INSIDER TRADING REGULATION AND THEIR EFFECTIVENESS MAINTAINING MARKET INTEGRITY

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7 months ago

ABSTRACT

Insider trading remains a contentious issue that has consistently garnered attention from investors, regulators, and the public alike. This illicit practice involves buying or selling stocks based on confidential information that provides certain individuals with an unfair advantage in the financial realm. Referred to as insiders, these individuals possess privileged access to critical information such as forthcoming corporate announcements, financial outcomes, or significant developments that could substantially impact a company’s stock price.

The act of insider trading poses a significant threat to the integrity and transparency of the financial system, contradicting the principles of fair and open markets. This article delves into the intricate realm of insider trading, encompassing its definition, various forms, notable occurrences, and the legal framework designed to prevent and punish such misconduct. By shedding light on this intricate subject, we aim to enhance our understanding of insider trading and its repercussions, ultimately fostering a more just and equitable investment environment for all stakeholders.

KEYWORDS

Insider trading, SEBI, Securities market, Legal framework, Market integrity, Investor confidence, Case law, Transparency, Globalization, stock market.

INTRODUCTION

Insider trading refers to the trading of a company’s securities based on confidential information not disclosed to the public, also known as unpublished price-sensitive information, with the aim of securing personal profits or mitigating losses. It represents a breach of fiduciary duties for company officers. This occurs when an individual with potential access to non-public company information engages in buying or selling shares or stocks of that company. Insider trading has been present since the advent of trading securities in joint stock companies and has evolved into a significant challenge over time.

The SEBI Act was enacted in 1992 to establish a regulatory framework aimed at fostering[1] healthy trading practices and safeguarding investors’ interests to facilitate the growth of the securities market. Sections 11(1) and 11(2) of the SEBI Act[2], along with Section 30, grant SEBI the legal authority to intervene and prevent insider trading, while also enacting additional regulations to curb illicit activities. The first instance of insider trading violation was recorded against Hindustan Lever Limited in India.

Insider trading presents a highly intricate challenge, as it stems from a fundamental human trait: greed. Individuals possessing insider information often find it exceedingly difficult to refrain from trading based on that privileged information, as they can foresee potential profits or losses. The ongoing endeavor is to comprehend the extent of this issue and the regulatory measures in place to address it.

the Securities and Exchange Board of India is really important for India’s money matters. It looks after investors, making sure they don’t get cheated or tricked when they put their money in stocks or other investments. SEBI sets rules for how companies and people involved in the stock market should behave, like being honest and telling the truth about their business. This helps investors feel safe and confident about putting their money on the market. SEBI also works to make the market fairer and easier to understand. It encourages companies to be honest and transparent, so investors can make smart decisions. By doing all this, SEBI helps the stock market run smoothly, which is good for India’s economy and everyone who invests in it.

WHAT IS INSIDER TRADING?

Insider trading encompasses the purchasing or selling of publicly-traded company stocks or other securities by individuals who possess undisclosed material information about the company. This confidential information may relate to forthcoming financial results, announcements of mergers or acquisitions, regulatory decisions, or other developments capable of substantially impacting the company’s stock value.

It’s essential to distinguish between legal and illegal insider trading:

1. legal insider trading [3]This occurs when corporate insiders, such as executives, directors, or employees, engage in buying or selling their own company’s stock. They are obligated to report these transactions to regulatory bodies within specific timeframes. Although permissible, legal insider trading is subject to stringent regulations and limitations to prevent exploitation.

2. Illegal Insider Trading: Illegal insider trading arises when individuals trade a company’s securities based on undisclosed material information, contravening securities laws and regulations. This form of insider trading compromises market fairness and integrity by granting unfair advantages to those privy to confidential information. Regulatory authorities often prosecute illegal insider trading, imposing substantial fines, penalties, and potential imprisonment on offenders.

In summary, illegal insider trading poses a significant threat to the openness and trustworthiness of financial markets and is explicitly prohibited by securities laws across most jurisdictions.

