MENACE
OF INSIDER TRADING IN THE EMERGING FINANCIAL MARKETS - WITH A SPECIAL FOCUS ON INDIAN
REGULATORY FRAMEWORK
SYNOPSIS
By K P C Rao.,
LLB., FCS., FCMA
kpcrao.india@gmail.com
"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
I.
EMERGING FINANCIAL MARKETS
The World
economy has been experiencing a progressive international economic integration
for the last half a century. There has been a marked acceleration in this
process of globalization and also liberalization during the last three decades.
Every modern economy is based on a sound financial system which helps in
production, capital and economic growth by encouraging savings habits,
mobilizing savings from households and other segments and allocating savings
into productive usage such as trade, commerce, manufacture etc.
A financial
system is a set of institutional arrangements through which financial surpluses
are mobilized from the units generating surplus income and transferring them to
the others in needs of them. The main factors influence the capital market and
its growth are level of savings in the household sector, taxation levels,
health of economy, corporate performance, industrial trends and common patterns
of living.
Meaning and Segments of
Financial Markets
What are the financial markets? If you are confused,
there is a good reason. That’s because financial markets go by many terms,
including capital markets, money market, securities market even the markets.
Some experts even simply refer to it as the stock market, even though they are
referring to stocks, bonds and commodities.
In economics, a financial market is a mechanism that allows people to buy
and sell (trade) financial securities (such as stocks and bonds), commodities
(such as precious metals or agricultural goods), and other fungible items of
value at low transaction costs and at prices that reflect the efficient-market
hypothesis.
Quite simply, that is what the financial markets are - any type of
financial transaction that you can think of that helps businesses grow and
investors make money. The financial markets have two major
components, (1) the money market and (2) the capital market. The money market
refers to the market where borrowers and lenders exchange short-term funds to
solve their liquidity needs. The Capital Market is a market for financial
investments that are direct or indirect claims to capital. It is wider than the
Securities Market and embraces all forms of lending and borrowing, whether or
not evidenced by the creation of a negotiable financial instrument. The money
market possesses different operational features as compared to capital market.
It deals with raising and deployment of funds for short duration while the capital market deals with long-term funding. The money market provides
the institutional source for providing working
capital to the industry, while the capital market offers long-term capital for financing fixed
assets.
The Securities
Market, however, refers to the markets for those financial
instruments/claims/obligations that are commonly and readily transferable by
sale. The Securities Market has two ‘inter-dependent’
and ‘inseparable segments’, viz., (1)
the primary market (new issues) and (2) the secondary market (stock).
History
of India Financial Market
The history of Indian capital markets spans back 200
years, around the end of the 18th century. It was at this time that India was
under the rule of the East India Company. The capital market of India initially
developed around Mumbai with around 200 to 250 securities brokers participating
in active trade during the second half of the 19th century.
Indian Financial market comprise of primary market, Foreign
Direct Investments (FDIs) alternative investment
options, banking and insurance and the pension sectors, asset management
segment as well. With all these elements in the India Financial market, it
happens to be one of the oldest across the globe and is definitely the fastest
growing and best among all the financial markets of the emerging economies.
The financial market in India at present is more
advanced than many other sectors as it became organized as early as the 19th
century with the securities exchanges in Mumbai, Ahmedabad and Kolkata. In the
early 1960s, the number of securities exchanges in India became eight -
including Mumbai, Ahmedabad and Kolkata. Apart from these three exchanges,
there was the Madras, Kanpur, Delhi, Bangalore and Pune exchanges as well. Today
there are 21 regional securities exchanges in India which are in operational
out of 25 exchanges. (Recognition of 4 stock exchanges have been withdrawn by
SEBI[2]
on different grounds)
Though, the Indian stock markets have remained
stagnant till 1990 due to the rigid economic controls, it was only in 1991, after the liberalization
process that the Indian stock market
witnessed a flurry of IPOs[3]
serially. The market saw many new companies spanning across different industry
segments and business began to flourish.
The launch of the NSE (National Stock Exchange) and
the OTCEI (Over the Counter Exchange of India) in the mid 1990s helped in
regulating a smooth and transparent form of securities trading.
