Company Law - Insider Trading: A Convictionless Crime?

                                       INTRODUCTION

Insider trading is often better known as a convictionless crime, because of the meager levels of conviction. Most of the countries make it only a criminal offence, as a result of which, the prosecution has to prove its case “beyond reasonable doubt”. Often this cannot be conclusively proved, as a result of which, most of the corporate insiders go Scot free. Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.[1]

Thus, when an insider of a company uses its price sensitive confidential informa­tion to buy or sell its securities thereby making a personal profit, he commits acts of insider trading. Due to its very nature, insider trading is an illegal transaction as it acts to the detriment of the interests of bona fide investors of the company. However, in reality, insider trading can be both legal and illegal. It is legal when the corporate insiders - officers, directors and employees - buy and sell stock in their own com­panies whereas illegal insider trading refers to the buying and selling of stock by corporate insiders not within their own company.

1.1 What is insider trading?

Insider trading is an act involving use or communication of any unpublished price sensitive information to any person dealing in securities of any corporate in order to allow him to make unfair profits. Examples of insider trading cases that have been brought by the SEC are cases against[2]:

1. Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments;
2. Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information;
3. Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
4. Government employees who learned of such information because of their employment by the government; and
5. Other persons who misappropriated, and took advantage of, confidential information from their employers.

1.2 Who is an insider?

The SEBI (Insider Trading) Regulations, 1992, define an insider to mean;

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 a company, or who has received or has had access to such unpub­lished price sensitive information.[3]

This definition has three important elements[4];

1. The person can be a natural person or a legal entity ;
2. He should be a connected person or a deemed connected person; and
3. He should have acquired the unpublished price sensitive information by vir­tue of such connection.

The third element seems to be quite ambiguous in the sense that it can be under­stood in two different ways. One, that the insider is expected to have access to un­published price sensitive information by virtue of a connection with the company. And the other that the insider has actually received or had access to such unpub­lished price sensitive information irrespective of his ‘connection’ with the company.

This issue actually came up before the SEBI in an action against Hindustan Lever Limited (or HLL) under the SEBI Act, 1992 and SEBI (Insider Trading) Regulations, 1992[5]. In this case, HLL as an insider purchased eight lakh shares of Brooke Bond Lipton India Ltd. (or BBLIL) from UTI on the basis of unpublished price sensitive information. This was done in the wake of an imminent merger of BBLIL with HLL, declared by the par­ent company, i.e., Unilever. On investigation, SEBI found out that HLL was an insider as it was covered by both the latter two elements under the definition of ‘insider’ as per the said regulations. That is to say, HLL as a deemed connected person to BBLIL was expected to receive the information by virtue of such connection and HLL had actually received information about the merger. Also, according to SEBI, the balance of evidence indicated that the information available to HLL went beyond purely self-­generated information arising out of its own decision-making regarding the merger, and hence, SEBI ordered HLL to compensate UTI.

At this point, SEBI realized the ambiguity that is created by the definition of in­sider. As a result, it removed the expression ‘by virtue of such connection’ from the definition of insider by way of the 2002 Amendment to the SEBI (Insider Trading) Regulations, 1992. The amended regulations known as SEBI (Prohibition of Insider Trading) Regulations, 1992, thus define an insider as:

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, to unpublished price sensitive information in respect of securities of a company, or who has received or has had access to such unpublished price sensitive information;[6]

So, at present no such ostensible connection with the company is required in order to be implicated as an insider. We see that the scope of the definition is being broadened by such omission. Earlier, for bringing a person within the definition of insider, it had to be proved that he was in any way connected to the company, and that by virtue of such connection, had he received the price sensitive information. Now, any person, who can be reasonable expected to have access to or who has actually received unpublished price-sensitive information can be brought under the said definition.

1.3 What is inside information?

What constitutes inside information is an extremely important issue. Inside information is any secret, material, known or unknown in­formation of the company, which if made public, would affect the price of the securi­ties of the company in the market, thereby affecting the interests of the investors of the company.

The next question that then arises is what is the nature of such inside information? Whether the information needs to be specific and precise to be called as inside information? The SEBI (Insider Trading) Regulations, 1992, were silent on this issue. Nevertheless, the amended regulations make it clear that unpublished informa­tion is the one that is not specific in nature[7]. Thus, the inside information may include inferences, hints and matters of supposition. Hence, now the inside information is not limited to ordinary meanings of facts as they are precisely stated. It is, therefore, to be noted that the new definition of 'inside information' is wider in its scope and application.

1.4 Regulation of insider trading in India:

The law relating to insider trading in India is rather new. The only existing provi­sion relating to the regulation of such transactions was enacted in 1995, i.e., section 15G of the SEBI Act which provides for imposition of penalty on persons who deal in securities on the basis of unpublished price sensitive information either on their be­half or on behalf of the others. Under this section, a penalty of rupees five lakhs can be imposed on the persons involved in insider trading. Due to situation specific cases of insider trading, this provision seems to be ineffective, as all the different kinds of cases of insider trading may not fall under this section.

Apart from that, regulation of insider trading largely depends upon the Securities and Exchange Board of India (Insider Trading) Regulations, 1992. These regulations strictly prohibit dealing, communicating or counselling on matters relating to insider trading and restrict any dealing in securities of a company listed on any stock ex­change on the basis of' any unpublished price sensitive information. And if a person does any of the above, he would be guilty of insider trading as under regulation 4 of the said Act. The SEBI has been given wide powers to investigate and give directions in the cases relating to insider trading. It has the power to issue directions to protect the interest of the securities market and for due compliance with the provisions of the Act. It also has the power to initiate criminal proceedings against an 'insider' under section 24 of the SEBI Act.

Although these regulations seem to be quite elaborate, they suffer from quite a many inadequacies, the most im­portant of which is that there is no civil penalty provision in the regulations. The Board has the power only to initiate criminal proceedings against the persons in­volved in insider trading. And since in a criminal proceeding, the prosecution has to prove the guilt of the accused beyond reasonable doubt, the problem arises; the na­ture of insider transaction being covert and the requisite mens rea for such criminal prosecution may be almost impossible to prove. In such cases, SEBI is left with the lenient options of suspending the insider for sometime; etc[8]. In addition, in such cases, the interests of the investors are not properly taken care of.

Another undecided issue is as to what is authentic price sensitive informa­tion. Also, the regulations do not address the issue of transnational trading. There is absolutely no provision where criminal proceedings could be initiated against the insiders of a foreign company listed on an Indian stock exchange who indulge in in­sider trading, Further, SEBI does not even have reciprocal arrangements with any of the countries in this regard. This makes it all the more important to have such provi­sions in the regulations itself.

In response to the irregularities of the SEBI (Insider Trading) Regulations, 1992, the SEBI passed the SEBI (Insider Trading) Amendment Regulations, 2002. These regulations came into existence as a result of recommendations of the Kumaraman­galam Birla Committee founded by SEBI to recommend steps to strengthen the ex­isting insider trading regulations for prevention of insider trading. The amendments in brief, are as under:

The inadequacy of the previous regulations has been removed with regard to the issue of civil penalty by the present regulations to some extent. Under regulation 11(f), the Board has been given power to direct the person guilty of insider trading to transfer an amount equivalent to the cost price or market price of the securities in which he has dealt with whichever is higher, to the investor protection fund of a recognised stock exchange. This provision al­though to a certain limit, empowers the Board to take care of the monetary interests of the investor, it does not at the same time authorise the Board to go as far as to provide for exemplary damages to tile investors.

Another major change brought in the new regulations is in the form of a new Chapter that provides for a policy on disclosures and internal procedure for prevention of insider trading[9]. Under this Chapter, regulation 12(2) makes it mandatory for all the entities to follow a Code of Corporate Disclosure Prac­tices for Prevention of Insider Trading[10]. It primarily seeks to achieve prompt and continuous disclosure of price sensitive information by the listed companies. It directs the listed com­panies to designate a senior official to oversee corporate disclosure. In this Code, the companies have to respond to stock exchange rumors as quickly as possible so that investors' interests are protected. It also directs the listed companies to provide only public information to the analysts so that unfair use of unpublished information is not made. Apart from these, the Code en­trusts a duty on the listed companies to disclose any relevant information through websites, stock exchange, and if possible, through live webcast.

