Insider Trading And its Legal Mechanism in India - Commercial Law

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. In simple terms ‘insider trading’ buying or selling a security, in breach of a fiduciary duty or other relationship of trust , and confidence , while in possession of material , nonpublic information about the security.

Thus , in nutshell , insider trading is the buying , selling or dealing in securities of a listed company by a director , member of management , employee of the company , or by any other person such as internal auditor , advisor , consultant , analyst etc, who has knowledge of material inside information which is not available to general public

Examples of Insider Trading-

Corporate officers -, directors and employees who , traded the company’s securities after learning of significant, confidentiality corporate developments;
Employees of law, banking , brokerage and printing firms- who were given such information to provide services to corporation whose securities they traded;
Government employees – who learned of such information because of their employment by the government.

Therefore, preventing such transactions is an important obligation for any capital market regulatory system, because insider trading undermines investor confidence in the fairness and integrity of the securities markets.

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.

The first country to tackle insider trading effectively however was the United States[1].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.

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. Now SEBI has with effect from 20th February 2002 amended these Regulations and rechristened them as SEBI 9 Prohibition of Insider Trading Regulation , 1992 . These Regulation have been further amended in November 2002

Rational Behind Prohibition of Insider Trading
The smooth operation of the securities market and its healthy growth and development depends on a large extend on the quality and integrity of the market .Such a market can alone inspire confidence in investors
Insider trading leads to loose of confidence of investors in securities market as they feel that market is rigged and only the few, who have inside information get benefit and make profits from their investments . Thus, process of insider trading corrupts the ‘level playing field’

Hence the practice of insider trading is intended to be prohibited in order to sustain the investor’s confidence in the integrity of the security market.

In Samir C Arora Vs SEBI [2]
It was observed that activities like insider trading fraudulent trade practices and professional misconduct are absolutely detrimental to the interests of ordinary investors and are strongly deprecated under the SEBI Act,1992 and the Regulations made there under. No punishment is too severe for those indulging such activities.

MEANING OF Insider and Insider Trading Defined

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-
. insider" or who is an "insider;[3]
. who is a "connected person[4]
. What are "price sensitive information".[5]

Insider
According to the Regulations "insider" means 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, connection, to unpublished price sensitive information in respect of securities of a company, or who has received or has had access to such unpublished price sensitive information;
The above definition in turn introduces a new term "connected person".

Connected person
The Regulation defines that a "connected person" means any person who-
(i) is a director, as defined in clause (13) of section 2 of the Companies Act, 1956 (1 of 1956) of a company, or is deemed to be a director of that company by virtue of sub-clause (10) of section 307 of that Act or

(ii) occupies the position as an officer or an employee of the company or holds a position involving a professional or business relationship between himself and the company whether temporary or permanent and who may reasonably be expected to have an access to unpublished price sensitive information in relation to that company;

Price Sensitive Information means any information, which relates directly or indirectly to a company and which if published, is likely to materially affect the price of securities of company.

American insider trading law

The United States has been the leading country in prohibiting insider trading and the first country to tackle insider trading effectively.

Thus it is important to discuss insider trading in American perspective. While Congress gave us the mandate to protect investors and keep our markets free from fraud, it has been our jurists, albeit at the urging of the Commission and the United States Department of Justice, who have played the largest role in defining the law of insider trading.

The market crash in 1929 due to prolonged lack of investors confidence in the securities market followed by Great Depression of US Economy , led to the enactment of Securities Act of 1933 in which Section 17 of the contained prohibitions of fraud in the sale of securities which were greatly strengthened by the Securities Exchange Act of 1934The 1934 Act addressed insider trading directly through Section 16(b) and indirectly through Section 10(b).Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibits fraud related to securities trading. Further the Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading..[ Much of the development of insider trading law has resulted from court decisions. In SEC v. Texas Gulf Sulphur Co.[6], a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading. (1966)

In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. (Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.)
The Dirks case also defined the concept of "constructive insiders," who are lawyers, investment bankers and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider.

In United States v. Carpenter (1986) the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted. [7]

"It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived therefrom."
However, in upholding the securities fraud (insider trading) convictions, the justices were evenly split.

In 1997 the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O'Hagan, 521 U.S. 642, 655 (1997),. O'Hagan was a partner in a law firm representing Grand Met, while it was considering a tender offer for Pillsbury Co. O'Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options.

The Court rejected O'Hagan's arguments and upheld his conviction

The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.

The Court specifically recognized that a corporation’s information is its property: "A company's confidential information...qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty...constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another."

In 2000, the SEC enacted Rule 10b5-1, which defined trading "on the basis of" inside information as any time a person trades while aware of material nonpublic information — so that it is no defense for one to say that she would have made the trade anyway. This rule also created an affirmative defense for pre-planned trades.

In May of 2007, representatives Brian Baird and Louise Slaughter introduced a bill entitled the "Stop Trading on Congressional Knowledge Act, or STOCK Act." that would hold congressional and federal employees liable for stock trades they made using information they gained through their jobs. The bill would also seek to regulate so called "Political Intelligence" firms that research government activities and sell the information to financial managers.

