duty. Any insider who deals in securities in contravention of the provisions of regulation 3 [or 3A] shall be guilty of insider trading.

Penalty for insider trading (Sec 15G)

SEBI has right to impose a penalty of 25 crore or 3 times of the amount of profit made by the company if found guilty of insider trading (whichever is higher)

Recent cases
Radhe Developers (India) Ltd case[22]
Recently, SEBI has slapped a total fine of ` 36 lakh on three individuals and Radhe Developers (India) Ltd for violating insider trading norms. The case relates to a sharp rally in the scrip of Radhe Developers (India) Ltd during March-May, 2008. It was observed that the price of the scrip opened at ` 47.25 on March 27, 2008 and touched a high of ` 165.35 on May 7, 2008 before closing at ` 157.70.
Axis bank case[23]

SEBI has disposed of the case against Axis Bank that had alleged the private sector lender of violating various norms, including those related to insider trading as well as regulations for merchant bankers. The matter relates to a period in 2011 when Axis Bank was acting as a merchant banker for the open offers in KSK Energy Venture and Bombay Rayons Fashion.
The market regulator had alleged that the bank traded in shares of the two companies, while in possession of the information relating to the proposed open offer, which was unpublished price sensitive information, hence violating norms on prohibition of insider trading (PIT) and merchant banker regulations.
However, in an order dated March 28, SEBI said "benefit of doubt can be given to the noticee (Axis Bank) in respect of the charges under PIT Regulations and Merchant Banker Regulations as mentioned in the Show Cause Notice."
Axis Bank had been alleged of violating insider trading norms as per which a firm is prohibited from dealing in the securities of another company or its associate while in possession of unpublished price sensitive information. Besides, a merchant banker or any of its employees cannot enter into any transaction in securities of bodies corporate on the basis of unpublished price sensitive information.
SEBI said that "in the absence of any evidence to show that the systems put in place by the noticee (Axis) were breached...the noticee can be given the benefit of doubt as regards the allegation of violation" of the provisions of PIT regulations and merchant banker norms.
Additionally, SEBI had also alleged that the bank broke norms pertaining to substantial acquisition of shares and takeovers (SAST). As per the SAST rules, a merchant banker cannot deal in the shares of the target company during the period commencing from the date of his appointment till the expiry of the 15 days from the date of closure of the offer.
However, SEBI observed that these charges were "not established".
IMS Health case[24]

SEBI has yet another challenge to deal with Insider Trading that is based on stolen Information. An interesting case has revealed wherein a person hacked the computer system of IMS Health, day before it was to announce it’s earning, and made huge profit by selling Put option. The question is whether he is accused of cyber crime or insider trading?

SEBI (Prohibition of Insider Trading) (Amendment) Regulations, 2011

Securities Exchange Board of India vide notification no LAD-NRO/GN/2011-12/16/26150, Dated 16-8-2011 has further regulations regarding ”Disclosure of interest or holding in listed companies by certain persons – Initial Disclosure.” through SEBI (Prohibition of Insider Trading) (Amendment) Regulations, 2011. These Regulations envisages:

“(2A) Any person who is a promoter or part of promoter group of a listed company shall disclose to the company in Form B the number of shares or voting rights held by such person, within two working days of becoming such promoter or person belonging to promoter group ;

“(4A) Any person who is a promoter or part of promoter group of a listed company, shall disclose to the company and the stock exchange where the securities are listed in Form D, the total number of shares or voting rights held and change in shareholding or voting rights, if there has been a change in such holdings of such person from the last disclosure made under Listing Agreement or under sub-regulation (2A) or under this sub-regulation, and the change exceeds INR 5 lakh in value or 25,000 shares or 1% of total shareholding or voting rights, whichever is lower.”

Change of Takeover threshold Limits (2011)

In order to open up India’s market for corporate control new takeover regulations are announced by markets regulator SEBI on 28th July, 2011. The Code has three major changes which are as follows: -

1)     The trigger point or threshold limit has been changed from 15% to 25%. This means that if the person/entity or persons acting in concert acquire shares of 25% of the company, the open offer would have to be made.
2)     The size of the open offer has been increased from 20% to 26%. The earlier limit of offer has been changed as the threshold limit has been changed and it makes sense that the size of the open offer should be bigger than the threshold limit.
3)     The contentious issue of non-compete fee has been abolished. This is a demand which has been made by minority shareholders and it has been finally accepted.

