This article is written by Megha Dalakoti of National Law University Orissa. The article has been edited by Smriti Katiyar (Associate, LawSikho).
Table of Contents
The effective functioning and governance of a corporate organisation are attributed to ensuring transparency, openness, and disclosure. To achieve these attributes, it is essential to maintain a positive relationship among the managers and the stakeholders, and embrace the faith of the investors. Investors are attracted by good corporate governance and this increases their reliance on the companies. The Directors of the companies constituting the Board of Directors play a major role in deciding the future of the company. The decisions of the board can affect the stock market reaction towards investors. Hence, the meetings and decisions of the board amount to confidential information. Confidential information is only shared when it is required for the benefit of the company. Hence, it is important to maintain the confidentiality of the information, until disclosed in public. It has been observed over the years that to gain an unfair advantage over others, the people working in the organisation manage to get their hands on confidential information and often engage in unfair trade. This is an unfair practice and morally wrong, which can have bad consequences. Hence, it is essential to curb these practices globally. There are steps taken by different governments to prohibit such practices via regulations globally.
The problem of insider trading emerged with the introduction of the concept of trading of securities in the global market. In India, SEBI regulates the functioning of the capital market. It was established in 1992 under the SEBI Act, 1992. It was necessary for the protection of investors to enact legislation and establish an authority that can regulate the securities market effectively. In 1952, it was recommended by the Bhabha committee to make it obligatory for the directors to disclose the information of sale/purchase of shares in a different register managed by the company. Consequently, Section 307 (provides for maintenance of a register by the companies to record the directors’ shareholdings in the company) and Section 308 (prescribed the duty of the directors and persons deemed to be the directors to make disclosure of their shareholdings in the company) were introduced in the Companies Act, 1956. By the Companies Amendment Act, 1960, Managers of the company were added to the scope of section 308. In 1978, it was recommended by the Sachar Committee to make stringent laws to acknowledge transaction details of traders so that it can be identified that no unfair gain has taken place by using price-sensitive Information. In 1986, a committeeheaded by G. S. Patel described the term ‘Insider Trading’ in their report recommendingto amend theSecurities Contract (Regulation) Act (“SCRA”), 1956 to allow the exchanges to implement strict policies to prohibit insider trading of information. In 1989, it was recommended by the Abid Hussain Committee to include the act of insider trading under civil and criminal offences and it was also suggested for stricter regulation by SEBI to restrain the unfair practice of Insider Trading. To regulate the unfair trade practices in the securities market, SEBI (Insider Trading) Regulations, 1992 was enacted. The regulations were amended in the year 2002.
Insider trading refers to the trading of unpublished price-sensitive information behind the corporations in order to gain unfairly or avoid loss. The Securities Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992 defines it as a breach of fiduciary duty by the officers of the company towards the shareholders. The regulations on restriction of Insider Trading were formed with the view of ensuring fair transfer and trade of securities in the market. However, it is still difficult to say that countries have successfully overcome the problem of insider trading.
Insider Trading is a practice of using confidential information (unpublished price-sensitive information) of a company to trade in the company’s securities. The unpublished price-sensitive information is not known to the general public as it is not published and is related to the decisions taken by the Board of Directors of the company. The use of such information to cause wrongful gain or loss is termed as insider trading. The information is referred to as ‘price-sensitive ‘ as it is capable of influencing a company’s securities’ price in the market.
“Insider trading is an act of buying, selling, subscribing or agreeing to subscribe in the securities of a company, directly or indirectly, by the key management personnel or the director of the company who is anticipated to have access to Unpublished Price Sensitive Information with reference to securities of the company and it is deemed to be insider trading.”
Information is said to be price sensitive if it is not published anywhere; is related to the decisions of the company; if known, it can affect the price of securities in the market; The following can amount to unpublished price-sensitive information; financial statements; declaration of dividends, public rights issue, merger or amalgamation information, buy-back of securities, information on de-mergers, policy revision or change in operations of the company.
