Insider trading as defined by the Black’s Law Dictionary is -“The use of material non public information in trading the shares of the company by a corporate insider or any other person who owes a fiduciary duty to the company.” [1]

Insider trading is most commonly misconceived to be illegal without exception, when there is a perfectly legal side to the same. The buying and selling of securities on the basis of material non- public information by an insider or a connected person is illegal insider trading. Material information is such information which will influence the price of securities. This material information should be unknown to the general public as this gives the person trading an unfair advantage over the other investors. Any person in possession of the material non public information of the company such as company officer, director, lawyer, accountant, broker, merchant banker, beneficial owner etc is called an insider. For example the director of a company learning that the company is having expansion plans (prior to a public announcement) buys the shares of that company knowing that the price of the company shares will increase thus making short swing profits. Insider trading increases the cost of capital and decreases the overall economic growth of the country.

Earlier, the concept of insider trading was limited to the aspect of a company insider tipping of an outsider and the outsider using the tip and trading in the company’s shares. This constitutes a breach of fiduciary duty owed by the insider to the company’s shareholders. This was called the classical theory of insider trading. Later US Supreme Court in the case US v/s O’Hagan in 1997 extended the scope of insider trading by including the misappropriation theory which said that a person commits insider trading when he obtains material confidential information and uses it in securities transactions in breach of fiduciary duty or similar relationship of confidence to the source of information but not necessarily to the shareholders of the company whose stocks are traded.

International Scenario

This activity has been prevalent since public funding became a norm, but, was considered illegal as late as the 20th century. International Organization of Securities Commission (IOSCO) has formulated three core principles of good securities market regulation namely:

(1) Investor protection,

(2) Ensuring that markets are fair, efficient and transparent and

(3) Reducing systemic risk to prevent insider trading, front running and misuse of client assets. [2]

More than 85 percent of the world's securities and commodities market regulators are members of IOSCO and have signed on to these core principles. The World Bank and IMF assess different financial systems based on these core principles. Of all the countries which have insider trading laws only very few are able to implement them effectively. United States, United Kingdom and Canada are viewed as the countries with the strictest of laws and make the most serious efforts to implement them.

1. In UK, the relevant laws are Financial Services Act 1986 and the Financial Services and Markets Act 2000.

2. Japan came up with its first legislation in this field in the year 1988 but even today they are not able to comprehend why insider trading is illegal.

3. In USA, the Securities and Exchange Act of 1934 along with the United States Securities and Exchange Commission attempts to restraint insider trading.

Indian Position

The first comprehensive step to curb insider trading was as early as 1947 when the government decided to set up the Thomas Committee which gave its recommendations in 1948. The recommendations were incorporated in Sec 307 and 308 of the Companies Act of 1956. The sections make it mandatory for the managers and the directors to disclose their shareholdings in the company. This however was not sufficient to effectively curb insider trading. Hence the Sachar Committee and the Patel Committee which came in 1977 and 1984 respectively emphasized the importance for a separate statute for insider trading.

The Securities scam of 1992 brought to light the wide prevalence of insider trading on Dalal Street. SEBI was established in 1992 and was given the power, with the prior approval of the Central Government, to bring about regulations to prevent insider trading and thus framed the SEBI ([Prohibition on][3] Insider Trading) Regulations 1992.

The regulation provides that, no insider shall deal in securities on his own behalf, or on behalf of someone else, while in possession of unpublished price sensitive information nor will he communicate, counsel or procure directly or indirectly any unpublished price sensitive information to any person while in possession of such unpublished price sensitive information not done in the ordinary course of business, profession or employment.[4]

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 price sensitive information to deal in securities.[5]

Price sensitive information is defined under the Regulation as any information which directly or indirectly relates to the company and can materially affect the price of the securities of the company.[6] Some of the examples are expansion programme, mergers, acquisitions, periodic financial statements of the company etc.

If SEBI suspects a violation of any of the provisions of this Regulation or is informed of the same by a third party, it can constitute an investigating body to make inquiries to form a prima facie opinion. On reasonable notice, the Board has the right of access to the premises, books of accounts and documents to aid the investigation.[7] Findings of the investigating authority are to be reported to the Board[8] on basis of which it has the right to initiate legal proceedings under Sec 24 or Chapter 6A of the SEBI Act, 1992.[9]

All listed companies, recognized stock exchanges, public financial institutions and professional firms are required to frame an internal code of conduct and procedure in line with the model provided under the Schedule 1 of the Regulation for the prevention of insider trading.[10]

Any person (including the director of the company) who holds more than 5% shares or voting rights in a listed company has to disclose the same to the company who in turn discloses the same to the relevant stock exchanges and any change in the voting rights shall also be disclosed within 4 working days.[11]

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 any body corporate on the basis of unpublished price-sensitive information shall be liable to a penalty not exceeding twenty five crores or three times the profit made the trading.[12]

Lacunae in the Indian Regulation and its comparison with the US laws.

Although the Indian Regulation is very much similar to the US laws on insider trading yet the implementation of the law suffers.

1. By the Amendment of 2002, the penalty was increased to 25 crores or three times of profit made during the trading. In US, the penalty for insider trading is three times of the profit made during the trading. They also provide for imprisonment of ten years. The Indian legislation also needs a clause for punishment for offenders.

2. In United States, any person who gives information to the SEC (Securities and Exchange Commission) about any insider trading activity gets a part of the profit made during such malpractice. This kind of reward for information is not yet incorporated in the Indian legal system.

