Insider Trading - An Evil For Retail Investors
Author: LawSphereX
Category: General Law
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INSIDER TRADING: AN EVIL FOR RETAIL INVESTORS
Mohd Yasin, B.B.A.LL.B. (Hons.), Galgotias University Ishita Singh, B.A.LL.B. (Hons.), Galgotias University
ABSTRACT
This paper examines the rising menace of insider trading in one of the world's fastest-growing economies, India, and its detrimental impact on the stock market's development. It begins by defining insider trading and outlining its negative consequences. It then provides concrete examples of misuse of unpublished price-sensitive information and breach of trust related to this issue. Understanding the historical context of regulatory efforts is crucial for analyzing their effectiveness, so the paper explores relevant committees and pre-1992 regulations. Next, it highlights the existing measures in place to prevent insider trading in India, including disclosure requirements, Section 195 of the Companies Act, 2013, SEBI regulations from 1992, and the more recent 2015 regulations on insider trading.
Through relevant case studies, the paper underscores the significance of addressing insider trading in India's dynamic economy. Further, the paper compares India's anti-insider trading measures with those in the UK and the USA, revealing the limitations and disadvantages of the current Indian framework. Finally, it concludes with potential reformative suggestions to propel India's insider trading regulations toward the forefront of effective market control and mitigate the economic disparities that can arise from such illegal activities.
Introduction The concept of trading in confidential information finds echoes in the UK's White Book on the Conduct of Company Directors (1977), which addressed the issue. While not yet subject to legal repercussions at the time, such practices could cause significant harm to trading entities. Maintaining public trust in directors necessitates that they refrain from leveraging privileged information for personal gain. Doing so would often constitute a breach of their fiduciary duties to the company and expose them to accusations of exploiting those they represent. Insider Trader: Meaning An insider is a person who is connected with the entity for a period of 6 months and who has information regarding UPSI (Unpublished Price Sensitive Information). Exception- If an individual holds the UPSI, then the connected period does not come into consideration.
Trading means the Buying and selling of commodities. Insider trading is the buying or selling of a company's stock or other securities based on material, non-public information about the company. This information is not available to the general public and can give the insider an unfair advantage over other investors. Scenario- Imagine a company executive who learns that the company is about to release a new product that is expected to be a huge success. This information is not yet public knowledge. The executive could use this information to buy up shares of the company's stock before the news is released. Once the news is released and the stock price goes up, the executive could then sell their shares for a profit. This is illegal insider trading. The executive used their non-public information to gain an unfair advantage over other investors.
To clarify, an "insider" possesses non-public information unavailable to the general public. This "insider information" pertains to knowledge about a company obtained by an insider before it becomes public. Such information, often termed "price-sensitive," demonstrably impacts the company's stock price in the market.
The term "insider" encompasses a broad range of individuals, including directors, officers, employees, individuals with professional or business relationships with the company, large beneficial shareholders, government officials, and even stock market employees. 1 Historical Evolution Pre-1970s: A Golden Age of Unfettered Information2 The early Indian stock market operated with minimal oversight of insider trading. Information asymmetry was not a major concern, and insider activities thrived in the shadows. 1970s-1980s: Changes are Sown Growing market maturity and scandals exposed the vulnerabilities of an unregulated environment. The Sachar Committee (1973) and Patel Committee (1987) advocated for stricter disclosure norms and penalties for insider trading, laying the groundwork for reform.
3 1992: Birth of the Regulator and Initial Regulations4 The Securities and Exchange Board of India (SEBI) is established with the SEBI Act, 1992, marking a turning point. The first set of regulations focuses on disclosure obligations for insiders and companies, introducing some level playing field. 2003-2009: Era of Landmark Cases and Continuous Improvement The Harshad Mehta scam (2001) serves as a catalyst for stricter regulations. SEBI introduces stricter surveillance and penalty measures. 1 RAJGIRI, Shradh. (2019) 'https://www. pramanaresearch. org/gallery/prj-p565. pdf,' Pramana Research Journal, 9(3), pp. 136–138. https://www. pramanaresearch. org/gallery/prj-p565. pdf.
