Insider Trading: A Critical Analysis
The practice of Insider Trading came into existence ever since the very concept of trading of securities of a company became prevalent among the investors worldwide and has now become a formidable challenge for investors all over the world.
“Insider Trading” essentially denotes dealing in a company’s securities on the basis of confidential information relating to the company which is not published or not known to the public (known as “unpublished price sensitive information”), used to make profits or avoid loss. It is fairly a breach of fiduciary duties of officers of a company or “connected persons” as defined under the Securities Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, towards the shareholders.
An ‘unpublished price sensitive information’ means information relating to the present or probable future state of the company, that can potentially affect the value of the securities of the company in the market, that has not been available to the public. By the use of such material non-public information, the insider himself, or the person to whom the information is made available to, can trade in the securities of the company for his own benefit, thus causing a loss to those who do not possess such information.
An insider deals in shares of a company to make unwarranted gains by virtue of his employment or such other connection, thereby rendering the underlying principle of fair and free transferability of shares unaccomplished in the capital market. This is the primary reason for the formation of these regulations viz. to promote free and fair transferability of stocks in the capital market wherein the investors can deal in the securities in an unperturbed manner.
An ‘insider’, as defined by the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992 is:
“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have been connected with the company, and who is reasonably expected to have access, by virtue of such connection, to unpublished price sensitive information in respect of securities of the company, or who has received or has had access to such unpublished price sensitive information.”1
The Amendment Regulations in the year 2002 were formulated to eradicate the loopholes in the Regulations of the year 1992. The changes in the definition of ‘insider’ in the Regulations of 2002 fundamentally include the substitution of ‘the’2 by ‘a’ in the group of words ‘securities of the company’ and also the omission of the words ‘by virtue of such connection’3 from the SEBI Regulations, 1992. The Regulations of 2002 were termed as the SEBI ([Prohibition of] Insider Trading) Regulations, 1992, which is also known as the SEBI (Prohibition of Insider Trading) (Amendment) Regulations, 2002. The reasons for this abovementioned amendment have been discussed elaborately later.
International Overview Of Insider Trading Regulations
Different countries have diverse enactments and codes of conduct to curb the ill practice of Insider Trading. While the US and the UK have comprehensive legislations and monitoring bodies in this regard, countries like Germany rely on a voluntary code of conduct.
The United States has been the most successful in prohibiting insider trading and the first country to tackle insider trading effectively. The market crash due to protracted lack of investor’s confidence in securities market and then the great depression in the US economy led to the enactment of the Securities Act, 1933 in which the provisions relating to prohibition of fraud in the sale of securities were included, which were greatly braced by the subsequent Act viz. Securities Exchange Act, 1934.
The Securities and Exchange Act, 1934, enumerates the provisions relating to the protection of interest of investors against Insider Trading. Thereafter in the year 1961, US came up with an enforcement prohibiting the practice of Insider Trading, being the first country to do so, while in most of the other countries it was legislated against only in the 80’s and 90’s. Moreover, the ‘triple damage remedy’4 which was found in the Racketeer Influenced and Corrupt Organization Provisions, 1970 and Organized Crime Control Act, is being strictly applied in the cases relating to securities, frauds and mainly dealing with Insider Trading. The Securities and Exchange Commission (SEC) has been further empowered to seek ‘triple penalty remedy’ under the provisions of the Insider Trading Sanctions Act, 1984. The SEC has been empowered by the Act to bring enforcement actions against any violations of the provisions of the securities laws.
The Insider Trading and Securities Fraud Enforcement Act, 1988 and the International Securities Enforcement Cooperation Act, 1990 widened the ambit of international cooperation and assistance in criminal investigations in cases related to Insider Trading. There were also provisions for reimbursement of expenses incurred by the Commission from the foreign securities authorities for the assistance provided to them.
Moreover, to ensure tidy and effective investigative procedures, the SEC has entered into 32 arrangements with its foreign counterparts to ensure assistance in investigative procedures that include information sharing and co-operation in the investigation. The aforesaid arrangements include two concepts- Mutual Legal Assistance Treaties and Memoranda of Understanding (Hereinafter referred to as MoU). The US has entered into Mutual Legal Assistance treaties with countries that include Switzerland, United Kingdom and Northern Ireland, Cayman Islands, Netherlands, Canada, Turkey, Bahamas and Italy5. These treaties aim at providing assistance in locating witnesses, obtaining their testimony, production and authentication of documents and other criminal investigations and these treaties are binding on the parties of the treaty. On the other hand, the MoU’s are non-binding statements of intents between the regulators. The US has entered into MoUs with countries that include Japan, Switzerland, UK, Brazil, Italy, Netherlands, France, Mexico, Portugal, Germany, etc.
