A company Z discovers a new, effective drug to cure a fatal disease. Director (D) of Z acquires this knowledge. D immediately buys the shares of Z. Subsequently, the news of the latest drug is made public. The price of Z’s shares soar in the stock market. D, who was aware of the soon-to-released drug benefits from his trading (buying of shares) vis-à-vis the others who had no knowledge of the impending announcement and may have sold their shares prior to the announcement or others who buy the shares at a much higher price post announcement.
Conversely, assume Z fails to develop the drug. The information reaches D, the director of Z. D immediately sells the shares of Z held by him. Subsequently, the failure of the findings becomes public. The share prices of Z plummet. Once again, D benefits by trading (selling) his shares from the prior knowledge acquired by him as against the public which was unaware of the outcome of Z’s experiments.
The common thread running through the above two illustrations is- D acquiring vital information about Z and accordingly acting upon his securities prior to public disclosure. In the process, D reaps profits and avoids potential losses. In short, D becomes an ‘insider’ guilty of the offence of ‘insider trading’.
As is apparent from the above, this bulletin aims to highlight the concept of insider trading, the governing laws in India, judicial precedents, and how the Indian capital market regulator, the Securities and Exchange Board of India (SEBI) has dealt with such cases.
1.0 Understanding ‘insider trading’
Literally speaking, ‘insider trading’ means dealing in securities of a company on the basis of ‘inside’ information i.e. information which is not disclosed to the public. In practice, it entails conscious misuse of unpublished price-sensitive information by ‘insiders’ such as officers, employees, directors, senior executives or any such person who is or deemed to be connected with the company(elaborated in the next section). Cases of insider trading also include circumstances of ‘tipping’ sensitive information, trading by the person ‘tipped’ and by those who misappropriate such information. It is important to understand that trading by a corporate insider per se is not illegal as long as it is reported to the company and stock exchanges.1 What is illegal is the act of trading in the company’s securities in breach of a trust on the basis of information which is not public. Therefore, there is a need to distinguish between legal and illegal insider trading. Illegal insider trading is harmful as it erodes investor confidence, hurts the small investors, distorts the market, deters flow of foreign investments (as abnormal market behaviour would send out bad signals to potential investors), and creates an unfair advantage to the insiders by destroying the level playing field. The idea is to ensure that no particular individual has an edge over the others who are also trading in the securities market. All the market players should be exposed to identical risks and opportunities. To that extent, there is a level playing field in the securities market and instances of insider trading will effect the smooth functioning of the markets. Thus, it becomes important to keep a check on such a malpractice.
2.0 Who is an ‘insider’ and when is he guilty of insider trading?
Section 2 (e) of the SEBI (Prohibition of Insider Trading) Regulations, 1992 (“SEBI Regulations”) defines an ‘insider’. The section has been analyzed below:
- Any person: (a) who is or was connected with the company, or (b) is deemed to be connected2 with the company, and
- Such person: (a) is reasonably expected to have access to unpublished price sensitive information in respect of securities of a company, or (b) has received, or (c) has had access to such information.
Hence, in order to bring a person within the ambit of the word ‘insider’, one has to establish any one of the three descriptions stated in (1) and one of the three conditions laid down in (2). Some of the expressions used in the definition connote specific meanings. It is important to understand what they signify.
For instance, the term ‘connected person’ (this is different from the phrase ‘deemed to be connected’ used in 1 (b) above) means: (a) a director or a deemed director3 (b) an officer or an employee of the company (c) a person who holds a position involving a professional or business relationship with a company and who may reasonably be expected to have an access to unpublished price sensitive information with respect to that company.4 Hence, relationship and accessibility to sensitive information facilitated by such relationship are essential ingredients. Similarly, the expression ‘price sensitive information’5 means any information which relates directly or indirectly to a company and which if publicized is likely to materially affect the price of securities of a company.
Thus, an insider is a person who by virtue of having access to privileged information trades in the securities of a company and takes advantage of the knowledge that he possesses to the detriment of others who do not have the ‘inside’ information. Merely by being privy to price sensitive information, a person does not become an insider. When a person abuses his position of trust, confidence and the fiduciary duty owed to the source of the information, he is guilty of the offence of insider trading. Also, there has to be an element of pecuniary gain for this individual.
As per Regulation 4 of the SEBI Regulations, an insider will be guilty of insider trading if he indulges in any of the following acts as stipulated in Regulation 3:
- Deals in securities of a listed company either for himself or on behalf of another person while in possession of any unpublished price sensitive information.