The regulatory body for the Indian capital markets
was the SEBI (Securities and Exchange Board of India). The capital markets in
India experienced turbulence after which the SEBI came into prominence. The
market loopholes had to be bridged by taking drastic measures.
Indian Financial Market helps in promoting the
savings of the economy and helping to adopt an effective channel to transmit
various financial policies. The Indian financial sector is well-developed,
competitive, efficient and integrated to face all shocks. In the India
financial market there are various types of financial products whose prices are
determined by the numerous buyers and sellers in the market. The other
determinant factor of the prices of the financial products is the market forces
of demand and supply. The various other types of Indian markets help in the
functioning of the wide India financial sector.
Securities Market
Reforms and Development
The development of the securities market what we are seeing today did not
happen overnight. Though the historical records relating to securities market
in India is meager and obscure, there is evidence to indicate that the loan
securities of the East Indian Company used to be traded towards close of the 18th
century. By 1830’s, the trading in shares of banks started. The trader by the
name of broker emerged in 1830 when 6 persons called themselves as share
brokers. This number grew gradually. Till 1850, they traded in shares of banks
and securities of the East India Company in Mumbai under a sprawling Banyan
Tree in front of the Town Hall, which is now in the Horniman Circle Park. It is
no surprise that the majestic Phiroze Jeejeebhoy Towers is located at the
Horniman Circle. In 1850, the Companies Act introducing limited liability was
enacted heralding the era of modern joint stock company which propelled trading
volumes.
The American Civil War broke out in 1861 which cut off supply of cotton
from the USA to Europe. This heightened the demand for cotton from India. Cotton
prices increased. Exports of cotton grew, payments were received in bullion.
The great and sudden spurt in wealth produced by cotton price propelled setting
up companies for every conceivable purpose. Between 1863 and 1865, the new
ventures raised nearly ` 30 crore in the form of paid up capital and nearly ` 38 crore of the premia. Rarely was a
share which did not command a premium between 1861 and 1865. The Back Bay
Reclamation share with `5,000 paid up was at ` 50,000 premium, the Port Canning
share with ` 1,000 paid up was at ` 11,000 premium, etc. There was a
share mania and everybody was after a piece of paper, variously called
‘allotments’, ‘scrips’ and ‘shares’. The people woke up only when the American
Civil war ended. Then all rushed to sell their securities but there were no
buyers. They were left with huge mass of un-saleable paper. This occurred then.
This also occurs today at regular intervals. However, the bubbles and burst
continue to be a perennial feature of the securities market world over.
The depression was so severe that it paved way for setting up of a formal
market. The number of brokers, which had increased during the civil war to
about 250, declined. During the civil war, they had become so influential and
powerful that even the police had only salams for them. But after the
end of the civil war, they were driven from pillar to post by the police. They
moved from place to place till 1874 when they found a convenient place, which
is now appropriately called Dalal Street[4] after their name. They organized an
informal association on or about 9th July 1875 for protecting their
interests. On 3rd December 1887, they established a stock exchange
called ‘Native Share and Stock Brokers’ Association’. This laid the
foundation of the oldest stock exchange in India. The word ‘native’ indicated
that only natives of India could be brokers of the Exchange.
In 1880s a number textile mills came up in Ahmedabad. This created a need
for trading of shares of these mills. In 1894, the brokers of Ahmedabad formed
"The Ahmedabad Share and Stock Brokers' Association".
The 1870s saw a boom in jute prices, 1880s and 1890s saw boom in tea
prices, then followed coal boom. When the booms ended, there were endless
differences and disputes among brokers in eastern India which was home to
production of jute, tea and coal. This provoked the establishment of "The
Calcutta Stock Exchange Association" on June 15, 1908.
Then followed the proliferation of exchanges, many of them even do not
exist today. The rest is history.
Legal Developments
Control of capital issues was introduced through the Defence of India
Rules in 1943 under the Defence of India Act, 1939 to channel resources to
support the war effort. The control was retained after the war with some
modifications as a means of controlling the raising of capital by companies and
to ensure that national resources were channeled to serve the goals and
priorities of the government, and to protect the interests of investors. The
relevant provisions in the Defence of India Rules were replaced by the Capital
Issues (Continuance of Control) Act in April 1947.
