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Published: Fri, 02 Feb 2018

NEED FOR INSIDER TRADING REGULATIONS AND ITS IMPLEMENTATION

CHAPTER 6

“Not appetite, spirit, wish or belief. It involves deliberation, the sphere of which is what is ‘up to us’ and we rationally chose to do what we have judged to be right as the result of deliberation. So rational choice is deliberative desire, and is the point at which the thought of virtuous person emerges in the world in his actions.”

-Roger Crisp

NEED FOR INSIDER TRADING REGULATIONS AND ITS IMPLEMENTATION: aiming towards corporate good governance

This chapter explores the need for the insider regulations comparing the same between different nations and India. It also suggests effective measures that should be brought in to control insider trading even better in future analysing the usefulness and extent of implementation of the existing laws. It tries to bring out the importance of the implementation of the already existing laws because before tucking in more laws in the basket, the methodology of implementation must be integrated into the Insider Regulations.

6.1 INTRODUCTION

In simple terms ‘insider trading’ means selling or buying securities of a listed corporate on the basis of unpublished price-sensitive information by the privileged few such as a director, member of management, an employee of the firm or advisor, agent, consultant or any other person who has access to such unpublished price-sensitive information which if published could lead to a fall or rise in the prices of securities of the company. If insiders withhold information in order to profit from trades on the basis of price-sensitive information, there will be less information available to the market, thereby impairing the efficiency of the market. Since, trading in capital market across the world is based on transparent flow of information , insider trading undermines investor confidence in the fairness and integrity of the securities market. Therefore, preventing such transactions is an important obligation for any capital market regulatory system. For instance, prior knowledge of a bonus issue would result in the insider acquiring a significant

exposure in particular scrip, knowing that his holding would increase significantly after the bonus is announced.

6.2 UTILITY IN TRUE SENSE

Imagine you are a financially-savvy United States congressman. In a week, you

intend to announce the proposal of an appropriations bill that will award a huge, no-bid

contract to a publicly traded energy company. You expect the news to increase sharply

the price of that company’s stock. Enticed by this foolproof investment opportunity, you

decide to purchase shares of stock in the company that will be receiving the contract—as

does your legislative aide, who can also foresee the stock price increase. A week after

your stock purchase, you make your announcement. The stock price rises, and the

privileged few who knew your announcement was coming make handsome capital gains.

Those who sold the shares to both you and your aide are deprived of a major windfall.

The apparent lack of fairness in this hypothetical is enough to make most advocates of corporate and legislative transparency cringe. The situation above presents some obvious analogues to corporate insider trading which brings in the need of regulations convenient enough so as to be implemented properly.

In India, SEBI (Insider Trading) Regulations 1992, framed under Section 11 of the SEBI Act, 1992, are intended to prevent and curb the menace of insider trading in Securities. In the UK, Insider Trading is dealt with in Criminal Justices Act, 1993. [1] The first country to tackle insider trading effectively however was the United States. In the USA, the Securities and Exchange Commission is empowered under the Insider Trading Sanctions Act, 1984 to impose civil penalties in addition to criminal proceedings. Most countries have in place suitable legislation to curb the menace of insider trading.

In classical economics, insider trading occurs when there is information asymmetry, resulting in one party having an advantage over the general market. Public policy dictates that that a person having access to such information should not be permitted to use the same for his personal gains by manipulating the share prices based on such information. Hence, the need to have a suitable legislation to protect the interest of general public (investors) and build up the faith of the general investors in the stock market.

