Company Law - INSIDER TRADING AND THE ROLE OF DIRECTORS

Introduction

Transparency, openness and disclosure are the hallmarks of today’s Corporate Excellence and Governance. There is a need for positive relationship, between the management and the stakeholders, and faith which the investors have imposed for redeeming the Board’s functions. Investors rely more upon the company’s governance and market rewards. Many of the Board decisions have a greater impact on the stock market reaction to the scrip of the company and as a result decisions of the Board are considered to be confidential information, till they are published. However, in actual practice there have been several cases, where the persons inside the company manage to get information about the decisions of the board meetings and utilized them for unfair purposes. This is considered not only as bad in practice but shall have wide repercussions. Globally concerns have been expressed about the insider trading practices and they are lawfully prohibited.

Insider is any person who accesses the unpublished price sensitive information of a company before it is available to the general public. Insider may be two groups; Registered or Inside insiders include corporate officers, directors and owners of firm, who may be having substantial interest in the equity of company. Outside Insiders - these are neither corporate officers nor large shareholders; however they may have access to non-public information due to their relationship with the entity. Insider Trading is the act of buying and selling of securities by a person having unpublished price sensitive information {which is not available in the market} with the intention of making abnormal profits and avoiding losses. This ‘Price Sensitive Information’ includes dividend declaration, issue or buy-back of securities, amalgamation, mergers, or takeovers, major expansion plans, or execution for new projects, disposal of whole or part of undertaking, change in polices plans, or operations etc. In this project work, my objective is to find out the ingredients of the price sensitive information and the responsibility of directors in this regard.

Research Methodology

Subject: Company Law II

Area: Corporate Governance

Topic: Insider Trading and the Role of Directors.

Introduction: Transparency, openness and disclosure are the hallmarks of today’s Corporate Excellence and Governance. There is a need for positive relationship, between the management and the stakeholders, and faith which the investors have imposed for redeeming the Board’s functions. Investors rely more upon the company’s governance and market rewards. Many of the Board decisions have a greater impact on the stock market reaction to the scrip of the company and as a result decisions of the Board are considered to be confidential information, till they are published. However, in actual practice there have been several cases, where the persons inside the company manage to get information about the decisions of the board meetings and utilized them for unfair purposes. This is considered not only as bad in practice but shall have wide repercussions. Globally, concerns have been expressed about the insider trading practices and they are lawfully prohibited.

Objectives: This research paper aims to explain the practice of Insider Trading prevalent in the Corporate System and the ways by which the Directors compete with the same.

Research Methodology: The methodology used in this research paper is deductive in nature.

Research Tools: The Research Of this Project was carried out with the help of the Internet and in the Library of the N.L.U. The tools used are mainly books and websites along with the primary Journal references.

Footnoting style: In whole of the Project Uniform Footnoting Style is adopted in conformity with the Harvard Blue Book as well the type of footnoting followed in National Law University, Jodhpur.

Sources of Information:

 Books

 Websites

Insider Trading and the Role of Directors

Insider trading denotes dealing in a company's securities on the basis of confidential information relating to the company, which is not published and not known to the public, used to make profit or avoid loss in the transactions in securities of the company. 'Insider' is a person who has knowledge of facts not available to the general public, and 'insider information' implies information about a company's affairs that is obtained by an insider before the public obtains it. The information is, of course, 'price-sensitive ' meaning that it is likely to have an impact on the company's securities' price in the market.

The insider trading is said to be indulged in when persons connected with the company, possessing confidential unpublished information, which is likely to affect the price of the company's securities, deal in the securities for their own profit (either by making gain or avoiding loss).

Unpublished price-sensitive information:-

An insider can be held guilty of an offence of insider trading if he has dealt in a company's securities on the basis of unpublished price-sensitive information in his possession or received by him, by virtue of being connected with the company or deemed to be connected with it. A piece of information will be regarded as unpublished price-sensitive information if:-

a) It relates to or concerns the company;

b) It has not been published by the company;

c) It is, if published or known, likely to affect materially the price of the securities of the company in the market.

The information relating to the following matters will be treated as unpublished price-sensitive information:-

a) Periodical financial results (both quarterly and annual) of the company;

b) Intended declaration of dividends (both interim and final);

c) Issue of shares by way of public rights, bonus, etc;

d) Buy-back of securities;

e) Any major expansion plans or execution of new projects;

f) Amalgamation, mergers and takeovers;

g) Disposal of the whole or substantially the whole of the undertaking;

h) Any significant changes in policies, plans or operations of the company.

