MYSTIQUE OF ‘INSIDER TRADING’ – HOW
FAR IT IS POSSIBLE TO ELIMINATE THIS MENACE FROM SHARE MARKET ALL TOGETHER THROUGH
REGULATORY MECHANISM? -A CRITIQUE
By K P C Rao.,
LLB., FCS., FICWA
Practicing
Company Secretary
kpcrao.india@gmail.com
Hyderabad
"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
Introduction
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.
Insider
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
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.
Conclusion
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.
[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)
[12] Dirks v. SEC; 463 U.S. 646 (1983)
[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)
No comments:
Post a Comment