This Code of Corporate Disclosure although seems to be quite comprehen­sive, but its effectiveness would depend upon its adoption by the listed com­panies. This is because there is no adequate cross-checking mechanism in case of non-adoption of the Code under the regulations. The companies themselves have to adopt the Code and they themselves are the ones to punish the persons in case of non-compliance.

Chapter: 2                   SEBI (Insider Trading) Amendment Regulations, 2002: A critical Study

2.1Prohibition on Insider trading:     

The provisions on prohibition of insider trading have been drafted on the lines of the Company Securities (Insider Dealing) Act, 1985 of UK which regulates insider trading.[11] Under the said Act an insider is prohibited from dealing on a recognised stock exchange in the listed securities of a company with which he is or at any time during the preceding six months has been knowingly connected if he has by virtue of his connection, unpub­lished price sensitive information relating to those securities which it would be reason­able to expect of him not to disclose except in the proper performance of his functions. Under the English Act, a third party recipient of unpublished price sensitive information is also in certain circumstances, prohibited from dealing in the shares of the company to which the information relates.

2.2 Penalty for insider trading:

The amended Regulation 4 states that an insider who deals in securities in contraven­tion of Regulation 3 shall be guilty of insider trading. The regulation does not contain any provision prescribing penalty for insider trading. Generally the penalty provision as con­tained in section 24 of the SEBI Act provides that any person who contravenes or at­tempts to contravene or abets the contravention of the provisions of the SEBI Act or any rules or regulations made thereunder, shall be punishable with imprisonment for a term which may extend to one year, or with fine, or with both. In terms of the provisions of section 24, insider trading shall be punishable with imprisonment up to one year or with fine or with both.

Under section 26 of the SEBI Act, no court shall take cognizance of any offence under the SEBI Act or any rules or regulations made thereunder, except on a complaint made by SEBI with the prior approval of the Central Government. The complaint should be filed with the Metropolitan Magistrate or a Judicial Magistrate of the first class.

Section 27 of the SEBI Act provides that where an offence has been committed by a company the company and the person responsible to the company for the conduct of the business of the company shall be deemed to be guilty of the offence. Though section 27 of the Act does not specifically extend its provisions to the rules and regulations made thereunder, the provisions of section 27 should be construed to cover contraventions un­der the rules and regulations made under the SEBI Act.

2.3 Investigation By SEBI: Rights of investigation:

Regulation 5 provides that where SEBI is of prima facie opinion, that it is necessary to investigate and inspect the books of account, other records and documents of an insider or any other person mentioned in clause (i) of sub-section (I) of section II of the Act, it may appoint an investigating officer for investigation and inspection of the books of. The powers conferred on the investigating authority are in the nature of powers of search, seizure and interrogation[12].

2.4 Policy On Disclosures And Internal Procedure For Prevention Of Insider Trading

Chapter IV inserted by the SEBI (Insider Trading) (Amendment) Regulations, 2002 has prescribed the following codes:

1. Model Code of conduct for prevention of insider trading listed companies
2. Model code of conduct for prevention of insider trading for intermediaries
3. Disclosure of interest or holding by directors and officers and substantial shareholders in a listed company

2.5 Compliance Officer

The Company to appoint a compliance officer (senior level employee) who shall report to the Managing Director/Chief Executive Officer. Under this Code, the listed companies have to appoint one of their senior employ­ees as the Compliance Officer who would be responsible for framing, monitoring and implementing policies relating to protection of price sensitive information of the company. The main thrust of this Code is preservation of price sensitive information. To ensure this, the Code makes it clear that the employees or the directors shall not pass on price sensitive information to any person unless there is a 'need to know', to discharge their duties[13].

­

2.6 Preservation of Price Sensitive Information

Price Sensitive Information is to be handled on a "need to know" basis, i.e., Price Sensitive Information should be disclosed only to those within the company who need the information to discharge their duty[14].

Trading window­

1. The company shall specify a trading period, to be called "Trading Window", for trading in the company's securities. The trading window shall be closed during the time the information is published.
2. When the trading window is closed, the employees/directors shall not trade in the company's securities in such period.

      The trading window shall be, inter alia. closed at the time of:­

(a) Declaration of Financial results

(b) Declaration of dividends

(c) Issue of securities by way of public/rights/bonus etc.

(d) Any major expansion plans or execution of new projects

(e) Amalgamation, mergers, takeovers and buy-back

(f) Disposal of whole or substantially whole of the undertaking

(g) Any changes in policies, plans or operations of the company

  

   All directors/officers/designated employees of the company shall conduct all their dealings in the securities of the Company only in a valid trading window and shall not deal in any transaction involving the purchase or sale of the com­pany's securities during the periods when trading window is closed, or during any other period as may be specified by the Company from time to time.

The Compliance officer shall maintain records of all the declarations in the appro­priate form given by the directors/officers/designated employees for a minimum period of three years. The Compliance officer shall place before the Mananaging Director/Chief Executive Officer or a committee specified by the company, on a monthly basis all the details of the dealing in the securities by employees/director/officer of the company and the accompa­nying documents that such persons had executed under the pre-dealing procedure as en­visaged in this code.

2.7 Role of the Compliance Officer in listed companies

The Company shall appoint a compliance officer (senior level employee) who shall report to the Managing Director/Chief Executive Officer. The compliance officer shall be responsible for the following:

  

1. Set forth policies, procedures, monitoring adherence to the rules for the preser­vation of "Price Sensitive Information", pre-clearing of designated employees' and their dependents' trades (directly or through respective department heads as decided by the company), monitoring of trades and the implementation of the code of conduct under the overall supervision of the Board of the listed company.
2. Assist all the employees in addressing any clarifications regarding the Securi­ties and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992 and the company's code of conduct.
3. Ensure that employees/directors shall maintain the confidentiality of all Price Sensitive Information and employees/directors do not pass on such information to any person directly or indirectly by way of making a recommendation for the purchase or sale of securities.
4. Ensure that Price sensitive Information is to be handled on a "need to know" basis. i.e., Price Sensitive Information should be disclosed only to those within the company who need the information to discharge their duty.
5. Specify "Trading Window" for trading in the company's securities and close the trading window during the time price sensitive information is published.
6. Obtain undertaking from the designated employee/director/officer as under:

(a)     That the employee/director/officer does not have any access or has not received "Price Sensitive Information" upto the time of signing the un­dertaking.

(b)    That in case the employee/director/officer has access to or receives Price Sensitive Informatjon after the signing of the undertaking but before the execution of the transaction he/she shall inform the Compli­ance officer of the change in his position and that he/she would com­pletely refrain from dealing in the securities of the company till the time such information becomes public.

(c)     That he/she has not contravened the code of conduct for prevention of insider trading as notified by the company from time to time.

(d)    That he/she has made a full and true disclosure in the matter.

7. Inform SEBI of any violation of SEBI (Prohibition of Insider Trading) Regu­lations, 1992.

2.8 Model Code of Conduct for Prevention of Insider Trading for Other Entities

2.8.1 Chinese Wall

1. To prevent the misuse of confidential information the organization/firm shall adopt a "Chinese Wall" policy which separates those areas of the organization/firm which routinely have access to confidential information, considered "inside areas" from those areas which deal with sale/marketing/investment ad­vise or other departments providing support services, considered "public ar­eas".
2. The employees in the inside area shall not communicate any Price Sensitive Information to anyone in public area.
3. The employees in inside area may be physically segregated from employees in public area.
4. Demarcation of the various departments as inside area may be implemented by the organization/firm.       ­
5. In exceptional circumstances employees from the public areas may be brought "over the wall" and given confidential information on the basis of "need to know" criteria, under intimation to the compliance officer.

2.8.2 Restricted/Grey list

In order to monitor Chinese wall procedures and trading in client securities based on inside information, the organization/firm shall restrict trading in certain securities and designate such list as restricted/grey list[15]. Security of a listed company shall be put on the restricted/grey list if the organiza­tion/firm is handling any assignment for the listed company or is preparing appraisal re­port or is handling credit rating assignments and is privy to Price Sensitive Information.

1.      Any security which is being purchased or sold or is being considered for purchase or sale by the organization/firm on behalf of its clients/schemes of mutual funds, etc. shall be put on the restricted/grey list.

2.      The restricted list shall not be communicated directly or indirectly to anyone out­side the organization/firm. The Restricted List shall be maintained by Compliance Offi­cer.

3.      When any securities are on the Restricted List, trading in these securities by desig­nated employees/directors/partners may blocked or may be disallowed at the time of pre­clearance.

