Insider Trading: World View
Published on Tue, Oct 09,2012 | 21 54, Updated at Wed, Oct 10 at 15 09Source : Moneycontrol com
By: Ruchi Biyani, Aditya Shukla, & Nishchal Joshipura,
Attorneys, Nishith Desai Associates, Mumbai
The recent enhanced scrutiny resulting in enforcement
actions against insiders have again brought the topic of
insider trading to the fore, as one of the unresolved
challenges to good corporate governance. Regulatory
action across the world, particularly in the United States
(US), as was observed in the prominent case of Raj
Rajratnam, highlights that insider trading is on their priority
list. This is further reflected in the active and rigorous enforcement proceedings brought
about by the Securities & Exchange Commission (SEC), the securities market regulator in
the US, as well as by the US Department of Justice (DOJ).
Despite existence of stringent laws to curb insider trading, there have been only a few
cases universally where enforcement has taken place. Further, growing use of technology
and social-media networks offers both obstacles and opportunities for law enforcement. All
this has led to an enhanced policing against insider trading to boost investor confidence
and to attract the international investors.
What Is Insider Trading And What Is Illegal About It?
Insider trading refers to the practice of trading in the shares of a publicly listed company by
a person having access to material information which is not publicly available, and which
may have a bearing on the stock price of that company.
The standards and the actual conduct which attract penal action vary across jurisdictions
(see table below), but the above mentioned core elements remain the same. US has been
at the forefront of securities regulation, which introduced the Securities Act of 1933 and
Securities Exchange Act of 1934 after stock market crash of 1929 to control the abuses
believed to have contributed to the crash. The US securities regulatory framework exerts a
strong influence on other jurisdictions’ regulatory framework and enforcement actions.
Indian securities regulatory framework is no exception and it is to an extent influenced by
the US securities regulatory regime.
Insider Trading Debate
The core philosophy guiding the need to regulate insider trading is the one based on
market efficiency. The story goes like this – in order to allocate capital in an efficient
manner in an economy requires the market to be efficient. For the markets to be efficient,
market participants should have equal access to information so that they may make their
guess on the price in a narrow range resulting in an equilibrium price which is reflective of
or nearer to the fair value and hence efficient. This is possible only in a market where there
is information symmetry i.e. all market participants have equal access to information.
The fundamental characteristic of insider trading is that market participants have access to
differential information resulting in information asymmetry. Once the market participants
discover that there is information asymmetry in the market and that they might not know
some information which their counterparty might know, they start factoring this knowledge
of the existence of information asymmetry into the prices they quote, resulting in higher
spreads. Gradually, market participants who don’t have access to inside information leave
the markets after suffering losses. All this results in the markets either becoming inefficient
or in some limited cases completely collapsing. In order to prevent this outcome and to
protect the interests of market participants who do not have access to inside information,
the prohibitions against insider trading are in place. The prohibition against insider trading
helps in ensuring fairness, achieving information symmetry and ultimately market efficiency.
The Contrarian View
Regulation of insider trading has always attracted diverse viewpoints and one of such
viewpoints is the argument against regulating insider trading. The argument goes like this –
insider trading based on non-public information in public markets help in the process of
price discovery, as the actions of market participants in possession of inside information
have a signaling effect to other market participants, bringing the prices closer to their fair
value and enhancing market efficiency. It is further argued that the primary purpose of the
regulations against insider trading is to prevent manipulation which necessarily involves
moving the market prices away from fair value. Trading actions by insiders based upon
inside information help the market participants to deduce information from actions of
insiders and act accordingly, in the process moving the prices closer to their fair value and
improving market efficiency.
Although there may be strong theoretical foundation for this contrarian viewpoint, it may not
get accepted as a mainstream view in the foreseeable future because of the general
perception of insider trading being inherently unfair and harmful for small investors, and
therefore the need to regulate insider trading to protect innocent market participants.
Insider Trading Laws In Various Jurisdictions And Regulatory Reforms By
Regulators
As discussed above, US was the first to enact the law on insider trading directly through
Section 16(b) and indirectly through Section 10(b) of the Securities Exchange Act,
1934.Rule 10b-5, codified by the SEC pursuant to the authority granted to it by Section 10b
of the Securities Exchange Act, 1934, is a broad and general anti-fraud provision in law
giving the SEC authority to tackle fraud in the securities markets. After this in November
1989, the European Community Directive Coordinating Regulations on Insider Trading was
adopted by the European Union requiring all members to enact legislation by June 1992.
Keeping pace with its counterparts, India also enacted the Securities Exchange Board of
India Act, 1991 and issued various regulations including the Securities Exchange Board of
India (Prohibition of Insider Trading) Regulations, 1992 to govern trading of shares of the
company by the insiders and related disclosures. Under Indian law, an insider is prohibited
from dealing in securities of the company based on unpublished price sensitive information
(UPSI) (a concept similar to that of Material Non Public Information in the US). UPSI
means price sensitive information likely to materially affect the price of the securities of a
company which is not published by the company. In the Indian context, there have been
only a handful of notable cases such as Rakesh Agarwal, Hindustan Lever Limited which
have contributed in advancing the jurisprudence on the subject.
Overview - Insider Trading Laws Around The World
Country Law Laws first enacted* Law first Sanctions (civil / criminal)
enforced*
Australia Australian 1991 1996 Different penalty for
Act individuals and corporations.
Currently the maximum
penalty for individuals for
insider trading is a prison term
of 10 years and/or a fine of up
to A$495,000 or three times
the value of the benefits
obtained.
For corporations the maximum
penalty is the greater of a fine
of A$4,950,000 or three times
the benefit obtained, or 10% of
the annual turnover if the
benefit obtained cannot be
determined.