Though the stock exchanges were in operation, there was no legislation
for their regulation till the Bombay Securities Contracts Control Act was
enacted in 1925. This was, however, deficient in many respects. Under the
constitution which came into force on January 26, 1950, stock exchanges and
forward markets came under the exclusive authority of the central government.
Following the recommendations of the A. D. Gorwala Committee in 1951, the
Securities Contracts (Regulation) Act, 1956 was enacted to provide for direct
and indirect control of virtually all aspects of securities trading and the
running of stock exchanges and to prevent undesirable transactions in
securities.
March
Forward to 1990s
In 1980s and 19990s, it was increasingly realized that an efficient and
well developed securities market is essential for sustained economic growth. The
securities market fosters economic growth to the extent it augments the
quantities of real savings and capital formation from a given level of national
income and it raises productivity of investment by improving allocation of
investible funds. The extent depends on the quality of the securities market.
In order to improve the quality of the market, that is, to improve market
efficiency, enhance transparency, prevent unfair trade practices and bring the
Indian market up to international standards, a package of reforms consisting of
measures to liberalise, regulate and develop the securities market is being
implemented since early 1990s. The package included liberalization, regulation
and development:
i) Liberalization
The more
liberalised a securities market is, the better is its impact on economic
growth. Interventions in the securities market were originally designed to help
governments expropriate much of the seignior age and control and direct the
flow of funds for favoured uses. These helped governments to tap savings on a
low or even no-cost basis. Besides, government used to allocate funds from the
securities market to competing enterprises and decide the terms of allocation.
The result was channelisation of resources to favoured uses rather than sound
projects. In such circumstances accumulation of capital per se meant little,
where rate of return on some investments were negative while extremely
remunerative investment opportunities were foregone. This kept the average rate
of return from investment lower than it would otherwise have been and, given
the cost of savings, the resulting investment was less than optimum. Hence, it
was necessary to do away interventions hindering optimum allocation of
resources.
ii) Regulation
Our laws
provide an inclusive definition of ‘securities’. It says that ‘securities’
include shares, bonds, debentures, units of CIS, etc. It does not define in
terms of ingredients an instrument must have to be considered as ‘securities’. We
hardly come across this ‘ingredient type of’ definition’ of ‘securities’ in any other jurisdiction.
It is precisely because ‘securities’ are most insecure instruments. The
only ingredient common to all types of securities is its associated
‘insecurity’. If it is a market for such insecure instruments, market would
collapse if somebody does not regulate away the insecurities.
We need
regulations to correct for identified market imperfections which produce
sub-optimal outcomes and to prevent market failures. In the absence of
regulation by a specialized agency, each participant would do its own due
diligence before undertaking any transaction in the market. This imposes huge
social costs. Besides, regulations signal minimum standards of quality and
hence enhance confidence in markets. With a known asymmetric information
problem, risk averse investors may exit the market altogether if such minimum
standards are not signaled. In its extreme form the market breaks down
completely.
There is an
apparent contradiction that the reforms aim at liberalization while regulations
appear to restrict liberalization. Liberalisation does not mean scrapping of
all codes and statutes, as some market participants may wish. It rather means
replacement of one set by another set of more liberal code / statute, which
allow full freedom to economic agents, but influence or prescribe the way they
should carry out their activities, so that the liberalized markets operate in
an efficient and fair manner and the risks of systemic failure are minimized.
It is, however, desirable to keep in mind the contradiction to ensure that we
do not resort to excessive regulation and regulations are designed and
implemented properly. Otherwise the costs of regulation would exceed the
benefits from regulation.
Development
Unless you
develop market, what do you regulate? Unless there is regulation, how does the
market develop? It is a chicken and egg issue. Regulation is necessary
to develop market and once the market develops, it needs to be regulated. That
is why many of the reform initiatives combine the elements of regulation and
development. Besides, some developmental measures are introduced as a part of
general programme for economic and political development. The macroeconomic
policies relating to interest rate, prices, etc can have salubrious effect on
the growth and development of the securities market. Other developmental
measures include provision of reliable payment system and clearing mechanism,
standardized accounting procedure, good corporate governance, skilled manpower
etc. which improve the efficiency and transparency of the market.
