15 November 2012

Insider trading – the optical illusion of failure

I have a piece in the current issue of Outlook Business. In brief it's a contrarian view that SEBI is an ineffective regulator of insider trading and that insider trading is extremely pervasive in India. My view: a) SEBI is active in the space (half the output with one hundredth the manpower of the US SEC) b) the problem may be pervasive but it's not as serious as in the west (in terms of size of loot) because of the type of investors in the west (big hedge funds with the wrong incentives) and the quality of audit trail in India (superior). Here is the full piece - feel free to disagree strongly in the comments:

"Insider trading has been a hot topic of discussion worldwide. It has been no less interesting in India, but chiefly because a large number of US cases of insider trading in the past three years involved people of Indian or Sri Lankan origin. The most high profile of the lot, Rajat Gupta, was recently sentenced to two years of imprisonment. Gupta who was born and mainly educated in India, headed blue blooded McKinsey globally and sat on various boards including that of Goldman Sachs. His fall from grace from one of the most high profile and respected individuals to one of shame and criminal conviction will probably give rise to several books on the subject.

However this piece is not about us looking outside at western systems, but looking inwards at the Indian system and how it engages with and fights insider trading. Here, I have a contrarian view. A view which few people will agree with at first blush. In my view the problem  of insider  trading is far less serious in degree in India than in many western countries. This is not saying that it is not widespread - it may be. I will explain my position shortly in case you are bewildered by this assertion. First let us restate a commonly held view of insider trading in India.

Attend any dinner conversation, and any discussion of corporate ethics will invariably have a mention of how rampant insider trading is in India. In the past year, there will also be an invariable comment on how efficient the US system is in punishing such trades and how everyone gets away with such trades in India. There will also be accompanying snorts and chuckles to support this universally acknowledged truth. To be sure, there has been some statistical evidence of insider trading before a market event. So there is no denying the fact that there is in fact insider trading activity going on - possibly based on some tips by employees of the company to friends and relatives.

However, the data on enforcement actions against classic insiders, like promoters and senior management and their relatives, points in a different direction. A vast bulk of the enforcement actions taken by SEBI relates to insider trading of merely one to five thousand shares. There are also cases involving a few hundred shares. There are some examples of much larger numbers, but most of them have either not been upheld by SAT (a recent order), relate to outsider trading (Hindustan Lever - where trades occurred in a target companies shares rather than where the inside information arose i.e. the acquirer) or are cases of front running, a different offence.

This data is surprising, but not inconsistent with the widely held belief of widespread insider trading. In other words, there appears to be many people doing low level insider trading, or even digging out some informational advantage even without any illegality. But few if anyone is doing insider trades in the millions of shares or even a fraction of that number. And I can think of two reasons which come to mind why this is the case in India. First, we don’t have the class of investors who exist in the US, classic hedge fund managers who have a strong incentive to beat the market returns of the index. Since it is difficult to beat the market, and since the managers get to keep 20% of the profits of investors’ money there is a strong incentive to commit insider trading. With the size of the funds which many of these managers invest running into billions of dollars, they can’t possibly do insider trading in a few thousand shares - they must necessarily do it in very large numbers. Thus the chance of getting caught also increases substantially. Second, the Indian system is far more transparent and the audit trail is very clear. As opposed to more opaque systems of holding in ‘street names’ for instance in the US where brokers hold shares  on behalf of investors in their own name, in India every investor buying a single share must provide an income tax PAN card number and shares must be held in their own name. The complete trail of purchase of securities and transfer of funds ensures that promoters and senior management are either not committing  illegalities are or are doing it by dividing it through dozens of other people, each one buying not more than a few hundred or thousand shares. Given the easy access to phone records (not phone taps) it is not impossible to connect the dots between these people.

Since insider trades occur at these small numbers, catching such persons is far more difficult as it is easier to merge with the crowd and assert lack of any access to inside information. Also, connecting a person who bought a thousand shares with the actual insider through phone call records may not be sufficient evidence as a judge is likely to ask why a person who had access to inside information profited only in such a limited manner. In  other words, short of access to the actual phone conversation, it would be difficult to prove that the trade occurred based on the access to inside information.

Even though Indian law is strict and imposes a deemed insider status on a variety of people who can be expected to have access to information - like lawyers, auditors or relatives of senior management, courts have not imposed the standard strictly. This is natural because the deeming provision imposes harsh standards of ‘guilty till proven innocent’ and judges are naturally averse to such an inverted frame of evidentiary law. Particularly so when the numbers traded are small.

Third, insider trade tips occur in the privacy of a room or on a phone conversation, where both sides are interested in not disclosing the illegal event.  Thus the evidence gathering is fairly difficult and  must usually be by way of gathering circumstantial evidence. Given the serious nature of the violation, insider trading is seen as a type of fraud, judges often apply standards of evidence closer to those applied in criminal convictions rather than those of civil suits.

Lastly, SEBI has a limited staff. Compared to an enforcement staff of over a thousand professionals in the US SEC, twice the entire strength of SEBI, clearly the evidence hungry insider cases will be fewer in number than in the US. Last year, according to the SEBI annual report (2011), the regulator brought around 30 new cases of insider trading. The relevant enforcement staff of SEBI would be under a dozen people working on such cases. Compared to the staff strength in enforcement the SEBI actions are actually quite large compared to their US counterpart’s bringing of 57 cases of insider trading (source annual report of the SEC, 2011) with an enforcement staff strength which is almost a hundred times larger.

Therefore, in my view, there clearly are challenges in catching insider trading in India, because there are many people doing it and because they aren’t doing too much of it at the same time. At the same time the opportunity costs of not pursuing other violations which may be easier to prove because of direct evidence must not also be discounted. That is not to say such cases should not be pursued with greater force, which they must. But that is to say that whipping SEBI for not doing much is not accurate."

1 comment:

Anonymous said...

Sandeep, I don't see where one can disagree with you here, let alone disagree strongly. Your comments are bang on target. But a couple of points, not exactly in disagreement.

As you rightly point out, Insider Trading (IT) in the US today is much more like organized crime, with hedge fund managers and expert network firms using a well cultivated network of insiders for large scale commercial advantage. This fact makes some of the traditional economic arguments in favour of permitting insider trading (market efficiency, effective executive compensation scheme) look a lot less convincing. On the other hand, Indian insider trading seems more like small time theft.

Some people are bothered by the fact that the Indian IT law brings in its sweep plenty of outsiders. But one should not read too much into the term `insider trading’. It’s just a term of art for the more formidable `trading on the basis of material / price sensitive non-public information’. So once someone is held to be an insider (deemed or otherwise), I don’t see why the same evidentiary rules should not apply to determine his / her guilt.

If you permit, your invitation to disagree strongly is reserved for another occasion!

-Mangesh Patwardhan