Britain Financial Services 1980 1981 Maximum allowable prison
and Markets Act 2000 sentence of 7 years or
unlimited fine.
India SEBI Act, 1991 and 1992 1998 INR 250 million or three times
SEBI (Prohibition of the amount of profits made out
Insider Trading) of insider trading, whichever is
Regulations, 1992 higher.
Japan Financial Products 1988 1990 Maximum allowable prison
Transaction Act sentence of 3 years.
(Translated name)
For individuals fine upto Yen 5
million plus disgorgement of
total trade value. For non-
natural persons fine upto Yen
500 million.
Singapore Securities and Futures 1973 1978 Maximum allowable prison
Act, 2001 sentence of 7 years. Fine upto
three times of profit gained or
loss avoided with a minimum
of SGD 50,000 for persons
other than corporations and
SGD 100,000 for corporations.
In case no profit gained or loss
avoided the court may impose
a penalty in the range of SGD
50,000 – SGD 100,000 on the
person.
United Exchange Act, 1934 1934 1961 Maximum allowable prison
States sentence of 20 years. Fine upto
three times of the profit made
or loss avoided. Liability for
person directly or indirectly
controlling the violator may
extend to USD 1 million or
upto three times of the profit
made or loss avoided. For
willful violations penalty may
extend upto USD 5 million for
natural persons and USD 25
million for others.
*Source: Bris, Arturo, Do Insider Trading Laws Work?, European Financial Management
(2005)/ The Economist (October 15, 2011) and other research.
Recent Regulatory Actions
After the global financial crisis, financial reforms have been on a fast track across the
world. In the US, the Dodd-Frank Act was enacted as a direct response to the perceived
failures of the regulatory mechanism during the financial crisis. New avenues for detecting
securities regulatory violations were introduced, such as, for e.g. the ‘whistleblower’
provisions in the Dodd-Frank Act. The provisions enables detection of corporate fraud by
incentivising whistleblowers in form of a percentage share of the fines/penalties imposed if
the information they provide leads to successful prosecution resulting in fines/penalties
beyond a certain threshold.
Even in India, some major regulatory developments have taken place in the recent past
with respect to insider trading. By virtue of recent amendment to the consent order scheme
in May, 2012, insider trading is now outside the ambit of the consent order mechanism. A
consent order mechanism is a process where violations can been settled by paying fine as
against full-fledged enforcement proceeding.
Inspite of stringent laws as can be seen above, insider trading being an extraordinarily
difficult crime to prove virtually goes unprosecuted as direct evidence against insider
trading are very rare and prosecution can only be carried out based on circumstantial
evidence.
Lessons For Corporates
Insider trading brings disrepute and dis-fame apart from adversely affecting the commercial
interests of an enterprise. Recent regulatory actions in different jurisdictions indicate that
regulators are now far more vigilante than ever before, especially in light of the financial
crisis. This heightened regulatory sensitivity coupled up with the risks posed by insider
trading to the long term commercial interests of an enterprise places the corporate leaders
in a position of increased responsibility, which requires them to take proactive measures to
address the risks and neutralize them.
Insider trading may result in a variety of risks which may adversely affect the commercial
interests of an enterprise. Some of the possible risks which may result from securities laws
violations related to insider trading are:
Reputational Risk
One of the biggest risks which an enterprise may face following an insider trading violation
is the damage such a violation may cause to the reputation of an enterprise. An insider
trading scandal may bring negative publicity to the enterprise and may affect its commercial
interests. This may pose challenges in retaining existing client(s)/business, acquisition of
new client(s)/business and retaining/hiring talent.
Access to Capital
Although not always, there is a possibility of a fallout in case a company gets embroiled in
an insider trading case in the form of reduced access to capital as investors become
cautious about investing in a so-called ‘tainted’ company. Further, there might be a
possibility that the cost of capital for the company may increase as a result of it being
involved in an insider trading scandal. Additionally, some significant market participants
such as pension funds may avoid investing in the company altogether owing to their
investment criteria based upon principles such as for e.g. good corporate governance
practice being followed in their portfolio companies.
Distractions Due to Regulatory Proceedings
One of the most damaging fallouts of a company being involved in an insider trading
scandal is the distraction it causes both to the management and the company as a whole
while the investigation is ongoing. It also hampers employee morale. The management
becomes preoccupied with tackling and defending the company in the investigations, in the
process losing sight of the strategic goals of the company.
Civil/Criminal Liability
A possibility of a heavy civil or even a criminal liability also poses a significant risk to the
operations of the company. Another possible action which the regulators resort to is to
restrict the company from accessing the capital markets for a defined time period, thus
foreclosing one of the important avenues for raising capital for the company.
In light of the above mentioned risks, it becomes very important for companies to address
the risks emanating from an insider trading scandal in a systematic and organized manner.
It is often observed that having a formal system and process in place capable of
reasonably detecting violations; taking of corrective measures; being forthcoming with the
regulatory authorities and cooperating with them during investigations is invariably always
helpful in setting the tone for future interactions and is generally seen in positive light.
In summary, the enhanced insider trading scrutiny in the recent past has forced
corporations across the globe to reassess and rethink their internal processes and
approach towards insider trading. The need to address insider trading goes beyond policy
objectives of governments, and into the core of corporate existence, having a bearing on
the commercial interests of an enterprise in todays connected world. Enforcement
approaches adopted by a regulator in one part of the world may be replicated by other
regulators, the same holds true for corporate best practices to be adopted to prevent such
violations. In a globalized world lessons may be learned and applied across borders, in the
process addressing issues which may crop up in future. It’s about time that corporate
leaders explore this path.
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