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Insider Trading: Treading a Fine Line

10 November, 2009
The recent arrest of billionaire Raj Rajaratnam, co-founder of New York-based Galleon Hedge Fund, and his five alleged co-conspirators after charges were filed against them by the Securities and Exchange Commission (SEC) for insider trading has once again highlighted one of the oldest offences in the securities markets. 
Rajaratnam was accused by US federal prosecutors of illegally obtaining information from his co-conspirators and others that he later used to trade securities for a profit. Some companies whose securities were allegedly illegally traded by Rajaratnam include Clearwire, Polycom, Google and Hilton Hotels among others. Rajaratnam was charged in a criminal complaint on October 15, 2009, with four counts of conspiracy and nine counts of securities fraud and his co-conspirators, Rajiv Goel, Director of Strategic Investments at Intel Capital and Anil Kumar, a director at McKinsey and Company, Inc. were charged with four counts of conspiracy and two counts of securities fraud each. 
Approximately two years ago, the SEC introduced data mining software which identified trades that were suspiciously timely. This software yielded one of its first cases in early 2009, when the SEC and US prosecutors charged employees at UBS AG and Blackstone Group, LP with insider trading in an $8-million insider-trading case. 
The current Rajaratnam case instead relied on a method traditionally used by investigators in a mob or “gangster” case.  Reports state that court authorised wiretaps were used to capture conversations of Rajaratnam and his conspirators.