2.8.3 Other restrictions

In case the sale of securities is necessitated by personal emergency, the holding pe­riod may be waived by the compliance officer after recording in writing his/her reasons in this regard.

2.8.4 Information to SEBI in case of violation of SEBI (Prohibition of Insider Trad­ing) Regulations:

In case it is observed by the organisation/firm/compliance officer that there has been a violation of these Regulations, SEBI shall be informed by the organisation/firm.

2.9 Role of Compliance Officer in other entities:

1.   The Compliance officer shall ensure that the employees in inside area are physically segregated from em­ployees in public area and do not communicate any Price Sensitive Information to anyone in public area.

2.   Demarcate the various departments as inside area to be implemented by the organization/firm.

3.   Ensure that only in exceptional circumstances, employees from the public ar­eas are brought "over the wall" and given confidential information on the basis of -need to know" criteria, under intimation to the compliance ,officer.     ­

4.   Obtain undertaking from the designated employee/director/partner that the employee/director/partner does not have any access or has not received "Price Sensitive Information" upto the time of signing the un­dertaking.

5.      Restricted/Grey list-Restrict trading in certain securities and designate such list as restricted/grey list.

2.10 Code Of Corporate Disclosure Practices Prevention Of Insider Trading (Schedule II )

2.10.1 Corporate Disclosure Policy:

   To ensure timely and adequate disclosure of price sensitive information. the follow­ing norms shall be followed by listed companies[16]:­

Prompt disclosure of price sensitive information.

1.      Overseeing and co-ordinating disclosure: Listed companies to designate a senior official (such as compliance officer) to oversee corporate disclosure who shall be responsible for ensuring that the company complies with continuous disclosure requirements overseeing and co-ordinating disclo­sure of price sensitive information to stock exchanges analysts, shareholders and media, and educating staff on disclosure policies and procedure.

2.      Information disclosure/dissemination may normally be approved in advance by the official designated for the purpose.

2.10.2  Responding to market rumours

Listed companies to clearly lay down procedures for responding to any queries or request for verification of market rumours by exchanges. The official designated for corporate disclosure to decide whether a public an announcement is necessary for verifying or denying rumours and then making the disclo­sure.

Chapter: 3

U.S.: Insider Trading Jurisprudence, Precedents & SEC

Insider trading regulation in the United States began with In re Cady, Roberts & Co., where Rule 10b-5, promulgated by the SEC under section 10(b) of the Securities Exchange Act of 1934, was invoked as prohibiting trading by insiders on the basis of nonpublic information[17]. The application of Rule 10b-5 in Cady, Roberts rested on two principal elements: the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for personal benefit; and the inherent unfairness involved where a party takes advantage of such information in the knowledge that it is unavailable to those with whom that party is dealing[18].

Equal Access Theory v. Fiduciary Duty Theory:

The ruling in Cady, Roberts was generally read as promoting an "equal access" theory of insider trading. This reading was followed by U.S. courts for more than a decade. According to the equal access theory, all traders owe a duty to the market either to disclose or to abstain from trading on material nonpublic information. This duty is imposed on the theory that it is unfair to exploit such information from which other market players are excluded. The equal access approach easily reaches most types of behavior that are intuitively recognized as "insider trading." The approach has been criticized, however, as giving rise to disincentives for the production and timely dissemination of material information.

In an attempt to restrict the field of application of Rule 10b-5, the Supreme Court rejected the equal access theory in its first insider trading case, United States v. Chiarella[19], and introduced the "fiduciary duty" theory of insider trading. Under the fiduciary duty theory, there is a bar against trading on material nonpublic information when an insider owes to uninformed market participants a duty that is based upon a pre-existing relationship of "trust and confidence." This theory works well when it functions through analogy to principles of common law fraud.

Fiduciary duty- Drawbacks: The greatest drawbacks of the theory are that it can be under-inclusive and that it does not provide insight as to what types of relationships in fact give rise to a fiduciary duty. For example, do duties exist among all market players or only among shareholders of a particular company?

Issues as to tippee liability were addressed in Dirks v. Securities and Exchange Commission[20].Dirks extended the reach of the fiduciary duty theory by holding that where there is a fiduciary duty owed by the tipper to the shareholders, and the tipper breaches that duty, the tippee who subsequently trades on that information has violated Rule 10b-5 if she had knowledge of the tipper's breach. On the other hand, a tipper must enjoy some benefit from divulging the information to the tippee in order for liability to be incurred by the tipper and thus, the tippee.

Furthermore, Dirks held that secondary insiders-e.g., underwriters, accountants, lawyers and consultants - working for a company have fiduciary duties towards shareholders, based on the fact that such persons "have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes."

The SEC and Congress began to concentrate their efforts on expanding the application of Rule 10b-5 in the insider trading context[21]. The SEC adopted Rule 14e-3 establishing liability for persons performing market transactions based on inside information regarding takeovers, whether the information concerns the target or the offeror. Congress passed the Insider Trading Sanctions Act of 1984, permitting the SEC to seek up to treble damages from inside traders[22]. This Act was followed by the Insider Trading and Securities Fraud Enforcement Act of 1988, which provided for new criminal and civil penalties against those persons who knowingly or recklessly fail to enforce procedures designed to thwart insider trading.

Misappropriation Theory-The Talk of the day:

The misappropriation theory proscribes trading on material nonpublic information obtained through theft or breach of a duty of confidentiality. It is therefore more expansive than the fiduciary duty theory, and allows the law to reach the conduct of market insiders as well as corporate insiders. The theory has been criticized on the ground that it relies on assumptions about allocation of informational property rights which do not sufficiently address the complex relationships that may exist among market participants; that is, in determining whether a theft or breach of confidentiality has ocurred, courts may be forced to draw arbitrary distinctions regarding informational property rights. The misappropriation theory has yet to be tested before the Supreme Court, and it is uncertain whether it would survive scrutiny at that level. The Court considered the theory in 1987, but split on its application. The Second Circuit generally continues to follow the misappropriation theory, however, and Congress gave implicit support for the theory in the Insider Trading and Securities Fraud Enforcement Act of 1988.

United States v. Chestman[23]: App;ycability of Misappropriation & Fiduciary Duty Thoery:

A takeover of Waldbaum, Inc. by the Great Atlantic and Pacific Tea Company had been negotiated, but had not yet been made public, for an offering price roughly double the price at which Waldbaum shares were trading on the over-the-counter market. The president and controlling shareholder of Waldbaum, Ira Waldbaum, told his sister of the pending sale, who then told her daughter, who in turn told her husband, Keith Loeb. Loeb related the information to his broker, Robert Chestman, who subsequently purchased 12,000 shares for his own account and the accounts of several of his clients, including Loeb. The Second Circuit Court of Appeals upheld conviction under Rule 14e-3 relating to tender offers, but overturned Chestman's convictions under the generally applicable Rule 10b-5[24].

The decision in Chestman is a clear demonstration of the shared theoretical premise upon which the fiduciary duty and misappropriation theories rely, and shows the theories' complementary applications[25]. First, the court stated that liability under the misappropriation theory can be predicated only on fraud committed "when a person misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence and uses that information in a securities transaction." Thus, the court construed the misappropriation formula as an application of the fiduciary duty theory to relationships in which material nonpublic information was divulged for reasons other than those involving gain on the part of the divulger - that is, where transmission of information is outside the reach of the tippee liability required by Dirks.

Second, the court applied the misappropriation theory to determine the culpability of Loeb, the original misappropriator, while simultaneously applying the fiduciary duty theory to assess Chestman's liability as a derivative tippee. By doing so, the court commingled the two theories, requiring: (1) that Loeb had access to information in the context of his fiduciary relationship with his wife; (2) that he had misappropriated that information by divulging it to Chestman; and (3) that Chestman had conducted market transactions knowing the information was given in breach of a fiduciary duty.

The court also acknowledged that "a fraud-on-the-source theory of liability extends the focus of Rule 10b-5 beyond the confined sphere of fiduciary/shareholder relations to fiduciary breaches of any sort; a particularly broad expansion of 10b-5 liability if the add-on, a 'similar relationship of trust and confidence,' is construed liberally."