In other words, under the changed regulations, an acquirer has to make an open offer once he crosses the threshold holding of 25% in a company, rather than 15% as before, and the open offer has to be for 26% (20% earlier) and at the full price at which the threshold was crossed. No more sweet deals for promoter-sellers in the form of ‘non-compete fees’, an element of the share price that was denied to minority shareholders, while making the open offer. The acquirer would end up with a controlling stake, and shareholders, with a higher price than was likely in the previous regime. The raising of the open-offer trigger threshold has two effects. It makes it easier to fund enterprises -private equity player can hold a much larger stake, just a sliver lower than 25%, without getting into control mode. At the same time, the fact that someone can come so close to the 26% threshold that endows the holder with veto rights on special resolutions would put the promoters on their toes, even when that holding is below the 25% takeover threshold.

 Judicial Interpretation - Indian courts

SEBI has extensively referred to the US laws while interpreting insider trading regulations. Over the years, US courts have developed two theories: traditional theory and misappropriation theory. The former emphasizes on disclosing or abstaining from dealings based on inside information by insiders who by virtue of their relationship have access to such information meant for corporate purposes. Misusing the information is a breach of duty and unfair to those who do not have this information. Misappropriation theory forbids trading on the basis of non-public information by a corporate ‘outsider’ in breach of a duty owed to the source of the information.[25] Essentially, under this theory, a person is liable if he misuses the information which has been entrusted to him for personal use. SEBI too has adopted these two theories.

Hindustan Lever Ltd (HLL) v SEBI[26] was one of the first cases where SEBI took action on grounds of insider trading. HLL and Brook Bond Lipton India Ltd. (BBIL) controlled by Unilever Inc. UK were both under the same management. HLL purchased 0.8 million shares of BBIL from UTI in March 1996 two weeks prior to the public announcement of the HLL and BBIL merger. Post announcement, the price of BBIL’s shares shot up thereby causing losses to UTI. SEBI suspected insider trading and issued a show cause notice to HLL after conducting enquiries for several months. SEBI held HLL liable for insider trading. According to SEBI, HLL had full knowledge of the impending merger and misused the unpublished price sensitive information to its advantage. However, the appellate authority of SEBI reversed the order on the ground that the information was not price sensitive as it was reported in the media and, hence, was public knowledge.

As a fall out of this case, SEBI amended the Regulations to specifically provide that speculative reports in the media (print or electronic) shall not be treated as publication of price sensitive information.

In another case, Dilip Pendse v SEBI, Nishkalp Investment and Trading Company Limited, a wholly owned subsidiary of TATA Finance Ltd. (TFL) was a listed company. Dilip Pendse was the Managing Director of TFL. At the end of the financial year of 2001 (March 31), TFL had incurred huge losses. This unpublished price sensitive information was in the knowledge of Dilip Pendse. He passed on this information to his wife who sold her shares of TFL held in her own name and in the name of companies (Nalini Properties Limited) controlled by her and her father-in-law. The information was disclosed to the public a month later.

The above transaction occurred prior to public disclosure. Hence, the case squarely fell within the scope of insider trading. Penalty of INR 500,000 was imposed on each of Dilip Pendse, his wife and Nalini Properties Limited.

There have been instances where the SEBI appellate authority has shown a peculiar stand. For instance, in Rakesh Agarwal v SEBI, former was the Managing Director of a listed company, ABS Industries Ltd (“the Company”). The company found a joint venture partner in Bayer, a company based in Germany which made an open offer to the Indian investors to acquire at least 51% stake in the Company. Before the open offer, Rakesh Agarwal informed his brother-in-law about the same and instructed him to purchase shares of the Company from the market (to meet the eventuality of a failed open offer). SEBI held Rakesh Agarwal guilty of insider trading. However, the appellate authority overruled the order on the ground that the motive/intention of the insider has to be considered. According to the authority, the insider did not intend to gain any unfair advantage and hence was not guilty.

The above decision was anomalous as the SEBI Regulations nowhere stipulate the presence of mens rea or malafide intention to implicate an offender. In fact, chapter VIA[27] of the SEBI Act does not stipulate that mens rea is an essential element for imposing penalties.