3. In US, the SEC has nation wide jurisdiction to monitor malpractices. The stock exchanges have SROs who conduct active market surveillance with the help of sophisticated computer systems which monitor the volume and price movements of stocks. If there are movements more than the predetermined parameters alert is generated and the SROs carry out preliminary investigation. If there is substantial evidence of insider trading it is referred to the SEC which carries out further investigation and has the power to initiate criminal prosecution. In India, the companies have to formulate a code of conduct and have to appoint a compliance officer to check insider trading within the company, but there is no mechanism to control major players like brokers and promoters. The SEBI is not equipped with such technology which can monitor large scale insider trading.

4. NASDAQ (National Association of Securities Dealers Automated Quotation System) alone has 180 fraud detecting officers along with 12 persons specially tracking insider trading activities and they are supplemented by 350 persons of the SEC. The SEC has support staff including lawyers and auditors amounting to 940, while SEBI employs a mere 356 persons in toto. The US stock exchanges have advanced surveillance systems like Edgar (electronic data gathering) and SWAT (stock watch automated tracking) unlike India.[13]

5. Sections 10b5-1 and 10b5-2 of the SEC Act makes mere possession of non public information punishable though the use of such information need not be proved while in India the mere possession of price sensitive information is not an offence. The SEBI does not unlike SEC have wide powers of search and seizure. It does not have the necessary jurisdiction to punish promoters which frequently indulge in insider trading.

6. The SEC prosecutes more than 50 cases a year on insider trading while the SEBI has within 4 years framed charges in mere 6 cases out of the detected 14 cases.[14] The SEBI hotly pursued the “HLL- BBLIL merger case” where HLL bought shares worth Rs.8 lakhs two weeks prior to the public announcement of the merger. SEBI suspecting insider trading conducted inquiries and issued show cause notice after 15 months and later passed an order to pay compensation to UTI. HLL filed an appeal which did not result in the punishment of the people involved.

Cases

SEBI Vs. Samir C. Arora

In this case, SEBI conducted investigations into the management, conduct and other affairs of the Alliance Capital Asset Management (I) Pvt. Ltd. (ACAML). Samir Arora was the fund manager of the company. Knowing that the company was inviting bids for takeover of the same, he made special arrangement with Henderson Global Investors. For helping this company takeover his present company, he purchased shares and when the price rose sold off the shares to get a considerable profit. The Authority found him guilty and directed him not to buy, sell or deal in securities, in any manner, directly or indirectly, for a period of five years.

“The conduct of Samir Arora is not in consonance with the high standards of integrity, fairness and professionalism expected from a fund manager. His conduct erodes the investors' confidence and is detrimental to their interests as well as the safety and integrity of the securities market. His association in the securities market in any capacity is prejudicial to the interests of the investors and the safety and integrity of the securities market.”

Rakesh Agarwal vs. SEBI.

Rakesh Agarwal, was the Managing Director of ABS Industries Ltd. (ABS), was involved in negotiations with Bayer A.G regarding their intentions to takeover ABS. It was alleged by SEBI that prior to the announcement of the acquisition, Rakesh Agarwal, through his brother in law, Mr. I.P. Kedia had purchased shares of ABS from the market and tendered the said shares in the open offer made by Bayer thereby making a substantial profit. The investigations of SEBI affirmed these allegations. He was an insider as far as ABS is concerned. By dealing in the shares of ABS through his brother-in-law while the information regarding the acquisition of 51% stake by Bayer was not public, the appellant had acted in violation of Regulation 3 and 4 of the Insider Trading Regulations. Rakesh Agarwal contended that he did this in the interests of the company. He desperately wanted this deal to click and pursuant to Bayer’s condition to acquire at least 51% shares of ABS, he tried his best at his personal level to supply them with the requisite number of shares, thus, resulting in him asking his brother-in-law to buy the aforesaid shares and later sell them to Bayer.

The SEBI directed Rakesh Agarwal to “deposit Rs. 34, 00,000 with Investor Education & Protection Funds of Stock Exchange, Mumbai and NSE (in equal proportion i.e. Rs. 17, 00,000 in each exchange) to compensate any investor which may make any claim subsequently.” On an appeal to the Securities Appellate Tribunal (SAT), Mumbai, the Tribunal, however, held that the part of the order of the SEBI directing Rakesh Agarwal to pay Rs. 34,00,000 couldn’t be sustained, on the grounds that Rakesh Agarwal did that in the interests of the company (ABS) to help Bayer A. G acquire his company.

India is a developing country and is catching up with the trends of globalization liberalization and privatization. Insider trading not only affects investors and corporate entities but also the development of the economy. When the cost of securities increases, it adversely affects the growth of industries and infrastructure and hence the development of the economy. This malpractice discourages small investors to invest in the capital market and also increases the cost of securities for the corporate entities. We need to bring in better technology, stronger manpower and more stringent laws to curb insider trading to increase the pace of economic growth.

[1] Black Law Dictionary, 7th edition

[2] The official website of IOSCO

[3] By the Amendment of 2002

[4] Section 3 of SEBI (Prohibition on Insider Trading) Regulations 1992.

[5] Section 2(e) of SEBI (Prohibition on Insider Trading) Regulations 1992.

[6] Section 2(ha) of SEBI (Prohibition on Insider Trading) Regulations 1992.

[7] Section 5 of SEBI (Prohibition on Insider Trading) Regulations 1992

[8] Section 8 of SEBI (Prohibition on Insider Trading) Regulations 1992

[9] Section 11 of the SEBI (Prohibition on Insider Trading)Regulations 1992

[10] Section 12 of SEBI (Prohibition on Insider Trading) Regulations 1992

[11] Section 13 of SEBI (Prohibition on Insider Trading) Regulations 1992

[12] Sec 15G of the SEBI Act, 1992.

[13] Business Line

[14] Business Line