The Hindu Business Line : Jury still out on dealing with insider trading

THERE is a raging debate among academics on the benefits and ills of insider trading. Though the law enforcers across international jurisdictions are united in treating insider trading as a criminal offence, there is a difference in the definition and scope of insider trading.

Typically, a charge of insider trading can be brought after two things are established: One, knowledge of unpublished price sensitive information "concerning the issuer company" and, two, the person who dealt had the information in a position of trust or was tipped about such information by a person in fiduciary capacity or in any position of trust.

In the classical theory, insider trading happens when a company insider uses unpublished price-sensitive information concerning the company for trading in its shares, in breach of a fiduciary duty owed by him to the company's shareholders.

The classical theory is extended to include the act of an insider tipping off an outsider and the outsider using the tip for his benefit. The classical theory does not include misappropriation of price sensitive information by persons who do not have fiduciary duty to the company whose stocks were traded.

The US Supreme Court extended the scope of insider trading by approving the Misappropriation Theory in the case of US versus O'Hagan (1997). Under this theory, a person commits insider trading when he obtains material confidential information and uses it in securities transactions in breach of fiduciary duty or similar relationship of confidence to the source of information but not necessarily to the shareholders of the company whose stock are traded.

Mr O'Hagan was a partner in a law firm, which represented a company in its offer for the shares of Pillsbury. He was not involved in the work related to this takeover, but learnt about it from another partner before the public announcement.

Mr O'Hagan purchased Pillsbury options and shares with this confidential information in his knowledge. When the public offer came out, Mr O'Hagan realised a profit of millions of dollars. As he was not an insider of Pillsbury, the US stock market regulator, Securities Exchange Commission, charged with him using the Misappropriation Theory.

The SEC charged him with misappropriating confidential information about the public offer from his law firm and its client and used it to his own benefit. After a long legal battle, the Supreme Court agreed with the SEC.

However, be it a Classical or Misappropriation Theory, to charge anybody with insider trading, it is necessary to establish a relationship of fiduciary duty or of confidence and trust between the person who dealt in the shares, and the source of information or between such person and the shareholders of the company whose shares are traded. The only exception is when a person gives a tip to another person and the other person uses it for his benefit.

However, it has to be established that the person giving the tip had fiduciary duty to the source of information or to the shareholders of the company. In this case, the person who is using the information himself does not owe a fiduciary duty. In case a person commits insider trading on the basis of a tip or even accidental leakage of price-sensitive information from a person having fiduciary duty or position of confidence and trust, the person giving such tip/information also violates the Insider Trading Regulations.

The SEBI (Prohibition of Insider Trading) Regulations deal with the responsibility of a corporate for disclosure of information and provide for a code of corporate disclosures to be adopted and followed by all listed companies. The Regulations also provide for the penalties in case of violations amounting to selective or partial disclosure of information.

In the US, in Dirks versus SEC (1983) the Supreme Court specified the obligations of the tipper and tipped to refrain from trading or to publicly disclose information that they know to be confidential. Till 2002, the SEBI (Prohibition of Insider Trading) Regulations mostly dealt with the Classical Theory. By amending the regulations in 2002, the Misappropriation Theory has been made a part of SEBI regulations.

In the case of Samir Arora versus SEBI, the Securities Appellate Tribunal has chosen not to comment on the relationship of fiduciary duty of the asset management company (Alliance Capital MF) or Samir Arora vis-à-vis the company (Digital Globalsoft Ltd) in whose shares the AMC traded. The judgement also does not comment on the fact that nobody was charged with tipping or selective disclosure of information. The SAT simply ruled that the unpublished price sensitive information about proposed merger of DGL with Hewlett Packard remained confidential and was not in the possession of Mr SamirArora or the AMC.

Any price sensitive information when used for gain at the cost of the general public does not always make a case of insider trading. For a case of insider trading to be established, the price sensitive information has to concern the company whose stock is traded and has to be information in the nature of events such as financial results, issue or buy-back of securities, expansion plans, mergers, takeovers and the like as mentioned in the SEBI Insider Trading Regulations.

A clear example is when a share broker misappropriates confidential information about a large pending order of a client for his own benefit, he is charged with front running under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations and not with insider trading.

In the Martha Stewart case in the US, a broker friend tipped off Stewart that the CEO of ImClone was unloading his own stock.

The CEO was selling because he had learnt before the public did that the US Food and Drug Administration was going to reject his application for registration of a cancer drug. Martha Stewart did not know the confidential information concerning the company ImClone itself, and she was only told by her friend that the CEO was selling. Charges of insider trading were, therefore, not brought against her by the SEC. It is a different matter that she was charged with not telling the truth during investigations as also to the shareholders of her own company Martha Stewart Living Omni Media.

The law relating to insider trading is still evolving in most jurisdictions in the world. Even in US, this is a comparatively recent addition to the various types of securities frauds.

Law evolves through executive actions, legislative enactments and judicial pronouncements. Obviously, the evolution of this branch of law in India is in a nascent stage and, as has been seen internationally, it will take many years and many other cases before it can be said to have settled.

(The author, Additional Commissioner, Income Tax, was a former General Manager of SEBI. The views expressed in are personal. He can be contacted at deepaksanchety@yahoo.com)

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