Insider Trading in Company Securities : An Overview

Ashlsh Kumar Sana,

Lecturer, Department of Commerce,
University of Calcutta

Insider trading refers to the illegal trading of securities based on confidential information from internal
company sources. which would not be generally available to the public. so that the trader has an unfair
advantage. Scholars. academicians. market players and market regulators have classified insider trading
into two categories: legal and illegal. Undoubtedly. insider trading is a white--collar financial crime.
Securities market players like Harshad Mehta, Hiten Dalal or Ketan Parekh were involved in insider
trading activities in the lndi"8 stock market. whereas Michael Milken, Ivan F Boesky, Manin Siegel and
Dennis Levin were their counterparts in the international stock market. The Sc;curities Exchange
Commission (SEC) in the USA has implemented insider-trading regulations and has penalized insiders in
many cases. In India, the Securities Exchange Board oflndia (SEBI) framed regulations in the year 1992
for the first time, and later, thoroughly revised its regulations in the year 2002. These regulations have
been criticized from different points of view.
Key-Words: Insider trading; Insider; Price-sensitive infonnation; Securities Exchange Commission;
Securities Exchange Board of India.

Introduction
History reminds us of some sad examples of Indian stock market. Big scamsters played an
important role behind of 1992 securities scam and price rigging. A number of new companies
were involved in fraudulent practices during 1997-2000. Few companies started functioning
during this time and thereafter vanished during the period 1996-1999. A list of phoney
IT( Infonnation Technology) companies were formed during the IT boom of 1998-1999. In
each and every case there were massive malpractices, price manipulations, price rigging and
insider trading involved. These facts exposed the impotency of the market regulators and the
effectiveness of the securities laws in India to tackle the scam and prevent fraud of the common
investors. This paper is a humble attempt to· discuss illegal and legal insider trading, and the
magnitude of the insider trading.

Insider Trading
Insider trading refers to the illegal trading of securities based on confidential information from
internal company sources, which would not be generally available to the public, so that the
trader has an unfair advantage. Insider traders use specific unpublicized information either for
their own fmancial benefit or for avoiding losses. The concept. implicit in the tenn 'insider
trading', includes any person having access to unpublicized price-sensitive infonnation about
the company. Once such unpublicized infonnation becomes available to the public, it affects
the share-prices of the company in such a manner that its benefit becomes available only to the
insiders, only at the first instance. Insider trading undoubtedly is a white-<:ollar financial crime,
 Jlmis1QanarS,,,,. 173

the volume of which is estimated to be around US$ 750 billion (UK£ 500 billion) all over the
world.
According to Phil Erlanger, a former Senior Technical Analyst with Fidelity, and founder of a
Florida firm that tracks short selling and options trading, insiders made off with billions (not
mere millions) in profits by betting on the fall of stocks during the tumble in the aftennath of
the World Trade Center and Pentagon attacks (http,l/www.erlangersqueezeplay.com).