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

The Securities and Exchange Board of India (SEBI) serves as the regulatory authority responsible for overseeing India’s securities market. It was founded in 1988 as an independent statutory body and was further empowered by the SEBI Act of 1992 to regulate and foster the development of the country’s securities market.

SEBI’s primary objectives are as follows:

1. Safeguarding the interests of investors in securities.

2. Facilitating the growth and regulation of the securities market.

3. Supervising the operations of stock exchanges and other securities markets.

4. Enforcing registration and regulation of intermediaries in the securities market, including brokers, sub-brokers, and merchant bankers.

5. Prohibiting fraudulent and unjust trade practices within the securities markets.

6. Promoting investor education and awareness initiatives.

SEBI’s regulatory scope encompasses various activities, including issuing guidelines and regulations concerning public offerings of securities, insider trading, takeovers, and disclosure requirements. Additionally, it oversees stock exchanges, depositories, mutual

funds, and other market participants to ensure adherence to regulatory standards and uphold market integrity.

SEBI’s role is pivotal in safeguarding investor interests, upholding market integrity, and fostering investor confidence in India’s securities market.

EFFECT OF INSIDER TRADING ON MARKET

Insider trading has far-reaching effects that extend beyond the individuals directly involved in the illicit activity. These effects contribute to undermining the integrity and fairness of financial markets, eroding investor confidence, and potentially harming those without access to privileged information.

One significant consequence of insider trading is the unfair advantage gained by insiders. By trading securities based on confidential information, insiders are positioned to profit at the expense of other market participants. This unfair edge creates a distorted market environment where those without access to such information are placed at a disadvantage. The resulting imbalance in trading conditions contradicts the principles of fairness and equality that underpin well-functioning financial markets.

Moreover, insider trading erodes investor confidence in the integrity of financial markets. When investors perceive that some participants have an unfair advantage due to access to confidential information, it undermines their trust in the fairness of market mechanisms. This loss of faith can lead to a reluctance to participate in the market or even withdrawal of investments, potentially destabilizing market dynamics and impeding overall market growth.

Another adverse effect of insider trading is the potential manipulation of stock prices. Insiders trading on confidential information can influence stock prices in a manner that does not reflect the true underlying fundamentals of the company. Such manipulation can lead to mispricing of securities, causing financial harm to investors who rely on accurate market information to make informed investment decisions. Furthermore, it can create an environment of uncertainty and volatility, deterring investors from participating in the market.

Additionally, insider trading diminishes the efficiency and openness of financial markets. Efficient markets rely on the free flow of information to ensure that prices accurately reflect all available information. However, when insiders trade on non-public information, it distorts market prices and undermines the efficiency of price discovery mechanisms. This reduction in market efficiency hampers the allocation of capital and resources, ultimately hindering economic growth and development.

In summary, insider trading exerts detrimental effects on financial markets and investors alike. It creates an unfair advantage for insiders, erodes investor confidence, facilitates stock price manipulation, and reduces market efficiency and openness. Addressing these effects requires robust regulatory measures to prevent and deter insider trading, promote transparency and fairness, and safeguard the integrity of financial markets. By combating insider trading, regulators can uphold market integrity, foster investor confidence, and promote a level playing field for all market participants.

CASE LAW

Hindustan Lever Limited vs. SEBI[4]

Hindustan Lever Ltd. (“HLL”) purchased 8 lakh shares of Brook Bond Lipton India Ltd. (“BBLIL”) from the Public Investment Institution, Unit Trust of India (“UTI”), two weeks before the public announcement of the merger between HLL and BBLIL. Suspecting insider trading, SEBI issued a Show Cause Notice (“SCN”) to the Chairman, all Executive Directors, the Company Secretary, and the then Chairman of HLL.

The parent company of both HLL and BBLIL was London-based Unilever, operating under the same management. SEBI concluded that HLL and its directors were insiders because they possessed prior knowledge of the merger. SEBI further determined that HLL held Unpublished Price Sensitive Information (UPSI) as defined under Section 2(k) of the 1992 Regulations. This included any information regarding amalgamation, mergers, or takeovers that “is not widely known or published by such company for general information, but which if published or known, is likely to substantially impact the price of securities of that company in the market”.