Who is an ‘insider’?

"Insiders" are persons connected with companies who are in a position to take advantage of confidential, price-sensitive information before it becomes public and thereby make speculative profits for themselves to the detriment of uninformed public investors. The word "insider" has wide coverage. It includes directors, officers and employees of a company and related companies, persons with professional or business relationship with a company (e.g. auditors, solicitors, bankers and brokers), large beneficial shareholders, government officials and Stock Exchange employees, etc. As a matter of course, directors and employees have most (and direct) access to price-sensitive information and are therefore most likely to deal or tip other persons to deal on the strength of such information. However, this practice is not limited to directors but can be engaged in by anyone who has access to such information. In this sense, an outsider may be held to be an insider by virtue of his engaging himself in this practice on the strength of inside information coming to his knowledge or obtained by him either directly by reason of his being connected with the company, or indirectly from anyone who is connected with the company.

The basis of insider trading is the buying or selling of securities while knowingly in possession of some piece of confidential information which is not generally available and which is likely, if made available to the general public, to materially affect the price of these securities. So, for example, there is insider trading where a company director knows that the company is in a bad financial state and sells his shares in it knowing that in a few days time this news will be made public together with an announcement of a cut in dividend payment. Likewise, the director would be insider dealing if, on being informed before it was generally known by the public, that the company has discovered oil or gold on its own land, he bought more shares in the company in the not unrealistic expectation of an increase in their market value as a result of the subsequent public 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. Similarly, a director of a company who is aware that the company has bagged a huge export order may buy more shares of the company in anticipation of a rise in the price of the company's shares.

The following persons will be treated as connected persons, i.e. persons connected with the company:-

a) A director or shadow director of a company,

b) An officer or employee of a company,

c) A person having professional or business relationship with a company, if he may reasonably be expected to have an access to unpublished price-sensitive information in relation to that company.

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 an access to unpublished price-sensitive information. The relationship and accessibility to unpublished price-sensitive information facilitated by such relationship is necessary.

Why is insider trading frowned upon?

Insider trading causes injury or detriment to those who do not possess such information and therefore do not and cannot deal in the securities. Insider trading, as it involves misuse of confidential information, is unethical amounting to breach of fiduciary position of trust and confidence. The misuse of inside information is bad for several reasons:

a) it involves taking a secret, unfair advantage;

b) it gives rise to potential conflicts of interests in which the company's best interest may wrongfully take second place to the insider's self interest , and;

c) it brings the market into disrepute and may be a disincentive to investment.

The insider buys or sells securities when he, but not the other party to the transaction, is in possession of confidential information which affects the value to be placed on those securities. Furthermore the confidential information in question is in his possession because of some connection which he has with the company whose securities are to be dealt in (e.g. he may be a director, employee or professional adviser of that company) or because someone in such a position has provided him, directly or indirectly, with the information.

A realistic hypothetical scenario in which insider dealing could occur might involve a director of a merchant bank which was advising a company in the process of mounting a takeover of another company. The fact of the announcement of a takeover offer could well have an immediate effect in pushing up the value of shares in the target company and perhaps also in the bidding company. If the merchant banker in question had acquired some of those shares in advance of the bid announcement, at the pre-bid price, he would be indulging in insider dealing if he disposed of them following the announcement of the bid.

Public confidence in directors and others closely associated with companies requires that such people should not use inside information to further their own interests. Furthermore, if they were to do so, they would frequently be in breach of their obligations to the companies and could be held to be taking an unfair advantage of the people with whom they were dealing.

The practice of insider trading needs to be checked to maintain investor confidence in the integrity of the securities market inasmuch as the use of inside price-sensitive information by insiders for their personal advantage is not only not conducive to good business ethics and morally wrong, but it may damage public confidence in the securities market.

Insider trading or dealing is a practice which most countries have now recognized to be objectionable. The first country to tackle it effectively was the United States of America. The Securities Exchange Act of 1934 of the US imposes statutory curbs on insider trading, requiring public disclosure of insiders' transactions in the shares of their companies and providing for recovery of 'short swing' profits made by them. The Act provides remedial measures for protection of investors against sharp practices and fraudulent schemes by insiders in making short-term, speculative profits. A corporation or issuer of a registered security can recover all profits realized by an insider, by unfair use of information which he may have obtained by reason of his relationship to the issuer, from any purchase and sale or vice versa of the security, within a period of 6 months. The quantum of compensation to the injured shareholder is determined by the federal court.

