THE ECONOMIC TIMES
EDITORIAL
Hear
me out
SANDEEP PAREKH
[ SUNDAY,
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 can create inside information by his
future actions, eg. 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.
There are three means of
controlling insider trading: criminal, civil/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.
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 Rs 25 crore
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.
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 large
windows. The regulation should not asphyxiate trading by insiders.
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.
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 or months from the date
of application.
‘Process’ reporting: There
is a clause which requires the CEO/MD to consider all insider trades and
accompanying documents. This kind of time for such a routine process by an MD
is wasteful and unworkable – it is a totally unworkable clause for large
companies and such micromanagement should not be part of corporate governance,
leave alone regulations.
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.
Unfortunately with the
unearthing of large frauds, even though
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. 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 penalised by its shareholders. The recent introduction of
corporate governance ratings would ensure such compliance in at least the most
visible companies.
(The author is an advocate
and a visiting faculty at the Indian Institute of Management, Ahmedabad)