In Attorney General’s Reference, Lord Lane described the rationale behind the prohibition as “the obvious and understandable concern … about the damage to public confidence which insider dealing is likely to cause and the clear intention to prevent so far as possible what amounts to cheating when those with inside knowledge use that knowledge to make profit in their dealing with others. [2] Insider trading undoubtedly undermines investor confidence in the fairness and integrity of the capital markets. Another theory propounded by advocates of market regulation is known as the ‘fiduciary duty’ theory. This is a notion, which has its roots in the common law tradition. The law relating to the fiduciary duty of the director cannot be applied to all insiders because it concentrates on the relationship between the director and the company rather than on the relationship between the director and the shareholders or other investors in the market. However, in the case Bajaj Auto Ltd., v. NK Firodia, [3] it was held that directors act in a fiduciary position both towards the company and towards the general body of shareholders; and that, in exercising their powers, they must act for the paramount interest of the company and towards the general interest of the shareholders. In United States, the special facts doctrine, as expounded by the US Supreme Court in Strong v. Repide [4] has extended the duties of directors to imply a fiduciary obligation to shareholders in situations where directors were acting contrary to the interests of other shareholders. Under the misappropriation theory of insider trading in the United States, however, a person may violate Section 10 (b) regardless of the relationship between the parties to the securities transaction. The misappropriation theory permits an individual to violate the antifraud provisions even though he does not owe a fiduciary duty to the other participant in the securities transaction. The requisite fraud occurs when the violator misappropriates confidential information entrusted to him and he subsequently trades on the basis of that information. The misappropriation theory of insider trading, upheld by the US Supreme Court in the O’Hagan case [5] , provides that a person commits insider trading by misappropriating and trading on inside information in breach of a duty of trust or confidence. The theory’s application is most clear in cases involving misappropriation of confidential information in breach of an established business relationship, such as lawyer-client or employer-employee.

From the point of view of company law, perhaps a more significant reason for attempting to regulate insider trading by law is that the insider with access to confidential information is thereby in a conflict-of-interest situation. [6] For example, he may be in such a position within the company as to be able to dictate or at least influence when the public disclosure of price-sensitive information is to be made. In that situation, his decision and his own desire to trade advantageously in the company’s shares may conflict; in other words, the best interests of the company may wrongly take second place to his own self-interest.

Meaning of ‘Insider’: ‘Insider’ is usually a person in possession of corporate information not generally available to the public, as a director, an accountant, or other officer or employee of a corporation, member of management, an employee of the firm or advisor, agent, consultant or any other person who has access to such unpublished price-sensitive information which if published could lead to a fall or rise in the prices of securities of the company. This is clearly a dealing in company securities with a view to making a profit or avoiding a loss while in possession of information that, if generally known, would affect their price. [7] For example, suppose a company makes an important discovery of a valuable mining asset, as Texas Gulf Sulphur did in the 1960’s, or invents a new drug that is likely to have a major impact on the bottom line, as Pfizer did with its impotence drug in 1998, such news would likely cause the price of the company’s shares to increase. If insiders who have that knowledge buy, it can be called as insider trading. In other words, the dealing in securities by an ‘insider’ is illegal when it is predicated upon the utilization of ‘inside’ information to profit at the expense of other investors who do not have access to the same information.

UK and US Section 52 of the Criminal Justice Act 1993 [8] creates three separate offences, each of which may only be committed by an individual and within the UK. [9] These offences can only be committed by individuals who are insiders. These are called by the Act “persons who have information as insider”. Under section 57 of the Act, an individual can only be in that position if the information he has is inside information and he knows both that it is inside information and that he has it from an inside source. There is also the concept of ‘potential insiders’ under the Act. The potential insiders are those directly connected with the company in question, those who come across the information professionally. To make them actual insiders, and so liable for any of the three offences, it must be shown that the potential insider knows both that it is inside information and came from an inside source. Under the UK Insider Dealing Act, it will be necessary for the prosecution to establish that the individual charged with the offence of insider dealing has intentionally dealt in the securities, knowing that he is connected with the company. It is no defence that the accused obtained the information without having actively sought it. [10] Hence, the criteria for mens rea has been laid down. But in India, the position is not the same in this regard. That is to say that a person may be convicted of the offence regardless of whether he has committed it knowingly, deliberately or intentionally, once it is established that he is an ‘insider’ within the scope of the SEBI regulations and he has committed any one of the acts prohibited by regulation 3 and 3A. But it is necessary to establish that the insider did any of the prohibited acts based on unpublished price-sensitive information. In United States, not every corporate insider who profitably trades in a manner consistent with undisclosed information is necessarily guilty of unlawful insider trading. The burden is on the government to prove that the trading arose out of the use of confidential information. Thus, if it can be shown that the trader planned to trade prior to learning of the confidential information, and that the trader acted in accordance with that pre-existing intent, rather than as a result of the recently-learned, undisclosed information, the trader may not be guilty of unlawful insider trading. [11] By virtue of section 57(2) (a) of the Criminal Justice Act in UK, two categories of insiders are defined. The first are those who obtain inside information “through being” a director, employee or shareholder of an issuer of securities. In other words there must be a causal link between the employment and the acquisition of the information, but not in the sense that the information must be acquired in the course of the employee’s employment. The second category of insider identified by section 57(2) (a) is the individual with inside information “through having access to the information by virtue of his employment, office or profession”, whether or not the employment, etc., relationship is with an issuer. The need to define the exact scope of the second category of insider is reduced by the third category, created in this country by section 57(2)(b). In the United States, persons in this third category are distinguished from primary insiders by the use of the graphic expression “tippee”. In US it does not matter whether the primary insider has consciously communicated the information to the secondary insider as long as the latter has acquired the information from an inside source or even indirectly he would fall within the scope of the act. The ban against insider trading also extends to corporate outsiders in the United States. The United States Supreme Court held in United States v. O’Hagan, [12] that outsiders who obtain confidential information through a breach of fiduciary duty owed to the source of the information are also prohibited from trading on the basis of such information. The use of this confidential information, the Court said, constitutes an unlawful “misappropriation” of such information. These “tippees” are not criminally liable, however, unless they knew or had reason to know that the insider breached a fiduciary duty by revealing the information. In India also, after the 2002 amendments, an outsider can also be held liable.