Apart from the above legislative measure, in the USA, the Supreme Court and Courts of Appeals of every State have issued guidelines on the subject to maintain proper 'fiduciary standards', to ensure justice and equity with regard to insider trading and to protect the interests of the investing public. The Securities and Exchange Commission has been empowered under the Insider Trading Sanctions Act, 1984 of the US to seek imposition of civil penalties, in addition to criminal proceedings, up to three times the profits gained or losses avoided, in cases involving use of non-published price sensitive information or material.

In the United Kingdom, in addition to the Company Securities (Insider Dealing) Act, 1985, the Companies Act, 1985 in its Part X (sections 323 to 329) contain provisions regarding share dealings by directors and their families. Besides, there exists a non-statutory model code relating to directors' share dealings, namely, 'the Stock Exchange Model Code for Securities Transactions by Directors of Listed Companies'. This Code, although non-statutory, is considered to be an effective restraint in relation to directors of listed companies. This is not directly binding on directors but is a model which listed companies are required to adopt.

What are the prohibitions and restrictions on insider trading under the SEBI Regulations?

The SEBI Regulations apply primarily to "dealing in securities" i.e. 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 unpublished price-sensitive information. Securities include shares, debentures and other marketable securities. These Regulations apply only to dealing in listed securities.

Besides, communication of any price sensitive information by an insider, or disseminating such information is also prohibited.

a) either on his own behalf or on behalf of any other person, deal in securities of a company listed on any stock exchange on the basis of any unpublished price sensitive information;

b) communicate any unpublished price sensitive information to any person, with or without his request for such information, except as required in the ordinary course of business or under any law; or

c) counsel or procure any other person to deal in securities of any company on the basis of unpublished price sensitive information.

An insider in possession of price-sensitive information relating to a listed company is prohibited from doing the following three things with regard to the concerned company's securities:

a) either on his own behalf or on behalf of any other person, deal in securities of a company listed on any stock exchange on the basis of any unpublished price sensitive information;

b) communicate any unpublished price sensitive information to any person, with or without his request for such information, except as required in the ordinary course of business or under any law; or

c) counsel or procure any other person to deal in securities of any company on the basis of unpublished price sensitive information.

Any contravention of any provision of the SEBI Regulations is an offence under the SEBI Act. It is punishable under section 24 of the SEBI Act by:

a) imprisonment up to ten years; and

b) fine upto Rs. 25 crores.

Contravention of any provision of the SEBI Regulations may be adjudicated (besides prosecution under section 24), which may result in a penalty imposed by the adjudicating officer. This is different from prosecution in a court. SEBI has the powers of investigation into insider trading and matters incidental thereto. The SEBI may exercise its powers of investigation for the following two purposes:

a) 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,

b) to investigate upon its own knowledge or information in its possession to protect the interest of investors in securities against breach of these regulations.

Why Forbid Insider Trading?

The prevention of insider trading is widely treated as an important function of securities regulation. In the United States, which has the most studied financial markets of the world, regulators appear to devote significant resources to combat insider trading. This has led many observers in India to mechanically accept the notion that the prohibition of insider trading is an important function of SEBI. In most countries other than the US, government actions against insider trading are much more limited. Many countries pay lip service to the idea that insider trading must be prevented, while doing little by way of enforcement. In order to make sense of insider trading, we must go back to a basic understanding of markets, prices and the role of markets in the economy. The ideal securities market is one which does a good job of allocating capital in the economy. This function is enabled by "market efficiency", the situation where the market price of each security accurately reflects the risk and return in its future. The primary function of regulation and policy is to foster market efficiency; hence we must evaluate the impact of insider trading upon market efficiency. It is not hard to see that when company insiders trade on the secondary market, they speed up the flow of information and forecasts into prices .

Insider trading is often equated with market manipulation, yet the two phenomena are completely different. Manipulation is intrinsically about making market prices move away from their fair values; manipulators reduce market efficiency. Insider trading brings prices closer to their fair values; insiders enhance market efficiency.

