Prevention of Insider Trading and

INTRODUCTION

Insider Trading

Insider trading is one of the most violent crimes on the faith of fair dealing in a capital market. The scope and stringency of the violation and penalties differ wildly from country to country. Trading by an insider of a company in the shares of a company is not per se a violation of law. For instance a person (an investigative journalist for example may interview an insider and thus become one) may come across insider information by his perseverance in uncovering a corporate fraud and disclose the fraud. A person can create inside information by his future actions, for instance a future tender offer bidder knows that the price of the target company will go up by his actions. In fact trading by insiders, including directors, officers and employees of the company in the shares of their own company is a positive feature which companies should encourage because it aligns its interests with those of the insiders. What is prohibited is the trading by an insider in breach of a duty of trust or confidence in the stock of a company on the basis of non public information to the exclusion of others. Insider trading violations may also include "tipping" such information and securities trading by the person "tipped".

Efficient Capital Market Hypothesis

In fact in an efficient market, even one share traded on insider trading would violate the integrity of the markets. According to the Efficient Capital Market Hypothesis, a buyer of just one share impacts not merely the counterparty seller, but the entire market. The buyer’s purchase order drives up demand of the shares and affects all contemporaneous traders on the sell side of the transaction. The US Supreme Court has used Eugene Fama’s theory of Efficient Capital Market Hypothesis in Basic v. Levinson to come to the conclusion that the requirement of reliance in a fraud action in the securities markets is highly diluted because information is converted into price in today’s anonymous markets. Thus anyone who relies on the price of a security, need not show the common law requirement of reliance in a suit for damages based on fraud.

Means of control

There are three means of controlling insider trading: Criminal, Civil and administrative actions, and introducing corporate governance standards.

Criminal: 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, the requirement of intent so strict, and the courts procedures so long and ‘due’ that conviction is an exceptional exception. For instance the only case of insider trading prosecuted by Dutch authorities in ten years failed on lack of proof. With a general conviction rate of less than 3% in India, SEBI should really concentrate on efforts to economically paralyze insider traders instead of the more high profile and far less successful criminal sanctions.

Civil and administrative penalties: Civil monetary penalties and issue of various administrative actions like bar from the industry without going to courts is a more effective remedy and with the enhanced powers granted to the regulator to impose penalties of 25 crores or three times the gain made, an economic harm can more easily be inflicted and deterrence more effectively administered.

Prophylactics: The third way of attacking the problem is by encouraging the companies to practice self regulation and taking prophylactic action. This is inherently connected to the field of corporate governance. It is a means by which the company signals to the market that effective self regulation is in place and that investors are safe to invest in their securities. In addition to prohibiting inappropriate actions (which might not necessarily be prohibited), self regulation is also considered an effective means of creating shareholder value. Companies can always regulate their directors/officers beyond what is prohibited by the law.

The 2002 Corporate Governance amendments

The 2002 amendments to the Regulations provide extensive suggestions and also extensive regulations couched in the language of corporate good governance. Most of the good governance provisions are provided for as mandatory provisions. This article critically evaluates some of the provisions introduced by this amendment.

Trading windows: Insiders are restricted from trading within a certain period of time i.e. before corporate announcements, buybacks etc. are made. Unfortunately, the wordings of the regulations are so broad, that it would chill trading in sometimes rather large windows. The regulation should not asphyxiate trading by insiders. As we have seen before trading by insiders and employees aligns their interests with those of the company and should be encouraged if there is no improper behaviour. To give an example, a company makes a large gas find, in one grid. It does not want to disclose that fact so that it can buy the neighbouring grids at a bargain price. It therefore, for a valid business purpose keeps the find a secret for six months. Even though the directors who know about the find would be expressly prohibited from trading in the securities under the substantive provisions of the regulations, all employees (who do not know) too would be barred from trading for six months in the shares of the company. This is obviously not an unusual hypothetical. An auto company comes out with secretive plans for introducing ‘new age’ models almost every month. Such companies would never allow employees to trade in their shares because there is a closed window for any ‘execution of new projects’. Let me clarify, that this does not in any way effect the substantive provisions which restrict insider trading.

Pre clearance of trades: Certain provisions are made for clearing of trades if certain officers/employees engage in shares of their own company. Once securities are pre-cleared, there is no necessity of prescribing just one week for the trades to occur. This would expose the employees / officers to unnecessary market timing risk. Personal experience from the market seems to suggest that it is not uncommon in large institutions for officers to get their approval for trading after weeks from the date of application. Given a one week window to execute their orders would penalize employees with market timing risk while trading in their own company’s stock. The company should be free to determine their own methodology and the window permitting execution of trade should certainly be restrictive regarding the quantity and the time frame should be far less material.

