INSIDER TRADING : A CRITICAL ANALYSIS

INSIDER TRADING : A CRITICAL ANALYSIS

PRAYAS ANEJA SECOND YEAR,NATIONAL LAW INSTITUTE UNIVERSITY,BHOPAL.

(I)                           INTRODUCTION

Forces of demand and supply regulate the prices of shares as well. When people buy the shares of a particular company from the stock market, the price of the shares of that company increases. Similarly, it decreases when people sell the shares (supply increases than demand).

By investing in a company’s share, a share holder becomes an owner of that particular company to the extent of the value of the shares held by him. He therefore is entitled to a share in the profits earned by the company. This share in profits that is distributed to a shareholder is known as dividends. The performance of a company is of primary importance to the investors and the general public who might invest in the company.

The Indian company law provides that a company should prepare an annual account showing the company’s trading results during the relevant year. It also makes it mandatory that the company publishes its assets and liabilities at the end of the period. This has been provided to ensure transparency in the functioning of the company. Also, the company should call at least one meeting of its shareholders each year known as the Annual General Body Meeting (AGM) and is kept with a view to ensure and review the working of the company. The information released in Annual Reports and Annual General Body Meetings plays a valuable role in shaping the minds of existing and prospective shareholders.

However persons in the company itself or otherwise concerned to the company are in possession of certain information before it is actually made public. For example, a Chartered Accountant, auditing the accounts of the company; directors of the company taking decisions etc. The knowledge of this unpublished price sensitive information in hands of persons connected to the companies puts them in an advantageous position over others who lack it. Such information can be used to make gains by buying shares at a cheaper rate anticipating that it might rise or selling them before the prices fall down. Such transaction entered into by persons having access to any unpublished information is called Insider Trading.

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. 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. "Insider trading" is a term subject to many definitions and connotations and it encompasses both legal and prohibited activity. 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. 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 organized 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. [1]

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 have 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. [2]

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 U.K. Insider Trading is dealt with in Criminal Justices Act, 1993. The first country to tackle insider trading effectively however was the United States.[3] 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

TITLE OF THE PROJECT

INSIDER TRADING

STATEMENT OF PROBLEM:-

In this project work we will basically be studying the growing problem of Insider Trading and steps tak

MEANING OF 'INSIDER'

Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, does not directly define the term "insider trading". But it defines the terms-

v   "insider" or who is an "insider;

v   who is a "connected person";

v   What are "price sensitive information".

Obviously an insider, who has deep insight into the affairs of the corporate body and holding knowledge about "price sensitive information" relating to the performance of the corporate body that could have a decided impact on the movement of the price of its equity, is at a vantage position with regards to a prospective trading in the shares of the company to the detriment of the common investors. Taking this fact into account the Regulation prescribes several "do-s" and "don'ts" with reference to these "insiders". The effect of the regulatory measure is to prevent the insider trading in the shares of the company to earn an unjustified benefit for him and to the disadvantage of the bonafide common shareholders.

 '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 have 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.[4] For example, suppose a company makes an important discovery of a valuable mining asset, as Texas Gulf Sulfur 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.

POSITION OF UK AND US AND INSIDER TADER

Insider trading is an extraordinarily difficult crime to prove. The underlying act of buying or selling securities is, of course, perfectly legal activity. It is only what is in the mind of the trader that can make this legal activity a prohibited act of insider trading. Direct evidence of insider trading is rare. There is no smoking guns or physical evidence that can be scientifically linked to a perpetrator. Unless the insider trader confesses his knowledge in some admissible form, evidence is almost entirely circumstantial. The investigation of the case and the proof presented to the fact-finder is a matter of putting together pieces of a puzzle .Section 52 of the Criminal Justice Act 1993 creates three separate offences, each of which may only be committed by an individual and within the UK 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. Hence, the criterion 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. [5]

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 United States. The United States Supreme Court held in United States v. O'Hagan, 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.

 POSITION OF INDIA

 In India Regulation 3 of the SEBI Regulations seeks to prohibit dealing, communication and counseling 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 [6]Directors and substantial shareholders have to disclose their holding to the company periodically. The New Regulations have added relatives of connected persons, as well as, the companies, firms, trust, 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 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. 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.

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 o f 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. [7]

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 'shortswing' profits made by them. Since the depths of the Great Depression, the Securities and Exchange Commission (SEC) has tried to prevent insider trading in U.S. 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. 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 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.

CONCLUSION

The new 2002 regulations in India have further fortified the 1992 regulations and have increased the list of persons that are deemed to be connected to Insiders. Listed companies and other entities are now required to frame internal policies and guidelines to preclude insider trading by directors, employees, partners, etc. In the past, it has been observed that insider trading legislation is ineffective and difficult to enforce and has little impact on securities markets. Low enforcement rates and few convictions against insiders have been cited as evidence of this ineffectiveness. Difficulty of detection of insider trading activity is also considered a factor adding to poor conviction rates Irrespective of whether or not the SEBI was bestowed with wide ranging powers; it has been a clear failure when it came to the task of administering the law. So, SEBI now should take the role of a regulator only. Special Courts could be set up for faster and efficacious disposal of cases.

 In the US even civil penalties are linked to the size of the profit made or loss avoided. The SEC is also allowed to let the offenders simply pay up without admitting to an offence but merely by publishing the settlement. This too, is an important deterrent, which prevents every case being locked up in court. In contrast, the maximum penalty allowed to be imposed by SEBI is Rs 500, 000.[8] Hence, the importance of exemplary damages is emphasized under Indian law to act as a good deterrent.

The terms and conditions of appointment of executives and employees of a company can stipulate clearly that any sensitive information, which may come to the knowledge or possession of an executive or an employee of the company during the course of his employment, shall not be used for personal profit or gains .

BIBLIOGRAPHY

                           BOOKS/ARTICLES

·         JAYSREEBOSE,INSIDERTRADING,FIRSTEDITION,ICFAI PUBLICATION,2007

·         Payal Verma, 4th  year, National University Of Juridicial sciences

·         SEBI (Insider Trading) Regulations Act, 1992

REPORTS

·         The Dhanuka Committee, appointed by SEBI in 1998

                              WEBLIOGRAPHY

·         www.legalserviceindia.com Dt:12/03/2010.Time:9:30P.M

·          www.lexisnexis.in Dt:12/03/2010.Time:9:30 P.M.

·         www.sebi.gov.in/acts/prohibition.pdfDt:12/12/2010.Time:11:30 P.M.