2 Saxena, S., Pathania, B. and Shenoy, A. (2020) 'EFFECTIVENESS OF INSIDER TRADING LAWS IN INDIA:
IDENTIFYING AND ADDRESSING LEGAL LACUNAE,' Indian Journal of Integrated Research in Law, 3(3), pp. 1–4. https://ijirl.com/wp-content/uploads/2023/06/EFFECTIVENESS-OF-INSIDER-TRADING- LAWS-IN-INDIA-IDENTIFYING-AND-ADDRESSING-LEGAL-LACUNAE.pdf. 3 Vinita Sharma, V. (2017) 'A review of Insider Trading provisions in the Securities Act of leading global Financial Markets,' International Journal on Global Business Management and Research, 6(1), pp. 88–
94. https://www.rajalakshmi.org/ijgbmr/downloads/IJGBMRFeb17.pdf#page=94.
4 Ibid.
SEBI (PIT) Regulations were amended in 2009 to address loopholes and enhance cross-border enforcement. 5 2010-2015: Embracing Technology and Strengthening Surveillance6 SEBI leverages technology for surveillance and detection of insider trading activities. Introduction of trading restrictions for designated persons in connected transactions. The SEBI (PIT) Regulations, 2015, further refine the framework with clearer definitions and enforcement procedures. Challenges emerge with technological advancements and cross-border transactions, requiring continuous adaptation and innovation. Origins of Insider Trading Regulations in India In 1984, the Indian government established the Patel Committee to comprehensively review the stock exchange's operations and make recommendations.
Recognizing the lack of legislation against insider trading, the committee proposed its prohibition and drafted relevant legislation. This followed the 1978 Sachar Committee recommendations, which also addressed insider trading and inspired a draft law based on Australian legislation. This draft eventually led to the 1992 Insider Trading Regulations. 7 The 1992 Securities and Exchange Board of India (SEBI) Act empowered SEBI to ban insider trading. SEBI further defined specific types of information deemed "insider information" affecting a company's business or subsidiaries, including: Earnings forecasts or material changes Merger and acquisition proposals Significant shifts in investment plans Major contract gains or losses 5 Sharma, A. , 2013. From Hawala scam to Coalgate: An analysis of financial scams in India. Available at SSRN 2395931.
6 Ibid.
7 Bhaskar, A. and Jash, U., 2023. Insider Trading in Bharat: Appraising the Repercussions on Economic Participants and the National Exchequer. Journal of Scientific Research and Technology, pp.16-24. https://www.jsrtjournal.com/index.php/JSRT/article/download/8/8.
Disagreements with key suppliers, customers, or contractors Key product pricing or profitability decisions The Purpose of Banning Insider Trading Lord Vane eloquently highlighted the core reason behind prohibiting insider trading: "the obvious and understandable concern about the damage to the general public confidence which insider dealing is likely to cause. Therefore, the clear intention is to stop, as far as possible, what amounts to cheating when individuals with privileged knowledge exploit it for personal gain, manipulating others in the process". 8 To maintain integrity and instil fair play within the stock exchange, two crucial practices are vital: Timely and adequate disclosure of price-sensitive information by companies. Strict prohibition against trading based on such undisclosed information. Consider the case of R v.
Titheridge9, where Joseph Stock and Sons Limited was the target of a takeover bid. Mrs. Titheridge, secretary to the acquirer's chairman, disclosed confidential information to her husband, who then illegally traded in Joseph Stock shares. Both were convicted and fined £4,000, demonstrating the legal consequences of such actions. Similarly, if a company is about to announce a highly profitable year, such news will naturally cause its share price to rise. In R v. Reardon-Smith (1985)10, this scenario was explored, where an impending announcement of exceptional performance triggered market anticipation of rising share prices. Throughout history, several landmark cases have solidified the concerns surrounding insider trading. In Securities and Exchange Commission v. Texas Gulf Sulphur Co. 11, a successful test drill by the company uncovered significant copper and zinc deposits.
News of this discovery rapidly spread, causing the stock price to double even before official confirmation or public 8 Singh, A. and Kumar, A. , 2014. Insider Trading: Comparative Analysis of India and USA. Available at SSRN 2552418.