Nevertheless, the Chestman decision did not broaden the application of the misappropriation theory by conducting an analysis conceptually different from that of the fiduciary duty theory[26]. Rather, the decision limited the definition of "similar relationship" in two ways. First, the court stated that a fiduciary duty cannot be imposed unilaterally by entrusting a person with confidential information. Second, family relations alone, including those of husband and wife, cannot give rise to a fiduciary duty. "At the heart of the fiduciary relationship lies reliance, and de facto control and dominance." The implications of the Chestman court's attempt to limit the reach of insider trading theory in the context of ad hoc jurisprudential decision-making is best illustrated by investigating the possible results of these limits on the definition of "similar relationship." In the first instance, the otherwise unremarkable ruling that a fiduciary duty cannot be imposed unilaterally serves as subterfuge for the formalist position which the court adopts.

SEC:

In the United States, liability for trading on the basis of nonpublic information is premised primarily on an anti-fraud rule, SEC Rule 10b-5. Since Rule 10b-5 is grounded on fraud, the plaintiff must show that the information was used or given in violation of a fiduciary or comparable duty[27].

Basing prohibitions against trading on nonpublic information upon a fiduciary or comparable duty has led to somewhat tortured analyses. For example, courts have found a Rule 10b-5 obligation based on the doctor-patient relationship and, on appropriate facts, a familial relationship. Thus, in United States v. Chestman, all eleven of the judges seemed to agree that a family relationship that is intertwined with a business relationship would be sufficient. Five of the eleven judges found such a confidential relationship based on marriage alone[28]. Characterizing the husband-wife relationship as confidential is, of course, a defensible position. However, the folly of requiring such an antecedent relationship before applying the "disclose or abstain" rule should be evident. One cannot seriously contend that Congress enacted the securities laws to protect the sanctity of the doctor/patient, husband/wife, or father/son relationship or, for that matter, state law fiduciary duties of officers or managers to stockholders. To premise an insider trading violation on such a relationship is thus a quirk of U.S. law.

There have been some modest steps to free the premise of insider trading regulation from its contemporary dependence upon an antecedent fiduciary relationship. For example, the SEC's only attempt to define improper trading is found in Rule 14e-3, which prohibits anyone other than a tender offeror or its affiliate from purchasing shares while in possession of material nonpublic information about a yet-to-be announced tender offer. Since Rule 14e-3 is not couched in terms of an antifraud rule, it does not require breach of a duty; rather, it bases liability upon the possession and use of nonpublic information[29].
Congress has considered the imposition of a "possession" test that, as is the case with Rule 14e-3, would prohibit trading while in possession of material nonpublic information[30].  Various observers have supported a "use" test which would have required proof that the trading was in fact based on the information. Opposition to a possession test was based in part on the argument that it cast too wide a net by prohibiting conduct that did not, in fact, involve misuse of information. The opponents of the proposed "use" test argued that it was inappropriate to impose liability for trading that was motivated by factors other than reliance upon the confidential information.

Chapter: 4            THE APPROACH IN FRANCE

Le Delit D'initie: The Insider Trading Law in France

Overall, France follows the U.S. regulatory model.

4.1. The Ordinance of 1967: Under the ordinance of 1967 the Commission des opérations de bourse (COB or Commission) was founded on the lines of the U.S. Securities and Exchange Commission (SEC) as an administrative public agency. The Ordinance of 1967 had introduced Article 162-1 into the Company Law of 1966. Article 162-1 stated that certain corporate insiders (directors, officers and salaried employees having access to privileged information)[31]

1. were required to register their holdings of quoted shares of the company for which they worked,
2. were also required to register the holdings of shares of the company's affiliates.
3. The new Article also required these insiders to report to the COB any subsequent acquisition or sale of such shares.

Formally, the Law of 1970 formally established the insider trading violation by adding Article 10-1 to the Ordinance. Article 10-1 established new criteria for determining who could be punished for insider trading, and adopted criminal penalties for persons found guilty of the infraction.

1. Article 10-1 was applicable to all persons who possessed, by virtue of their profession or function, information privilégiée (privileged information) concerning the technical, commercial or financial functioning of a company, and who made, directly or indirectly, transactions exploiting such information before the public had knowledge of it[32].
2. The Law of 1970 also provided penalties for violation of Article 10-1: two months to two years in prison, and/or a fine of FF 5,000 to 5 million, or up to four times the profit realized on the transaction.

Yet much remained outside the scope of the Ordinance, as modified by the Law of 1970. Insiders responsible for improper transactions carried out by third persons escaped all punishment, as did corporate entities.

One major problem was the currency of the view that the text of the Ordinance was repressive and, therefore, to be interpreted only restrictively against parties falling within its scope. The most significant repressive element, remnants of which still limit the COB's efforts to prosecute insider trading violations, was that only criminal penalties could be used to punish infractions.

4.2 1983-1989­[33]:

1. It helped fill the gaps left by the Law of 1970. It extended the Article 10-1 definition of "insider" to include personnes morales, made insiders liable for passing privileged information to tippees who subsequently traded, extended Article 10-1's coverage to all securities, and widened the definition of information to cover any privileged information regarding future prospects of an issuer or a security.
2. In 1988, the legislature again strengthened insider trading law by removing from Article 10-1 the requirement of establishing a causal link between possession of privileged information and the offending operation. Henceforth it was no longer necessary that the transaction be effectuated "on the basis of" privileged information held by the insider. It now would suffice that the information be privileged and not publicly known. However, the courts still required that the defendant be aware of the fact that the information had not been disseminated to the public.
3. The Law of 1988 also extended the application of Article 10-1 to include transactions involving all financial products, extending the COB's competence to encompass regulation of all insider trading in instruments on the futures and options markets. By eliminating the requirement of proving causation, the modifications adopted in 1988 facilitated the prosecution's task of proving that a defendant had committed an insider trading offense. The corporate insider in possession of privileged information henceforth would be assumed to have traded on such information, and would bear the burden of proving the contrary.
   Reform of Insider Trading Law
4. The Law of 1989 amended Article 10-1 of the Ordinance to create a new violation related to insider trading: communication of privileged information to a third person inconsistent with the normal practice of one's profession or functions. Thus, it is no longer necessary for the third party to have traded after having received privileged information in order for the tipper to be found liable. Those insiders who knowingly communicate privileged information to a third person outside the normal requirements of their professions can be sentenced to jail for one to six months or fined FF 10,000 to FF 100,000.
5. The Law of 1989 also gave the COB the power to initiate administrative proceedings against persons suspected of the above conduct and to impose fines directly on offenders after an adversarial proceeding; the fine may not exceed FF 10 million, or, if profits  were realized, ten times the profits received. The Law of 1989 marks the first time that sanctions may be imposed against insider traders without recourse to criminal procedure and penalties. The COB may impose pecuniary penalties only; it may not assess penal sanctions.

Some commentators challenge Bardy's interpretation of the degree to which the Commission is empowered to regulate under Articles 4-1 and 9-1 of the Ordinance. They argue that the text of Article 4-1 permits regulation only of persons falling under the COB's regulatory mandate - those who, because of their professional activities, conduct operations involving securities. There are also challenges to the assertion that the COB is authorized to prohibit insider trading on the "unofficial" market - an unregulated market in which securities are traded. Because Article 1 of Rule 90-08 does not specifically state the securities traded on the marchè hors cote fall within the scope of the Rule, some legal commentators maintain that trading on that market while possessing privileged information is not actionable by the COB.

4.3 Recent Developments in the Law:

1. Parties who initiate takeovers, or otherwise possess privileged information as a result of their professional contact with issuers, are prohibited from using that privileged information, whether for themselves or someone else, for any reason other than that for which it was originally communicated.
2. Rule 90-08 defines "privileged information" as that which is nonpublic, precise, concerns one or more issuers or securities, and is capable of affecting the valuation of said securities.
3. Rule 90-08 specifies four categories of persons who can be held liable for trading on privileged information:

(1) Primary insiders are persons who possess privileged information because of their status with an issuer, e.g., directors and officers.

(2) Secondary insiders are persons who possess privileged information because of their involvement in the preparation or implementation of a takeover or recapitalization, e.g., financial analysts and corporate raiders.

(3) Temporary insiders are persons to whom privileged information was communicated in the context of their professional capacity or function. This group includes all persons having professional relations with an issuer, as well as persons with access to information about the issuer, e.g., accountants, civil servants, journalists and lawyers.

(4) Tippees are persons who possess information they know to be privileged and that was acquired directly or indirectly from a primary, secondary or temporary insider whom they know to be an insider.

