19 December 2013

Insider trading proposals - good overhaul

In the first part of a two part article on the insider trading regulations as proposed by a committee of SEBI, I discuss why punishing fraud and focusing less on “unfairness” should be at the heart of laws against insider-trading.

Copied below is the full piece Overhauling insider trading laws from the Financial Express. The second part will follow tomorrow.

The advisory committee for the review of the SEBI (Prohibition of Insider Trading) Regulations, 1992, constituted under the chairmanship of Justice NK Sodhi has submitted its report to SEBI and is in the public domain for comments. The report, along with draft regulations, would form the foundation for a new law governing insider trading laws in India. The draft regulations proposed under the report seek to infuse clarity and predictability into the regulatory mechanism.

While I am rarely an advocate of the complete re-writing of a law, I believe the prohibition of insider trading is one of those few areas which actually needs an overhaul. The reason I am usually against re-writing a law is because the decades long jurisprudence which has formed around the legal provision as interpreted by courts is lost. The beauty of the common law system is that statutory provisions provide the broad skeleton to the law while the flesh and ligaments to the body are provided by case law. This provides a human form to the rather inert written-law and also gives flexibility to the law to grow and adapt. Unfortunately, the case law on insider trading till now has created an amoeba rather than an agile human being. The case law till now is both amorphous and unclear. For instance, despite the name of the regulations, trading based on outside information has been prohibited. A classic example is a hostile acquirer whose acquisition plan of a target company will increase the price of such target. This is by no stretch of imagination inside information. Yet more than one case has held it to be. While courts can stretch the definition at times, it is almost perverse to use the antonym of the word used in the title of the regulation to pass a penal order, i.e., ‘insider’. The law is against insider trading with its origins in fraud, not outsider trading based on some perception of unfairness.

Before we can get into the recommendations, it would be useful to peep into the soul of the prohibition against insider trading. The origins and soul of insider trading lie in the general rule against fraud in securities markets. In fact, one securities appellate tribunal case explicitly connects the two despite the regulations not requiring fraudulent conduct as an element of insider trading. Since an insider, say a director, has a fiduciary duty to the company/shareholder, such insider is supposed to put the interest of the shareholder ahead of their own interest. With special information available to them as a fiduciary, trading against such shareholders in the absence of disclosure would amount to breach of a fiduciary duty and fraudulent conduct.

There is a significant and important distinction between fraud and unfairness. The former is illegal, the latter merely undesirable. Income inequality may be unfair, but we don't penalise rich people. More accurately, one can draw an analogy between theft from someone's pocket which is illegal and a situation where a person finds a hundred rupee note on an empty road and picks it up, which is not illegal but can be called unfair. Equating the two is treating unequals as equals, and therefore is wrong. This, in summary, is the debate worldwide between classical insider trading (fraudulent) and parity of information rule (unfairness). While India has, in the past and in the report, chosen the latter route, my own preference is for the former. The report does however make an effort to pull towards the anti-fraud definition as explained later in this piece.
There are two ways to prohibit insider trading. One is to rely on the law against securities fraud to capture insider trading. This is the route the US law has taken—they have assiduously avoided defining insider trading for the past half-century, even though they have provided penalties for insider trading. This route leaves the prohibition completely in the territory of the courts without any guidance from written law. The US had the luxury of time as the law evolved slowly over decades out of case law on fraud. The other is the path of trying to define insider trading and prohibiting it. This is of course the easier path, but runs the risk of being both over-broad and over-narrow depending on which sub-area one looks at. Though only the second route is open to us, there is a need to draft this law extremely carefully. It is very easy to get the law over-broad and over-narrow, over-specific and too-vague all at the same time.

Keeping this in mind, the committee has done a commendable job in drafting the regulations. The prohibition reads as “No insider shall trade in securities that are listed on a stock exchange when in possession of unpublished price sensitive information relating to such securities". As the word 'possession' should alert the reader, the committee recommends the unfairness standard rather than the fiduciary/anti-fraud standard. To give a practical example, imagine two directors who have exchanged price-sensitive information through email. The email is marked by mistake to a third party, this third party trades based on such information. Under the possession theory, the third party would be liable even though neither the director has tipped the information dishonestly, nor has the third party stolen the information or breached any duty. This standard penalises unfairness rather than fraud. While I support the latter standard, the committee has while supporting the possession standard, somewhat veered towards the anti-fraud rule. This it does through providing a defence in the draft regulations, which protects an "innocent recipient" of unpublished price sensitive information. This is an acceptable, if not the perfect answer, to the unfairness versus illegal debate.

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