When the trading is done by keeping in mind all the regulations and rules of fair trading, it is termed as fair trading whereas when trading is done by violating such rules and regulations for unfair gain, it is termed as unfair trading. Similarly, unfair trading is termed insider trading when such trading takes place by involving the use of unpublished price-sensitive information. It is ethically and morally wrong to share such information in the market as this provides an unfair advantage to the person possessing the information whereas the traders not having the information are left at a disadvantageous position.
In India, members of a company can trade in their company’s stocks subject to disclosure of transaction records to maintain transparency and restrict the use of confidential information. SEBI has framed several regulations on disclosure by insiders to bring the investors into confidence and ensure transparency in trading. To ensure fair market trade, the practice of insider trading is made a punishable offence in the country.
“Insiders” can be referred to as persons who are in a position to access confidential price-sensitive information, connected with the company. They use such information against uninformed investors in making huge profits before it comes to the knowledge of the public. The term “insider” has wide interpretation and includes partners, directors, officers and employees of a company and related companies, persons holding some kind of official relationship with a company, professional or business (e.g., auditors, consultants, bankers, and brokers), stockholders, government officials, and stock exchange employees, etc. It can be noted that the board of directors and employees have direct access to price-sensitive information and therefore are in a position to use such information in the manner they want. There can be instances where the insider can supply the information to an outsider and hence, deal with the outsider without letting the blame fall on him. The insider can engage in many other such malpractices and remainunnoticed. Hence, it becomes important to point out such deficiencies in the system.
The basis of insider trading is the exchange of securities willingly on receipt of some piece of confidential information that is not publicly available and which has the potential to affect the price of these securities drastically. For instance, a director of a company is aware that the company is in a bad financial state and sells his shares in the company knowing that there will be an announcement made to the public about the cut in a dividend. Similarly, the director would be engaged in insider trading if he buys more stocks in a company on receiving information about the discovery of diamond or gold on the company’s land, before public announcement expecting the price of stocks to rise on such announcement. Thus, an insider who knows that the company is in a financial mess may sell his shares in the company knowing that shortly there will be a public announcement of the news.
Any person having any kind of professional or business relationship may become a connected person and thereby an insider, if he may reasonably be expected to have access to unpublished price-sensitive information. The relationship and accessibility to unpublished price-sensitive information facilitated by such a relationship are necessary.
The effect of insider trading is borne by those who are not aware of the confidential information. Due to this, they do not deal in securities. Insider trading is unethical and amounts to a breach of fiduciary position as it involves a breach of trust and confidence. The misuse of insider information is discouraged for numerous reasons:
a) Insider takes unfair advantage over the information deprived person;
b) It results in a conflict of interest as it is beneficial for insider’s self-interest and not in the company’s best interest;
c) It lowers the market reputation and acts as a disincentive to investment.
The conditional buying or selling of securities by the advantageous person only when in possession of confidential information affects the determination of the value of those securities. Also, the possession of confidential information in question implies that the advantageous person has some connection in the corporation who is yielding the essential information to that person. He may be a director, employee, or professional adviser of that company. This is disadvantageous for the corporation as well.
Let us suppose a hypothetical scenario of insider trading activity in which a director of a merchant bank was advising a company regarding the process of mounting a takeover of another company. It was known that the publication of the information of a takeover offer could result in an immediate rise in the prices of shares of the target company or in the acquiring company. The acquisition of some shares by the merchant banker in advance of publication, at the pre-bid price, and disposing of them immediately after the announcement of the bid, would constitute the act of insider trading.
It is essential for a fair trade that insider information must not be utilised by the directors or employees to further their own interests. Doing such an act would amount to a breach of their obligation towards the company. People will lose interest in such companies. There should be a continuous check on such practices to ensure the integrity of the market is not degraded by the loss of confidence of investors. These practices are immoral, unethical and can cause damage to a large number of innocent investors.
Over time, countries have expressed their objections to such practices. The USA was the first country to tackle the problem of insider trading effectively. The United Kingdom has imposed a lot of obligations and duties on the Directors to control the transfer of confidential information. India has also developed various regulations in this regard. The Companies Act and SEBI Regulations 1992, are examples of such regulations. However, the country has not been effective in fighting such practices.