Although the reforms
in true sense happened since early 1990s but the reforms in securities market
in India have taken place after the establishment of the SEBI in 1992. These
reforms have been designed and implemented jointly by all stakeholders,
including the government, the regulator, and the regulated.
A few major
reforms are furnished below:
a)
Control
over Issue of Capital
A major
initiative of liberalisation was the repeal of the Capital Issues (Control)
Act, 1947 in May 1992. With this, Government’s control over issue of capital,
pricing of the issues, fixing of premia and rates of interest on debentures
etc. ceased and the market was allowed to allocate resources to competing uses.
In the interest of investors, SEBI issued Disclosure and Investor Protection
(DIP) guidelines. The guidelines allow issuers, complying with the eligibility
criteria, to issue securities the securities at market determined rates. The
market moved from merit based to disclosure based regulation.
b)
Establishment
of Regulator
A major
initiative of regulation was establishment of a statutory autonomous agency,
called SEBI, to provide reassurance that it is safe to undertake transactions
in securities. It was empowered adequately and assigned the responsibility to
(a) protect the interests of investors in securities, (b) promote the
development of the securities market, and (c) regulate the securities market.
Its regulatory jurisdiction extends over corporate in the issuance of capital
and transfer of securities, in addition to all intermediaries and persons
associated with securities market. All market intermediaries are registered and
regulated by SEBI. They are also required to appoint a compliance officer who
is responsible for monitoring compliance with securities laws and for redressal
of investor grievances.
c)
Screen
Based Trading
A major
developmental initiative was a nation-wide on-line fully-automated screen based
trading system (SBTS) where a member can punch into the computer quantities of
securities and the prices at which he likes to transact and the transaction is
executed as soon as it finds a matching sale or buy order from a counter party.
SBTS electronically matches orders on a strict price/time priority and hence
cut down on time, cost and risk of error, as well as on fraud resulting in
improved operational efficiency. It allowed faster incorporation of price
sensitive information into prevailing prices, thus increasing the informational
efficiency of markets. It enabled market participants to see the full market on
real-time, making the market transparent. It allowed a large number of
participants, irrespective of their geographical locations, to trade with one
another simultaneously, improving the depth and liquidity of the market – over
10,000 terminals creating waves by clicks from over 400 towns / cities in
India. It provided full anonymity by accepting orders, big or small, from
members without revealing their identity, thus providing equal access to
everybody. It also provided a perfect audit trail, which helps to resolve
disputes by logging in the trade execution process in entirety.
The SBTS
shifted the trading platform from the trading hall of an exchange to brokers’
premises. It was then shifted to the PCs in the residences of investors through
the Internet and to hand-held devices through WAP for convenience of mobile
investors. This made a huge difference in terms of equal access to investors in
a geographically vast country like India.
d)
Risk
management
A number of
measures were taken to manage the risks in the market so that the participants
are safe and market integrity is protected. These include:
i) Trading
Cycle
The trading
cycle varied from 14 days for specified securities to 30 days for others and
settlement took another fortnight. Often this cycle was not adhered to. This
was euphemistically often described as T+ anything. Many things could happen
between entering into a trade and its performance providing incentives for
either of the parties to go back on its promise. This had on several occasions
led to defaults and risks in settlement. In order to reduce large open
positions, the trading cycle was reduced over a period of time to a week
initially. Rolling settlement on T+5 basis was introduced in phases. All scrips
moved to rolling settlement from December 2001. T+5 gave way to T+3 from April
2002 and T+2 from April 2003.
