Insider Trading

Insider trading is a crime in securities law which tampers with the free functioning of the market forces of demand and supply. It disrupts the core of fairness and integrity which instils confidence in the minds of investors. This article aims to provide a brief overview of what constitutes insider trading by providing an understanding of the evolution of insider trading and related regulations. It also explores the argument as propounded by Henry Mann for the deregulation of insider trading and its feasibility.

Introduction

“Insider Trading can have no place in any fair-minded law-abiding economy,” according to Former Chairman of Securities Exchange Commission, Mr Arthur Levitt.[1] Regarded as a form of theft or misappropriation of information, insider trading affects not only market efficiency but also the integrity and confidence of the securities market.

History

Owing to the period of prolonged “lack of investor’s confidence” followed by the Great Depression, there existed a pressing need for the regulation of the securities market in the US. This paved way for the enactment of the Securities Act of 1933.[2] Though this Act failed to address the scope of insider trading, the Supreme Court in Strong v. Reptide[3]laid down the foundation for it. Subsequently in 1934, the Securities Exchange Act strengthened the law on insider trading in the US.[4]

Development of insider trading regulations in India[5]

  • Pioneered by the Thomas Committee, the first laws against insider trading in India was the Securities Exchange Act of 1934.
  • In 1956, insider trading was incorporated under Section 307 and 308 of the Companies Act, making it mandatory for directors and officers to make disclosures.
  • Later in 1979, the possibility of misuse of insider information by employees for manipulation of stock prices was recognised by the Sachar Committee.
  • In 1986, Patel Committee proposed the amendment of the Securities, contract (Regulations) Act 1956 to provide for a reduction of insider trading in exchanges.
  • It was the Abid Hussain Committee of 1989 which suggested the imposition of civil and criminal penalties on persons engaging in insider trading. It also recommended that SEBI formulate regulations against insider trading.
  • In 1992,
  • the establishment of the Securities and Exchange Board of India, shortly followed by the formulation of SEBI (Insider Trading) Regulations, 1992 formed the first dagger against insider trading activities.
  • In 2002, the regulations were considerably reformed and renamed as the SEBI (Prohibition of Insider Trading) Regulations, 1992.

In 2015, SEBI appointed a High-Level Committee headed by Justice N. K. Sodhi for the renovation of the regulations to meet the international standards. Based on the Committee Report, the SEBI (Prohibition of Insider Trading) Regulations were issued. SEBI (Prohibition of Insider Trading) Regulations, 2015 is the law that currently prevails on the matter.[6]

Concept

The price of shares of a company is determined by the market forces of demand and supply created by the performance and success of the Company. The shareholders and prospective investors are made aware of the performance of the company during the Annual General Body Meetings and Annual Reports. However, while the shareholders and the public gain knowledge of the company’s documents through statements released annually by the company, the employees have access to this information before it goes public. This knowledge of unpublished price sensitive information puts such employees in an advantageous position. It can be utilised in making gains by purchasing shares at a cheaper price anticipating a subsequent rise. It can also be used to insulate oneself against probable loss by selling shares before falling in prices. Such transactions entered into by persons in possession of unpublished information regarding potential price sensitivity of shares is known as insider trading.[7]

Thus, insider trading involves trading in the securities of a publicly listed company, directly or indirectly. Such trading may be by any individual, whether involved in managing the company or not by utilising information unavailable to the public. Further, such an act must result in the influence of the market price of securities of the company concerned.

Regulations

Who is an insider?

Regulation 2(e) of the Regulation defines an insider as a person who is connected to the company and may have access to, has received or has had access to UPSI relating to securities of a company. An insider maybe someone who has or has had a connection or deemed connections with the company and during such period had to access to UPSI.[8]

Who is a connected person?

What amounts to Price Sensitive Information (PSI)?

The following information is considered to be price sensitive:

  • Periodical financial statements
  • Declaration of dividends intended
  • Issue or buy-back of securities
  • Execution of new project or major expansion plans
  • Information regarding potential amalgamation or takeovers
  • Significant changes to policies, plan or operation of the company concerned.[9]

Legal insider trading[10]

Powers of SEBI &Penalties

Legal Insider Trading

Employees in an organisation exercise stock options and they have access to inside information. Dealings of promoters and other employees who have access to information in stocks cannot be considered as illegal trading so long as such information is publicly available.

Penalties for insider trading under the SEBI (PIT) Regulations

  • SEBI may impose a fine of Rs. 25 Crore or sum amounting to three times the profit gained from insider trading whichever is greater. (Section 15(G))
  • SEBI may initiate criminal prosecution.
  • SEBI may declare dealing on securities to be based on UPSI by issuing orders.
  • SEBI may order an insider to refrain from or prohibit him from dealing in the securities of the company.

Case Analysis

Hindustan Lever Limited v. SEBI, 1996[11]

SEBI initiated charges of insider trading against HLL regarding its recent merger with Brooke Bond. The claims made by SEBI was that the HL had acquired the shares of BB before the announcement of merger which amounted to insider trading as HL was an insider under S. 2(e) of the 1992 Regulation. SEBI alleged that both HL and BB being under the same management of London based Unilever, HL had prior knowledge of the merger.

The matter was dismissed by the appellate authority on the ground that the information regarding the merger was already available on the public domain at the time. Further, SAT stated that the information would not have had much impact on the price of the merger.