Legal Insider Trading

There is a debate among the scholars, academicians, market players and market regulators
whether the insider trading is legal or illegal. Further, the issue arises how it could be proved?
A number of financial economists and law professors take the position that insider trading
ought to be legal. They base their case on the proposition that insider trading makes the stock
market efficient. Presumably, the inside information will come out at some point. Otherwise.
the insider would have no incentives to trade on the information. If insider trading was legal,
this group argues that insiders would bid the prices of stock up or down in advance of the
information being released. The result is that they would more fully reflect all information
both public and confidential about a company at a given time.
Insider trading might be advantageous for some companies and not for others and if so would
not be sensible to pennit firms to opt out of insider trading enforcement? An interesting example
in this respect is that Charles F. Fogarty purchase of Texas Gulf Sulfur shares during I 963 and
1964. Fogarty, an executive Vice-president of Texas Gulf Sulfur, knew that the company had
discovered a rich mineral lode in Ontario that it could not publicize before concluding leases
for mineral rights. In the meantime Fogarty purchased 3,100 Texas Gulf shares and earned
$125,000 to $150,000. For this reason Fogarty was elevated to chief executive officer of his
company. Moreover. following Fogarty's death, another insider who was also known to have
traded on the same information was elevated to replace him. Clearly Texas Gulf's Board of
Directors and shareholders must not have found the trading completely reprehensible. Yet the
law makes no provision for opting out, implicitly assuming that inside trading ignores all
companies policymakers never seriously ask who is harmed and who is helped and by how
much.
The legal version of insider trading occurs when corporate insiders i.e. directors, officers and
greater than 10% beneficial owners buy and sell stock in their own companies. In this case
insiders must report to the market regulators in USA (Securities Exchange Commission) by
filling the required forms as per section 16 of Securities & Exchange Act of 1934. After
appointing an officer, director or beneficial owner they must fill up the Fann 3 within 10 days.
Changes in ownership within IO days of the end of the month in which the change took place
should be reported in Form 4 and an annual statement an annual statement of ownership of
securities in Form 5.
Who are Insiders ?
An insider is one who has access to valuable information concerning the company before it is
available to the general investing public. Directors and other key company officials, bankers,
substantial shareholders, profe&sional advisors, auditors, stock exthange officials, share transfer
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agents and any other party or persons having any kind offiduciary relationship with the company
may be considered as insiders. Insider trading may be conducted not only the insiders mentioned
above but also by relatives, friends, and associates of such insiders. It is also mentioned that
past officers and agents of company are also sometimes included as insiders.

Price-sensitive Information

Some of the important company related, insiders use events and phenomena that have the
potential of changing prices as follows:
Decisions concerning payment of dividends, bonus shares or right shares
New investment decisions
Changing financial policies
Entry or exit of key managerial personnel
Impending mergers and acquisitions etc.
Launching of new products and introduction of new production technologies.
Exploration of new markets
Entry or exit of key managerial personnel
Initiation of new sales and pricing policies

Effects of Insider Trading

An efficient and effective stock market should have excellent information processing ability.
But the fact is that the most active stock markets in the world sometimes lack these attributes.
The ill effects of insider trading are as follows :
i) Insider trading undermines investor confidence in the fairness and integrity of the
capital market.
ii) The privileged few benefit and the common investors are left to suffer.
iii) Rampant insider trading defers foreign investors from the capital markets.
iv) Insider trading is often coupled with rigging of share prices to attract investors or
lure genuine investors into deals of mergers and acquisitions etc. The ultimate gain
accrues to an unscrupulous investor and ultimate loss to a genuine investor.

Imporlant Insider Trading Cases in USA

USA is one of the most regulated stock market so far in the world market. Great securities
scam were found not only in the US stock market but throughout the world. The compsnies
such as Marcus Scholoss & Co., Drexel Burnham Lambert and the names of Michael Milken,
Ivan F Boesky, Martin Siegel or Dennis Levin have cropped up and hurt the market sentiment
which indicates and tends to suggest that there is large scale involvement of corporate insiders
in the USA and also in the international arena.
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The landmark market players in USA accused for insider trading by the courts are as follows :

Trader Occupation Fines &Repayments Jail sentence

of Illicit Profit
Michel. R. Milken Banker, Drexel $600million Pending
Burnham Lam hart
Ivan F Boeskey Arbitrage $JOO million 3 years
Dennis Levine Banker , Drexel Co. $11.6 million 2 years
Paul Bilzerian Investor, Chainnan, $1.5 million 4 years
SigerCo
Martin Siegel Banker, Kidder $9million 2 months
Peabody, Drexel
Charles Zarzecki Partner, $1.6 million 4 years
Princeton/Newport
Boyd Jefferies CEO, Jefferies& Co. $250,000 Probation

Important Insider Trading Cases in India

Although the~ is no statistical evidence of the incidence of insider trading in India. Indian
companies such as Hindustan Lever limited. Colgate Palmolive etc. and the activities of the
market operators Harshad Mehta, Hiten Dalal or Ketan Parekh prompt us to believe the existence
of this crime in the country. The landmark case of insider trading in India can be discussed as
an example (Hindustan Lever Limited).

