Insider Trading & Securities Law: Regulation, Enforcement & Market Integrity

What is Insider Trading?

Insider trading is the buying or selling of a company's securities by individuals who possess material, nonpublic information about that company.

Insider trading—the practice of buying or selling a company's securities based on material, nonpublic information—has long been a contentious issue in financial markets. While the term often evokes images of corporate executives secretly profiting from inside knowledge, the reality is more complex.

Some forms of insider transactions are perfectly legal, while others can result in severe criminal penalties.

Insider Trading in India

India was not late in recognizing the harm that insider trading can inflict upon the rights of the public shareholders, corporate governance in India and the financial markets.

1. The first concrete attempt to regulate insider trading was the constitution of the Thomas Committee in the year 1948, which committee evaluated the global practices in restricting insider trading inter alia, the Securities Exchange Act, 1934.
2. Pursuant to the recommendation of the Thomas Committee,5 sections 307 and 308 were introduced in the Companies Act 1956. This change paved way for certain mandatory disclosures by directors and managers, but was not very effective in achieving the objective of preventing insider trading.
3. Subsequently, the Sachar Committee and the Patel Committee were constituted in the years 1978 and 1986, respectively, to recommend measures for controlling insider trading in India.

The Patel Committee had defined insider trading as “the trading in the shares of a company by the person who are in the management of the company or are close to them on the basis of undisclosed price sensitive information regarding the working of the company, which they possess but which is not available to others”.

Along with other recommendations, both the Sachar Committee and the Patel Committee had recommended the enactment of a separate statute for curbing insider trading.

4. The Abid Hussain Committee constituted in 1989 had recommended that a person guilty of insider trading should be penalized, both in the form of civil and criminal proceeding.
5. A separate statute for prevention of insider trading was one of the recommendations of the Abid Hussain Committee too. On the basis of the recommendations madeby these committees, a comprehensive legislation, ‘SEBI (Insider Trading) Regulations, 1992’ was promulgated and brought in to force.

This regulation was substantially amended in the year 2002 to plug certain loopholes revealed in the cases of Hindustan Lever Ltd. v. SEBI and Rakesh Agarwal v. SEBI and was renamed as the SEBI (Prohibition of Insider Trading) Regulations, 1992.

Ever since then, the Insider Trading Regulations have been amended 5 (five) times and the last amendment was in the year 2011.

As on date, SEBI, the market watchdog regulates insider trading through the SEBI Act and the Insider Trading Regulations.

Rationale for Insider Trading regulations

It is well known that high standards of corporate governance and transparency are essential to the development of capital markets. The disclosure of information regarding a company enables investors to take decisions regarding investments in securities of such a company.

• For prices of securities to accurately reflect relevant information about a company - an essential precondition for efficient functioning of capital markets - such information should be equally available to all market participants at the same time. Naturally, distortions occur in the market if company insiders possess superior information that they use to trade in the securities of their company, which is unavailable to the counterparties with whom they trade or to the market generally.

Hence, countries generally tend to enact laws that prohibit insider trading. Aside from preserving capital market efficiency, there are other justifications too for regulating insider trading.

• Insider trading causes unfairness to investors who possess inferior information, it undermines investor confidence and integrity of the securities markets, and it is also regarded as theft or misappropriation of information.

Yet, opponents of regulating insider trading wax eloquent about its virtues, including the fact that it may result in greater market efficiency and operate as a form of compensating employees, thereby motivating them to generate greater corporate performance that benefit all shareholders.

• Despite some voices continuing to support insider trading, most countries prohibit insider trading in some form or the other. The fairness objective seems to have trumped any perceived arguments in favor of insider trading.
• In fact, empirical evidence suggests that "more stringent insider trading laws are generally associated with more dispersed equity ownership, greater stock price accuracy and greater stock market liquidity".

These would in turn facilitate better corporate governance.

Mechanisms to Prevent Insider Trading

SEBI has put in place a twofold mechanism for preventing and controlling insider trading in India.

• The primary responsibility to monitor and regulate insider trading is vested on the company itself.
• The second level of check is maintained by SEBI through the Insider Trading Regulations.

I. Model Code

Regulation 12 of the Insider Trading Regulations obligates all listed companies and organisations associated with the securities market to frame and adopt a code of internal procedures and conduct (“Code of Conduct”).

II. Disclosure

The Insider Trading Regulations stipulates that all directors, officers and substantial shareholders in a listed company to make certain periodic disclosures of their shareholding in the company.

Conclusion

The Insider Trading Regulations in entirety had not undergone any systematic review ever since it was enacted in the year 1992. Independent and separate amendments by SEBI to various provisions of the Insider Trading Regulations had resulted in lacunae in the Insider Trading Regulations. Further, the regulator was not able to garner requisite support from the language of the Insider Trading Regulations, especially from the perspective of presenting evidence, for establishing the offence of insider trading. Also, it was felt in the industry circles that it was high time the Insider Trading Regulations were modified in light of global best practices.

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