In SEBI v Cabot International Capital Corporation[28], the Bombay High Court has summarized certain principles in respect of imposition of penalties:

a)     The relevant consideration for determining the nature of proceedings is the nature of the functions being discharged by the authority and the determination of the liability of the contravener and the delinquency.
b)     There can be two distinct liabilities: civil and criminal under the SEBI Act.
c)     The administrative authority has to act judiciously and follow the principles of natural justice, to the extent applicable.
d)     Mens rea is not essential for imposing penalties.
e)     Though looking to the provisions of the statute, the delinquency of the defaulter may itself expose him to the penalty provision yet the authority may refuse to impose penalty for justifiable reasons like if the default occurred due to bona fide belief that he was not liable to act in a manner prescribed by the statute etc.

In the case of Ispat Industries Ltd. v SEBI decided on 1st Dec., 2005, it was held that the amount of disproportionate gain or unfair advantage to the notice and amount of loss caused to the investors as a result of the default cannot be quantified in view of the absence of availability of any data/material on record in this regard in as much there is no allegation of actual trading by the notice on the basis of the said unpublished price sensitive information.

Securities laws provide for penalties for violating the provisions of the same. Adherence to regulatory framework is a sine qua non for healthy growth and safety of the securities market. Any violation of the provisions of the said regulations can be treated as a serious offence. Therefore, imposition of quantum of penalty has to be decided keeping these factors also in mind; in addition to the factors laid down under section 15J of SEBI Act.

In the light of the above judicial pronouncements, the ruling given in the case of Dilip Pendse is appears to be harsh.


Efficient market is good for the economy from investment point of view, it boost confidence of the investors and also help in the price discovery of the assets. On the other hand, prevalent of illegal insider trading cause loss of faith of the investors and is detrimental to the interest of the market.

Despite strict regulation, illegal Insider trading is prevalent all over the world, in all size of companies and in all types of instruments like equity, debt, mutual funds, derivatives, IPO etc. Several countries have found it difficult to frame insiders because of the nature of the offence. Identifying the insider and then proving the charge is an onerous task due to the heavy burden of proof involved in each case.

It is important to remember that capital markets are a source of large pool of funds for all kinds of investors. Most Funds say that the systems and processes are proper but one individual can beat these systems by being unethical. The argument is unacceptable. If systems are proper that means front running should not be possible. There will always be some individuals who will try to beat the system. Process has to be continuously upgraded to catch these people. Hence, it becomes important that the regulator has to maintain its integrity and efficiency by following a consistent approach which is designed to provide a level playing field in enforcement securities laws of the land. Nobody is more equal than the others and, therefore, trading by ‘insiders’ to the detriment of ‘outsiders’ should be strictly dealt with. Therefore, fighting against Insider trading is a biggest challenge before the Indian Watch Dog, the "SEBI”

Although SEBI has implemented laws on insider trading yet the number of offenders actually brought to book is dismal. In fact, many a time SEBI has been unable to detect instances of insider trading. SEBI Regulations do stipulate safeguards like initial and continual disclosures by insiders to companies, code of conduct to be followed by listed companies etc. but there is room for improvement.

To conclude, the Regulator is finding it difficult to curb the menace of insider trading as the line between legal and illegal insider trading is very thin. Other problem is small penalty awarded by SEBI does not have exemplary effect and big players get away just by paying smaller fine. Sometime decision is delayed or overlooked because of political connection of the corporate. Financially powerful corporate give huge amount of donation to the political parties during election and create political pressure over SEBI. Strong willpower and strict regulation like mandatory prison for insider traders which is in force in European Union will certainly help bringing down the cases of insiders trading. Bestway to control it would be, if the companies themselves come forward and have proper policy and effective compliance officer to check illegal insider trading.
It is all the more important that the SEBI should strong enough to  play a proactive and vigilant role by introducing stringent measures designed to provide greater deterrence, detection and punishment of violations of insider trading law. It should introduce greater transparencies, keep a check on sudden abnormal trends in the market, provide adequate safeguards like prohibition of trading by insiders prior to corporate announcements viz. mergers, takeovers, monitor the trading patterns and undertake swift investigations in case of a spurt of buying or selling activity in the market, take stringent action against the guilty to act as deterrence for others. At the same time, it is the prerogative of companies to strictly adhere to the code of conduct prescribed by SEBI, and ensure good corporate governance in order to protect the overall interest of investors against unfair and inequitable practices of insider trading.