This is one of the situations where the insights of modern economics contradict common intuition. The fact that securities regulation in the US is primarily the creation of lawyers is not unrelated of the fact that the US is unique in emphasizing restrictions on insider trading. Insider trading appears unfair, especially to speculators outside a company who face difficult competition in the form of inside traders. Individual speculators and fund managers alike face inferior returns when markets are more efficient owing to the actions of inside traders. This does not, in itself, imply that insider trading is harmful. Insider trading clearly hurts individual and institutional speculators, but the interests of the economy and the interests of these professional traders are not congruent. Indeed, inside traders competing with professional traders is not unlike foreign goods competing on the domestic market the economy at large benefits even though one class of economic agents suffers.

Let us imagine two islands countries with different policy regimes. On island A, insider trading is swiftly detected and severely punished, hence it is essentially absent. On island B, insider trading is rampant. If insider trading were an unambiguous evil, then island B should clearly have inferior market efficiency.

On island B, insiders would play a major role in price discovery. Individual and institutional speculators would find it very difficult to compete, and they would settle into passive strategies like owning index funds. On island A, in the absence of insider trading, market inefficiencies would flourish, which would attract significant resources into research and speculation by both individuals and institutions. Markets would become quite efficient on island A too, but the price discovery would be dominated by retail and institutional speculators who stand outside listed companies and subject them to intense scrutiny.

In this analysis, it is not clear that insider trading is intrinsically bad. What is at stake is the monopoly of outside speculators in exploiting market inefficiencies. It appears that both islands can achieve the desired outcome, i.e. a state of market efficiency. Island B expends greater human resources on research and speculation as compared with island A, where these resources become available for other purposes. Hence the insider trading approach is probably a preferable way for an economy to obtain the allocative function of the efficient market at the minimum cost.

In this perspective, the State could enhance market efficiency by imposing a reporting requirement. Since trades by insiders are unusually informative, it would help market efficiency if these were required to be rapidly disclosed. The price, quantity and identity of the insider should be revealed shortly after a trade is consummated. Such requirements are in place in the US today.

Once again, a mechanical adoption of regulation from the US is inappropriate. Given the higher degree of automation of the Indian markets, it is not difficult to imagine a situation where trades by insiders are disclosed to the market within five minutes of the trade being matched by the computer. Such a reporting requirement would harness the informational potential of insider trading, and enhance market efficiency by speeding up the full impact of the trade upon market prices.

Insider Trading: Indian Scenario and the Role of SEBI

In India SEBI is making all efforts to prevent the insider trading and to build up investor confidence. Consequently, it has constituted several committees like Sachar committee (1978) and Patel's committee (1985) and etc., The Reports of these committees highlighted the following aspects.

1978 - Sachar Committee.

• Insider shall notify his intention of trading.

• Insiders should be prohibited to trade the securities before, and after two months to the closing of accounting year, same will be applicable for right's issue also.

• Company should be required to maintain a Register for the insiders dealings of shares.

• Provision for compensation and civil remedy.

1985 - Patel Committee

• To frame the rules on the lines of Australian legislation

• Extends the definition of insider to a substantial shareholder having 5% shareholdings.

• Publication of half-yearly financial results.

• Availability of price sensitive information to the general public.

• Mandatory to declare trading of securities by the insiders.

Based on the recommendations of the committees, SEBI has framed various regulations and implemented the same to curb the insider trading. These regulations are as under:-

a) SEBI [Insider Trading] Regulation-1992

b) SBEI [Substantial Acquisition of Shares & Takeover] Regulations 1994.

c) SEBI [Prohibition of Fraudulent & Unfair Trade Practice relating to securities market] Regulations-1995.

Recently, SEBI has made several changes to strengthen the existing Insider Trading Regulations 1992. The amendments in brief are as under: -

i. The new Regulation would be called SEBI [Prohibition of Insider Trading] Regulations 2002.

ii. The definition `deemed to be connected person' (Insider) includes 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.

iii. A new clause of relatives of the connected person is included, (a concern, firm, trust, HUF, company, association of persons) who by virtue of professional or business relationship can access insider information.

iv. The meaning of Price sensitive information is redefined as "any information, which relates directly or indirectly to a company and which if published is likely to materially affect the price of securities of company". The deemed to be price sensitive information includes, periodical financial results of the company intended declaration of dividends, issue of securities or buy-back of securities

v. Speculative reports in print or electronic media would not be considered as published information.

vi. Price sensitive information should be disclosed only to those within the organization/firm who need the information to discharge their duty and whose possession of such information will not give rise to a conflict of interest or appearance of misuse of the information.