US Position on Insider Trading
After the Great Depression in 1929, the US Congress enacted the Securities Act, 1933 and the Securities Exchange Act, 1934 (Exchange Acts), aimed at regulating the securities markets. The US was one the first countries to enact significant insider trading regulations in the form of the Exchange Acts. The ‘34 Act addresses insider trading directly through Section 16(b) and indirectly through Section 10(b). Section 16(b) of the ’34 Act prohibits short swing profits (profits realized in any period less than six months) by directors or officers of the corporation holding greater than 10 % of the stock in their own corporation’s stock, except in very limited circumstance.  Section 10(b) of ’34 Act and Rule 10b-5 prohibit fraud related to securities trading without specifically referring to insider trading.  However, these general provisions have been widely used by the SEC and the federal courts to crack down on insider trading. The types of activities and classes of individuals captured under the purview of insider trading have expanded over the years.
The traditional definition of an ‘insider’ (as developed by SEC v. Texas Gulf Sulphur (1968, CA2 NY)) covered within its ambit those persons who possessed access to non public information with the knowledge that such information was non public and received such information through a fiduciary relationship with the issuer (for e.g. director and officers of the issuer of securities, lawyers, accountants, etc.).  In 1983, the US Supreme Court adopted the theory of ‘constructive insiders’ in (Dirks v. SEC, 463 US 646 (1983)) where investment bankers, advisors and others who legitimately receive confidential information from an issuer while providing services to the issuer acquire the direct fiduciary duties of the true insider, provided the issuer expected the constructive insider to keep the information confidential.  
In addition to the above, the practice of tipping has also been cracked down upon, wherein an insider tips of another person (tippee) as to material, non public information.  Both the tipper and the tippee may be held liable for insider trading if the tippee makes a trade based on this information and even if providing the tip has not resulted in any personal financial gain to the tipper (SEC v. Grossman et al., CCH Fed. Sec. Law Rep., 99,518)
The restriction on insiders from making trades only applies when the information possessed by them is material and non public. Information is generally considered material if there is a substantial likelihood that a reasonable investor would consider it important in deciding to buy, hold or sell a security, i.e. if it will have a positive or negative effect on the company  (For eg: earnings estimates, bankruptcy or reorganization proceedings, potential merger or acquisition, litigation or regulatory developments, etc.).  Additionally, information is considered non public only if it has not been disseminated to the general investor at large. 
The ‘34 Act provides for injunctive and equitable remedies for insider trading activities against the insider and also allows private citizens to claim damages without proving actual reliance on the fraud caused by the insider (Section 20A, added by the Insider Trading and Securities Fraud Enforcement Act) apart from civil remedies (penalties up to the greater of $1,000,000 or 3 times the profits made or losses avoided) and criminal remedies (penalties are up to a maximum of $1 million ($2.5 million for corporate entities) and 10 years imprisonment for each wilful insider trading violation). 
The Rajaratnam case demonstrates a greater effort on the part of the SEC to prosecute insider trading cases.
Indian Position on Insider Trading
Insider trading was regulated in India in 1992 when the stock market was liberalised and the Securities and Exchange Board of India (SEBI) was given the mandate to investigate instances of alleged insider trading.  Similar to the US definition of an “insider”, the SEBI (Prohibition of Insider Trading) Regulations, 1992 (Regulations) defines the term “insider” as any person who is or was connected with the company or deemed to have been so connected and who is reasonably expected to have access or who has had access to unpublished price sensitive information in respect of securities of a company. 
The definition of ‘unpublished price sensitive information’ was inserted in the Regulations in 2002 and it means any information, which is not specific in nature and not published by the company or its agents, which relates directly or indirectly to the company and which will materially affect the price of securities of the company if it is published. The explanation to this definition includes financial results of the company, buy back of securities, mergers and takeovers, as examples of deemed price sensitive information. According to amendments made in November 2008 by SEBI to the Regulations, directors, officers or designated employees are prohibited from carrying out an opposite transaction for six months, i.e., such a person cannot buy shares within six months of selling it and vice versa. These are similar to the prohibition of “short swing profits” rule in US, discussed above.   
Hindustan Lever Ltd v. SEBI (1998 SCL 311) was one of the first cases where SEBI took action on grounds of insider trading. Hindustan Lever Ltd. (HLL) and Brook Bond Lipton India Ltd. (BBIL) controlled by Unilever, Inc. UK were both under the same management. HLL purchased 0.8 million shares of BBIL from UTI in March 1996 two weeks prior to the public announcement of the HLL and BBIL merger. Post announcement, the price of BBIL’s shares shot up thereby causing losses to UTI. HLL was held liable by SEBI for insider trading. According to SEBI, HLL had full knowledge of the impending merger and misused the unpublished price sensitive information to its advantage. However, the Securities Appellate Tribunal reversed the order on the ground that the information was not price-sensitive as it was reported in the media and, therefore, was public knowledge. As a result of this case, SEBI amended the Regulations to specifically provide that speculative reports in the media (print or electronic) would not be treated as publication of price sensitive information.   
There is relatively limited Indian case law on insider trading and relatively fewer convictions as compared to the US. Section 15G and Section 24 of the SEBI Act, 1992, provide for civil remedies (a fine which is the greater of Rs 25 crore or three times the amount of profits made out of such unlawful trade) and criminal remedies (imprisonment for a term which may extend to ten years or fine or both) for violation of the insider trading regulations.  However, unlike the US, there is no provision allowing private citizens to claim damages.
Detecting Insider Trading Cases in India
An interesting question is whether SEBI will follow the US lead on trapping insider trading cases using the method of wiretapping. Wiretapping is regulated under Section 5(2) of the Indian Telegraph Act, 1885 which allows the central and state government or any officer authorised by such governments to direct any message relating to any subject to be detained or intercepted or stopped from transmission if it is satisfied that it is necessary for preventing an incitement to the commission of an offence. 
Additionally, the Supreme Court, in PUCL v. The Union of India ((1997) 1 SCC 301), held that telephone tapping is a ‘serious invasion of an individual’s privacy’ and that an order for a tap can be issued only by extremely senior government personnel such as the Union Home Secretary or his counterparts in the states.   
Another permissible method of tracking insider trading cases is by accessing the data/information of any suspect in such insider trading cases. Section 69 of the IT Amendment Act, 2008 allows the Central or State Government to intercept, monitor or decrypt any information generated, received, transmitted or stored in any computer resource if it is satisfied that it is expedient to do so for investigation of any offence. 
Legitimate Research and Illegal Trading  
Many traders in investment banks and funds depend on research in order to trade more effectively. Trades may not be based on such research if such research has been obtained or transmitted illegally.  For e.g., a meteorologist or a scientist may be hired to provide clues as to certain facts that may affect the price of securities because such practice of hiring a professional is not illegal in itself.  But if clues are obtained about a company from an ‘insider’ (as defined above), then such an act may be termed illegal. 
In addition, the SEC’s Regulation Fair Disclosure (the “Regulation FD”), introduced in 2000, is a disclosure rule which addresses selective disclosure of information.  It requires an issuer, or any person acting on its behalf, who discloses material non public information to certain persons (security markets professionals and holders of the issuer’s securities) to make a public disclosure of such information.   
Financial services companies may adopt internal mechanisms to prevent the misuse of material confidential information. These include Chinese walls (physical and intangible barriers between departments to prevent flow of sensitive information between departments; for e.g. the research team and an investment banking team), disclosure of personal transactions to the employers and an internal code of ethics. 
Insider trading is a difficult crime to prevent and to prosecute since the underlying act of buying or selling securities is a legitimately legal activity. It is in the nature of the information used that may make this legal activity a prohibited act of insider trading. As the Rajaratnam case demonstrates, regulatory bodies are using increasingly sophisticated methods to detect insider trading cases. 
(Shantanu Surpure, Managing Attorney, Sand Hill Counsel. Assisted by Rashi Saraf, Associate, Sand Hill Counsel)


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Insider Trading: Treading a Fine Line

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