It is pertinent to note here that United States has entered into the abovementioned treaties and Memoranda in order to deal with trans-national violations of Insider Trading Regulations more efficaciously.
Insider trading was first exposed in the UK in Para 22 of the White Paper on the Conduct of Company Directors 19776. However, the United Kingdom first legislated against this practice in the year 1980 and promulgated its first enforcement in the year 1981 which preceded the enactment of the Company Securities (Insider Trading) Act, 1985 or the “English Act” which principally regulates the practice of Insider Trading today. The Act prohibits an individual from dealing on a recognized stock exchange in the securities of the companies which are listed, with which he is or has been, in the past six months, connected and by virtue of his connection, has acquired unpublished price sensitive information. The contravention of the provisions of the Act involves both civil and criminal liabilities.
One interesting aspect of the Act in UK is that the prohibition extends to dealing in the securities of a company, apart from that with which the individual is connected, if the information relates to another company or to any other transaction involving both companies. Furthermore, the recipient of such an unpublished price sensitive information is also prohibited from dealing, with the exception of certain circumstances.
It is seen by practical examples that the success of Insider Trading laws in the UK has been pretty low. Most of the defendants have been acquitted on technicalities owing mainly to the rigidity in the definition of Insider Trading and partly because of the inadequate powers granted to the Securities and Investments Board (SIB). Another aspect that emphasis should be laid on is the undesirable degree of burden of proof required to prove any case of Insider Trading.
In Germany, a voluntary code of conduct is emphasized upon, which is to be strictly followed by the Companies, Stock Exchange dealers and banks so as to preclude the wrong use of confidential inside information by the persons concerned. This code has astonishingly been very successful as there has been no major Insider Trading scandal notwithstanding the flourishing market and the ever-increasing take-over bids.
History & Development Of Insider Trading Laws In India
The history of Insider Trading in India relates back to the 1940’s with the formulation of government committees such as the Thomas Committee of 1948, which evaluated inter alia, the regulations in the US on short swing profits under Section 16 of the Securities Exchange Act, 1934. Thereafter, provisions relating to Insider Trading were incorporated in the Companies Act, 1956 under Sections 307 and 308, which required shareholding disclosures by the directors and managers of a company.
Due to inadequate provisions of enforcement in the companies Act, 1956, the Sachar Committee in 1979, the Patel Committee in 1986 and the Abid Hussain Committee in 1989 proposed recommendations for a separate statute regulating Insider Trading.
The Patel committee in 1986 in India defined Insider Trading as,
“ Insider trading generally means trading in the 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 which is not available to others.”7
The concept of Insider Trading in India started fermenting in the 80’s and 90’s and came to be known and observed extensively in the Indian Securities market. The rapidly advancing Indian Securities market needed a more comprehensive legislation to regulate the practice of Insider Trading, thus resulting in the formulation of the SEBI (Insider Trading) Regulations in the year 1992, which were amended in the year 2002 after the discrepancies observed in the 1992 regulations in the cases like Hindustan Levers Ltd. vs. SEBI8, Rakesh Agarwal vs. SEBI9, etc. to remove the lacunae existing in the Regulations of 1992. The amendment in 2002 came to be known as the SEBI ([Prohibition of] Insider Trading) Regulations, 1992.
The regulations of 1992 seemed to be more punitive in nature. The 2002 amendment regulations on the other hand are preventive in nature. The amendment requires all the listed companies, market intermediaries and advisers to follow the new regulations and also take steps in advance to prevent the practice of insider trading. The new regulations include mandatory disclosures by the Directors and other officers of listed companies and also by the persons holding more than 5% of the company’s shares10. Insider trading practice is also required to be curbed during vital announcements of the company. These preventive measures ensure the reduction of the cases involving the practice of Insider Trading and also informing the persons who indulge in such practices, of the laws relating to Insider Trading.
The new regulations particularly emphasize on the delegation of powers on the entities themselves to conduct internal investigations before they present their case before the SEBI in relation to insider trading. The guidelines provide for a definite set of procedures and code of conduct for the entities whose employees, directors and owners are most expected to be in a position to take an undue advantage of confidential inside information for their personal profits.
