A transparent system is a must for tracking insider trading

The enforcement of insider trading laws has been a formidable challenge for regulators across the world. The Indian regulators introduced various measures since 1947 to curb insider trading, which means trading by insiders of a listed company possessing unpublished price sensitive information (UPSI), the latest being the proposed ‘shorts swing profits’ regulations.

While assessing the proposed regulations’ scope, the adequacy and effective implementation of the existing laws must also be analysed.

The history of insider trading laws in India dates back to the government committees such as the Thomas Committee of 1948, which inter alia evaluated the US regulations on short swing profits under section 16 of the Securities Exchange Act of 1934 (SE Act).

The recommendations resulted in Sections 307 and 308 of the Companies Act, 1956 which required shareholding disclosures by directors and managers.

However, the Companies Act did not have adequate provisions for enforcement. Thereafter, the Sachar Committee of 1977 and the Patel Committee of 1984 also emphasised the requirement of a separate statute to curb insider trading. 

As the liberalised and evolving Indian securities market required a more comprehensive legislation to regulate insider trading, Securities and Exchange Board of India (Sebi) had framed Sebi (Prohibition of Insider Trading) Regulations, 1992 (the “ Insider Trading Regulations”).

The Insider Trading Regulations were significantly amended for the first time in 2002 to plug certain loopholes revealed during the case of Hindustan Lever Ltd Vs Sebi; Rakesh Agarwal Vs Sebi etc, which introduced mandatory disclosures by persons holding 5% or more voting rights, directors or officers of the listed companies, and restrictions in respect of insiders trading during vital announcements.

The proposed short swing profit regulation, to be introduced by  amendments to the Insider Regulations is admittedly in lines of section 16 (b) of the SE Act and therefore, a brief comparison of the enforcement mechanisms in both the countries will be relevant. 

Section 16 of the SE Act provides for a threefold attack against the possible abuses of inside information by corporate insiders, which inter alia include:(i) reporting by insiders of their stock holdings and transactions in the company’s securities, (ii) prohibition to engage in short sales of the company’s equity securities, (iii) company’s or a security holder’s right to initiate an action to recover the short swing profits. 

The Insider Regulations have several provisions to regulate the trades entered by specific categories of insiders, a specific trading window, as well as a pre-clearance option for trades.

In addition to this, the proposed regulations stipulate that it will also apply to ‘designated insiders’.  The proposal does not define ‘designated insiders’ and suggests that the definition will be narrower than the existing definition of a “deemed insider” and broader than an “insider” as defined under the Insider Regulations.

Thus, a new category of insiders (designated insiders) will also be liable to surrender the profits made in a short-swing trade.

It will be interesting to understand who will be covered under this new category, considering that the Insider Regulations have detailed definitions for the terms “deemed insider”, “insider” and also an inclusive definition for the term ‘designated employee’ which covers (i) top three tiers of the company management; and (ii) employees designated by the company.

The adequacy of section 16 of the SE Act has been subject to judicial and academic scrutiny over the years. According
to Donald C Langevoort, a US author on insider trading laws, section 16 (b)’s scope is limited because: (i) It applies to only “high level” insiders and not all insiders and tippees, with access to sensitive corporate data; (ii) It covers only short swing profits and does not cover situations where high level insiders buy the securities and do not sell them within a six month period (or sell securities without buying) and that Rule 10b-5 is a more effective and widely used weapon against abusive trading practices. (Donald. C Langevoort, Insider Trading: Regulation, Enforcement, and Prevention, Securities Law Series, vol 18 at 10-3).

Section 16(b) has been termed ‘unique’ as the Securities Exchange Commission (SEC) cannot initiate action against violators. Section 16 (b) is enforced only when the company, or if it fails to do so, a security holder initiates an action. 

Although the proposed regulations seek surrender of profits to the company, it is unclear whether the regulator proposes to capture these trades through a specific system and take suo moto action.

Otherwise, similar to the US, the shareholder may have to bring an action against the company or insiders to recover the short swing profits. In any event, a clear and transparent system for tracking these trades under the Insider Regulations will be a must for enforcement.

The proposal exempts certain trades in lines of the US law, i.e., transactions approved by Regulatory authority, transaction between an Issuer and its officers or directors, bona fide gifts and inheritance, derivative securities, mergers, reclassifications, consolidations and voting trusts.

Regarding enforcement, as proposed by Sebi, the liability of insiders must be strict, without requiring proof of intention behind the trade or the use of insider information. 

Notwithstanding section 16, the main weapon used against insider trading in US is the single anti-fraud rule under Rule 10b-5 of the SE Act and still, US has built an efficient enforcement mechanism against insider trading cases.

On the contrary, although India has had detailed provisions to tackle insider trading practices, the cases that have withstood the tests of judiciary are minimal.

According to reports, out of the 87 countries which has insider trading laws, only 38 countries were able to use it effectively (Utpal Bhattacharya and Hazem Daouk, World Price of Insider Trading).

Thus, before tucking in more laws in the basket, the methodology of implementation must be integrated into the Insider Regulations.

Anitha Anoop is an assistant legal adviser with Sebi. She’s currently on leave, pursuing a PhD in insider trading laws. The views are personal .