Rule 90-08 attempts to make clear that privileged information may be used only for purposes necessitated by one's profession or function. Thus, while the offense of communicating privileged information does not require proof that a person had a fraudulent or speculative intent, it does exclude persons who have used privileged information inadvertently or imprudently.

 In many respects, the evolution of the COB's authority and the modification of French insider trading laws and rules during the past twenty years have brought the French regulatory structure and goals into synchronicity. In fact, the COB was empowered to levy pecuniary penalties before the SEC was granted a similar power in 1990[34].

4.4 Principles French Law:

Since France's adoption of insider trading laws in 1970, an equality theory of insider trading law has assumed a position of doctrinal and jurisprudential dominance[35]. With rare exceptions, the only challenge in academic debate to this equality theory of insider trading has been that of the fiduciary duty theory. Judicial decisions by and large have adopted the equality approach, with little acknowledgement of the fiduciary duty theory. Legislation, as well as Rule 90-08, also follows the equality theory.

The equal access approach can permit much broader application of insider trading law than either the fiduciary duty or misappropriation theory. Interestingly, the equality theory as expressed in French law seems to have an even broader application than the equal access theory in the United States. Whereas equal access requires parity of access to information, the French equality theory prohibits all insider transactions that infringe upon either market integrity or the ideal equality of investors. Thus, French law moves one step beyond U.S. law, to address explicitly the entire marketplace, not merely shareholders of a particular issuer.

4.4.1 The Advantages of Using the Equality Theory:

Only an equality theory, as is espoused by French law, can avoid the disruption of the allocation of risk among investors caused by insider trading. French law in fact is capable of providing an alternative approach to the theoretical analysis of what wrongs result from insider trading, and of how the law should correct those wrongs. More importantly, the equality theory as embodied in French law would operate to correct those wrongs by enforcing equality of opportunity among investors.

4.4.2. Defining Privileged Information:

The eroding importance of subjective criteria has led to greater development of the objective elements of the délit of insider trading, especially as concerns the parameters of the "privileged information" category. Since the Ordinance of 1967 fails to provide a definition of privileged information, it has been left to jurists and commentators to develop workable criteria for determining whether information is privileged.

1.      First, to be classified as privileged, the information in question must not be public. A 1977 decision of the Cour d'appel de Paris held that information can remain privileged even after being divulged to several persons. Information loses its privileged status when published according to the requirements set out in Rule 90-02, which stipulates how information must be communicated to ensure complete, effective and legally cognizable transmission to the market. According to Rule 90-02, issuers must inform the public of important information that is within the issuing company's field of business and that could provoke a significant variation in the value of the issuer's securities.

2.      As a second criterion for determining whether information is privileged, French courts have required that the information be precise, specific and certain. This means that generalized rumors or information, such as a statement that "the company has fallen on hard times," cannot constitute privileged information. In order to determine whether information is privileged, the court is to consider the time at which the sell or purchase order was placed. Information can retain its privileged character even when published, if the medium of publication was a periodical with limited circulation.

3.      Finally, much of the academic commentary posits that privileged information may concern not only an issuer, either corporate or governmental, but also the market itself. For example, information that a large sell or purchase order has been or will be placed by an institutional shareholder may be privileged information. Privileged information also may relate to an event not emanating from a corporation, such as an imminent modification of a stock market regulation.

4.5 French versus U.S. Principles:

The French equality theory lends itself to wider application than the various American approaches because of its broad language such as "moralizing the markets" and creating an "ideal equality" among all investors[36]. Due in part to a broad consensus on its theoretical basis, French insider trading law has remained stable in its grounding principles, as evidenced by more than twenty years of consistent application of the equality theory. By contrast, during the past thirty years the United States has adopted and discarded one theory, while two other theories currently vie for prominence--although the misappropriation theory in fact is little more than a gloss on the fiduciary duty theory.

The misappropriation theory does not require a showing of any fiduciary duty to the company whose shares are being traded or to its stockholders. Instead, "the predicate act of fraud is perpetrated on the source of the nonpublic information, even though the source may be unaffiliated with the buyer or seller of securities." In short, a court need not find fraud by the trader on the shareholders, but rather a fraud by the trader on the source of the information. Therefore, the misappropriation theory is not distinct from, but rather an extension of, the fiduciary duty theory. The misappropriation theory requires no less a "duty" than does the fiduciary duty theory; the only difference is to whom the duty is owed. The existence of the misappropriation theory stems simply from courts' desire for a basis of liability under Rule 10b-5 in situations where the fiduciary duty theory does not apply. For example, if a psychologist has received information from a patient who did not divulge the information in order to gain "direct or indirect personal benefit from the disclosure," the patient is not a tipper, the doctor cannot be a tippee, and, thus, there should be no liability under the fiduciary duty theory. However, the misappropriation theory should permit a finding of liability because of the fraud worked on the patient by virtue of her relationship of trust and confidence with the psychologist.

4.6 The International Implications of French Insider Trading Law: (French Law versus European Community Directive on Insider Trading): Over the past two decades, French insider trading law has broadened its application, strengthened its sanctions and expanded its jurisdictional competence. French law sets forth a cohesive regulatory system that fits well into the international framework, as is indicated by its conformity with the mandates of the European Community Directive on Insider Trading. The French system relies upon neither common-law notions of fiduciary duty nor breach of duty of confidentiality for its application, and so it is readily adaptable to civil-law countries and those common-law countries wishing to adopt a regulatory system with more precise guiding principles and predictable results.Recent European initiatives relating to insider trading, as embodied in the Directive on Insider Trading and in the Council of Europe's Convention on Insider Trading have focused on harmonization of insider trading law and on cooperative exchanges of information relating to insider trading investigations. To date, the Directive has not had a notable impact on French law, because the modifications implemented by the Laws of 1988 and 1989 went a long way in anticipating the Directive's final form. Article 1 of the Directive defines "privileged information" as nonpublic, precise, and capable of influencing share valuation. The information may concern one or more issuers, one or more shares, information internal to the issuer (e.g., the company is going to increase dividends next quarter), or information external to the issuer (e.g., a takeover is going to be announced). Some commentators extend the definition of privileged information to include generalized information affecting shares, such as knowledge that a central bank is going to raise its prime lending rate in the near future. The categories of persons considered insiders under the Directive are similar to those under Rule 90-08. Primary insiders are those persons who possess privileged information for one of three reasons.

1. First are those persons who possess privileged information because of their professional functions, e.g., directors and officers. These persons are also subject to a presumption, as under French law, that they possess privileged information[37].
2. Second are persons who possess privileged information due to their participation in the capital of the issuer[38].
3. Third are persons who have access to information through their professional functions. These people may be either internal or external to the company: either salaried employees of the issuer or journalists, lawyers and accountants associated with the company on a temporary basis[39].

The Directive also forbids trading by initiés secondaires (secondary insiders), persons whose only connection with the issuer is the fact that they have received privileged information from a primary insider and know that the information is privileged.

Neither primary nor secondary insiders can purchase or sell directly or indirectly, on their own or any other person's behalf, shares of an issuer implicated by such information.

4.7 Conclusion:

Three decades ago, the state of capital market regulation in France was dismal[40]. Having operated under very loose constraints for over four hundred years, the Paris Bourse was ill-equipped to compete globally for investors' capital. Government desires to make Paris competitive as an international financial center naturally translated into attempts to align French rules and regulatory procedures more closely with those of the SEC. Early on, modifications in the structure and power of the Commission des opérations de bourse increased the autonomy and the regulatory, enforcement and investigatory powers of the COB, and strengthened French insider trading law. Likewise, modification of the substantive content of French insider trading statutes has reduced the importance of restrictive, subjective principles of penal law in the judiciary's interpretation of insider trading law. Thus, the COB and the French judiciary have become increasingly empowered to enforce the goal of promoting equality among market investors.

Chapter: 5

           LESSONS FROM THE EUROPEAN COMMUNITY

The EC Insider Trading Directive stands in stark contrast to the failed congressional effort to proscribe insider trading[41]. The Directive establishes a minimum uniform standard for legislation in each of the member states. The Directive not only defines "insider trading," but also categorizes various participants.

1. The Directive sets forth four basic elements of the type of "inside information" that can form the basis of illegal trading: (1) the information is nonpublic; (2) the content is of a precise nature; (3) it relates either to an issuer of publicly traded securities (fundamental information) or to publicly traded securities (market information); and (4) if made public, the information would likely have a significant effect on the market price[42].

The Directive divides persons who possess nonpublic information into two categories[43].