- Communicates, counsels or procures directly or indirectly any unpublished price sensitive information to another person.
A company will be guilty of the offence if it deals in securities of another company or its associate while in possession of sensitive information in respect of the latter.
The requirement for establishing a breach of fiduciary duty to successfully establish a violation of insider trading under regulation 4 is implicit in regulation 3 and has to be read into the same. If an insider is found guilty, he is liable to a penalty of INR 0.25 billion6 or three times the amount of profits made out of insider trading, whichever is higher.7 SEBI can also initiate criminal proceedings against the offender (section 24 of the Act) and issue orders against him viz. (a) direct him not to deal in securities in any particular manner; (b) prohibit him from disposing of any of the securities acquired in violation of the Regulations; (c) declare the transaction as null and void.
3.0 Judicial principles and precedents
SEBI has extensively referred to the US laws while interpreting insider trading regulations. Over the years, US courts have developed two theories: traditional theory and misappropriation theory. The former emphasizes on disclosing or abstaining from dealings based on inside information by insiders who by virtue of their relationship have access to such information meant for corporate purposes. Misusing the information is a breach of duty and unfair to those who do not have this information. Misappropriation theory forbids trading on the basis of non-public information by a corporate ‘outsider’ in breach of a duty owed to the source of the information.8 Essentially, under this theory, a person is liable if he misuses the information which has been entrusted to him for personal use. SEBI too has adopted these two theories.
Hindustan Lever Ltd (HLL) v SEBI was one of the first cases where SEBI took action on grounds of insider trading. HLL and Brook Bond Lipton India Ltd. (BBIL) controlled by Unilever Inc. UK were both under the same management. HLL purchased 0.8 million shares of BBIL from UTI in March 1996 two weeks prior to the public announcement of the HLL and BBIL merger. Post announcement, the price of BBIL’s shares shot up thereby causing losses to UTI. SEBI suspected insider trading and issued a show cause notice to HLL after conducting enquiries for several months. SEBI held HLL liable for insider trading. According to SEBI, HLL had full knowledge of the impending merger and misused the unpublished price sensitive information to its advantage. However, the appellate authority of SEBI reversed the order on the ground that the information was not price sensitive as it was reported in the media and, hence, was public knowledge.
As a fall out of this case, SEBI amended the Regulations to specifically provide that speculative reports in the media (print or electronic) shall not be treated as publication of price sensitive information.9
In another case, Dilip Pendse v SEBI, Nishkalp Investment and Trading Company Limited, a wholly- owned subsidiary of TATA Finance Ltd. (TFL) was a listed company. Dilip Pendse was the Managing Director of TFL. At the end of the financial year of 2001 (March 31), TFL had incurred huge losses. This unpublished price sensitive information was in the knowledge of Dilip Pendse. He passed on this information to his wife who sold her shares of TFL held in her own name and in the name of companies (Nalini Properties Limited) controlled by her and her father-in-law. The information was disclosed to the public a month later.
The above transaction occurred prior to public disclosure. Hence, the case squarely fell within the scope of insider trading. Penalty of INR 500,00010 was imposed on each of Dilip Pendse, his wife and Nalini Properties Limited.
There have been instances where the SEBI appellate authority has shown a peculiar stand. For instance, in Rakesh Agarwal v SEBI, former was the Managing Director of a listed company, ABS Industries Ltd (“the Company”). The company found a joint venture partner in Bayer, a company based in Germany which made an open offer to the Indian investors to acquire at least 51% stake in the Company. Before the open offer, Rakesh Agarwal informed his brother-in-law about the same and instructed him to purchase shares of the Company from the market (to meet the eventuality of a failed open offer). SEBI held Rakesh Agarwal guilty of insider trading. However, the appellate authority overruled the order on the ground that the motive/intention of the insider has to be considered. According to the authority, the insider did not intend to gain any unfair advantage and hence was not guilty.
The above decision was anomalous as the SEBI Regulations nowhere stipulate the presence of mens rea or malafide intention to implicate an offender. In fact chapter VIA11 of the SEBI Act does not stipulate that mens rea is an essential element for imposing penalties.
In SEBI v Cabot International Capital Corporation12, the Bombay High Court has summarized certain principles in respect of imposition of penalties:
- The relevant consideration for determining the nature of proceedings is the nature of the functions being discharged by the authority and the determination of the liability of the contravener and the delinquency.
