Vol 1 No.

48 February 14, 2011

A Financial Technologies Group Initiative

developments that matter in financial markets

Insider Trading Issues

Introduction
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Our markets are a success precisely because they enjoy the worlds highest level of confidence. Investors put their capital to work and put their fortunes at riskbecause they trust that the marketplace is honest. They know that our securities laws require free, fair, and open transactions. Arthur Levitt, Former Chairman of the Securities and Exchange Commission, USA

In common parlance, insider trading refers to trading in securities on the basis of information that has not been made public. This issue has been a cause of concern in the financial markets across the world as it undermines the confidence of the investors and may destroy the integrity of the markets. Insider trading issue raises an apparent conflict between fairness and efficiency.

Practical Issues in Monitoring

Despite a number of rules and regulations to prohibit insider trading, it is still rampant in many financial markets. In India, the market regulator seems to have been able to contain the abuse of insider trading by the inside-insiders to a certain extent by imposing stringent reporting requirements. Regarding the second category, outside-insiders, listing them itself is difficult let alone monitoring their trades. The following table shows the penal provisions of insider trading in the US, UK and India. Country USA UK India Fine for Insider Trading Individuals: $5 m Corporates: $ 25 m Unlimited Up to Rs 25 crore Imprisonment for Insider Trading Up to 20 years Up to 7 years Up to 10 years

Fairness vs. Efficiency

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Fairness requires that all the market participants should have equal access to all available information to price the securities. If insider trading is allowed, i.e., if a few investors hold and exploit privileged information, it would be unfair to the rest of investors. In contrast, strong form of efficiency postulates that securities prices should also incorporate insider information in the prices and hence, it would not be possible for even insiders to systematically and consistently gain from inside information. But without insider trading, it is difficult that securities prices factor in such information; hence efficiency in pricing is compromised to that extent. Across the world, in all the financial markets, concern for fairness dominates the efficiency issues. Most of the markets do have simple or complex laws prohibiting insider trading.

Preventive Strategies

Categories of Insiders

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There are broadly two categories of insiders. The first is registered insider or inside-insider. This category includes corporate officers, directors, the management and large shareholders. They are believed to have access to corporate non-public information. Most of the provisions of insider trading require them to report or get prior approval or both for trading in securities of their company or associated companies. The second is outsideinsider. This category includes others who may have access to privileged information due to their relationship with the company or its officers. Individuals in these two groups are expected to hold the privy information in a fiduciary capacity for the company and its shareholders. Some Landmark Cases Cady Roberts & Co. (1961) United States vs. Newman (1981) Dirks vs. SEC (1984) Chiarella vs. United States (1980) Insider trading by insider/outsider is prohibited Supported misappropriation theory Crystallized tippee and tipper liability Making it illegal for anyone to trade on the basis of material non-public information, if the information emanated from an insider

Companies are advised to take preventive steps to avoid such situation by creating Chinese walls, water-tight compartmentalization of departments susceptible to exploit inside information. Legal departments need to prepare a restricted list of companies in which their employees are not allowed to trade without prior permission. Notifying opening or closure of Trading window for employees in trading in their company or associated companies. All the listed companies are required to commit to their internal code of conduct that particularly includes detailed process for employees to trade in their own company or associated companies.

Legislations/Directives

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India: SEBI Prohibition of Insider Trading Regulations, 1992 USA: Insider Trading Sanctions Act, 1984 UK: Company Securities ( Insider Trading) Act, 1985 EU: Insider Dealing Directive (Directive 89/592/EEC)

Insider Trading and Ethics

For details, contact: Ms Meena Kulkarni Tel: +91 22 6731 8842 Email: meena.kulkarni@ftkmc.com

It requires strong commitment to ethics and value system to overcome the temptation of indulging in insider trading in order to gain in cash or kind. Reputation of some of the highly valued companies have been damaged due to violation of insider trading rules by their employees. Boards in companies with good governance practices are generally highly sensitive to these issues. Contributed by Dr Jinesh Panchali & M Ravindran

Published by Financial Technologies Knowledge Management Company Limited Exchange Square, 1st Floor, Suren Road, Chakala, Andheri (East), Mumbai - 400093. India. Tel: +91 22 6731 8842 Fax: +91 22 6726 9541 Email: marketsinmotion@ftkmc.com Website : www.ftkmc.com

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Disclaimer: This Newsletter is prepared to enhance awareness and for information only. The information is taken from sources believed to be reliable but is not guaranteed by FTKMC as to its accuracy. The contents are not meant for taking decisions of any strategic nature or for investments, for which FTKMC will not be responsible.