1. "Primary" insiders are those persons who have acquired the information as a result of their employment or other direct positional access to the source of the information.
2. "Secondary" insiders are those persons who have obtained the information, but not as a result of such a special relationship, from a source who was, directly or indirectly, a primary insider.

Primary insiders are prohibited from either trading and tipping, whereas secondary insiders are prohibited from trading but are not subject to the antitipping prohibitions. This gap in the legislation may reflect the impracticality of detecting and successfully prosecuting remote tipping of nonpublic information. Nevertheless, the commentary is devoid of any explanation for not subjecting secondary insiders to the antitipping provisions. Consistency mandates extending the antitipping rules to remote parties, at least to those who knowingly make a selective disclosure of information that they know originated from a corporate insider and that they know is inside information.

Under the EC Directive, determination of improper trading is based not on a fiduciary duty, but rather on trading while in possession of the information. This is the rule for both primary and secondary insiders. In contrast, the antitipping rule is limited to primary insiders. Once it is established that a primary insider possesses material nonpublic information, he or she is prohibited from disclosing the information to a third party, unless such disclosure is in the normal course of the primary insider's employment, profession, or duties.

The EC Directive attempts to strike a balance between the need to provide a clear and predictable rule and the fear of overregulating trading that does not present the pernicious effects of the unfair use of nonpublic information. The different tipping rules applicable to primary and secondary insiders may reflect an attempt to balance the need for effective insider trading enforcement against the risk of establishing too broad a prohibition. Another example of the desire to place limits on the scope of what is considered to be improper trading is found in the exclusions from the mandated trading prohibitions. While member states can, of course, decide to adopt more stringent legislation, they are not required to do so.

United States And The EC Directive: A Comparison

The clear definitional approach taken by the Directive is preferable to the murky rule in this country. Not only does the Directive provide certainty and predictability, it is capable of handling the difficult question of the liability of persons other than true insiders.
The advantages of the Directive are evident from examining how it would be applied to the facts of some of the key cases in this country. As is the case in the United States, true insiders are prohibited from trading on inside information[44]. Similarly, insiders are not permitted to pass the information on to others for their personal gain or for the purpose of improper trading by the tippees.

1. In Chiarella, the printer would qualify as a primary insider under the EC directive and thus would be prohibited both from trading on the information and from passing it on to someone else[45].
2. The psychiatrist who trades on information provided by a patient would qualify as a primary insider because he had access to the information "by virtue of the exercise of his employment, profession, or duties." This language would not include a family relationship and thus would track Chestman insofar as it would not find that the customer who obtained the information from his wife was more than a secondary insider and thus could not be liable for tipping (as opposed to trading on) the information[46].
3. On the other hand, the broker obtained the information in the course of his employment and thus would seem to qualify as a primary insider under the EC directive and hence would be precluded from either trading or tipping[47].

A major difference between the EC Directive and the law in the United States is that the Directive would apply to remote tippees. A remote tippee who overhears the information, knowing it to be material and nonpublic, would qualify as a secondary insider since the "direct or indirect source of [the information] could not be other than a [primary insider]." The Directive thus focuses on the source of the information, not on whether the source breached a duty in passing on the information. Congress stands to benefit from the EC's lesson if it is willing to adopt a definition that focuses on possession and use of information rather than on a duty tied to a fraud-based rule.

Lacuna:

Various activities are not addressed by the Directive. For example, the Directive does not prohibit a tender offeror or its affiliate in a control transaction from acquiring shares prior to announcement of a takeover attempt. Other practices not covered by the EC directive include: analyst estimates derived from publicly-available information, and legitimate market-making, brokerage, and stabilization activities by investment firms. On the other hand, the Directive's attempt to eliminate material nonpublic information through its mandate that issuers disclose such information is not well designed. It is badly designed because, as described above, it leaves a gap in its coverage of secondary insiders. The EC Directive goes beyond insider trading by mandating issuer disclosure of material information. The intent of the provision is to reduce the frequency of insider trading by regulating one of the factors that contributes to the environment that facilitates personal gain on nonpublic information. The environmental factor is weak affirmative disclosure requirements for issuers. The affirmative disclosure mandate is designed to eliminate the existence of nonpublic material information.

It is questionable whether the EC affirmative disclosure mandate can or will have a significant effect in reducing insider trading. Furthermore, it puts companies in a most awkward position. Encouraging prompt disclosure is quite different from mandating it. Strict prohibitions against insiders who trade, coupled with an effective enforcement program, are adequate weapons against trading on the basis of material nonpublic information. Although some observers might quibble with the location of the EC Directive's lines, at least the lines are clearly drawn.

 

Chapter:  6        

China: The Case with a Hitherto Communist Economy

After the 1949 Chinese Revolution, Chinese society frequently restricted or challenged the idea of private ownership of capital in China. In fact, the notion of private, third party ownership of enterprises, through shares or other means, was largely unthinkable. Approximately fifteen years after the initial domestic economic reforms, the capital markets are still in an early stage of development. Not surprisingly, the challenges of regulating these markets are great: Undertrained and understaffed government regulators must tackle such problems as insufficient disclosure, insider trading, and shareholder rights in a precedential vacuum. Chinese efforts to combat insider trading demonstrate the government's ability to react to market demands in an incremental, yet rapid, manner. Most importantly, the development of an insider trading jurisprudence demonstrates the importance of "stakeholders" in the legal system.

The capital structure of Chinese firms differs somewhat from those of other nations. While companies listed on the New York Stock Exchange (NYSE) often have only one or two classes of stock (e.g., common or preferred), the Chinese stocks consist of two classes, three pools, and five categories. The different "pools" of stocks in Chinese companies represent groups of shares available to strictly defined groups of potential purchasers. These three pools of stocks include state shares (guojia gu), legal person shares (gongsi gu or faren gu) and individual shares (geren gu)[48]. Only the individual shares are traded on the domestic stock markets in any noticeable volume.

In addition to the three pools of stocks, there are five categories of shares, differentiated by eligible buyers, denominating currency, and the listing location[49]. The first category is the A-share (A gu). A-shares reflect most of the common elements of stock ownership. There are two classes of A-shares: common and preferred. Voting rights are allocated on the basis of one-share-one-vote, which is a universally recognized arrangement. A-shares are listed on the national exchanges, where the principal and dividends of the stock are denominated in the local currency (the Chinese yuan, or renminbi (RMB)). The unusual feature of the A-shares is that both classes are limited to domestic purchasers. The exclusion of foreign investors from a market denominated in a semi-convertible currency serves, ironically, as a double obstacle to foreign investment, which is one of the reasons for establishing a securities market.  In addition to the third category, known as C-shares, which are largely non-tradable corporate shares in the company, foreign listings belong to two categories of shares. H-shares, also referred to as "red chips" hongchou gu in Chinese, are stocks of Chinese companies listed on the Hong Kong Stock Exchange (HKSE). N-shares are New York-listed stocks, and exist in the form of American Depository Receipts.

This creation of stakeholders is one reason for the orderly, but rapid, development of securities law in China, exemplified in the developing law of insider trading. The fragmentation of the equities market through the use of five classes of shares helped to diversify the stakeholders in the securities market. The classes of shares created five distinct groups of stakeholders that are able to independently or collectively press their demands for an improvement of the securities system upon the Chinese government. Of these five groups of stakeholders, the two groups that have had the largest impact on the formulation of anti-fraud and insider-trading measures are the A-share domestic investors and the B-share foreign investors.

In order to attract foreign investment in China's markets, and to keep domestic capital from fleeing to foreign exchanges in the future, the Chinese government resorted to a capitalist model of public ownership and safeguards like strict insider trading laws.

1.         Small domestic investors the most prominent group of new stakeholders created by the Chinese securities regulations is the small Chinese investor who purchases A-shares.

2.         Foreign Investors, the second major group of stakeholders created by the new securities regime is the collection of foreign investors supplying capital for the Chinese markets through investments in B-, H-, or N-shares.

