INSIDER TRADING

Regulatory Aspects of Financial Markets

Group 1
Parth Kushwaha
Shivam Gupta
Shubham Randhar
Aditya Kondawar
NVR Sandeep
NVR Pradeep
Ateeq

Introduction
The buying or selling of a security by someone who has access to material, nonpublic information
about the security.
It was only about three decades back that insider trading was recognized in many developed
countries as what it was - an injustice; in fact, a crime against shareholders and markets in
general. At one time, not so far in the past, inside information and its use for personal profits was
regarded as a perk of office and a benefit of having reached a high stage in life.
Insider trading can be illegal or legal depending on when the insider makes the trade: it is illegal
when the material information is still nonpublic-trading while having special knowledge is unfair
to other investors who don't have access to such knowledge. Illegal insider trading therefore
includes tipping others when you have any sort of nonpublic information. Directors are not the
only ones who have the potential to be convicted of insider trading.
Insider trading is legal once the material information has been made public, at which time the
insider has no direct advantage over other investors. The SEC, however, still requires all insiders
to report all their transactions. So, as insiders have an insight into the workings of their company,
it may be wise for an investor to look at these reports to see how insiders are legally trading their
stock.
Why Insider Trading must be stopped?
The prevention of insider trading is widely treated as an important function of securities
regulation. In the United States, which has the most-studied financial markets of the world,
regulators appear to devote significant resources to combat insider trading. This has led many
observers in India to mechanically accept the notion that the prohibition of insider trading is an
important function of SEBI. In most countries other than the US, government actions against
insider trading are much more limited. Many countries pay lip service to the idea that insider
trading must be prevented, while doing little by way of enforcement.
In order to make sense of insider trading, we must go back to a basic understanding of markets,
prices and the role of markets in the economy. The ideal securities market is one which does a
good job of allocating capital in the economy. This function is enabled by market efficiency, the
situation where the market price of each security accurately reflects the risk and return in its
future. The primary function of regulation and policy is to foster market efficiency, hence we
must evaluate the impact of insider trading upon market efficiency.
Insider trading appears unfair, especially to speculators outside a company who face difficult
competition in the form of inside traders. Individual speculators and fund managers alike face
inferior returns when markets are more efficient owing to the actions of inside traders. This does
not, in itself, imply that insider trading is harmful. Insider trading clearly hurts individual and
institutional speculators, but the interests of the economy and the interests of these professional
traders are not matching. Indeed, inside traders competing with professional traders is not unlike
foreign goods competing on the domestic market -- the economy at large benefits even though
one class of economic agents suffers.
History behind the Regulatory Mechanism in India
Insider trading in India was unhindered in its 125 year old stock market till about 1970. It
was in the late 1970s this practice was recognized as unfair. In 1979, the Sachar committee said
in its report that company employees like directors, auditors, company secretaries etc. may have
some price sensitive information that could be used to manipulate stock prices which may cause
financial misfortunes to the investing public. The company recommended amendments to the
Companies Act, 1956 to restrict or prohibit the dealings of employees / insiders. Penalties were
also suggested to prevent the insider trading.
In 1986 the Patel committee recommended that the securities contracts (Regulations) Act,
1956 may be amended to make exchanges curb insider trading and unfair stock deals. It
suggested heavy fines including imprisonment apart from refunding the profit made or the losses
averted to the stock exchanges.
In 1989 the Abid Hussain Committee recommended that the insider trading activities may
be penalized by civil and criminal proceedings and also suggested that the SEBI formulate the
regulations and governing codes to prevent unfair dealings.
Following the recommendations by the committees, SEBI has, in exercise of the powers
conferred on them by section 30 of the Securities and Exchange Board of India Act 1992, made
regulations which are known as the Securities and Exchange Board of India (Insider Trading)
Regulations 1992. This regulation of 1992 has prohibited this fraudulent practice and a person
convicted of this offence is punishable under Section 24 and Section 15 G of the SEBI Act 1992.
These regulations were drastically amended in 2002 and renamed as SEBI (Prohibition of Insider
Trading) Regulations 1992. Both the Insider Trading Regulations are basically punitive in nature
in the sense that they describe what constitutes insider trading and then seek to punish this act in
various ways. More importantly, they have to be complied with by all listed companies; all
market intermediaries (such as brokers) and all advisers (such as merchant bankers, professional
firms, etc.).
Until these regulations were framed there were no specific provisions in India for the
offence of insider trading. Now, by virtue of the said regulations, definitions have been provided
as to what is an ""insider", and dealing, communicating or counseling on matters relating to
insider trading have been prohibited. Regulation 4 of the said Regulations makes any insider who
deals in securities or communicates any information or counsels any persons dealing in securities
in contravention of the provisions of the said Regulations a person guilty of insider trading who
is liable to be punished with imprisonment for a term which may extend to one year or with a
fine or with both under the provisions of section 24 of the Securities and Exchange Board of
India Act 1992.
In general these are the provisions in India as regards making a family business public and the
consequent on-going compliance requirements. Many changes are required to the existing
provisions of the Companies Act in India on account of recent liberalization. For the protection
of the interests of minority shareholders, the laws governing companies are required to be
changed. On October 15, 1996 Mr Ratan Tata, the Chairman of the Tata Group of Companies,
announced that the Tatas would levy a charge on group companies for the use of the ""Tata"
