Insider Trading in U.S.

and India
Dr. Rajesh Kumar
 Background
► Capitalism and information asymmetry in the corporations
► Development and growth of the securities market and
establishment of SEC as Market regulator with the aim of
creating trust of the investors
► Insider trading Law is mostly developed not by the
legislature but by the SEC and defined by the courts.
► Legal insider trading v illegal insider trading
► Problems in prevention, detection and prosecution
► Problems in implementation
 Rationale
► Inherent unfairness in use of information by someone where
others are not having the access. ( Uneven level Playing field)
► Certain positions provides access to some information . Such
positions should not be used for personal benefit.
► Information as a corporate property should not be used in an
unauthorised manner
► Individual Selfishness and greed v Collective Selfishness
► Public confidence and trust being the main element of
securities market should not be breached by a few people.
 Idea of insider trading
• Difficulty in
• Classical theory establishing
(Connected person) link
• Extended idea of • Trading after
Insiders Insider Trading on having the
• Others having (Fiduciary)
the basis of possession but
information without
access and
possession knowledge

Legal
Material
Insider
Information
• Problem of Trading
definition
• Effect is known
only after being • Trading by Insider
disclosing trading
put in public plan in advance
domain
 Contd.
► Insider trading refers generally to buying or selling a security, in breach
of a fiduciary duty or other relationship of trust and confidence, on the
basis of material, nonpublic information about the security.
► Insider trading violations may also include "tipping" such information,
securities trading by the person "tipped," and securities trading by those
who misappropriate such information.
► Examples of insider trading cases :Corporate officers, directors, and
employees who traded the corporation's securities after learning of
significant, confidential corporate developments;
► Friends, business associates, family members, and other "tippees" of
such officers, directors, and employees, who traded the securities after
receiving such information;
 Contd.
► Employees of Company, banking, brokerage and printing firms who traded
based on information they obtained in connection with providing services to
the corporation whose securities they traded;
► Government employees who traded based on confidential information they
learned because of their employment with the government;
► Political intelligence consultants who may tip or trade based on material,
nonpublic information they obtain from government employees; and
► Other persons who misappropriated, and took advantage of, confidential
information from their employers, family, friends, and others.
► Because insider trading undermines investor confidence in the fairness and
integrity of the securities markets, the regulator has to treat the detection
and prosecution of insider trading violations as one of its enforcement
priorities
 Law of Insider Trading in U.S.
► Securities Exchange Act of 1934 Rule 10b5-1 prohibits Trading "on the Basis
of" Material Nonpublic Information
► The "manipulative and deceptive devices" prohibited by Section 10(b) of the
Act and Rule 10b-5 thereunder include, among other things, the purchase or
sale of a security of any issuer, on the basis of material nonpublic information
about that security or issuer, in breach of a duty of trust or confidence that is
owed directly, indirectly, or derivatively, to the issuer of that security or the
shareholders of that issuer, or to any other person who is the source of the
material nonpublic information.
► Definition of "on the basis of." Subject to the affirmative defenses in paragraph
(c) of this section, a purchase or sale of a security of an issuer is "on the basis
of" material nonpublic information about that security or issuer if the person
making the purchase or sale was aware of the material nonpublic information
when the person made the purchase or sale
 Defences available in Insider trading cases in U.S.
► Before becoming aware of the information, the person had:
► Entered into a binding contract to purchase or sell the security,
► Instructed another person to purchase or sell the security for the instructing
person's account, or
► Adopted a written plan for trading securities. However, The contract,
instruction, or plan described must state the specified amount of securities to
be purchased or sold and the price at which and the date on which the
securities were to be purchased or sold
► Included a written formula or algorithm, or computer program, for determining
the amount of securities to be purchased or sold and the price at which and the
date on which the securities were to be purchased or sold.
 Contd.
► Did not permit the person to exercise any subsequent
influence over how, when, or whether to effect purchases or
sales; provided, in addition, that any other person who,
pursuant to the contract, instruction, or plan, did exercise
such influence must not have been aware of the material
nonpublic information when doing so; and
► The purchase or sale that occurred was pursuant to the
contract, instruction, or plan. . . .
► Duties of trust or confidence in misappropriation insider
trading cases
 Punishment and Penalty
► Up to 20 years imprisonment
► Fines up to $5 million or twice the gain
► Criminal forfeiture of profits
► Example: assume a single trade with profits of $500,000
► Under Sentencing Guidelines, even for a first time
offender, and assuming a prompt guilty plea:
► Prison for up to 37 to 46 months on the low end
► Could be up to 70 to 87 months (depending on various
factors)
 Civil Action
► Disgorge “ill-gotten gains”
► Pay monetary penalties up to three times the amount
of those gains
► Defendants lost their jobs and their hedge funds are
out of business
► SEC bars against future employment in the securities
industry
► Under pending legislation, bar will include the hedge
fund industry
 Interpretation of law

► Trading involving fraud and deceit was prohibited .