ii) Dematerialisation
Settlement
system on Indian stock exchanges gave rise to settlement risk due to the time
that elapsed before trades are settled. Trades were settled by physical
movement of paper. This had two aspects. First, the settlement of trade in
stock exchanges by delivery of shares by the seller and payment by the
purchaser. The process of physically moving the securities from the seller to
the ultimate buyer through the seller’s broker and buyer’s broker took time
with the risk of delay somewhere along the chain. The second aspect related to
transfer of shares in favour of the purchaser by the company. The system of
transfer of ownership was grossly inefficient as every transfer involved
physical movement of paper securities to the issuer for registration, with the
change of ownership being evidenced by an endorsement on the security
certificate. In many cases the process of transfer took much longer, and a significant
proportion of transactions ended up as bad delivery due to faulty compliance of
paper work. Theft, forgery, mutilation of certificates and other irregularities
were rampant, and in addition the issuer had the right to refuse the transfer
of a security. All this added to costs, and delays in settlement, restricted
liquidity and made investor grievance redressal time consuming and at times
intractable.
To obviate
these problems, the Depositories Act, 1996 was passed to provide for the
establishment of depositories in securities with the objective of ensuring free
transferability of securities with speed, accuracy and security by
(a) making securities of public limited companies freely transferable
subject to certain exceptions; (b) dematerialising the securities in the
depository mode; and (c) providing for maintenance of ownership records in
a book entry form. In order to streamline both the stages of settlement
process, the Act envisages transfer of ownership of securities electronically
by book entry without making the securities move from person to person.
Currently 99% of market capitalization is dematerialized and 99.9% of trades
are settled by delivery.
iii) Derivatives
To assist
market participants to manage risks better through hedging, speculation and
arbitrage, the Securities Contracts (Regulation) Act,1956, (SCRA) was amended
in 1995 to lift the ban on options in securities. The SCRA was amended further
in December 1999 to expand the definition of securities to include derivatives
so that the whole regulatory framework governing trading of securities could
apply to trading of derivatives also. A three-decade old ban on forward
trading, better known as BADLA[5], which had lost its relevance and
was hindering introduction of derivatives trading, was withdrawn. Derivative
trading took off in June 2000 on two exchanges.
iv) Settlement
Guarantee
A variety of
measures were taken to address the risk in the market. Clearing corporations
emerged to assume counter party risk. Trade and settlement guarantee funds were
set up to guarantee settlement of trades irrespective of default by brokers.
These funds provide full novation and work as central counter party. The
Exchanges /clearing corporations monitor the positions of the brokers on real
time basis.
Various measures taken over last decade or so have yielded
considerable benefits to the market, as evidenced by the growth in number of
market participants, growth in volumes in securities transactions, increasing
globalization of the Indian market, reduction in transaction costs, and
compliance with international standards.
Insider trading
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[6].
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’.
II.
AIMS / OBJECTS
OF THE STUDY
The following
are the objectives of the study:-
1)
To find out the reasons for insider trading.
2)
To find out to what extent this evil permeated in the
financial system and the resultant
consequences and overall impact on the society.
3)
To suggest suitable measures in the Indian regulatory
framework to stop this menace.
4)
To give reasons for the suggestions based on empirical
research.
III.
SIGNIFICANCE
OF THE TOPIC OF RESEARCH
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.
In the United States and several
other jurisdictions, trading conducted by corporate officers, key employees,
directors, or significant shareholders[7] 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.[8]
Insider Trading Law in the US
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[9]] 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.
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 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[10] 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.
Insider Trading - Position
in India
According to Regulation 2 (e) of the Securities
and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992[11] “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;
Price
Sensitive Information
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)
significant changes in policies,
plans or operations of the company;
Prohibition on dealing, communicating or counseling
on matters relating to insider trading (R.3& 3A)
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 [12][when
in possession of] any unpublished price sensitive information; or
[[13](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 [14][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)
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)
If any insider who,-
(i)
either on his own behalf or on
behalf of any other person, deals in securities of a body corporate listed on
any stock exchange on the basis of any unpublished price sensitive information;
or
(ii)
communicates 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
(iii) counsels,
or procures for any other person to deal in any securities of anybody corporate
on the basis of unpublished price-sensitive information,
Shall be liable to a penalty of
twenty-five crore rupees or three times the amount of profits made out of
insider trading whichever is higher.
Insider
trading is considered to be a serious economic offence. The enormity of the challenge posed by economic offenders’
calls for a professional and pro-active approach. Despite regulations, 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. 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.