brand name. This is viewed very seriously and the government-controlled financial institutions
who earlier would not have questioned this move of the Tatas have now decided to ascertain
officially the details concerning the same from the Tatas and to move further in the matter. This
move on the part of the Tatas is considered to be a questionable management practice. In
November 1996, the government-controlled financial institutions also announced their decision
to seek clarification and, if found necessary, to take remedial measures as regards the recent
practice adopted by the family groups of companies in creating cross-holding between the
holding company and other group companies. The government-controlled financial institutions
have been directed by the Financial Secretary of the Government of India that the nominees of
these institutions who are on the board of the company should no longer remain passive
watchers. On October 16, 1996, in a meeting held in New Delhi between the Finance Secretary
of the Government of India and the heads of the financial institutions, a decision was taken that
the top 50 family-owned companies should be put on a special watch list and their managements
should be monitored by a special task force of the financial institutions' nominees to ensure that
they adhere to the norms of ethical corporate governance and that these companies do not
compromise small shareholders' interests. A new Companies Act is now being drafted which
would permit the formation of ""group resources companies". These group resources companies
would enter into contracts with other group companies for lending management expertise for a
fee. The proposed change in the new Companies Act is also expected to allow consolidation of
accounts in the annual reports. The company which opted for alliance would have to lift the veil
of secrecy that usually surrounds the maze of inter-corporate holdings; because in opting for
consolidation of accounts they would be required to declare the accounts of even the closely held
companies in which major investments had been made. The Managing Agency System is also
sought to be revived under the new Companies Act, though under a different name. The new
Companies Act would try to check the areas of misuse under the old system, and it is likely that
the group resource companies would be prohibited from charging the management fee linked to
the profits of the company under their management. All these would definitely be disliked by the
families, but changing times will compel them to comply.
SEBI guidelines on Insider Trading
The SEBI Act (Insider Trading) Regulations prohibit "insiders" from dealing in exchange-listed
securities on his or another's behalf based on unpublished price sensitive information,
communication of such information unless in the ordinary course of business, or counseling
others based on that information. "Dealing in securities" means trading or agreeing to trade either
as a principal or agent. Liability is not imposed on tippers, persons who have been given
information by the insider.
An "insider" is a person connected to a corporation, and is reasonably expected to have access
to, has received, or has previously had access to unpublished price sensitive information. A
"connected person" can include directors, officers, employees, or "professionals" who may be
reasonably expected to have access to such information. The "professionals" included under this
definition include stock exchange members, self-regulatory organization (SRO) members, and
bankers. The "information" is any unpublished information that relates to the company that if
published would materially affect the market.
SEBI may delegate an investigative authority if it receives a complaint of insider trading
by investors, intermediaries, or others. SEBI may also investigate an insider based on supposition
arising out of its own knowledge or information. The insider must be given notice of the
investigation, unless public interest dictates that no notice should be given. The insider is then
required to give reasonable access to relevant records with him or others, such as his
stockbroker. The authority can interview partners, employees, or members of the insider, and
these persons are required to give full assistance to the authority. Unlike broker violations, the
authority is required to give a report to SEBI within a month. The report can also be generated
through a qualified auditor, provided that the auditor has the same access to information as
would the authority.
Before taking any action, SEBI must give the insider a statement of its findings and an
opportunity to respond. The Board can then proceed with criminal prosecution after receipt of
the response. Other actions the Board can take include injunctions against dealing with
securities, prohibition of disposal of securities, and the restraint of communication or counsel to
deal in securities. An insider may appeal to the Central Government if the Board sanctions him.
The recent draft guidelines issued by SEBI for public discussion are the latest of the
developments in India in this direction. Earlier, one would recollect the 1992 regulations, which,
at best, would be described as a sleeping beauty (or a sleeping giant) since they did not appear to
be aggressively pursued or enforced. In this article, the latest guidelines as proposed have been
discussed. The importance of these guidelines cannot be understated. The insider trading
regulations are basically punitive in nature in the sense that they describe what constitutes insider
trading and then seek to punish this act in various ways. The new guidelines are basically
preventive in nature. More importantly, they will have to be complied with by all listed
companies; all market intermediaries (such as brokers) and all advisers (such as merchant
bankers, professional firms, etc.).
Duties/ Obligations of the Company
Every listed company has the following obligations under the SEBI (Prohibition of Insider
Trading) Regulations, 1992
To appoint a senior level employee generally the Company Secretary , as the Compliance
Officers;
To set up an appropriate mechanism and to frame and enforce a code of conduct for
internal procedures,
To abide by the Code of Corporate Disclosure practices as specified in Schedule ii to the
SEBI (Prohibition of Insider Trading) Regulations , 1992
To initiate the information received under the initial and continual disclosures to the
Stock Exchange within 5 days of their receipts;
To specify the close period;
To identify the Price Sensitive Information
To ensure adequate data security of confidential information stored on the computer;
To prescribe the procedure for the pre- clearance of trade and entrusted the Compliance
Officers with the responsibility of strict obedience of the same.