3.        The Government.

6.1 The Creation Of A Securities Regulatory Regime

The diversification of stakeholders in the insider trading laws helped spur the development of a securities regulatory mechanism, and is likely to ensure vigorous and effective enforcement of its provisions in the future. Over a dozen different government bodies share the task of supervising different aspects of the market. The People's Bank of China (PBOC) and the Commission of Economic System Reform were originally the nominal, official government regulators, but local governments supplemented (or hampered) the national regulatory efforts, especially the governments of Shanghai and Shenzhen which have their own municipal securities regulatory commissions, and a number of administrative organs, (including the CSRC, the National Asset Control Bureau, the Finance Ministry, the Taxation bureau, the structural reform commission, and the economics and trade commission) which issues a variety of forms of regulations The State Council and its subordinate institutions, the Securities Commission (Guowuyuan Zhengquan Weiyuanhui) and the CSRC (Zhongguo Zhengquan Jiandu Guanli Weiyuanhui), which is the Chinese counterpart of the Securities and Exchange Commission, were both established in 1993. The effectiveness of  CSRC can be seen as in 1994 alone, there were 110 resignations or discharges of directors, chairpersons, and presidents of 56 publicly traded companies following charges of corruption and incompetence[50].

6.2 Insider Trading: the Popular View:

Given that we can conclude that insider trading is "wrong" in China, the next question is: Is insider trading illegal? Determining what is illegal in China can be a tricky exercise because China still does not have a national securities law, though one has been promised for several years. In the absence of a securities law, the legal hierarchy looks to the many varieties of regulations, and insider trading certainly violates the regulations, if not the law. Violation of the regulations in China carries penalties such as fines and, in some cases, incarceration; therefore, a distinction between the violation of a regulation and a law may not be meaningful. One of the earliest pieces of national securities legislation to address insider trading, the 1990 Zhengquan Gongsi Guanli Zanxing Banfa Temporary Measures Controlling Securities Firms , stated clearly that "securities firms must not engage in price-fixing, insider trading, fraud, or other trading or behavior which influences the quoted market prices in order to reap undeserved profits.[51]"

The current national law on insider trading is provisional, consisting of a pair of 1993 regulations: the Temporary Regulations for the Oversight of Stock Issuance and Trading (Temporary Regulations)[52], and the Temporary Measures Forbidding Fraudulent Behavior (Temporary Measures)[53].

6.3 The Definition of Insider Trading:

The Chinese literature generally distinguishes between two main types of insider trading[54]:

1.      the use of inside information by an insider for self enrichment, and

2.      the leaking of information by an insider to a third person, causing the third person to engage in illegal trade practices.

The most specific definition of "insider trading" comes from the Temporary Measures, which define insider trading as follows[55]:

(1)    an insider trading on inside information or suggesting to a third person that he buy or sell certain securities;

(2)    an insider leaking inside information to a third person, enabling that person to use the information to engage in insider trading;

(3)    a non-insider, through improper means or other channels, obtaining inside information and trading on the basis of that information, or encouraging another person to trade;

(4)    other insider trading behavior. "Other insider trading behavior" includes: [A] work unit or an individual, with the purpose of earning profits or mitigating losses, [using] its capital, information, or superior position, or abuses the powers or authority of its office to manipulate the market, to influence stock prices, to foster a false perception of the condition of the market, to cause investors who do not understand the real situation to decide to make a securities investment, [or] to disrupt the order of the securities market .

The Shenzhen Measures set forth a simpler definition of insider trading. They define it as "the use of inside information" when "engaged in securities trading.[56]" This definition includes trading in a company's stock, warrants, or other marketable securities by its directors. Like Shenzhen, the Shanghai Measures also prohibit insider trading, although the definition of insider trading in the Shanghai Measures is less elaborate. They state simply that "in securities trading, it is forbidden for any unit or individual to . . . use inside information to engage in the purchase or sale of securities or to, . . . through other direct or indirect means, manipulate the market or disrupt the orderliness of the market."

It is also worth noting that in China, as in the United States, "short swing profit (duanxian jiaoyi)" constitutes insider trading[57]. In China, an "incorporated company's directors, supervisors, officers, or shareholders with over five percent of the voting shares who sell shares bought within the last six months, or who buy shares sold within the last six months, must remit to the company the profit gained on the transaction." One should note that this is a strict liability system. Hence, a purchase and a sale within six months are automatically deemed as insider trading. As a Chinese article notes, however, this system may serve only to "postpone insider trading," although it does present a barrier to some types of insider trading on the presumption that inside information has a short useful life.

6.4 The Definition of Inside Information:

he careful efforts made in defining "insider" are surprisingly sparse when defining "inside information," as shown by the only one available, but rather cursory, definition of "inside information." The Temporary Measures define inside information as information which is "not yet public and capable of influencing the listed price of a security." The Temporary Measures include twenty-six specific categories of potential inside information, which include, inter alia, events such as the signing of an important contract by the issuer, the changing of the issuer's management policies, large investments or expenditures by the issuer, the shouldering of large debts, non-public difficulties for the repayment of debts, and non-public knowledge of operating losses.

6.5 Sanctions for Insider Trading:

6.5.1 Administrative Sanctions

 Both the Temporary Regulations and the Temporary Measures provide for a RMB 50,000 to RMB 500,000 fine for insider trading, and also permit the confiscation of "illegally-obtained stocks and other illegal income." Furthermore, for insider trading by the directors, officers, or other insiders connected with an issuer during a public offering, a wider range of sanctions is available. In addition to criminal liability, "an issuer who commits insider trading during the issuance of securities can receive a reprimand, have illegal income confiscated, pay a fine, or have its issuance approval stopped or canceled." De facto insiders who violate the trading prohibitions "by either directly or indirectly holding or trading stock, except for those instructed to sell their stock within a definite time, can, according to the specific circumstances, be assessed one or both of the following: confiscation of the illegal income, or a RMB 5,000 to RMB 50,000 fine[58].

6.5.2 Civil Sanctions:

Civil sanctions also exist as an alternative or a supplement to administrative sanctions. The Temporary Regulations imply a civil remedy for insider trading which is strikingly similar to the American derivative suit, where a shareholder sues the company's directors or officers on behalf of the corporation, often seeking restitution (for the company) of the director's or officer's improper income. In China, when a third party experiences a loss as a result of insider trading, "that person can institute a civil action for compensation." For insider trading during a public offering, a separate, but equivalent, provision mandates that an inside trader return (suochou kuanxiang) improperly obtained income to the company.

6.5.3 Criminal Sanctions:

While, in theory, criminal liability for insider trading exists in China, this punishment has not yet been implemented in practice. The Temporary Regulations provide that violations of the insider trading provisions "which constitute a crime can be subject to criminal liability." Similarly, the Temporary Measures state that "insiders who leak inside information, in addition to the above-mentioned provisions regarding administrative fines, still must, under the government's other provisions, face charges of criminal guilt." Criminal liability may also exist on the exchange level. The "catch all" provision of article 93 of the Shenzhen Measures states that "the serious plots can be concurrently referred to the judiciary for resolution, which implies criminal liability. Because at present, China has no specific criminal offense for insider trading, these provisions are without force, though that will change in the future. A recent draft of the securities law reportedly contains a provision that makes insider trading a crime punishable by a five-year jail term. The passage of such a law will expedite the implementation of existing criminal liability provisions, and increase the penalties for insider trading exponentially. While the Chinese courts have proven to be weak in deciding civil cases, no one doubts their ability to quickly impose criminal penalties in cases of economic crime.

At present, only administrative sanctions are effective deterrents to, or punishment of, insider trading[59]. This is likely to change after the passage of the Securities Law, which should, in addition to prescribing sanctions for violations of the Securities Law, explicitly provide a criminal cause of action which will place prosecutions of insider traders under the authority of the insider trading provisions. Civil causes of actions will also become more important as the Chinese legal system develops and the courts become widely accepted enforcers of individual rights.

6.6 Challenges and Problems in Enforcement:

The deficiencies of the Chinese equity  securities market is still at its initial stage with some congenital deficiencies and non-standard performances, such as an imperfect legal system, lack of powerful supervision and management."

(1)    The primary goal of the CSRC should be to discipline the market players, traders, underwriters, and issuers, although the problem of government insiders, who are largely beyond the scope of the CSRC's authority, still remains.  

(2)    The central government is still the largest investor, and it lacks internal discipline. This kind of public-private overlap only increases the natural ability of government officials to make killings on inside information of future political events, especially in the Hong Kong market.

Obviously, the country needs a comprehensive securities law, a unified regulation system, and a way of disciplining the few companies that refuse to obey the limits of the regulations. The implementation of criminal punishments and private civil causes of action is also important. These changes require a better training of the judiciary, or at least a select group of judges trained in securities matters, and a stricter enforcement of judicial judgments.