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”
Therefore, 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.
IV. RATIONALE OF
STUDY
Insider trading
has the dangerous potential of market manipulation and misuse of un published
price sensitive information by a privileged few insiders who are in possession
of such information. This kind of malpractice defeats the very principle of
fair and ethical business practices, besides spelling a doom for the common and
small investors. The Capital Markets in India have been victims of this malady
for years and more particularly when liberalization attracted small investors
to the markets. Instances of artificially jacking up prices of shares and
thereby inducing gullible people to buy them are also common. People have lost
heavily on account of frauds of this nature committed by unscrupulous market
players.
Till
the early nineties, the Indian economy functioned in an environment regimented
by control and regulations. With the reforms initiated by the Government, the
economy moved from controlled to market driven. The forces of globalization and
liberalization compelled the corporate to restructure the business by adopting
the tools, viz., mergers, amalgamations and takeovers. All these activities, in
turn, impacted the functioning of the capital market, more particularly the
movement of share prices.
In
tune with these changes, certain developments have been brought into Legal
frame work governing the Securities market in India. The four main legislations
governing the securities market in India are (1) the Securities Contracts
(Regulation) Act,1956, which provides for regulation of transactions in
securities through control over stock exchanges; (2) the SEBI Act,1992 which
establishes SEBI to protect investors and develop and regulate securities
market; (3) the Depositories Act,1996 which provides for electronic maintenance
and transfer of ownership of ‘demat’
securities and (4) the Companies
Act,1956, which sets out the code of conduct for the corporate sector in
relation to issue, allotment and transfer of securities, and disclosures to be
made in public issues.
Recent changes
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 issued 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.
Efficient transfer of resources from those having
idle resources to others who have pressing need for them is achieved through
financial markets. Stated formally, financial markets provide channels for
allocation of savings to investment. These provide a variety of assets to
savers as well as various forms in which the investors can raise funds and
thereby decouple the acts of saving and investment. The savers and investors
are constrained not by their individual abilities, but by the economy’s
ability, to invest and save respectively. The financial markets, thus,
contribute to economic development to the extent that the latter depends on the
rates of savings and investment.
An efficient and robust financial system acts as a
powerful engine of economic development by mobilising resources and allocating
the same to their productive uses. It reduces the transaction cost of the
economy through provision of an efficient payment mechanism, helps in pooling
of risks and making available long-term capital through maturity
transformation. By making funds available for entrepreneurial activity and through
its impact on economic efficiency and growth, a well functioning financial
sector also helps alleviate poverty both directly and indirectly. In a
developing country, however, financial sectors are usually incomplete in as much
as they lack a full range of markets and institutions that meet all the
financing needs of the economy.
V.
HYPOTHESIS
The frame work
of hypothesis is based on the following postulates:
1)
Efficient transfer of resources
from those having idle resources to others who have pressing need for them is
achieved through financial markets.
2)
Financial Markets provide channels
for allocation of savings to investment.
3)
The Financial Markets contribute to
economic development to the extent that the latter depends on the rates of
savings and investment.
4)
As a natural corollary of the
liberalization and globalization, the Indian Capital Market has undergone a sea
change in terms of innovations, growth and deregulation.
5)
The securities market fosters
economic growth to the extent that it:
a) augments
the quantities of real savings and capital formation from any given level of
national income;
b) increases
net capital inflow from abroad;
c) raises
the productivity of investment by improving allocation of investable funds; and
d) reduces
the cost of capital.
6)
The securities market provides a
fast-rate breeding ground for the skills and judgment need for
entrepreneurship, risk bearing, port folio selection and management.
7)
An active securities market serves
as an ‘engine’ of general financial development may, in particular, accelerate
the integration of informal financial systems with the institutional financial
sector. Securities directly displace traditional assets such as gold and stocks
of produce or, indirectly, may provide port folio assets for unit trusts,
pension funds and similar FIs that raise savings from the traditional sector.
8)
The existence of the securities
market enhances the scope, and provides institutional mechanisms, for the
operation of monetary and financial policy.