9 R v Titheridge & Titheridge (1983) (unreported, see 1983 4 Co Law 117).
10 Reardon Smith Line Ltd v Yngevar Hansen-Tangen (trading as H. E. Hansen-Tangen) [1976] 1 WLR 989.
11 SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).
knowledge. The court held the company liable for compensating investors who suffered losses due to this information asymmetry. Likewise, in Diamond v Oreamuno12, a shareholder sued company directors and officers for profiting from insider information, highlighting the legal responsibility of such individuals to conduct themselves ethically and avoid exploiting privileged knowledge for personal gain. By ensuring fair access to information and prohibiting the exploitation of privileged knowledge, we can foster a healthy and ethical stock market that benefits all participants. Laws of Insider Trading in UK and USA United Kingdom Legal Framework: Financial Services and Markets Act 2000 (FSMA) and Criminal Justice Act
1993 (CJA).
Definition: "Market abuse" (including insider dealing) is defined as trading or attempting to trade securities based on price-sensitive inside information. Penalties: Up to 7 years imprisonment and unlimited fines for criminal offences. Key elements: Similar definitions of "price-sensitive information" and "insider" compared to India, but distinct legal frameworks for criminal and civil liabilities.13 United States Legal Framework: Securities Exchange Act of 1934 and case law interpretations (e.g., Misappropriation Theory, Abstain Theory). Regulation: The Securities Exchange Commission (SEC) is responsible for preventing insider trading. Penalties: Civil and criminal penalties, including jail time and financial penalties.
12 Diamond v. Oreamuno, 29 A.D.2d 285 (N.Y. App. Div. 1968).
13 King, M. and Roell, A., 1988. Insider trading. Economic policy, 3(6), pp.163-193.
Key elements: Broader scope than the UK, encompassing not just information from insiders but also misappropriation of information and maintaining market integrity. Recent focus on areas like corporate IT personnel and political insider trading.14 Measures in Place to Prevent Insider Trading Disclosing company information serves two key purposes:
1. Deterring insider trading: Public awareness of sensitive information reduces the potential for
individuals with access to it to exploit it for personal gain through trading.
2. Levelling the playing field: Disclosure allows everyone equal access to price-sensitive
information, preventing insiders from using their advantage to manipulate the market. Before the implementation of SEBI's anti-insider trading regulations, emphasis was placed solely on mandatory disclosure of certain insider transactions as a means to curb insider trading. While regular company performance announcements can indirectly reduce opportunities for such activity, their effectiveness in the Indian context has been limited. Section 195 of the Companies Act, 2013 This section explicitly prohibits individuals from engaging in insider trading. The mandatory language ("shall") underlines the strict nature of the provision. It applies to both listed and unlisted companies, with additional regulations set by SEBI for listed companies.
Unlike Regulation 3 of the SEBI Regulations, which requires individuals with price-sensitive information to utilize it for trading to constitute an offense, Section 195's definition of "trading" doesn't explicitly state this requirement. The section allows exemptions for information communicated in the ordinary course of business, employment, or legal obligations. Furthermore, it imposes significant penalties, ranging from a minimum of ₹5 lakh to a maximum of ₹25 crore (or three times the profit gained, whichever is higher) imprisonment for up to five years, or both.
14 Fried, J.M., 2013. Insider trading via the corporation. U. Pa. L. Rev., 162, p.801.
SEBI’s Prohibition of Insider Trading Regulations, 2015 In 1992, SEBI implemented the "Chinese Wall" concept to combat insider trading. This aimed to separate departments within organizations with access to "unpublished price sensitive information" (UPSI) from those involved in trading or influencing investment decisions. This internal barrier limited the misuse of confidential information. Monitoring Chinese Wall procedures and client security trades involved designating a "restricted grey list" of securities. However, to prevent the list itself from becoming insider information, its existence and contents were kept confidential, and accessible only to the Compliance Officer. Recognizing the need for a more robust framework, SEBI introduced the SEBI (Prohibition of Insider Trading) Regulations, 2015.
