19 January 2011

Looking inside insider trading laws

I have a piece today in the Economic Times on insider trading. While I acknowledge that no one really gets insider trading laws right (including myself), I think a fundamental re-think is quite essential - especially in India where the law is so broad that it can catch innocent conduct. Not just that, the law even catches outsiders for outside traders which is in the interest of the shareholders of the outsider. Here is the full piece:

The law on insider trading is one which everyone thinks they understand but is amongst the most misunderstood laws in the financial sector . The hubris that they understand this law extends not only to market participants and lawyers but to regulators and judges. The problem is universal and is by no means unique to India or the developing world. While I claim no higher understanding of this law, like the Greek philosopher at least I know that I don’t know. Here are some of the issues I think are important and which need resolution in the Indian context.

The classic insider trading violation is when a senior officer or director who is privy to price sensitive inside information, like a quarterly profit report, trades based on such information before disclosure is made to shareholders of the company. Such trading is outlawed virtually the world over because it is a violation of the fiduciary duty of the insiders to their shareholders, and are thus obliged to keep shareholder interest ahead of their own. Unfortunately, there is a vast minefield outside this simple scenario. The minefield exists both in countries which do not define but outlaw insider trading (US) and which define and outlaw insider trading (India ). The haze surrounds such basic issues as the definition of an insider, what is inside information and when does violation occur.

First, insider trading has to be insider trading . Sounds axiomatic? It isn’t . When an acquirer seeks to acquire a listed company, the information about the potential acquisition within its domain is price-sensitive , but is outside information. If anyone knows through an information leakage from the acquirer that a takeover is planned, they may trade ahead and make a profit. This trading ahead has often been wrongly branded as insider trading, even though the information is outside information rather than inside information . A slight variation of this was evidenced in the Hindustan Lever Limited (HLL) insider trading case, where there was no trade based on inside information, but rather a trade by HLL ahead of its own merger with a target company. The price-sensitive information thus was the swap ratio rather than any inside information. If an IOSCO (a global body of securities regulators) report on insider trading is to be believed, India is perhaps the only country in the world to penalise outside information ‘It appears, however , that the best approach is to include in the definition of inside information only information relating to the issuer, rather than information concerning other entities’ .

Second, the definition of insider itself has been amended post the HLL case to include not just insiders like directors and senior management who have access to inside information but to any person who ‘has received or has had access to [such] price sensitive information’ . While this definition surely includes tippees of the inside information , for instance the wife of the director, whether this includes: a) the company’s sweeper, who is not a fiduciary of its shareholders ; b) one who has access to outside price-sensitive information like a takeover bid; c) millions of readers who reads the ‘heard on the street’ column of this newspaper , assuming the news is accurate; d) a private equity investor who does due diligence and invests in a company; e) an equity analyst who uncovers fraud and tells his clients to sell their stock. To include any of the five would in my opinion be wrong and is such a violent departure from the principles based on which the law was developed around 110 years ago because it not only outlaws unfair conduct but also legitimate trades. Even where unfairness occurs (as in the sweeper example), can a law treat pickpocketing on the same level as a person who picks up a hundred rupee note from the street? 

Third, almost throughout the world, insider trading is restricted to individuals like senior employees who misuse inside information . India amended the law post the HLL case to include companies and worded the violation even more broadly. The Indian law on companies’ possible abuse of insider trading absurdly makes no reference to inside information or being an insider. Thus, for acquiring companies with no access to inside information, which trades based on the knowledge that their bids will drive up the price of the target company, would have committed a crime of insider trading even though it is the company and its shareholders who are gaining from such a transaction . In other words, while insider trading typically arises from a breach of fiduciary duties around much of the world, in India being faithful to your shareholders can be a crime even without being an insider and without trading on insider information.

An excessively broad and vague definition ironically contradicting the very name of the regulation in its plain English meaning makes offenders out of honest traders and makes it difficult for people to determine whether their innocuous actions are legitimate or criminal.


Anonymous said...

very good analysis but if we take this advise seriously we cannot solve any insider trading case. It would be obviously that insider who is in position and is in possession of the unpublished information will never trade in his own name and going by the logic given in the article we cannot book the sweeper even though he has dealt on the inside information and made money. Regulations should always give more wider options to the regulators so that the same can be used to catch the violators who gets away with the loopholes in the regulations or with the narrow interpretation of the law.

Sandeep said...

I don't think if we take this advice seriously - we cannot solve any insider trading case.

Yes, the sweeper (asumming he has made an accidental discovery), unless a tippee will not be prosecuted under the classical theory (and many countries do catch any possessor of inside information).

But I don't think any of the 4 other examples would sensibly be made violators in any jurisdiction.

Anonymous said...

From what I understand, the standard of proof in insider trading cases is sufficiently high (in any SEBI proceeding, it lies between preponderance of probabilities and beyond reasonable doubt anyway), such that whilst one may fall foul of the definition, but may still be given benefit of doubt if how exactly the information was used cannot be proved. Therefore, it would make sense to have such a wide definition rather than a narrower one. Correct me if I am wrong.