6.3 COMPARITIVE INDIAN CONTEXT

In India, Regulation 3 of the SEBI Regulations seeks to prohibit dealing, communication and counselling on matters relating to insider trading. The SEBI Regulations 2002 define ‘insider’ “as 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 of the company, or who has received or has had access to such unpublished price-sensitive information.” It also included any person connected in the above capacity “six months prior to an act of insider trading.” But a person acting on information after six months, the question arises what kind of information is this? The UK Insider Dealing Act does not give the definition of “insider”, but the definition given in the SEBI Regulations is virtually based on section 1 of that Act with certain changes. The Criminal Justice Act, 1993 of UK does not use the usual term “person” to express the scope of its prohibition, so that bodies corporate are not liable to prosecution under the Act. It is to be noted here that the provisions of the UK Insider Dealing Act apply only to individuals , the SEBI Regulations apply to any ‘person’. Section 3(42) of the General Clauses Act, 1897 gives an inclusive definition of this word thus – “person shall include any company or association or body of individuals, whether incorporated or not.” Thus, the definition is wider in its application than that of the UK Insider Dealing Act. The term “insider” has not been defined by the Securities Exchange Act, 1934 of United States.

Insider Trading Regulations have been tightened by SEBI during February 2002. New rules cover ‘temporary insiders’ like lawyers, accountants, investment bankers etc. [13] Directors and substantial shareholders have to disclose their holding to the company periodically. [14] The New Regulations have added relatives of connected persons, as well as, the companies, firms, trust, etc., in which relatives of connected persons, bankers of the company and of persons deemed to be connected persons hold more than 10%.The definition of relative [15] under the New regulations is in line with that of the Companies Act, 1956, which ranges from parents and siblings to spouses of siblings and grandchildren. The term “connected person” is defined to mean either i) a director or deemed to be a director, ii) occupies the position as an officer or an employee or having professional or business relationship whether temporary or permanent, with the company. Thus, there are two categories of insiders: Primary insiders, who are directly connected with the company and secondary insiders who are deemed to be connected with the company since they are expected to have access to unpublished price-sensitive information. [16] The jurisprudential basis for the ‘person-connected’ approach seems to be founded in the equitable notions of fiduciary duty. As defined under the Act, the definition of insider information is driven by the notion that a person in a fiduciary position should not use the privileged information for his or her own advantage. The practical limitation of the ‘person-connected’ approach is chiefly the practical difficulties of ensuring that all people who trade on inside information are caught. It may be quite difficult for the prosecution to show the existence of a ‘connection’, even when they can show that the secondary insider in question has been dealing and using the information. The secondary insider, who would have traded with an unfair informational advantage, may escape from being caught simply because there can be no trace of how he derived this information in the first place. This is because the information in question must have been obtained by the insider by reason of his connection with the company. In reality, much of the flow of the price-sensitive information often does not operate by way of such established networks of relational links between individuals. Very often, such price-sensitive information is communicated and spread out through very loosely connected and informal networks of brokers, clients and even between friends and through electronic networks etc., or an elaborate nexus of company official, brokers, traders. These individuals are very often privy to strategic policy decisions or developments that may influence the valuation of a company’s scrip on the bourses.

Hence, it is the author’s submission here that the test should be whether there is trading by a person while in possession of undisclosed price-sensitive information, irrespective of his connection with the company. In other words, we should follow the “Information Connection” approach rather than the “Person Connection” approach here.