These regulations establish stricter rules and a stronger legal and enforcement infrastructure for preventing insider trading. 15 Key changes include: Mandatory Disclosure: Employees exceeding a defined trading threshold (Rs. 10 lakhs in a quarter) must report the details to the Compliance Officer within two trading days. This includes trades by immediate relatives and individuals whose trades they manage. Pre-clearance for Large Trades: A new concept of "trading plans" was introduced. Any designated person (insider) or their immediate relative planning to trade securities exceeding Rs. 42 lakhs in a month must seek pre-clearance from the Compliance Officer, even during open trading windows. Closed Windows for Sensitive Periods: Trading windows are mandatory during periods sensitive to UPSI, such as the adoption and review of financial results and other significant developments.
Additionally, the Compliance Officer has the authority to close windows for specific individuals or groups if they are likely to possess UPSI. Trading Restrictions: During closed windows, designated persons and their immediate relatives are prohibited from trading any securities. 15SEBI | SEBI (Prohibition of Insider Trading) Regulations, 2015 (2015). https://www. sebi. gov. in/legal/regulations/aug-2015/sebi-prohibition-of-insider-trading-regulations- 2015_32384. html.
Advancement after 2015 Amendment Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2018 (Dec 31, 2018)16 Introduced the concept of "connected persons" who are also prohibited from insider trading based on their relationship to insiders. Broadened the definition of unpublished price-sensitive information (UPSI) to include mergers, acquisitions, and divestments. Increased the penalty for insider trading to ₹10 crore or three times the profit made, whichever is higher. Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2019 (Jan 21, 2019)17 Clarified the scope of connected persons and introduced the concept of "temporary insiders. " Mandated listed entities to disclose UPSI to designated persons within a specified timeframe.
Introduced the concept of "grey market manipulation" as a form of insider trading. Securities and Exchange Board of India (Prohibition of Insider Trading) (Third Amendment) Regulations, 2019 (Sep 17, 2019)18 Introduced the concept of "specified significant beneficial owner" (SSBO) and their obligation to disclose holdings. 16SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2018 – dated December 31, 2018 (2018). https://www. sebi. gov. in/legal/regulations/dec-2018/securities-andexchange-board-of-india-prohibition-of-insider-trading-amendment-regulations-2018-dated-december-31- 2018_41570. html. 17 SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2019 – dated January 21, 2019 (2019). https://www. sebi. gov.
in/legal/regulations/jan-2019/securities-andexchange-board-of-india-prohibition-of-insider-trading-amendment-regulations-2019-dated-january-21- 2019_41761. html.
18 SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Third Amendment)
Regulations, 2019 (2019). https://www.sebi.gov.in/legal/regulations/sep-2019/securities-and-exchange-boardof-india-prohibition-of-insider-trading-third-amendment-regulations-2019_44341.html.
Prescribed the manner of disclosure of UPSI by listed entities. Enhanced the framework for investigation and adjudication of insider trading cases. Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2020 (Jul 17, 2020)19 Introduced the concept of "alternative trading platforms" and brought them under the purview of insider trading regulations. Clarified the scope of connected persons in the context of investment advisors and portfolio managers. Streamlined the process for filing insider trading complaints with SEBI. Securities and Exchange Board of India (Prohibition of Insider Trading) (Second Amendment) Regulations, 2020 (Oct 29, 2020)20 Further clarified the scope of connected persons and introduced the concept of "deemed connected persons. " Strengthened the framework for regulating offshore derivative transactions.
Introduced provisions for cross-border cooperation in investigating insider trading cases. Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2021 (Apr 26, 2021)21 Introduced the concept of "trading restrictions" for designated persons during specific periods. 19 SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2020 (2020). https://www. sebi. gov. in/legal/regulations/jul-2020/securities-and-exchange-board-of-indiaprohibition-of-insider-trading-amendment-regulations-2020_47104. html.
20 SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Second Amendment)
Regulations, 2020 (2020). https://www.sebi.gov.in/legal/regulations/oct-2020/securities-and-exchange-boardof-india-prohibition-of-insider-trading-second-amendment-regulations-2020_48084.html. 21 SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2021 (2021). https://www.sebi.gov.in/legal/regulations/apr-2021/securities-and-exchange-board-of-indiaprohibition-of-insider-trading-amendment-regulations-2021_49947.html.