Other entities having access to inside information: Intermediaries in the capital markets like underwriters, lawyers, auditors are also required to comply with Part B of the first Schedule. The regulation of these other entities is overworked and overregulated at times and operationally impossible at other times. For instance having a compliance officer who inspects insider trades and grants pre-clearance for trades of securities of employees is absolutely uncalled for. To give an example practically every law firm advices listed companies. To have a compliance officer in every firm and monitoring of trades by each employee is completely unworkable – and even partial compliance will never happen. The fact that it is coupled with penalties of 10 years in jail, suspension, fines etc. should create a powerful argument for removal of these ‘corporate governance’ penalties for non corporates and in particular because adequate remedies are in place for actual insider trading. Certain other provisions are made for the intermediaries which need to be relooked at.

Other recommendations

There are some other provisions the Indian legislature/regulator should consider adding to the existing framework of regulations to reduce the occurrence of insider trading.

Designated or qualified brokers: To facilitate compliance with the new reporting of transactions, issuers should either designate a single broker through whom all transactions in issuer stock by insiders must be completed or require insiders to use only brokers who will agree to the procedures set out by the company. A designated broker can help ensure compliance with the company’s pre-clearance procedures and reporting obligations by monitoring all transactions and reporting them promptly to the issuer. If designating a single broker is not feasible, issuers should require insiders to obtain a certification from their broker that the broker will:

· Verify with the issuer that each transaction entered on behalf of the insider was precleared; and

· Report immediately to the issuer the details of each of the insider’s transactions in the issuer’s securities.

Derivatives amendments: Parts of the regulations refer to ‘shares’ for the purpose of proscription while they should prohibit “securities” trading. For instance, one could, using derivatives, economically sell the shares without physically trading in those shares.[1] Similarly, one can easily create synthetic securities with the same economic impact as an equity share of a company. By reclassifying shares into securities, one can eliminate the problem because securities are defined to include equity, quasi-equity, derivatives and any combination of the three. Pure debt instruments can be excluded specifically from the regulations. Similarly, under Regulation 13 the disclosure requirements should refer to not merely a 5% stake in the equity but also to a minimum stake in derivatives of the company’s securities. The minimum can be a rupee amount of the market value of the derivative (since calculating 5% of the derivatives market is neither possible and if possible not meaningful)

Civil private cause of action by contemporaneous traders: People trading in the market contemporaneously - not just the regulator or the counterparties to the insider should also have specific powers to rescind trades and charge damages to the insiders during the period when they traded. This will provide a broader remedy and will have many people exerting an economic pressure on the violator to make his trades unviable.

Proactive Stock Exchanges: The stock exchanges should take up at least a substantial burden of filing action against persons violating the regulations. Since the Rules and regulations of the stock exchanges are considered ‘enactment’, and court judgments[2] have found exchange regulations to have the force of law – they could easily enforce the requirements of the listing terms or the rules and regulations by seeking civil action in courts against persons or companies who violate such regulations. The exchanges should also better coordinate monitoring and surveillance of listed companies to track unusual activity in the stock of a company across markets for traces of insider dealings or manipulation.

Bounty system: Section 21A(e) of the American Securities Exchange Act of 1934 authorizes the Securities and Exchange Commission to award a bounty to a person who provides information leading to the recovery of a civil penalty from an insider trader, from a person who "tipped" information to an insider trader, or from a person who directly or indirectly controlled an insider trader. This could be a useful addition to cracking into new cases of insider activity.

Short Swing’ profits: There should be a regulation introduced in the Insider Trading regulations which compels an insider to disgorge or turn in profits made by insiders to the company for any transaction in equity based securities in the company’s securities (including it’s parents or subsidiary’s shares) if both the buy and sell side of the transaction is entered into within six months of the other. Such a liability should be imposed without any necessity for guilt or wrongfulness. This would be a provision which would get automatically attracted as soon as two things are established. First, the fact of being a designated insider. And second, the fact that the same securities were bought and sold within six months of each other. Such a regulation would be relatively easy to administer, since an intent of the person is immaterial. Merely the fact of the trade is sufficient to take action. Thus the appearance of impropriety is removed from the markets.

The mystery penal clause: In the schedule clause 7.1 penalises violation of the regulations and whistle blowing duties of senior officers. It is not clear whether the ‘corporate governance’ schedule is included in the duty to report a violation i.e. does it include a procedural violation as well. However, a look at Section 14 clears all doubts that one can go to jail for 10 years for violating simple or minor process oriented details.

A survey of CEOs and MDs.

This author recently carried out a survey about the perception of Corporate Governance standards amongst CEOs and Managing Directors of large, medium and small sized companies. The survey was sent to both listed and unlisted, public and private companies. The survey was also carried out amongst professionals who represent these companies as well as some institutions (10% of the respondents). The survey sought to quantify how the newly recommended standards and recommendations of corporate governance are perceived by corporate chieftains (as opposed to investors’ perceptions). Approximately 120 people responded to the survey. The three questions posed in the survey were:

1. Are the corporate governance standards as set down by the three committees on Corporate Governance too oppressive?

Answer on a scale of 1 to 10:
(1 = highly oppressive, 10 = not at all oppressive)

In response to the survey around 35% did not find the reports or their implementation oppressive at all (a rating of 8 or above); another 42% found the reports as not oppressive (a rating of 5 to 7).