6.4 LEGAL MECHANISMS IN US, UK AND INDIA

The Criminal Justice Act in UK places exclusive reliance upon criminal sanctions for its enforcement. The criminal sanctions imposed by the Act are, on summary

conviction, a fine of not exceeding the statutory maximum and/or a term of imprisonment not exceeding six months, and on conviction on indictment, an unlimited fine and/or imprisonment for not more than seven years. But the requirement of mens rea has made the enforcement of the legislation often difficult. In addition to the traditional criminal penalties which may be visited upon insiders, it seems that the disqualification sanction is available against some insiders in some cases, the effect of which is to disable the person disqualified from being involved in the running of companies in the future.

The Securities Exchange Act of 1934 in US imposes statutory curbs on insider trading, requiring public disclosure of insider’s transactions in the shares of their companies and providing for recovery of ‘short swing’ profits made by them. [17] Since the depths of the Great Depression, the Securities and Exchange Commission (SEC) has tried to prevent insider trading in US securities markets. Even before the thirties, insiders were liable under the common law if they fraudulently misled uninformed traders into accepting inappropriate prices. But the Securities Exchange Act of 1934 went further by forbidding insiders from even profiting passively from superior information The Act provides remedial measures for protection of investors against sharp practices and fraudulent schemes by insiders in making short-term, speculative profits. The Exchange Act permits the Commission to bring suit against insider traders to seek injunctions, which are court orders that prohibit violations of the law under threat of fines and imprisonment. Unlike in the UK, the Securities and Exchange Commission in the USA has been empowered under Insider Trading Sanctions Act, 1984 to seek imposition of civil penalties, in addition to criminal proceedings. Since criminal cases are difficult to prove and drag on for years, leading ultimately to jail terms, the SEC has been consciously following civil proceedings that offer a much wider range of sanctions, including trading bans and forcing repayment of illegally-obtained profits. Being a civil agency, the SEC has sweeping powers to gather evidence prior to a trial and it does not need to prove each element of its case beyond a reasonable doubt. It only has to show ‘a preponderance of evidence’, which works very effectively in cases where the guilt is closely linked to the motivations of the defendant in an insider trading case. This explains why the SEC handles a much larger number of cases more effectively.

The amount of a civil penalty can be up to three times the profit gained (or loss avoided) as a result of insider trading. With minor exceptions, any person who provides information leading to the imposition of a civil penalty may be paid a bounty. [18] However, the total amount of bounties that may be paid from a civil penalty may not exceed ten percent of that penalty. While the SEBI regulations in India governing insider trading can be said to be preventive, in the United States the provisions of the Securities Exchange Act of 1934 thus, contain remedial measures for protection of investors. A provision of remedies similar to those in the United States must be made even in India to compensate parties injured by the insider’s activities. In India, under the prevalent insider regulations, the Securities Appellate Board has been granted the power to issue any directions as it may deem fit to protect the interest of investors, and in the interest of the securities market, and for due compliance with the provisions of the Act, and gives it the mandate to initiate criminal prosecution against an ‘insider’ under section 24 of the Act, or give such directions for due compliance with the provisions of the Act as to protect the interest of the investors and the securities market, as it deems fit. Under the present SEBI insider trading regulations, the Board/investigative authority has powers to initiate criminal prosecution against the insider; but here it is essential to be abreast of the fact that in case of criminal prosecution the offence has to be proved ‘beyond reasonable doubt’. The very nature of insider transaction is such that it is difficult to adduce evidence. Hence, the need for civil penalties and compensation arises. In cases where the offence of insider trading is proven, damages should be made payable by the insider. Such damages could be deposited in an investor protection fund. In the case of United States insider regulations impose civil penalties for insider trading where it shall appear to the Commission that any person has violated any provision of these regulations by purchasing or selling a security or by communicating such information in connection with a transaction which is not a part of public offering by an issuer of securities. This is an important incentive for people to speak up against colleagues and senior officials.

Hence, as is followed in United States, there should be civil penalties and high levels of compensation in addition to criminal proceedings, which should work as an effective deterrent.

6.5 PROPHYLACTICS OF CORPORATE GOOD GOVERNANCE

The 2002 amendments to the regulations provide extensive suggestions and also extensive regulations couched in the language of corporate good governance. Corporate good governance has been married to the penal provisions of the regulations provided by SEBI to create a smothering framework of regulations. Of course, there is no denying that the regulations create a fair market and create a framework which more and more Western countries are moving towards.