Penalties
Following penalties /punishments can be imposed in case of violation of SEBI (Prohibition of
Insider Trading) Regulations, 1992
SEBI may impose a penalty of not less than Rs. 25 Crores or three times the amount of
profit made out of insider trading; whichever is higher.
SEBI may initiate criminal prosecution.
SEBI may issue orders declaring transactions in securities based on unpublished price
sensitive information.
SEBI may issue orders prohibiting an insider or ceasing an insider from dealing in the
securities of the company.


Cases
Raj Rajaratnam and Insider Trading-
Summary
In October 2009, the Justice Department charged Raj Rajaratnam, a New York hedge
fund manager, with 14 counts of securities fraud and conspiracy. Rajaratnam, who was
found guilty on all 14 counts on May 11, 2011, and had allegedly cultivated a network of
executives at, among others, Intel, McKinsey, IBM, and Goldman Sachs. These insiders
provided him with material nonpublic information. Preet Bharara, the governments
attorney, claimed in the case that Raj Rajaratnam had made approximately $60 million in
illegal profits from inside information. Rajaratnams conviction was in fact part of a
larger agenda of post-recession crackdown on insider trading undertaken by the SEC and
the US Justice Department, led by Preet Bharara.
Raj Rajaratnam was the 35
th
person to be convicted of insider trading of 47 people
charged since 2010. This effort to prosecute insider trading has been marked by more
aggressive tactics such as wiretapping to prosecute insider-trading cases, which might
otherwise be difficult to prove. The case will focus on Rajaratnams trading immediately
before and after Warren Buffets infusion of $5 billion into Goldman Sachs on September
23, 2008.

The Players
Raj Rajaratnam was the Sri-Lankan manager of the hedge fund Galleon Group,
which managed $6.5 billion at its height.
Rajat Gupta is a former director at Goldman Sachs and head of McKinsey
consulting. He also served on the board of Procter & Gamble.
Warren Buffet is the CEO of Berkshire Hathaway, an investment company.
Preet Bharara is the United States Attorney for the Southern District of New York.

Facts and Claims
Facts
On September 23, 2008, Warren Buffet agreed to pay $5 billion for preferred
shares of Goldman Sachs.
This information was not announced until 6 p.m., after the NYSE closed on that
day.
Before the announcement, Raj Rajaratnam bought 175,000 shares of Goldman
Sachs.
The next day, by which time the infusion was public knowledge, Rajaratnam
sold his shares, for a profit of $900,000. In the same period of time financial
stocks as a whole fell.

Claims
Rajat Gupta had called Rajaratnam immediately after the board meeting at which
Warren Buffets infusion had been announced, and told him of the money
Goldman expected to receive.
This information was material to the price of Goldman stock, thus inciting
Rajaratnam to make the trade, something he would otherwise not have done.

The incident
In October 2009 Rajaratnam and five others were arrested and charged with multiple
counts of fraud and insider trading. Rajaratnam pleaded not guilty and remained free on
$100 million bail, the largest in United States history.
Other former and current traders at Galleon were subsequently arrested and charged with
contributing to the alleged conspiracy. Several former employees of the firm have
cooperated in the investigation. As of January 2012 over 50 people have been convicted
or pleaded guilty to date in the extensive probe.