► Therefore, we may establish three key elements that define the
scope of inside information. The first one is materiality, the second
is non-public character and the last one is the relation of the inside
information to a security.
► In the United States, the emphasis of the materiality is not on the
potential change of the price, but rather on the mind of the
investor.
 Cases : Cady, Roberts & Co. 40 S.E.C.
907 (1961)
► SEC found broker sold stock in several customer discretionary accounts
on the basis of inside information that an NYSE listed company was
about to cut its dividend
► The SEC fined the broker $3,000 and suspended him for 20 business days
from the brokerage industry
► The defendants argued that they did not expressly make false
representations or otherwise manipulate the market. Broker was fined
by the Exchange. The defendants offered a settlement under which
Broker would be suspended from the Exchange for 20 days.
► Next morning, the broker found a long line of prospective customers
lined up in front of his office. From the broker’s point of view, it was a
good investment.
 SEC v. Texas Gulf Sulphur Company
► The Texas Gulf Sulphur Co (TGS) was on a mining exploration throughout
Canada based on a geological survey. TGS began mining in a particular area
that the survey stated was promising for mineral deposits. After finding
quite a bit of minerals and then verifying their existence, TGS was quite
confident they had found a rich mineral deposit. This information was not
released to the public. Officers, employees, and others closely connected to
TGS began buying shares in the company.
► The purchase of shares by these insiders led to speculation and rumoring
throughout the industry that TGS had found a promising area. TGS issued a
false statements to quell the rumors, which actually incorrectly stated the
results of the findings. Three days later company announced the real
findings, although the news did not reach the public until four days later.
Between the initial misleading statement and the eventual correct
announcement Ds continued to trade TGS stock.
 Contd.
► The SEC brought this action for insider trading. Defendant argued the
information was not “material” and didn’t rise to the level required for
public disclosure. Persons are held guilty of insider trading on the basis
of following reasoning.
► A reasonable person would believe the information was relevant to the
share price. In this case, the uncertainty regarding the information was
not substantial enough to justify withholding the information.
► The information was material to all shareholders and Ds explicitly
traded on that basis, thus their actions constitute insider trading.
► When reviewing whether their actions constituted insider trading, the
court looked to the conduct as evidence that information was material.
 Contd.

► Defendant actually purchased the shares.

► Defendants intentionally withheld the
information from others, even going out of their
way to do so.
► Defendants purchased the shares in the
timeframe where the information was non-public
► In this case, Defendants should have waited until
the information was sufficiently public so that the
public could have a “reasonable opportunity to
act” on the information.
 Chirella v U.S.
► Vincent Chiarella was an employee in a company that prepared
tender offer disclosure materials. Although the company used codes
to hide the names of the companies involved in the tender
procedure, Chiarella managed to break those codes, and acquired
shares of a target company before the bid was announced.
► announcing the bid, the stock price of the target company went up
significantly and as a result Chiarella made considerable profits.
Although Chiarella had been caught and convicted of insider trading
and his conviction was upheld by the Second Circuit, the Supreme
Court reversed the judgement.
► Court established a new fiduciary liability rule .
 Contd .
► Court stated that in order to affirm the equal access to information principle it would have
to recognise the general duty between all participants of the market transaction to forego
trades based on material non-public information and it refused to do so.
► Instead, the court created a concept which requires a fiduciary relationship to be
established between the parties of the particular transaction, a so called ‘duty to speak’. In
other words, if there is no fiduciary duty between the parties, then trading on the basis of
inside information is not prohibited and if there is a fiduciary duty between the parties then
the duty to disclose arises.
► Court found that Chiarella had no fiduciary duties towards shareholders of the company
whose shares he acquired and, therefore, he had no obligation to disclose inside information
to them.
► Therefore, the Court had set forth two conditions under which it is prohibited to trade on
the basis of inside information: 1) Violating a fiduciary duty between the parties of a
transaction (duty to disclose); 2) Trading on the basis of material non-public information.
 SEC V Cuban