Shortcomings Of The Sebi Regulations For Insider Trading
There have been many lacunae in the SEBI Insider Trading Regulations that have been observed over the years, eventually making it tough for the investors to repose their confidence in the laws designed to safeguard their rights and interests against the practice of insider trading. SEBI has time and again encountered difficulties in establishing and proving a case (beyond reasonable doubts in case of criminal proceedings) to convict the person/s accused of insider trading, substantially owing to the lack of evidence.
One of the most famous cases highlighting the vulnerability of the SEBI’s 1992 regulations in this regard is Rakesh Agarwal vs. SEBI. In this famous case, Rakesh Agarwal, the Managing Director of ABS Industries Ltd. (ABS), was involved in negotiations with Bayer A.G (a company registered in Germany), regarding their intentions to takeover ABS. Therefore, he had access to this unpublished price sensitive information. 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. Bayer AG subsequently acquired ABS. Further he was also 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.” along with a direction to “(i) initiate prosecution under section 24 of the SEBI Act and (ii) adjudication proceedings under section 15I read with section 15 G of the SEBI Act against the Appellant.”
On an appeal to the Securities Appellate Tribunal (SAT), Mumbai, the Tribunal 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), as is mentioned in the facts above.
Similarly, in the case of Samir.C.Arora vs. SEBI11, Mr. Arora was prohibited by the SEBI in its order not to buy, sell or deal in securities, in any manner, directly or indirectly, for a period of five years. Also, if Mr. Arora desired to sell the securities held by him, he required a prior permission of SEBI.
Mr. Arora in the Securities Appellate Tribunal contested this order of SEBI. SAT set aside the order of SEBI on grounds of insufficient evidence to prove the charges of insider trading and professional misconduct against Mr. Arora.
The abovementioned cases throw light on the inability of SEBI in proving its cases so as to prove the allegations of Insider Trading. Most of this can be accounted to the lack of evidence in cases relating to Insider Trading in India which make it difficult for the prosecution to prove the criminal liabilities that may be imposed on the person accused of Insider trading. Unlike the balance of probabilities that is required in proving a civil liability, a case involving criminal liability requires the allegations to be proved beyond reasonable doubts.
Another interesting aspect about the SEBI (Prohibition of Insider Trading) Regulations, 1992 is the amendment brought in the definition of ‘insider’ in the definition provided in the 1992 Act. As it is already mentioned, the 1992 Act defined an ‘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, by virtue of such connection, 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.”
SEBI experienced a lot of complexities in proving a case of insider trading because of the words ‘by virtue of such connection’ included in the definition of an insider in the 1992 Act. To prove a person to be an insider, even before proving the liability of the accused, the SEBI had to establish first, his connection with the company and how he acquired such information. This proved to be a very tedious and problematic task for the SEBI. In most of the cases, SEBI could not establish the connection of the person accused to be an insider with the company, thus, leading to an acquittal of the accused based on the grounds of insufficient proof. Perplexed by this, SEBI introduced the 2002 amendments in which the words ‘by virtue of such connection’ were omitted from the definition of an ‘insider’. This simplified SEBI’s task of proving its cases against the insiders significantly, reason being, that now SEBI did not have to establish the connection of the insider with the company or how he acquired the unpublished price-sensitive information. This resulted in an increase in the number of insider trading cases being filed. This proved to be a good change that SEBI experienced, after being restricted by the rather rigid regulations for insider trading.
An example of this has been mentioned earlier in the case of ‘SEBI vs. Samir. C. Arora’ wherein, relieved by the new amendment, SEBI based its case against Mr. Arora on the ground of insider trading, without having to prove the circumstances of his position in the company as a fund manager which might have led to his knowledge of the disputed confidential information and convicted him for the offence. But, on an appeal to the SAT, Mr. Arora was exonerated of all the charges against him on the grounds that Mr. Arora acted in the course of his duties and that such allegations are “presumably the professional hazards for those entrusted with the management of investors' funds”, as observed by the honorable judges.
Insubstantial Investigative Infrastructure
Proving Insider Trading is a bizarrely difficult task owing to the lack of material proof in majority of cases. Insider Trading cannot be proved beyond reasonable doubts unless there is substantial material proof supporting it or when the insider himself confesses in an admissible form, to have indulged in the dealing of confidential information for personal gains, which is very rare a possibility and is not expected to happen in practical world. Indulging in buying and selling of Securities is a legal practice. It is only what’s in the mind of the dealer that constitutes the basis of its legality.