Ethical Analysis
Several academics, including Milton Friedman, have argued that insider trading ought to
be legal. Several other commentators have renewed that argument in articles over the past
year, often citing the Rajaratnam case. Their arguments are as follows:
It is difficult to prosecute.
It is a victimless crime.
It increases the information in the market, thus increasing market efficiency.
Essentially saying that if an insider knows that stock X is severely over-valued,
and sells his or her holdings in X, then the price of X will drop, thus more
accurately reflecting its value.
It increases incentives for company officers to make profits.

Insider Trading is Illegal and Unethical
Insider trading is an unethical practice for 2 reasons:
It is unfair. Insiders have access to information that is not given to the public.
Unequal possession of information is an advantage that cannot be dismissed
because this advantage depends on a legal privilege to which an outsider cannot
gain access.
On a practical basis, the greater good for society is not achieved in the long term.
It is true that insider trading may increase market efficiency in the short-term. Yet,
insider trading may in fact, decrease efficiency in the long term.

Conclusion
Experiments in behavioral finance show economic participants do not appreciate
unequal and unfair behavior. When participants in an experiment see others in the
experiment benefiting monetarily due to what is perceived as unfair behavior, these
participants let go of profits to punish the other participant who behaves unfairly.
According to the current model of economics, this result cannot occur because the
participant who is unfairly treated prefers to maximize profits, even if he is treated
unfairly. However, unfairness upsets human feelings and people may either punish
those who treat them unfairly, or opt out of the game. Thus, investors may stay out of
the market if they see widespread insider trading. If enough investors stay out of the
market and instead, say, buy government bonds only, market efficiency will be
harmed.
Indeed insider trading has negative consequences for investors and markets.
Analyzing the Rajaratnam case uncovers these negative consequences. Supporters of
legalizing insider trading hold up the Rajaratnam trial as an example of the
disorganized and ineffectiveness insider trading charges. The 4 main arguments
advanced in favor of legalizing insider trading do not stand up against the latter. Raj
Rajaratnam did act unethically by trading shares of Goldman Sachs on September 23
and 24, 2008, and demonstrated why insider trading ought to continue to be illegal.



Samir Arora vs. SEBI-
Summary
Sameer Arora was the brilliant fund manager of Alliance Capital Mutual Fund (ACM)
and one of the most celebrated of the Indian Mutual Fund Industry. He was managing Rs
2264 crores with Alliance Capital Asset Management (ACAM) invested in Indian equity
and fixed income markets as of 31
st
August 2003. ACMF became quite popular with the
investors.

Incident
The fund was launched in 1995, had been generating a return of 2.463% since inception
under the growth option. In April 2003, there were talks about the consolidation of
Digital Global Soft Ltd (DGL) with Hewlett Packard Indian Software Operations
(HPISO) a 100% subsidiary of HP.
On May 8, 2003 an internal analyst of Alliance recommended reducing position in the
stock. On May 12, 2003 ACMF sold 3.35 lakh shares while ACM sold 2.5 lakh shares.
Before the results for DGL were announced Arora was quoted saying, Even risk from
tomorrows results is too high. Bipolar situation, but we do not like to take such risks
post-very high volatility in technology stocks around results/corporate issues. On May
13, 2003 DGL announced Q4 results in line with the expectations of the market. June 7,
2003 DGL announced demerger ratio which was perceived as unfavorable by the market.
Hence, the stock prices fell by 26%.

Charges
In August 2003, SEBI charged Samir Arora of insider trading under Section 11B and
11(4)(B) of the SEBI Act. SEBI indicated Arora on many charges:
Trading DGL shares on the basis of unpublished price sensitive information.
Non-disclosure after crossing 5% limit in several companies.
Causing panic in the market by making public his decision to quit Alliance
Capital, leading to the redemption of Rs1300 Crore.

Consequences
In April 2004, SEBI debarred Arora from dealing in securities directly or
indirectly for 5 years.
SEBI charged penalty of Rs15 Crore on ACM and two associated Alliance
entities.
However in October 2004, the Securities Appellate Tribunal set aside the order of
SEBI on grounds of insufficient evidence to prove the charges of insider trading
and professional misconduct against Mr. Arora.

Conclusion
SEBI was unable to prove the accused guilty.
Lack of Assistance from Central Economic Intelligence Bureau (CEIB) to
investigate the cases.
Absence of an adequate remedy available to the investors at large.