6.6 AIMING TOWARDS CORPORATE GOOD GOVERNANCE IN CAPITAL MARKETS: AN OVERVIEW

With the discovery of massive frauds in the Indian and international capital markets, regulators and legislatures have increasingly turned towards making corporate governance standards and have attached penalties for violation of these ‘corporate governance’ ‘guidelines’. The concept of insider trading is based on the availability of unpublished price-sensitive information about a company listed in the stock market. Use of such information by the persons having access to it for trading in the stocks for purpose of making personal gains is called ‘Insider Trading’. Insider trading has been explained by the high-powered Committee on Stock Exchange Reforms (Patel Committee), 1986 in its report as trading in shares of a company by the persons who are in the management of the company or are close to them on the basis of undisclosed price-sensitive information, regarding the working of the company which they possess but not available to others. Such trading involves misuse of confidential information and is unethical that tantamount to betrayal of fiduciary position of trust and confidence. The persons who have access to such information may be those closely associated with the company either as (1) top management as promoters or directors (2) executives and employees (3) persons associated with the company in their professional capacities as lawyers, auditors, financial consultants, etc. (4) persons working in banks and financial institutions dealing with the company (5) persons manning the firms having business relationship with the company and (6) persons not falling in above categories but have come in possession of price-sensitive information. If insider trading is allowed unchecked in the capital markets, persons with insider information will have a consistent edge in trades executed with such information and those without the information will be consistent losers on the market.

6.7 MEANS OF CONTROLLING INSIDER TRADING: PROHIBITIONS IN INDIAN CIVIL SANCTION

There is a need to add heavy civil consequences on the insider trader. According to SEBI, it does not have the power to impose civil penalties on the violator but SEBI could seek civil powers over violators with assistance from civil courts. Section 11 of the SEBI Act gives the Board broad discretionary powers to issue appropriate remedies. To quote “Subject to the provisions of this Act, it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit”. It also has the powers to issue to any person connected to the securities market such directions “as may be appropriate in the interests of the investors in securities”. SEBI has, like Harry Potter, powers it does not know of!!!

Criminal Sanctions

Of course there is the usual threat of a jail sentence for the offender under Section 24 of the SEBI Act. The section is more of a paper tiger. Though the jail sentence may look good on the statute, history bears out the difficulty in enforcing criminal prosecution against an economic offender. The burden of proof of proving a criminal charge is so onerous that a matter lies in the courts to unravel the complicated issues of facts of illegal transactions consummated over a period of time.

Other Sanctions

The Securities and Exchange Board of India may without prejudice to its right to initiate criminal prosecution under Section 24 or any action under Chapter VIA of the SEBI Act, to protect the interests of investors and in the interests of the securities market and for due compliance with the provisions of the Act, Regulations made there under issue any or all of the following order, namely:

(a) directing the insider or such person as mentioned in clause (i) of subsection (2) of section 11 of the Act not to deal in securities in any particular manner;

(b) prohibiting the insider or such person as mentioned in clause (i) of subsection (2) of section 11 of the Act from disposing of any of the securities acquired in violation of these regulations;

(c) restraining the insider to communicate or counsel any person to deal in securities;

(d) declaring the transaction(s) in securities as null and void;

(e) directing the person who acquired the securities in violation of these regulations to deliver the securities back to the seller;

(f) directing the person who has dealt in securities in violation of these regulations to transfer an amount or proceeds equivalent to the cost price or market price of securities, whichever is higher to the investor protection fund of a recognized stock exchange.

6.8 EXPERIENCE OF ADVANCED NATIONS

To curb the menace of insider trading, many developed nations have framed laws. UK and USA have comprehensive legislations and monitoring agencies to ensure enforcement of the law. In some nations, there are voluntary code of conduct to check insider trading like in Germany. In USA, Securities and Exchange Board has been vested with powers to check insider trading and take preventive measures. Insider Trading Sanctions Act, 1984 was enacted to strengthen the hands of SEC further to prevent insider trading.

In UK there is a self-regulatory code known as City Code to curb this corporate malaise. A person connected with the company in any capacity is prohibited to deal with Securities at the Stock Exchange. Such person may be a director, employee or other person standing in professional or business relationship with the company or related company whose relationship gives him price-sen


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