6.7 Hopes for Improvemnet:

The CSRC has begun to flex its regulatory muscle. The first significant prosecution was in February, 1994, when the CSRC fined Xiangfan Credit & Investment, a securities broker, RMB 2 million and confiscated a further RMB 16 million for trading on inside information[60]. This prosecution is all the more notable for the fact that Agricultural Bank of China, which owns Xiangfan, is a major state-owned commercial bank and policy lender. Switzerland and Italy have yet to bring a successful prosecution under their insider-trading laws. Japan has nabbed just one culprit since it banned the practice back in 1989." This regulatory zeal has begun to affect the behavior of listed firms.

The CSRC plans to be even more active in the future. It has promised that it will "suspend the underwriting rights of securities firms with irregular actions, and will turn down applications from the firms involved to issue stocks."

Chapter: 7                   Conclusion & Recommendations

Corporate governance is very vital in a profit-driven market and regulation of insider trading is essentially a part of corporate governance. Market manipulation strategies to one's own advantage are welcome provided they are not illegal. Whereas insider trading is an illegal market manipulation mechanism, as it strikes at the root of the principle of good faith in corporate dealing.

1. Recommendation as far as Appointment of Compliance Officer is Concerned:

(1)    Compliance officer may be appointed by SEBI or the Govt.:As per the 2002 Amendment to the SEBI (Insider Trading) Regulations, 1992  Company to appoint a compliance officer (senior level employee) who shall report to the Managing Director/Chief Executive Officer. Under this Code, the listed companies have to appoint one of their senior employ­ees as the Compliance Officer who would be responsible for framing, monitoring and implementing policies relating to protection of price sensitive information of the company. The main thrust of this Code is preservation of price sensitive information. To ensure this, the Code makes it clear that the employees or the directors shall not pass on price sensitive information to any person unless there is a 'need to know', to discharge their duties.

The amended regulations talk of appointment of the compliance officer from among the seniormost employees of the Company. But this regulation is insufficient in the respect, it again raises the question, as to whether the compliance officer would act impartially in discharge of his functions as a compliance officer, to report compliance or non-compliance the the SEBI

The effective enforcement can be created only of the compliance officer is appointed by the SEBI or the Government. He should necessarily under the employment of the Government.

2. Recommendations as to Proper Reporting of Abuse:

As per the amended regulations, in case it is observed by the organisation/firm/compliance officer that there has been a violation of these Regulations, SEBI shall be informed by the organisation/firm.

Till such time as the compliance officer is in the employment of the Company, question would remain as in whether he would take to proper timely reporting of any abse to the SEBI. The compliance officer, being the employee of the company would not in any case, act against the prospective insiders of the company.

3. Recommendations as to Defining of “personal Emergency” or “Necessity”:

As per the amended regulations, the holding pe­riod may be waived by the compliance officer after recording in writing his/her reasons in this regard, in case the sale of securities is necessitated by personal emergency.

But the regulations are silent about what constitutes such personal emergency. It is a generalized provision. More specific conditions, which would constitute personal emergency, should be enumerated.

4. Recommendations as to Check & Balance Mechanism:

A major flaw in the present regulations is that there is no effective check and balance mechanism. Tought some advances have been made by inclusion of the provision that the compliance officer has to obtain undertaking from the designated employee/director/officer that the employee/director/officer does not have any access or has not received "Price Sensitive Information" upto the time of signing the un­dertaking.

The lack of check and balance mechanism is due to the fact that initial investigation of any mischief is left solely in the hands of the compliance officer. Often, the compliance officer, himself being the employee of the company, may not discharge with his duties effectively.

5. Recommendations as to Liability of Compliance Officer:

Liability for non compliance with the duties vested in the compliance officer, may be imposed. This can range from a fine to sentence of imprisonment.

6. Recommendations as to Disclosure:

Though, by way of the amended regulations of 2002, increased disclosure is talked about, by way of;

(1)    Prompt disclosure of price sensitive information

(2)    Responding to Market rumors

(3)    Dissemination by Stock Exchanges

Such disclosure should be made more specific. Expert opinion about the prospective security price movements by the analysts such institutional investors, brokers etc. should be published.

7. Recommendations as to Effective Civil Remedy(Chinese Lessons):

An effective implementation of the regulations can be possible only if there is an effective civil remedy for Insider Trading. Because insider is a criminal offence, it is strenuous to prove in all cases, “beyond reasonable doubt”, an offence of insider trading. As such most of the mischief goes unaccounted.

Though the amended regulations provide for civil remedy, it has to be made more effective.

8. Recommendation as to Transnational Trading:

Hitherto, there has been no provision regarding initiation of proceeding against transnational corporations. Specific regulations must be made in this regard.Measures can be in the form of:

1. Restricted/Grey Area
2. Code of Conduct
3. Corporate Disclosure

SEBI Insider Trading (Amendment) Regulations, 2002, introduce stricter provisions for regulating insider trading thereby improving the level of protection granted to the investors. It is hoped that the amended regulations would change the deteriorating scenario. Though the new regulations seem to be effective on paper, their viability would solely depend upon their implementation. Hence, there is a great responsibil­ity on the SEBI to ensure compliance of provisions of the new regulations by the con­cerned corporate entities.

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[1] <http://www.sec.gov/answers/insider.htm> (visited on 11th September, 2005)

[2] Ibid

[3] Regulation 2(e) of SEBI Insider Trading Regulations, 1992

[4] Divya Bharadwaj, Regulations of Insider Trading in India, (2003) 3 Comp LJ

[5] UTI v. SEBI (1998) 3 Comp LJ 473 (SAT)

[6] Regulation 2(e) of SEBI Insider Trading Regulations, 1992

[7] Ibid

[8] Sumati Dwiwedi and Saurabh Awasthi, SEBI and Insider Trading – The Inside Story (2002) 2 Comp LJ 57

[9] Chapter IV of the SEBI (Prohibition of Insider Trading) Regulations, 1992

[10] Schedule II of the SEBI (Prohibition of Insider Trading) Regulations, 1992

[11] K Shekhar, Guide to SEBI, Capital Issues, Debentures & Listing (Wadhwa & Co., Nagpur, 3^rd  edn., 2003, Vol 2)

[12] Ibid

[13] Divya Bharadwaj, Regulations of Insider Trading in India, (2003) 3 Comp LJ

[14] K Shekhar, Guide to SEBI, Capital Issues, Debentures & Listing (Wadhwa & Co., Nagpur, 3^rd  edn., 2003, Vol 2)

[15]Ibid

[16] Ibid

[17] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[18] Ibid

[19] 445 U.S. 222 (1980), Cf.

[20] 463 U.S. 646 (1983), Cf.

[21] Benjamin Alarie, Dividend Entitlements And Intermediate Default Rules, 9 Stan. J.L. Bus. & Fin. 135 (2004)

[22] Ibid

[23] 903 F.2d 75 (2d Cir.1990), Cf.

[24] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[25] Ibid

[26] Ibid

[27] Karen Schoen, Insider Trading: The "Possession Versus Use" Debate, 148 U. Pa. L. Rev. 239 (1999)

[28] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[29] Ibid

[30] Ibid

[31] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[32] Ibid

[33] Ibid

[34] Ibid

[35] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[36] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[37] Ibid

[38] Ibid

[39] Ibid

[40] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[41] Thomas Lee Hazen, International Regulatory Competition And The Securities Laws, 55-Aut Law & Contemp. Probs. 231 (1992)

[42] Ibid

[43] Ibid

[44] Stephen Bainbridge, A Critique Of The Insider Trading Sanctions Act Of 1984, 71 Va. L. Rev. 455 (1995)

[45] Carol Umhoefer, Alain Pietrancosta, Insider Trading Law In France, 30 Colum. J. Transnat'l L. 89

[46] Ibid

[47] Ibid

[48] Brian Daly, Of Shares, Securities, And Stakes: The Chinese Insider Trading Law And The Stakeholder Theory Of Legal Analysis, 11 Am. U. J. Int'l L. & Pol'y 971 (1996)

[49] Ibid

[50] Ibid

[51] Ibid

[52] Ibid

[53]

[54] Brian Daly, Of Shares, Securities, And Stakes: The Chinese Insider Trading Law And The Stakeholder Theory Of Legal Analysis, 11 Am. U. J. Int'l L. & Pol'y 971 (1996)

[55] bid

[56]Ibid

[57] Ibid

[58] Ibid

[59] Ibid

[60] Ibid