- There can be two distinct liabilities: civil and criminal under the SEBI
- The administrative authority has to act judiciously and follow the principles of natural justice, to the extent
- Mens rea is not essential for imposing
- Though looking to the provisions of the statute, the delinquency of the defaulter may itself expose him to the penalty provision yet the authority may refuse to impose penalty for justifiable reasons like if the default occurred due to bona fide belief that he was not liable to act in a manner prescribed by the statute etc.
Therefore, in the light of the above, decision in Dilip Pendse’s case is jarring.
Insider trading is considered to be a serious economic offence. Despite regulations, several countries have found it difficult to frame insiders because of the nature of the offence. Identifying the insider and then proving the charge is an onerous task due to the heavy burden of proof involved in each case. Although SEBI has implemented laws on insider trading yet the number of offenders actually brought to book is dismal. In fact, many a time SEBI has been unable to detect instances of insider trading. SEBI Regulations do stipulate safeguards like initial and continual disclosures by insiders to companies, code of conduct to be followed by listed companies etc. but there is room for improvement.
It is important to remember that capital markets are a source of large pool of funds for all kinds of investors. Hence, it becomes important to maintain its integrity and efficiency. No body is more equal than the others and, therefore, trading by ‘insiders’ to the detriment of ‘outsiders’ should be strictly dealt with. SEBI should play a proactive and vigilant role. It should introduce greater transparencies, keep a check on sudden abnormal trends in the market, provide adequate safeguards like prohibit trading by insiders prior to corporate announcements viz. mergers, takeovers, monitor the trading patterns and undertake swift investigations in case of a spurt of buying or selling activity in the market, take stringent action against the guilty to act as deterrence for others. At the same time, it is the prerogative of companies to strictly adhere to the code of conduct prescribed by SEBI, and ensure good corporate governance in order to protect the overall interest of investors against unfair and inequitable practices of insider trading.
1 For example, in case there is a change in the shareholding or voting rights of a director or officer of a listed company, this has to be disclosed to the company and the stock exchanges. There are certain forms prescribed by SEBI in which the director has to intimate his shareholding (initial and continual) to the company. If the change exceeds INR 5, 00, 000 (US $ 12,500) in value or 25,000 shares or 1% of total shareholding, whichever is lower, disclosure has to be made in Form D prescribed by SEBI.
2 According to Regulation 2(h) of the SEBI Regulations, a person is deemed to be a connected person if he is a company under the same management or group or a subsidiary, an intermediary, investment, trustee, Asset Management Company (AMC) or an employee, director, official thereof of a stock exchange, corporation or a merchant banker, company’s banker, share transfer agent, broker, portfolio manager, investment advisor, investment company/its employee or a member of the board of trustees or board of directors of the AMC of a mutual fund or its employee having a fiduciary relationship with the company or a member of the board of directors or an employee of a public financial institution or an official, employee of a self regulatory organization recognized or authorized by the board of a regulatory body or a relative of any of the aforesaid persons or of the connected person or a concern, firm, trust, Hindu undivided family, company or association of persons wherein any of the ‘connected persons’ have more than 10% holding or interest.
3 According to section 370(10) of the Companies Act, 1956, any person in accordance with whose directions, the board of directors of a company is accustomed to act, shall be deemed to be a director of the company. Further, a director of a company shall be deemed to hold or have an interest or right in or over any shares or debentures if a body corporate other than the company holds them and the body corporate or its board of directors is accustomed to act in accordance with his directions or the director is entitled to exercise or control the exercise of one-third or more of the total voting power in a general meeting of the body corporate.
4 In terms of Regulation 2(c) of the SEBI Regulations, a connected person would also mean any person who is a connected person six months prior to an act of insider trading.
5 Regulation 2(ha) of the SEBI Regulations. The Regulation also includes information viz. periodical financial results of the company, intended declaration of dividends (interim and final), issue of securities or buy-back of securities, expansion plans or execution of new projects, amalgamations, mergers, takeovers, disposal of undertaking, significant changes in policies or operations of company constitute price sensitive information.
6 (US$ 6,250,000) 1 US$=INR 40.
7 Section 15G of the SEBI Act, 1992.
8 United States v O’Hagan (521 US 642).
9 Explanation to Regulation 2 (k) of the SEBI Regulations.
10 US $ 12,500.
11 Chapter VIA of the SEBI Act deals with penalties and adjudication of cases.
12 2004 2 CompLJ 363 (Bom).