Rakesh Agrawal vs. SEBI[5]

In 1996, Rakesh Agrawal, the managing director of ABS Industries Ltd., entered into an agreement with Bayer AG, a German company, to acquire 51% of ABS Industries Ltd.’s shares. Upon the announcement of the acquisition, the accused sold a significant portion of his ABS Industries ownership, which was held through his brother-in-law, Mr. I. P. Kedia. SEBI, considering Mr. Kedia as a well-connected individual, accused Mr. Rakesh Agrawal of insider trading and directed him to deposit Rs. 34 lakhs with the Investor Protection Funds of Stock Exchange, Mumbai and NSE (in equal proportion i.e., Rs.17 lakhs in each exchange) to compensate any investors who might make claims later.

On appeal to the Securities Appellate Tribunal (SAT), it was determined that even if Mr. Agrawal had traded securities while in possession of Unpublished Price Sensitive Information (UPSI), he was not guilty of insider trading because his actions were deemed to be in the best interests of the company (as Bayer AG had stipulated a requirement of acquiring a minimum of 51% of the shares). Additionally, there was no intention on his part to profit personally from the trades.

Moreover, SAT ruled that in order to penalize an insider for violating the Regulations, it must be demonstrated that the insider unfairly benefited from the trade. The tribunal also dismissed SEBI’s argument that insider trading jurisprudence is based on the principle of ‘disclose or abstain’, and that an insider in possession of UPSI cannot trade in a company’s stocks until disclosing the UPSI. After reviewing the entire jurisprudence of insider trading regarding the requirement of Mens Rea under the Indian legal system, the tribunal held that: “Considering the objective of the SEBI Regulations which prohibit insider trading, the intention/motive of the insider must be considered. While it is true that the regulation does not expressly include mens rea as a component of insider trading, this does not imply that motive should be disregarded.”

CONCLUSION

The impact, scope, and consequences of insider trading may vary from one country to another, but any instance of insider trading can profoundly affect the reputation of a nation. Shareholders entrust their investments to markets based on the belief in transparency and efficiency. When making investment decisions, investors rely on price-sensitive information provided by listed companies on the stock exchange. With the recent surge in securities market investments, globalization has opened up numerous avenues for cross-border investments by individuals from different nations.

Investors expect the information they rely on to be accurate and fair, as it influences the value of the securities they trade. However, even after public disclosure of price-sensitive information, certain individuals within a company may possess additional, non-public information that significantly impacts security values. These individuals, known as insiders, gain access to such information due to their positions within the company. When insiders use this information for personal gain, either by trading securities themselves or disclosing it to others, they engage in insider trading.

In recent decades, global securities markets have evolved significantly, both in terms of trading mechanisms and the diversity of tradable securities. The integrity of securities markets is vital to a country’s economy, necessitating regulators to enforce laws that prohibit market abuse and safeguard market integrity. These changes have led to truly global markets, enabling traders to transact almost instantaneously across a wide range of products and international markets.

REFERENCES

[1] Insider trading – Wikipedia, https://en.wikipedia.org/wiki/Insider_trading ( last visited 5^th April 2024)

[2] Securities and Exchange Board of India, https://www.sebi.gov.in/ ( last visited 5^th April 2024)

[3] Insider Trading: Meaning, Types, Effects & Examples | 5paisa, https://www.5paisa.com/blog/what-is-insider-trading ( last visited 6^th April 2024)

[4] Five landmark cases on insider trading – iPleaders, https://blog.ipleaders.in/five-landmark-cases-insider-trading/ ( last visited 7^th April 2024)

[5] Five landmark cases on insider trading – iPleaders, https://blog.ipleaders.in/five-landmark-cases-insider-trading/ ( last visited 7^th April 2024)

Disclaimer: The materials provided herein are intended solely for informational purposes. Accessing or using the site or the materials does not establish an attorney-client relationship. The information presented on this site is not to be construed as legal or professional advice, and it should not be relied upon for such purposes or used as a substitute for advice from a licensed attorney in your state. Additionally, the viewpoint presented by the author is of a personal nature.

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