Dilip Pendse v SEBI[12]

Pendse was the Managing Director of Tata Finance Ltd(TFL). Nishkalpa was a listed company, a subsidiary of NFL. It was alleged by SEBI that Pendse had provided information regarding the huge losses incurred by Nishkulpa to his wife before the information was made public. His wife based on the information sold several shares. The case was dismissed by the SAT for not conducting the cross-examination of Pendse and due to lack of proper evidence against him.

This case exhibits the lack of a thorough investigative mechanism and ability of SEBI to provide evidence to prove allegations raised, beyond a reasonable doubt.

Deregulating Insider Trading

Henry Manne in his book, “Insider Trading and the Stock Market” daringly proposed the deregulation of insider trading. He identified two possible ways in which insider trading is beneficial to the economy:

Firstly, it creates increased price accuracy. He stated that insider trading results in the movement of the stock prices towards the price which would be commanded by the security if such information was made public. Thus, it will result in an increased price accuracy which is beneficial to both the society and the firm.

Secondly, it acts as an incentive for managers to produce additional information of value to the firm. He opined that insider trading is an efficient way of providing compensation to managers in exchange for information. This will encourage the managers to work towards providing information of value benefiting both the society and the firm.[13]

Manne thus stated that insider trading will improve market efficiency by bringing more information to the securities market leading to rational allocation of capital. However, it has been rejected as the same is likely to impair hierarchy in the corporate chain as subordinates may grab the opportunity to make personal financial gains.[14]Further, it may also result in unfair practices and affect the actual value of the firm due to misinformation.

Though heavily criticised, the theory of deregulation by Mann eventually stimulated the emergence of the view that the information is a ‘property right’ of the firm concerned. It paved the way for the development of stocks being used as compensation for executives and the recognition of property rights over intangible assets such as intellectual property.[15]

Conclusion

Conducted secretively, insider trading poses a challenge for detection and prosecution. This has compelled SEBI to adopt any legitimate means for the detection of insider trading activities to ensure the confidence of investors and the integrity of the market.

SEBI has as a last resort, announced a reward worth Rs. 1 Crore for insider trading informants in 2019 to uncover the clandestine dealings.[16] The same has been incorporated as ‘Informant Mechanism’ rules under the Prohibition of Trading Regulations. The rules provide for the creation of a hotline, providing amnesty or settlement for minor wrongdoings as a reward for cooperation.

The substantive law regulating insider trading has been strengthened over the years. Mann’s idea of an efficient market through deregulation has been rejected since it has been proven that the cost thereby incurred trumps the benefits accrued.

Though insider trading has its roots set deep in the Indian market, the data depicts that the number of cases investigated is very few. Of the 85 cases tan up for investigation in the year 2018, merely 25 have been completed as of January 2020.[17] SEBI is not empowered with sufficient investigative powers to obtain the necessary evidence to prove its claims.

Despite the efforts of SEBI to put an end to insider trading, there persists a lacuna in Insider trading regulations. It is pertinent at this stage that companies adopt precautions to prevent insider trading to avoid subsequent legal consequences. Though the option of deregulation has been completely ruled out, there still exists a need for an airtight investigative and prosecution mechanism. Insider trading is malpractice which needs to be wiped out to ensure the fair functioning of an efficient market.

Questions

  1. What is Insider Trading?
  2. How has the law on insider trading evolved in India?
  3. What are the regulations related to Insider Trading in India?
  4. Is the deregulation of Insider Trading as advocated by Mann an economically feasible option?
  5. How has SEBI strived to tackle the issue of Insider Trading?

[1]https://taxguru.in/sebi/amendments-sebi-prohibition-insider-trading-regulations-2015.html

[2]http://www.riskpro.in/download/insider_wp.pdf

[3] Strong v. Reptide, 213 U.S. 419

[4]Supra note 2.

[5]https://www1.nseindia.com/research/content/res_QB13.pdf

[6]https://www.latestlaws.com/wp-content/uploads/2018/09/Insider-Trading-Law-in-India-By-Baishali-Das.pdf

[7]http://www.legalserviceindia.com/article/l268-SEBI-on-Insider-Trading.html

[8] KLG Capital Services Limited, WTM/MSS/ISD/18/2009.

[9]http://www.legalservicesindia.com/article/1421/Insider-trading-laws-in-India.html

[10]http://www.legalservicesindia.com/article/1421/Insider-trading-laws-in-India.html.

[11]Hindustan Lever Limited v. SEBI, (1998) 18 SCL 311 MOF.

[12]DilipPendse vs. SEBI (Appeal No. 90 of 2007).

[13]https://poseidon01.ssrn.com/delivery.php?ID=580124069074123015031067020068090126084045031036095011024099024101102121060019018059021055001092000079003100124020058033078020104012064116097091123126083122007069046025011006094087118087114086065115092089118110001018124000121071091098016120102&EXT=pdf

[14]https://oxfordre.com/economics/view/10.1093/acrefore/9780190625979.001.0001/acrefore-9780190625979-e-372

[15]https://oxfordre.com/economics/view/10.1093/acrefore/9780190625979.001.0001/acrefore-9780190625979-e-372#ref_acrefore-9780190625979-e-372-note-8

[16]https://www.thehindubusinessline.com/markets/stock-markets/sebi-announces-reward-worth-rs-1-crore-hotline-access-for-insider-trading-informants/article29212640.ece#

[17]https://www.livemint.com/market/stock-market-news/how-india-cracks-down-on-insider-trading-11580199120367.html

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