Indian law development
The Indian Government started giving importance to the issue of insider trading after independence in light of the recommendations of the Thomas Committee of 1948 which evaluated the US regulations. Subsequent to this, sections 307 and 308 were incorporated under the Companies Act, 1956 seeking certain disclosures from core insiders i.e., directors and employees. In the 1970s, insider trading was recognised as an “undesirable practice” for the first time. However, there was still no adequate enforcement provision under the Companies Act, 1956. The recommendations to formulate separate legislation in this regard were proposed by the Sachar Committee in 1979, the Patel Committee in 1986, and the Abid Hussain Committee in 1989. This led to the establishment of SEBI in 1992. The Committees made the following observations in its report:
Sachar Committee (1979)
The committee was formed in June 1977 for reviewing the Companies Act, 1956 and Monopolies and Restrictive Trade Practices Act (MRTP), 1969. The committee submitted its report recommending: Insider shall notify his intention of trading; prohibition on trade by Insiders, of the securities before and after two months of the closing of the accounting year, it shall be applicable for right’s issue also; the insider’s dealings of shares is required to be maintained in a register by the company; provision for compensation and civil remedy.
Patel Committee (1986)
The committee was formed in May 1984 with the aim of conducting a thorough review of the dealings of stock exchanges and making recommendations in that regard. The committee identified the essential need for the legislation on insider trading in the country, the absence of which was the primary cause of these activities.
Abid Hussain Committee (1989)
It was created in 1989. The committee recommended the declaration of insider trading as a civil as well as a criminal offence. It advised SEBI to form regulations in this regard. In furtherance of the recommendations by the committees, SEBI enacted regulations to curb the practice of insider trading: –
- ‘SEBI [Insider Trading] Regulation-1992’
- SEBI [Substantial Acquisition of Shares & Takeover] Regulations 1994.’
- ‘SEBI [Prohibition of Fraudulent & Unfair Trade Practice relating to securities market] Regulations-1995.’
SEBI has incorporated some significant changes to improve the then-existing Insider Trading Regulations, 1992. The regulation was amended to overcome certain loopholes that were highlighted in the cases of Hindustan Lever Ltd. v. SEBI and Rakesh Agarwal v. SEBI. The new legislation was named “SEBI [Prohibition of Insider Trading] Regulations 2002.” The definition of ‘deemed to be connected person’ (Insider) was amended to include “a person who is an ‘intermediary’, ‘investment company’, ‘trustee company’, ‘Asset Management Company’ or an ‘employee’ or ‘director’ thereof or an ‘official of stock exchange’ or ‘of clearing house’ or ‘corporation’.” The definition of ‘insider’ was amended again in 2008. In 2015, SEBI (Prohibition of Insider Trading) Regulations, 2015 were notified by SEBI which were further amended in 2018 as SEBI (Prohibition of Insider Trading) (Amendments) Regulations, 2018.
In India, SEBI is the regulating authority for insider trading. SEBI derives its power to form the regulations for insider trading under the SEBI Act, 1992. It is the responsibility of SEBI to regulate and safeguard the securities market in India. Also, SEBI keeps a check on the insider trading of securities.
The Indian market has no depth because of which it is considered to be highly volatile. However, there has been significant growth in the capital market due to the increasing number of investors, more participation of different companies, capitalisation, stock exchanges, foreign direct investment, turnover, mutual funds, brokers, etc. The growing economic reforms in the country are a big reason behind the development of the capital market. The market has also improved its volume, transparent operations, and investment holding methods by way of a depository.
The Harshad Mehta scam of 1992 and other fraudulent practices in the Indian capital market have negatively impacted the image of the market that many investors fear the credibility of investment in the security market, nowadays. Some of the common reasons for these apprehensions are:
- Activity of insider trading;
- Less transparency in transactions;
- Unwarranted transactions;
- Lack of knowledge to general investors.
Indian authorities have tried hard to regulate and encourage investment in the market through its various agencies namely, the Company Law Board (CLB), Reserve Bank of India, SEBI, and various stock exchanges.
There have been various regulations issued by SEBI to control insider trading and other mal-practices of market manipulations. However, for the first time with respect to insider trading, SEBI issued the SEBI (Insider Trading) Regulation, 1992 which was last amended in 2018.