9)
The responsibility for regulating
the securities market in India is shared by the Department of Economic Affairs
(DEA), Ministry of Corporate Affairs (MCA), Reserve Bank of India (RBI) and
SEBI.
10)The twin
objectives of the regulator (SEBI) in India are:
a)
to protect the interest of investors in securities;
b)
to promote the development of, and to
regulate the securities market by taking appropriate measures.
VI. METHODOLOGY
As is well-known at the present day, a research scholar cannot depend
upon any one particular method for the preparation of a thesis. A combination
of different methods is required to achieve the best possible results. Thus a
Historical-cum Analytical method has been applied mainly in the preparation of
the present work. Where ever necessary, comparative and critical methods also
are employed to have a detailed study of the subject under consideration.
VII.
SOURCES OF INFORMATION
The required materials for the thesis have been
collected mainly by applying the Doctrinal Approach. This approach deals with
formal sources of Law like Legislation, Case law, Text Books, Articles etc. It
is basically textual in approach as contrasted to Non-Doctrinal Approach which
is primarily contextual in nature. In the preparation of this thesis, by
adopting the above-mentioned technique, data have been collected from various
enactments including the SEBI Act, 1992; The Companies Act, 1956; The
Securities Contracts (Regulation) Act, 1956 and The Depositories Act, 1996 and
the rules and regulations made under
these enactments, Reports of the Securities
Exchange Commission (SEC) USA, and the reports of the Securities and Exchange
Board of India (SEBI), judgments of the Securities Appellate Tribunal (SAT) / Company
Law Board (CLB) / Supreme Court, High Courts etc.
VIII.
CHAPTERIZATION
The
thesis is divided into 6 chapters as under:
Chapter
– I
Emerging Financial Markets: In this chapter an outline of the scheme of research
intended for the thesis is brought out.
The objectives of the study, methodology, sources of information are
also discussed in this chapter.
Chapter
– II
Capital Markets: In this chapter the Primary and Secondary Market functions, Capital Market
Instruments like Prime Instruments, Hybrid Instruments, Derivatives, Mutual
Funds, Venture Capital, Collective Investment Schemes and the importance of
Credit Rating have elaborately brought out.
Chapter
– III
Legal
and Regulatory Frame Work: In this chapter,
the relevant provisions of law under different enactments including the SEBI
Act, 1992; The Companies Act, 1956; The Securities Contracts (Regulation) Act,
1956 and The Depositories Act, 1996and the rules and regulations made under these enactments
have been discussed elaborately.
Chapter
– IV
Judicial
Approach: In this chapter, the
relevant case laws and the approach of the courts / quasi judicial authorities
in interpreting the relevant provisions of the statutes and in imposing the
penalties in case of violations of the prevailing laws have discussed
elaborately.
Chapter
– V
Recent
Trends and Reforms: A developed securities market enables
all individuals, no matter how limited their means, to share the increased
wealth provided by competitive private enterprises. The legal structure of
society forms an important pillar in the fight against corrupt practices in the
financial markets. To fight against these corrupt practices, there is a need
for a strong legal framework. In India, the legal framework for curbing and
controlling Insider Trading is primarily based on statutory and common law. Certain
changes have taken place recently in the Indian regulatory framework, as the
existing legislations and other regulations are not sufficient to tackle this menace;
there still remain some areas that require change. In this chapter, the changes that have taken place recently in the
regulatory frame work are brought out elaborately.
Chapter
– VI
Conclusion
& Recommendations: In the
last chapter, a brief summary of the thesis together with observations and
findings of the Researcher have been highlighted.
Every
effort will made to make the thesis as exhaustive and as comprehensive as
possible.
Further Readings:
I.
Books
1)
G.S. Batra : Financial Services and
Market (Deep & Deep Publication)-2005
2)
L.M. Bhole : Financial Institutions
and Markets (TA MC-Graw Hill)
3)
H.R. Machiraju; The Working of
Stock Exchange in India.
4)
H.R. Machiraju : Indian Financial
System (Vikas)
5)
V. A. Avadhani : Investment &
Securities Market in India (Himalaya Publishing House)
6)
Young Patrick; Capital Market
Revolution: The Future of Markets in an Online Word.