Lowering down the degree of proof required to prove a case of Insider Trading would be unaccounted for, as Indian Judiciary has always believed in “acquitting 100 guilty offenders in an attempt not to convict one innocent person”. Even though the removal of the words, “by virtue of such connection” came as a relief to SEBI and simplified its task of proving an insider trading case to a great extent, it is still recommended that the SEBI should be granted slightly extended powers for more exhaustive and efficacious investigation of cases involving Insider Trading, which would definitely be helpful in imparting justice and convicting every such violator of the Insider Trading regulations by providing greater degrees of positive evidence supporting every such conviction thus proving every case beyond reasonable doubts. Because despite of not having to prove the connection of the accused with the company, most of the cases are not established owing to the lack of evidence gathered against the accused.
Furthermore, it is advised that the SEBI should be provided downright assistance of the official government investigative agencies like Central Economic Intelligence Bureau (CEIB) to investigate into the matters relating to Insider Trading so as to improve the standards of investigation and hasten up the process of gathering proof against the insider. SEBI already has access to the CBI (Central Bureau of Investigation) whenever it seeks help in investigation and collection of evidence. But any additional help would prove to be useful and very much welcome by SEBI. Such a practice of official governmental assistance in investigation into Insider Trading matters has also proved to be extremely successful and efficient in the United States, where The Federal Bureau of Investigation (FBI) aids the Securities and Exchange Commission (SEC) in inspecting the cases of Insider Trading in a more comprehensive and yet expeditious way. It has, therefore, shown a higher rate of indictments in the recent past.
Remedy for Investors
Talking about the SEBI regulations in India, another glaring loophole is of the absence of an adequate remedy available to the investors at large. The insider is more often than not, acquitted scot-free. Even in the cases where they are convicted, they are required to pay a sum of money much less than the amount of profits that they might have actually made or they have to undergo a prohibition of dealing in securities for a time period stipulated in the order. The end result is that the insider walks away satisfied with the profits he eventually is left with. If this trend continues, then the investors would be apprehensive about investing in the securities market. Although it sounds practically impossible to provide a remedy for the investors, owing to the difficulty in calculating the comparative losses suffered by each and every investor, SEBI should work out a way in which such aggrieved investors may be refunded the losses that they might have suffered due to any act of insider trading.
In order to provide the compensation to the investors, the first step would be to ascertain the number of aggrieved investors and also to calculate how much losses they might have suffered comparatively, due to an act of insider trading. It is thus suggested that after convicting a person of insider trading and ordering him to pay the penalty in consequence of his indictment, a public notice to be issued for a certain period of time, asking the aggrieved investors to demand compensation for the losses that they might have suffered due to a biased trading activity by the insider. The compensation would be paid out of the amount recovered from the person indicted. The investors not acknowledging to such a notice would simply lose their right to ask for repayment.
After the number of investors has been ascertained, SEBI would have to calculate and decide how much money does each investor individually deserve to get. Calculating this amount can prove to be a tedious task but very useful howsoever. SEBI has the records of the scrip at the time the insider trading activity happened and also the present scrip for the same securities. It can thus calculate the difference in the two and further determine the investors’ individual holdings in the securities both at the time of dispute and presently and thus award them compensation accordingly.
Another question that arises is that if the price of the securities had fallen after the insider trading activity happened, then how and what to pay the investors? The answer is simple. In case the price of the securities on the present date is lesser than on the date in dispute, then it is almost impossible to provide the investors with any kind of remedy. Therefore, there wont be any need of issuing a public notice or even calculating the amount.
These suggestions however, are very crude, and SEBI can effectively introduce new regulations providing a remedy for the innocent investors aggrieved of the acts of insider trading.
Scope of the term ‘Insiders’
The accountants of a company supervising the financial operations in any company have the furthermost prospect of gaining knowledge to any kind of confidential price sensitive information. Likewise, the lawyers or the law firms hired by a company to handle its legal undertakings are the first to know about any kind of information that may be deemed to be price sensitive, especially in cases where they design the framework and involve in negotiations for amalgamations, mergers, takeovers, etc. So the question that arises here is that can the lawyers or accountants of a company be deemed to come under the purview of ‘insiders’?
The answer is Yes. The abovementioned entities have an easy access to all the price sensitive information of a company. Practical experiences depict that lawyers have been the foremost in indulging in the practice of insider trading. They get firsthand information about the affairs and the future prospects of a company and often involve in trading their securities accordingly so as to make profits or avoid losses that might be incurred when the information goes public. Although a lawyer is expected not to disclose any kind of information relating to his client to a third person, he is most susceptible to being indulged in the activity of insider trading and it can be truly said that these rules of professional ethics are more commonly found to be limited to the books only.