Mean score was 6.3.

2. Are you in favour of a voluntary standard of corporate governance (CG) along with disclosure of standards adopted rather than mandatory regulations to enforce CG?
Answer on a scale of 1 to 10:
(1 = favour voluntary standard of compliance; 10 = favour mandatory standard of regulations).

This question elicited strong opinions which tilted in either extreme direction. 20% answered the question with a 1 and 17% with a score of 10. The rest were evenly spread out between 2 and 9.

Mean score was 5.3

3. Do you think the corporate governance ratings would solve many of the ills even without a mandatory regulatory structure?

Answer on a scale of 1 to 10:
(1 = CG ratings alone are sufficient; 10 = CG ratings need to be complemented by strong regulations).

50% favoured strong regulations (rating of 7 or above) to complement voluntary corporate governance; only 24% thought ratings alone to be sufficient (rating of 3 or below).

Mean score: 5.9

The results of the survey were surprising because of the large number of chieftains not finding the regulations burdensome. Not only do they face additional scrutiny but there is an increased likelihood that they will have to shell out additional funds in compliance costs and face reduced control over their companies (since more power would flow to independent directors, audit committees etc.). This is complemented by the higher probability of prosecution for errors of process e.g. not having processes in place for prevention of insider trading.

There may be two reasons why top managers want more regulatory scrutiny rather than less. First, the CEO/MDs are not responding to the survey in their function as heads of those businesses but also as corporate citizens and even more possibly in their role as investors in other companies. For a large number of CEO/MDs would be invested in a portfolio of securities which have returned an embarrassing return over the last several returns. Perhaps the result of the survey is at least partly reflective of this universal hurt which all investors have faced over the past decade.

The other possible explanation is what is known in economics as the “market for lemons”. In a world replete with fraud, investors in companies will not believe a company. They will assume that all companies are infested with fraud and self dealing. Share of good companies thus will not be able to trade and even if they do, they can only get bad firm prices. This would then be a market dominated by junk companies where good companies are indistinguishable from the bad ones. This is known as a market for lemons and is evidenced in the used car market. A potential buyer of a second hand car would not know if the dealer is selling him a good car or one with an inherent problem (a lemon). Second hand cars (whether in fact good or not) sell for low prices because people do not believe that a car which the dealer claims to be good is in fact good (and there is no easy way a layperson can see a car and make out the inherent problems with the engine.

In a world of lemons bad companies will lie therefore good companies will also be not believed. The good firms consequently get bad prices. Thus a second hand car which is good in all respects will be priced the same as a lemon. In such a securities market, investors suffer on lost opportunity because of asymmetrical information about the company. Because people are willing to pay only lemon prices the market in good second hand cars becomes indistinguishable and the end customer and the seller of good cars is hurt. By the same analysis, chieftains of good companies would want to reduce a market for lemons amongst companies and are therefore supportive of more regulations which will improve their own stock.

Conclusion

The core of securities regulations is the implementation of the purpose that all investors should have equal access to the rewards of participation in securities transactions. In other words all members of the investing public should be subject to identical market risks. Inequities based upon unequal access to knowledge should not be shrugged off as inevitable in our way of life. It is therefore important for there to be markets free from all types of fraud and in particular insider trading which disenchants the common investor from the workings of the markets as if he is being invited to play a game of crap with loaded dice.

Unfortunately with the unearthing of large frauds, even though India is not unique in this, the concept of corporate good governance has been lost in the war cry for blood. And as a result, the government has gotten into overregulation and micromanagement by converting good governance into statutory provisions. We tend to forget that fraudulent action cannot be stamped out by micromanagement, it can only be reduced by effective enforcement of the laws which should prohibit obvious illegalities.

It should not be forgotten that what is sought to be caught is crime and treating all insiders as inherently tending towards a presumption of unfair dealing should be avoided. Standards of corporate governance should be left at the helm of the managers of the company. The regulator should specify in the Schedule to the regulations a list of optional procedure for limiting the possibilities of insider trading. What should be mandated instead should be a statement in the annual report of the degree of compliance with the standards of set forth in the Schedule. Thus companies which do not follow corporate governance guidelines in substance would be penalized by its shareholders. The recent introduction of corporate governance ratings, similar to debt ratings, would pressure management to comply with such measures. This could be the missing link providing a simple number which can be appreciated and understood by the masses and would indicate the processes a company has put in place for the benefit of their non-insider shareholders.

[1] By selling futures in the derivatives market of the exchange.

[2] See Vinay Bubna V. Stock Exchange, Bombay, 1999 (6) SCC 215