7)
Sanjeev Aggarwal; Guide to Indian
Capital Market; Bharat Law House, 22, Tarun Enclave, Pitampura, New Delhi –
110034.
8)
V.L. Iyer; SEBI Practice Munual,
Taxman Allied Service (P) Ltd., 59/32, New Rohtak Road, New Delhi – 110005.
9)
M.Y. Khan; Indian Financial
Systems; Tata McGraw Hill, 4/12, Asaf Ali Road, New Delhi – 110002.
II. Journals, Articles and Reports
1)
NSE (2009). Indian Securities Market:
A Review, Mumbai: National Stock Exchange of India.
2)
Planning Commission (2008). A Hundred
Small Steps-Report of the Committee on Financial Sector Reforms, New Delhi:
Sage Publications India.
3)
SEBI: Various reports of the annual
report from 1992-93 to 2008- 09.
4)
Corporate Law Adviser; Corporate Law
Adviser, Post Bag No. 3, Vasant Vihar, New Delhi – 110052.
5)
Supreme Court Journal; 2011(7) SCJ; Article
By Dr T. Padma titled ‘What is an insider trading?’ Need for
stringent regulations to fight against this menace – an overview.
III.
Legislations, Orders and Regulations
1)
Securities Exchange Board
of India Act, 1992
2)
The Securities Contracts (Regulation) Amendment Act,
2007
3)
Securities Contracts
(Regulation) Act, 1956
4)
Depositories Act, 1996
5)
The Companies Act, 1956
(As Amended)
IV. Newspapers and Magazines
1)
Chartered
Accountant, Monthly Journal of ICAI.
2)
Chartered
Secretary; Monthly Journal of ICSI.
3)
Management
Accountant; Monthly Journal of ICWAI.
V. Web-sites
1)
www.sebi.gov.in
2)
www.bseindia.com
3)
www.nseindia.com
4)
www.sbidfhi.com
5)
www.
mca.gov.in
6)
www.indlaw.com
7)
www.icai.org.in
8)
www.icwai.org
9)
www.icsi.in
10)
www.rbi.org.in
[1] In United States v. O'Hagan, 521 U.S. 642, 655 (1997)
[2] The Securities and Exchange Board of India
[3] Initial public offer
[4] Dalal street located in Mumbai, India
[5] A
carry-forward system in stock trading
[6] Information Page from U S Securities and Exchange
Commission accessed on 20th September, 2011
[7] In the U.S., it is defined as
beneficial owners of ten percent or more of the firm's equity securities
[8] Excerpts from Speech of SEC Staff on ‘Insider
Trading – A U.S. Perspective’ at 16th International Symposium on Economic
Crime, Jesus College, Cambridge, England
[9]
The U.S.
Securities and Exchange Commission (frequently abbreviated SEC) is a federal
agency which holds primary responsibility for enforcing the federal securities
laws and regulating the securities industry, the nation's stock and options
exchanges, and other electronic securities markets in the United States. In
addition to the 1934 Act that created it, the SEC enforces the Securities Act
of 1933, the Trust Indenture Act of 1939, the Investment Company Act of 1940,
the Investment Advisers Act of 1940, the Sarbanes-Oxley Act of 2002 and other
statutes. The SEC was created by section 4 of the Securities Exchange Act of
1934 (now codified as 15 U.S.C. § 78d and commonly referred to as the 1934
Act).
[10] CEO is the highest ranking executive in a company
whose main responsibilities include developing and implementing high-level
strategies, making major corporate decisions, managing the overall operations
and resources of a company, and acting as the main point of communication
between the board of directors and the corporate operations. The CEO will often
have a position on the board, and in some cases is even the chair.
[11]
Amended by the SEBI (Insider Trading)
(Amendment) Regulations, 2002, w.e.f. 20.02.2002.
[12]
Substituted for “on the basis of”, ibid.
[13]
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"
[14]
Inserted by the SEBI (Prohibition of Insider Trading) (Second Amendment)
Regulations, 2002, w.e.f. 29.11.2002.
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