Clarified the scope of UPSI related to bonus issues, open offers, and buybacks. Strengthened the framework for monitoring and surveillance of trading activities. Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations,
2021 (Aug 5, 2021)22
Introduced the concept of "disclosures by market intermediaries" regarding suspicious trading patterns. Enhanced the powers of SEBI to conduct search and seizure operations in insider trading investigations. Streamlined the process for adjudication of insider trading cases. Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2022 (Nov 24, 2022)23 Introduced the concept of "specified persons" with stricter obligations for disclosure and trading restrictions. Clarified the scope of connected persons in the context of certain categories of individuals. Enhanced the framework for international cooperation in investigating and prosecuting insider trading Institutional Mechanism for Prohibition of Insider Trading: Regulatory Framework:
1. Securities and Exchange Board of India (SEBI): The regulatory body responsible for
overseeing the securities market in India.
22 SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Second Amendment)
Regulations, 2021 (2021). https://www.sebi.gov.in/legal/regulations/aug-2021/securities-and-exchange-boardof-india-prohibition-of-insider-trading-second-amendment-regulations-2021_51932.html. 23SEBI | Securities and Exchange Board of India (Prohibition of Insider Trading) (Amendment) Regulations, 2022 (2020). https://www.sebi.gov.in/legal/regulations/nov-2022/securities-and-exchange-board-of-indiaprohibition-of-insider-trading-amendment-regulations-2022_65437.html.
2. SEBI (Prohibition of Insider Trading) Regulations, 2015: The main legislation that prohibits
insider trading in India. Key Components of the Institutional Mechanism: a) Every listed company, intermediary, and person in possession of unpublished price-sensitive information (UPSI) must have a code of conduct that prohibits insider trading and outlines procedures for handling UPSI. b) Designation of Insiders: Companies must identify and designate employees and other individuals who have access to UPSI as insiders. c) Insiders are prohibited from trading in securities when in possession of UPSI. d) Companies and intermediaries must maintain records of all trades by insiders and UPSI. e) SEBI has the power to investigate suspected insider trading and impose penalties on violators. Financial Penalties: The minimum penalty for insider trading is Rs. 10 lakh and the maximum penalty can be as high as Rs.
25 crore or three times the amount of profits gained from the illegal trade, whichever is higher. Criminal Penalties: In addition to the above penalties, insider trading is also a criminal offense in India. The offender may be sentenced to imprisonment for up to 7 years. f) Informant and Incentive Award- The informant who knows that the Information has been leaked has two options either he can directly reach out to SEBI or can go to the Office of Informant Protection where they need to fill up the Voluntary Informant Form and submit it to OIP, then OIP forwarded the same to SEBI for further Investigation. 24
24 Bainbridge, S.M., 1998. Insider trading: an overview. Available at SSRN 132529.
If the information is true then the informant will receive the award for the same which is 10 percent of Monetary Sanctions & Subject to Maximum of 10 crore. g) The Concept of Whistle Blowing Policy. Conclusion While SEBI's recent committee initiatives addressing market surveillance are encouraging, continuous adaptation and strengthening of regulations is essential to truly deter insider trading and bolster investor confidence. To achieve this, a comprehensive "Insider Trading Policy" is needed, encompassing key elements like: Clear Blackout Periods: Specifying defined windows where insiders cannot trade company stock eliminates ambiguity and minimizes loopholes. Simplified Definitions: Clearly defining "insider", "insider information", and related terms in readily understandable language ensures wider comprehension and adherence.
Internal Compliance Officers: Companies should appoint dedicated individuals to vigilantly monitor and report suspicious insider trading activity. Independent Verification: Engaging third-party firms, like accounting professionals, to verify insider holdings adds an extra layer of accountability and transparency. Whistle-blower Program: Establishing a government-run complaint department with rewards for reporting potential insider trading incentivizes information sharing and proactive prevention. Enhanced Transparency: Extending the Right to Information Act to private companies increases public scrutiny and encourages ethical trading practices across the board. By implementing these reforms, SEBI can create a more refined and effective regulatory framework for insider trading in India.
This will foster a fairer and more secure environment for investors, ultimately strengthening the integrity and stability of the Indian stock market.