Insider trading - time for a requiem

In continuation to my piece from yesterday on the proposed Insider Trading regulations, my column in today's Financial Express discusses some of the defenses against a charge of insider trading. One key defense relates to conduct of due diligence. This and other defenses are discussed on today's column titled "Differentiating due diligence from insider trading". Below is the full piece:

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. This is an overdue overhaul of the insider trading norms. In my column here yesterday, I had discussed the need for the overhaul proposed and some of the significant additions and changes which will help the regulator and market participants focus on the right issues. The current formless, vague and amoeba-like development of the law which confuses the market participants and sometimes harms legitimate conduct required an overhaul.

There are many well-thought and sophisticated defences provided in the draft regulations. This column seeks to discuss a few. These include defences like trading against the insider’s interest. Thus, a person who has good news—before the good news is publicly available—and sells in the market would not be charged with insider trading. While this may be somewhat obvious, providing a clear framework giving such a defence provides clarity even to non-experts in the field.

Another significant defence against the charge of illegal insider trading is the one relating to due diligence, which caused heartburn to institutional and private equity investors under the current regulations. The current regulations virtually deem illegal all due diligence of a company before making significant investments. This occurs because due diligence gives access to unpublished price-sensitive information. Since investment is partly made on the basis of the due diligence, this falls under the informational advantage definition of insider trading. This is, of course, wrong and hurts India without providing any benefit to the investors.

Any strategic investor or even a large passive investor in a company will want to conduct due diligence before investing—the purpose of which is never to get access to inside information, but to make sure the representations made to them are correct and accurate. While reviewing the information, the person conducting the diligence—and there are many areas where due diligence is needed, such as legal or financial—may chance across a fair amount of confidential information. After all, information doesn't sit in one room with the label 'legal documents' and in another with the label 'financial documents'! In this task, there will rarely be undiscovered happy news. More likely will be the discovery of undisclosed contracts which may create legal liability or litigation or other bad news. This is, of course, the purpose of due diligence. A company will market to the investor that it has the performance of Google and the corporate governance of Infosys. To verify the company's claim, the investor will want to dig further. As discussed, information doesn't sit in sealed rooms. In the due diligence processes, the person conducting them is bound to come across significant confidential information. To give just one example, while inspecting contracts for their enforceability, the person may need to see a database of all the customers of the company and the pricing of the company's product.

The draft regulations prescribe that the company must disclose the diligence findings that constitute unpublished price-sensitive information. This is a good exemption. It will not impose an obligation to share the customer database and customer-specific pricing to the public, as some commentators will surely argue ought to be put in the public domain. If that stand were taken, the competitors will grab such information with eagerness and not only have a ready list for their marketing departments but also price their products more competitively. This, by all accounts, would hurt the company and the shareholders. In my view, due diligence should get the protection of the law so long as the board trusts the potential investor. This judgment should be left to the wisdom of the board. In any case, if an individual in the diligence team commits insider trading based on access to price-sensitive information, he can be caught and penalised. But to scare potential investors in a company from protecting their interest or alternatively, hurt the company by mandating them to act against their own interest would harm the common investors rather than protect them. It may be recalled that the interest of the potential investor who conducts due diligence is typically identical to the interests of the minority investor. Of course, any negative information, which has been suppressed from the common investors ought to be disclosed if such information has been uncovered in the due diligence. This is what the exemption provides and will be a big relief to large investors and will also provide a lot of significant hidden information to the common investors.

There are some areas which have not been considered by the committee and which need some attention. These include instruments and transactions which cannot, except in some extreme events, be subject to mischief. The focus of the regulations ought to be on equity instruments, convertibles and derivatives on equity. Also, there should be an explicit shifting of focus from very low-risk transactions. Other instruments and transactions—the LIBOR rate manipulation comes to mind—if fraudulent will, of course, already be covered by the anti-fraud rule of Sebi as discussed below.

What the regulations should do is cover insider trading and not try to capture all securities frauds. Such frauds are captured in another regulation of Sebi. Thus, the attempt to extend the regulations to market-timing mutual fund units should be avoided. That is best left to the anti-fraud Sebi (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, commonly called FUTP regulations, which in any case require a complete over-haul themselves. Similarly, countries are slowly moving towards making public authorities accountable for misusing certain confidential information in public policy. The committee makes a brave thrust in this direction by requiring public officials whose actions would impact the price of listed securities from trading in advance of making such policy or judicial pronouncements public. While this is a laudable move, the change should not be contained in the insider trading regulations but in the FUTP Regulations of Sebi.

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.

New book - Fraud, Manipulation and Insider Trading in the Indian Securities Markets

I am delighted to announce the publication of my first book “Fraud, Manipulation and Insider Trading in the Indian Securities Markets” by CCH, Wolters Kluwer. The foreword to the book is given by Mr. M Damodaran, former Chairman of SEBI. The book covers important aspects of securities regulations – fraud, manipulation and insider trading. The book also looks at common law fraud, mis-statements in public offers, mis-selling and recommending unsuitable products and carries a detailed coverage of powers of SEBI, enforcement action and remedies for investors. It covers landmark domestic as well as international cases.

I hope you will find it useful and I look forward to hearing your thought about the book and its contents on the micro-site of the book linked here.

An ebook will be available shortly, possibly today - availability at Flipkart etc. will also happen in a day or two. I will put updates on the micro site with respect to the availability.

You can buy the book today from this link.