The SEBI regulations provide for compulsory disclosures by directors, officers and substantial shareholders (more than 5% of shares or voting rights) of a company to ensure transparency in the organization in relation to personal shareholdings so as to determine the individuals most susceptible to the practice of insider trading. These regulations also provide for a Compliance Officer13 (who shall report to the Managing Director/ Chief Executive Officer) to be appointed in all the listed companies to set forth policies, monitoring adherence to rules relating to price sensitive information, to monitor the trades and to regulate the code of conduct in the company. The compliance officer has to maintain the records of all the transactions and declarations made by the directors/designated employees/partners. But when the practice of insider trading is ensued at the apex of the hierarchy of administration or at a very small scale, then it is very difficult to notice or to point out any discrepancies in the flow of information between different levels of administration or out of it. However, it is also recommended that the offices that have an access to price sensitive information, such as law firms or auditors employ officers (such as Compliance Officers) just to keep a check on its employees and their respective investments so that no one is involved in the practice of insider trading.
The SEBI has strengthened the anti-insider trading laws by the amendment introduced in the year 2002. This amendment has simplified the task of curbing and tracking down the practice of insider trading in more than one ways. With the expansion of the domain of the persons coming under the category of ‘Insiders’, a different trend is observed in the cases that followed the amendment. The persons who were earlier precluded from the purview of insiders have now been added to the list and attempts have been made to prove their liability too in cases of insider trading.
Then again, the disclosures required to be made by the directors, officers and substantial shareholders of a company and the appointment of a compliance officer in every listed company has proved to be effective in managing the accounts and noticing any abnormalities in the trading patterns.
Despite the desirous changes that the amendment brought in, SEBI has not been able to utilize this to its best. It has failed many times in proving its cases owing to lack of evidence. As discussed earlier, there should be a strong and more efficient investigative mechanism to aid the SEBI in its investigations for insider trading.
SEBI should welcome any kind of information that leads to the discovery of the practice of insider trading being indulged in and it should also encourage people to share with it, any kind of information relating to insider trading activities in progress. Though it is a bit too much to expect out of people without any reward therefore SEBI should throw some light on its US counterpart, the SEC, as far as this issue is concerned. The SEC gives away rewards, or what it terms as Bounty, to the individuals who provide them with any kind of information leading to the discovery of an insider trading scam. This bounty, as fixed by the SEC, is 10% of the amount of money recovered of that made in profits by the insider until the discovery of his deeds.
Similarly the SEBI should also introduce the concept of giving away bounties or rewards so as to lead to a decline in this practice by inducing fear in the minds of insiders of being exposed. If not 10%, then whatever amount that SEBI deems just, can be given as rewards to any person on the basis of whose information, an act of insider trading can be uncovered or even better, prohibited.
Insider Trading is a practice that has been prevalent since the very inception of stock markets and can never possibly be ended completely. But an endeavor can be made to curb this practice at all the levels of the society and not just by the SEBI but also by the people aware of any kind of insider trading practices being indulged in. Practically speaking, the practice of insider trading cannot be eradicated completely, but an effort can be made to limit it to a great extent. This can be only possible if there are deterrents to set examples for all the offenders and also the people likely to involve in this evil practice.
1. Clause 2(e), SEBI (Insider Trading) Regulations, 1992.
2. Subs. for ‘the’ by amendment regulations, 2002 vide Notfn. No. S.O.221 (E), dt.20/02/02.
3. Omitted by amendment regulations, 2002 vide Notfn. No. S.O.221 (E), dt.20/02/02.
4. A 23, Chartered Secretary (February, 1992) Pg 111.
5. SCL May 8, 2000, Vol.25, Pg 16.
6. Cmnd. 7037 (UK)
7. The High Powered Committee on Stock Exchange Reforms, 1986 (Ch. 7.25).
8.  18 SCL 311 (AA)
9.  49 SCL 351 (SAT-Mum)
10. Cl. 13(1), SEBI ([Prohibition of] Insider Trading) Regulations, 1992
11.  59 SCL 96 (SAT-Mum).
12.  59 SCL 96 (SAT-Mum)
13. Schedule 1 (Part A), 1.0 SEBI ([Prohibition of] Insider Trading) Regulations, 1992.
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