Insider trading in India is prohibited by theCompanies Act, 2013and the SEBI Act, 1992. SEBI has formed the SEBI (Prohibition of Insider Trading) Regulations, 2015 which prescribe the rules of prohibition and restriction of Insider Trading in India.
The Regulations passed by the Securities Exchange Board of India i.e., SEBI (Prohibition of Insider Trading) (Amendments) Regulations, 2018, are applicable mainly to “dealing in securities” which involves “buying, selling or agreeing to buy, sell or deal in any securities by any person either as principal or agent, by insiders on the basis of any private confidential information.” The Regulations are only applicable to the exchange of listed securities.
The Regulations provide that the communication or dissemination of any confidential information, by an insider, is prohibited. The information communicated or disseminated must be unauthorized. The information can be used by the person himself or any other person on his behalf. If any person contravenes with any provision of the SEBI Regulations, it amounts to an offence under the Act and is punishable with imprisonment up to 10 years or a fine up to 25 crores, whichever is higher. Under the SEBI Regulations, the adjudicating officer may impose a penalty on any person who contravenes with the provisions of the regulations except for the offence committed under section 24 of the Act. SEBI also has the power to investigate the case of Insider Trading and related matters. The powers of Investigation may be exercised by SEBI for two main reasons:
- to investigate into the complaints received from investors, intermediaries or any other person on any matter having a bearing on the allegations of insider trading; and,
- to investigate upon its own knowledge or information in its possession to protect the interest of investors in securities against breach of these regulations.
Under the Regulations, promoters of the company will be held liable irrespective of their shareholding status if they are found violating insider trading norms using unpublished price-sensitive information of the company in absence of anylegitimate purpose.
There are certain exceptions to these prohibitions by SEBI such as,
- Disclosure is allowed for legitimate purposes, performance of duties or discharge of legal obligations. In the case of Dirks v. SEC, it was held that “persons like lawyers, accountants, etc. who are actually outsiders will be construed as insiders from the point at which the UPSI was shared with them under ordinary course of business.”
- Disclosure is allowed when there is an obligation to make an open offer; and where disclosure is required in the best interest of the company. In the case of Samir Arora v. SEBI, it was held that to attract a provision of Insider Trading, the unpublished private information needs to be true.
The regulation of the practice of Insider Trading has been quite a task for the Indian Authorities. The Annual Report of SEBI for the year 2016-2017 revealed that of all the investigations taken up by SEBI, the Insider Trading cases covered 14% cases (34 in number) in the year 2016-2017 as opposed to 12 cases in the year 2015-2016. With each passing year, the offence of Insider trading is significantly increasing and so is the demand for stricter regulations. The pendency of cases is also a major concern as of 34 cases investigated, only 15 were finished. The allegations of insider trading are raised on the basis of circ*mstantial evidence and lack of concrete evidence makes it difficult to detect and prove the offence. Though the regulatory system is very robust, the rate of successful cases is quite less. This is because SEBI does not hold the required technological expertise to effectively perform investigations. The acute shortage of resources and manpower is also one reason for the failure of SEBI. Further, the Indian law does not cover the cases where the offence of Insider Trading has been committed by a foreign national. There is no provision of penalty or investigation in such cases. The Acts lack the application on the extra-territorial applicability of the regulations.
There has been an evolution of the laws prohibiting the practice of insider trading to a great extent since 1992. The authorities have considered the practice of insider trading as an alarming offence and have amended the statutes with new and stringent provisions from time to time. SEBI has succeeded in punishing the offenders of insider trading to some extent.
The Directors of a company plays a major role in the preservation of the unpublished price sensitive information and hence, to eliminate the offence of insider trading and for the preservation of interest of investors in the market, it is essential to make the people who are considered as ‘Insider’ in the company, accountable for their unlawful dissemination of price-sensitive information. It is not possible to fully control the actions of the Insiders and hence, the people holding the top managerial positions i.e The directors, officers, and other members of the company should set high standards of ethical behaviour in their organisations to ensure that the company’s goodwill is not damaged. This behaviour cannot be imposed compulsorily on anyone. The Indian authorities can also focus on adapting such techniques or technologies that can help in the faster redressal of pending cases.
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