In fact, world over, the regulatory focus is now shifting towards containing the rising menace of insider trading effectively. There can be no denying that ‘Operation Perfect Hedge’ in US has been effective due to the use of wiretaps. If wiretaps were to be introduced in India, one can expect many skeletons to come tumbling out. If the SEBI is able to quickly deprive the alleged wrongdoers of the fruits and proceeds of their insider trading, it will deter such conduct and send a strong message that the cop is back on the beat. Therefore, there is an urgent need that the policy makers in India should take effective steps to strenghten the regulatory framework dealing with insider trading.

[Published in the Corporate Secretary -Monthly Journal of Hyderabad Chapter of ICSI  during  2014]

[1]  In United States v. O'Hagan, 521 U.S. 642, 655 (1997)
[2] Information Page from U S Securities and Exchange Commission accessed on 20th September, 2011
[3] In the U.S., it is defined as beneficial owners of ten percent or more of the firm's equity securities
[4] Excerpts from Speech of SEC Staff on ‘Insider Trading – A U.S. Perspective’ at 16th International Symposium on Economic Crime, Jesus College, Cambridge, England
[5] Strong v. Repide, 213 U.S. 419 (1909).
[6] Henry B. Manne, Insider Trading and the Stock Market (1966) (insider trading increases market efficiency because it produces desirable incentives on corporate managers).
[7] Herman & MacLean v. Huddleston, 459 U.S. 375 (1983).
[8] SEC v. Stevens, 91 Civ. 1869 (S.D.N.Y. March 19, 1991), Litig. Rel. No. 12813.
[9] In re Cady Roberts & Co; 40 SEC 907 (1961)
[10] SEC v. Texas Gulf Sulphur Co; 394 U.S. 976 (1969)
[11] Strong v. Repide; 213 U.S. 419 (1909)
[12] Dirks v. SEC;  463 U.S. 646 (1983)
[13] United States v. Carpenter ; 484 U.S. 19 (1987)
[14] In United States v. O'Hagan[14], 521 U.S. 642, 655 (1997)
[15] The Williams Act (USA) refers to amendments to the Securities Exchange Act of 1934 enacted in 1968 regarding tender offers. Under this Act, filing and public disclosures with the SEC are also required of anyone who acquires more than 5 percent of the outstanding shares of any class of a corporation subject to federal registration requirements. Copies of these disclosure statements must also be sent to each national securities exchange where the securities are traded, making the information available to shareholders and investors.
[16] A method of analysis used by security analysts to gather information about a corporation. Mosaic theory involves collecting public, non-public and non-material information about a company in order to determine the underlying value of the company's securities and to enable the analyst to make recommendations to clients based on that information.
[17] Business Line, 5th April, 2013
[18] Amended   by the SEBI (Insider Trading) (Amendment) Regulations, 2002, w.e.f. 20.02.2002.
[19] Substituted for “on the basis of”, ibid.
[20] Substituted by the SEBI (Insider Trading) (Amendment) Regulations, 2002, w.e.f.20.2.2002. Prior to substitution, clause (ii) read as under:
"(ii) communicate any unpublished price sensitive information to any person, with or without his request for such information, except as required in the ordinary course of business or under any law; or"
[21] Inserted by the SEBI (Prohibition of Insider Trading) (Second Amendment) Regulations, 2002, w.e.f. 29.11.2002.
[22] Economic Times, 28th March, 2013.
[23] Press Trust of India April 01, 2013
[24] In the case of SEC v. Dorozhko, the district court for the Southern District of New York while Interpreting Rule 10b-5 of the Securities Exchange Act, held that “device, scheme, or artifice to defraud” as interpreted by the Supreme Court requires a breach of fiduciary duty. As Dorozhko had neither professional nor personal ties to IMS Health, it would have been nearly impossible to convict him under traditional insider trading law, which typically requires the existence of a fiduciary relationship. Certainly, he could be criminally charged for other crimes, such as theft, but the issue here was solely the contours of the insider trading laws. Later on, the Second Circuit overturned the district court’s ruling and held in favor of the Commission.
[25] United States v O’Hagan (521 US 642).
[26] Hindustan Lever Ltd. v SEBI (1998) 3 Comp LJ 473

[27] Chapter VIA of the SEBI Act deals with penalties and adjudication of cases.
[28] SEBI v Cabot International Capital Corporation ; 2004 2 Comp LJ 363 (Bom)

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