SEBI’S Role in Curbing Insider Trading:-

Indian market is highly volatile and the volatility is created by various market forces because it has no depth. The capital market has witnessed a tremendous growth during the last one decade in terms of number of companies, capitalization, increase in number of investors, brokers, stock exchanges, turnover, foreign investment, mutual funds, etc.

The economic reforms in the country have also acted as a catalyst in the development of capital market and the Indian market has matured with rising volumes, transparency in operations and depository mode of holding of investment.

But the various scams, more particularly the 1992 security market scam (Harshad Mehta Case’) and the fraudulent practices prevalent in the Indian capital market has created such an impression that investors are always apprehensive about the security of there investment in the security market. Indian investor has the feeling of once bitten twice shy, regarding any investment in the stock market more particularly. Some of the common reasons for these are as follows:-

 Existence of practice of insider trading;

 Non transparency in transactions;

 Speculations;

 Ignorance, innocence and lack of knowledge of general investors.

The government of India has been through its various agencies such as SEBI, Company Law Board (CLB), RBI and Stock Exchanges trying to regulate and encouraging investment cult on the other.

SEBI has issued various regulations for controlling insider trading, fraudulent and unfair trade practices, market manipulations, market disciplines and investor protection under the power conferred on it by the SEBI Act, 1992 .

The SEBI’s steps for Investor Protection can be classified as follows:

However, with regard to insider trading, SEBI came out with SEBI (Insider Trading) Regulation, 1992, the main objectives of which are highlighted below. These regulations are divided into three chapters containing twelve sections in all, and aims at prevention of insider trading.

According to section 2 (e) of above regulation, “Insider” means any person who, is or was connected with the company or is deemed to have been connected with the company, and who is reasonably expected to have access, by virtue of such connection, to unpublished price sensitive information in respect of securities of the company, or who has received or has had access to such unpublished price sensitive information. Persons who would be considered as deemed to be connected has been defined under section 2 (h) of the above regulations.

“Unpublished price sensitive information” has been defined under section 2(k) of the above regulations as, "unpublished price sensitive information” means any information which relates to the following matters or is of concern, directly or indirectly, to a company, and is not generally known or published by such company for general information, but which if published or known, is likely to materially affect the price of securities of that company in the market.

Section 4 is the charging section which defines as what will amount to insider trading. Chapter III lays down the Investigation mechanism to be followed. Section 11 gives power to the SEBI to initiate criminal proceeding under power conferred under section 24 of the SEBI Act, 1992 without prejudice to any thing.

Though SEBI has devised appropriate mechanism for curbing insider trading, but in spite of the various laws in India and around the world, the practice of insider training is still commonly prevalent and the regulators are facing difficulties in the investigation and prevention of insider trading practices. Whatever be the law and practice on the matter, what is desirable is ethical corporate behaviour and concern and care for protection of the investors at large, which in my opinion can’t be imposed upon the corporate bodies and henceforth should be adopted as a voluntary step on their part i.e. the corporate bodies .

Conclusion

After doing this project work, I have come to the conclusion that whatever laws or the mechanisms be devised by the regulatory bodies, for the preservation of price-sensitive information and for the prevention of insider trading, the situation can never be made foolproof. This is because for the efficient conduct of the affairs of a company or a firm, it is essential that certain people be in possession of the price sensitive information and other trade details which are not disclosed. And, it becomes the duty as well as the responsibility of these people to ensure that this information is not leaked or are not used for making undue profits.

Now, if we see the role of directors of a company in this regard, we would find that they have more or less a kind of fiduciary relationship with the company. And, it is very essential that they are provided with all the price sensitive information and other trade details for the efficient conduct of the business of the company.

So, it becomes the duty of the directors to be honest in their dealings and not to take any undue advantage of their position. If, we see the laws relation to prevention of insider trading in our country as well as round the globe, we would find that though the laws are quite exhaustive in this regard, but even though the practice of insider trading is quite rampant.

So, according to me, in order to curb the menace of insider trading and for the preservation of price sensitive information, the people holding the concerned positions i.e. the directors, officers and other members of the company should themselves take voluntary steps and should set high standards of ethical behaviour, because this is something which can’t be imposed in any manner or the compliance of which be made mandatory.