► The Securities and Exchange Commission (SEC) (Plaintiff)

contended that Cuban (Defendant) undertook a non-use of
information duty before selling his 6.3 percent stake in
Mamma.com, Inc. on the basis of material, confidential
information, and that Defendant was therefore liable of
insider trading under the misappropriation theory.
► Cuban was found not guilty and the case created the
requirement that in order to hold a trader reliable for
breaching the Rule 10b5-2, it needs to be proven that he not
only agreed to keep the information confidential but also that
he agreed to refrain from trading
 Dirks v U.S. : Extended insiders
► Dirks, received material information from insiders who wanted Petitioner
to report fraudulent practices in their company. Petitioner tipped clients
and investors by disclosing the information to them. Clients sold their
shares.
► In this case, not all the corporate agents are employees of the company,
but this category includes people from outside of the corporation.
► Court found that certain relations between the outsiders and a
corporation are qualified as fiduciary, for instance with accountants,
lawyers, underwriters, and consultants.
► Those insiders are called constructive insiders. The trial court and
appellate court agreed with Respondent, reasoning that anytime a tippee
knowingly has inside information that they should publicly disclose it or
refrain from acting upon it.
 The misappropriation principle : United States v.
O’Hagan case
► O’Hagan, a partner of a law firm that was providing legal services to a company called
Grand Metropolitan PLC that was interested in acquiring a company called Pillsbury
Company. O’Hagan did not work on the case himself, but using the information about
the planned acquisition he acquired a significant number of shares of the target
company, without disclosing that fact to the law firm in which he worked.
► The court held him liable of breaching Rule 10b-5 and made the misappropriation
theory the law of the land.
► The scope of the liability under the misappropriation theory is therefore as follows:
► 1) Duty of confidence and trust between the source of the material non-public
information and the trader;
► 2) Trader uses the information without disclosing it to the source of the information;
► 3) Trader uses the information for personal gain.
 SEC v. Dorozhko
► The court found Dorozhko liable for insider trading, even though
there was no fiduciary duty applicable to him.
► He was a Ukrainian citizen who hacked the computer of an
employee of the IMS Health Inc. and stole the financial report of
the company that was supposed to be disclosed the next day.
► Based on the information that he obtained ‘put options’ and
inquired significant profits after the report was disclosed.
► The court found Dorozhko liable for insider trading based on
fraudulent access to inside information, not the breach of
fiduciary duties.
 Salman v. United States

► In late 2016, the Supreme Court attempted once again to

clarify the crime of insider trading, this time regarding the
secondary and tertiary recipients of information commonly
referred to as “remote tippees.”

► In doing so, the Court seemed to put to rest any question

that a person who “gifts” a friend or family member with
material non-public information for the purposes of trading on
such information does in fact trigger a violation of law.
Indian Law : SEBI Act,1992 and SEBI PIT
Regulations 2015
► Insider: Fiduciary relationship
► Person Connected With The Company Or Deemed To
Have Been Connected
► Reasonably Expected To Have Access to unpublished
Price Sensitive Information received Or Access
► Connected Person Includes Inter Alia A) Merchant
Banker B) Share Transfer Agent C) Registrar To Issue D)
Debenture Trustee E) Broker /Sub-broker F) Portfolio
Manager G) Investment Advisor
 Contd.
► Price Sensitive Information
► i. If Published Likely to Materially Affect Price Of Securities
► ii. Periodical Financial Results
► iii. Declaration Of Interim & Final Dividends
► iv. Issue/Buyback Of Securities
► v. Major Expansion Plans Amalgamations
/Mergers/Takeovers
► vi. Disposal Of Whole Or Substantial Part Of Undertaking
► vii. Significant Changes In Policies/Plans
Contd.

► Unpublished
► 1. Not Published By Company/Its Agents &
► 2. Not Specific In Nature
 SEBI Powers
► Right To Initiate Criminal Proceedings Under Section
► Insider Not To Deal In Securities
► Prohibiting Disposal Of Securities Acquired In Violation
► No Communication To Deal/Counsel
► Disgorgement
► Deliver Back Securities to Seller
► Pay To Seller Market Price At Time Of Issuing
Directions Or At Transactions Time
► Transfer To Investor Protection Fund Higher Of
Cost/Market Price Of Securities
 Cases

► Rakesh aggarwal v SEBI

► Sameer Arora v SEBI
► Dilip pendse v SEBI
► HLL AND BBIL Merger case
► Abhijit Rajan v SEBI
► Balram Garg V SEBI
► A few other cases where penalty was imposed
 Prevention , Investigation and
prosecution
► Both U.S. and India follows disclosure of certain
information to the compliance officer of the company
► Company has to create a mechanism for protection of
unpublished price sensitive information
► From 2019 April , record of chain of information and
financial dealing by the insiders have to be maintained
► U.S. follows reward of tips, compliant and referral
services , whereas India still relies on complaint and
investigation
 Prosecution of Insider trading

► Problems as SEBI is not empowered for telephone

tapping or internet access
► Further, use of Whats app and Facebook is more
problematic
► Data protection and privacy issues in
implementation of laws
► Disclosing financial connections may create tax
burdens
► Other issues
 Conclusion

► Information protection network : chain of

information
► Empowering SEBI with police powers
► Pre-Clearance by Compliance Officer in case of
connected person
► Trading Window Periods
► Black-out Communications
► Use of technology for Insider Trading Policy of the
company