Insider trading in India

In India Regulation 3 of the SEBI Regulations seeks to prohibit dealing, communication and counseling on matters relating to, insider trading. Regulation 3 provides that no insider shall either on his own behalf of any other person deal in securities of a company when in possession of any unpublished price sensitive information on communicate, counsel or procure , directly or indirectly any unpublished price sensitive information to any person , who while in possession of such unpublished price sensitive information shall not deal in securities. However, these restrictions are not applicable to any communication required ordinary, course of business or profession or employment or any law.

Further 3 A prohibits any company from dealing in the securities of another company or associate of that other company while in possession of any unpublished price sensitive information.

Insider Trading Regulations have been tightened by SEBI during February 2002. New rules cover 'temporary insiders' like lawyers, accountants, investment bankers etc.[8]

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, etc.in 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[9]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.[10] The jurisprudential basis for the 'person-connected' approach seems to be founded in the equitable notions of fiduciary duty.

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. 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.

Duties/ Obligations Of the company

Every listed company has the following obligations under the SEBI(Prohibition of Insider Trading)Regulations , 1992
To appoint a senior level employee generally the Company Scecretary , as the Compliance Officers;
To set up an appropriate mechanism and to frame and enforce a code of conduct for internal procedures,
To abide by the Code of Corporate Disclosure practices as specified in Schedule ii to the SEBI (Prohibition of Insider Trading)Regulations , 1992
To initiate the information received under the initial and continual disclosures to the Stock Exchange within 5 days of their receipts;
To specify the close period;
To identify the Price Sensitive Information
To ensure adequate data security of confidential information stored on the computer;
To prescribe the procedure for the pre- clearance of trade and entrusted the Compliance Officers with the responsibility of strict adherence of the same

Penalties

Following penalties /punishments can be imposed in case of violation of SEBI (Prohibition of Insider Trading)Regulations , 1992
SEBI may impose a penalty of not Rs 25 Crores or three times the amount of profit made out of insider trading; whichever is higher
SEBI may initiate criminal prosecution
SEBI may issue orders declaring transactions in securities based on unpublished price sensitive information
SEBI may issue orders prohibiting an insider or refraining an insider from dealing in the securities of the company

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. 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.

The importance of policing insider trading has also assumed international significance as overseas regulators attempt to boost the confidence of domestic investors and attract the international investment community. So, SEBI now should take the role of a regulator only. Special Courts could be set up for faster and efficacious disposal of cases.

References
1. Where an insider discloses the inside information to another person, otherwise than in the proper performance of the functions of his employment, office or profession. (Section 52(2) (b)).
2. 83 /2004
3. SEBI (Insider Trading) Regulations 1992[Reg2(e)]
4. [Reg 2(c)]
5. Reg 2(ha)]
6. (1966)
7. Christopher Cox, U.S. Securities and Exchange Commission Speech by SEC Chairman:Remarks at the Annual Meeting of the Society of American Business Editors and Writers
8. academyofcg.org/marchissue.htm

9. On September 15, 2002 the SEBI Board decided to relax the meaning of the term `relative' in the Insider Trading Regulations. Only direct relatives of those who are deemed to have price-sensitive insider information on securities will now come under the ambit of the Securities and Exchange Board of India (Insider Trading) Regulations. SEBI officials pointed out that the decision to exclude the third category of relatives from the ambit of the insider trading regulations comes in the wake of a host of representations saying that the existing definition of the term relative was too restrictive.

10. Regulation 2(h) identifies seven broad categories of secondary insiders within which these are a few sub-categories, such as
(a) Companies under the same management
(b) Members and employees of Stock exchanges;(c) Market Intermediaries, Mutual Funds etc
(d) Directors and employees of financial institutions
(e) Officers and employees of self-regulatory bodies
(f) Relatives; (g) Bankers

End-Notes
[1]Where an insider discloses the inside information to another person, otherwise than in the proper performance of the functions of his employment, office or profession. (Section 52(2) (b)).
[2] 83 /2004
[3]SEBI (Insider Trading) Regulations 1992[Reg2(e)]
[4] [Reg 2(c)]
[5] Reg 2(ha)]
[6](1966),
[7]Christopher Cox, U.S. Securities and Exchange Commission Speech by SEC Chairman:Remarks at the Annual Meeting of the Society of American Business Editors and Writers
[8]www.academyofcg.org/marchissue.htm
[9]On September 15, 2002 the SEBI Board decided to relax the meaning of the term `relative' in the Insider Trading Regulations. Only direct relatives of those who are deemed to have price-sensitive insider information on securities will now come under the ambit of the Securities and Exchange Board of India (Insider Trading) Regulations. SEBI officials pointed out that the decision to exclude the third category of relatives from the ambit of the insider trading regulations comes in the wake of a host of representations saying that the existing definition of the term relative was too restrictive

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