• Hindullan Lever Umiled vs. SEBI

A core team consisting common directors of Hindustan Lever limited (HLL) & Brook Bond
India Ltd.(BBD..), had been formed to consider modalities of a merger between HLL&BBIL.
Unilever Inc.of U.K. is the parent company HLL & BBD...On January 17, 1996, the Regional
Directors of Unilever had granted in principle for the merger.
HLL purchased a total of 19.74 lakhs shares of Brook Bond Lipton India Ltd. in the phases.
First lot of 7 lakhs shares were purchased prior to January 1996, the second lot of 8 lakhs
shares were purchased in March 1996 through public financial institutions, UT! for Rs. 350.35
per share by paying a premium of I 0% over the market price of Rs.318. The purchase deal was
finalised on March 25, 1996. The public announcement of the merger was made on April 19,
1996. The third lot of 4.7 lakhs shares, were purchased in December 1996.
Pursuant to a large number of complaints, SEBI investigated the matter and came to a conclusion
that HLL as an 'insider' purchased 8 lakhs shares of BBD.. on the basis of unpublished price-
176

sensitive infonnation and bad therefore, violated SEBI (Insider Trading ) Regulations, 1992.
SEBI also held that since infonnation about merger would have affected the price of securities
and reasonable investor would have attached importance to such inform&tion, non-disclosure
of this infonnation to IJTI put it to a distinct disadvantage and prevented it from taking an
infonned decision. So, HLL has been charged to be involved in insider trading practices. SEBI
thus passed an order directing HLL to compensate UT! to the extent of Rs. 3.04 crores and also
didected prosecution against HLL and its five directors.

Thereafter HLL appealed to the Appellate Authority. The Appellate Authority raised the
following questions :

i) Whether HLL was an insider?

ii) Whether the infonnation available to HLL constituted unpublished price-sensitive

information ?

iii) Whether it was necessary for SEBI to establish that the purchase of shares was
motivated by the price-sensitive unpublished information and whether it was also
necessary to establish the motive for profit or gain for proving insider trading ?

iv) Whether SEBI was empowered to award compensation of RS. 3.04 crores to UTJ?

v) Whether SEBI was justified in ordering prosecution of the Directors of HLL under
Section of SEBI Act ?

After thorough investigation by the appellate authority the following conclusions were arrived-

i) HLL and BBil.. were closely interconnected under the same management of Unilever.
Thus HLL was to treat as an insider in respect of the information. about the merger
before it was made public.

ii) The information relating to merge was in price-sensitive and contention of IH..L that
only information relating to swap ratio was sensitive was not tenable.

iii) The circumstantial evidence available established strongly that the purchase of 8
lakhs shares ofBBIL by HLL was motivated by the impending merger proposal. Bui
the Section 3( I) of SEBI Regulations of insider trading reveals that there is no necessity
to prove the motive of profit or avoiding loss to provide insider trading.

iv) SEBI did not have the power to award of compensation as a direction under section
llJ of SEBI Act, 1992. Even SEBI was not given opportunity of being heard to
HLL.

v) Lastly, the prosecution ordered by SEBI was not justified since the charge of IT was
not established . Thi$ is due to the fact that the infonnation about the merger was
publicly known as several newspapers reported.
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The whole episode from 1996 to 1998 is detailed below :

I Pre- January ,1996 UTI sells 7.0 lalch shares of BBIL To HLL
2 March 19, 1996 UTI sells another 8 lakh shares to HLL @ 350/ per share
3 April 19, 1996 HLL, BBLIL inform the stock exchanges about their
proposal of merger.
4 April, 22, 1996 Boards approve merger in the ratio of 9 equity shares
of HII for 20 equity shares of BBLIL; market being
Rs. 390/-
5 April, 30 1996 SEBI commences investigation into insider trading.
6 December, 1996 Third lot of 4.7 lakh shares of BBLIL was sold to
HLL< taking Unilevers's direct and indirect holding in
BBLIL
7 August 4, 1997 SEBI issues communication of findings to Iil..L
8 March II, 1998 SEBI issues order for presentation, for filL and its five
directors and Rs. 3.08 Crore compensation to UTJ.
9 April, 2 I 998 HLL appeals to appellate authority against SEBJs order
10 July 14, 1998 Appellate authority sets aside SEBI order

Need for Change of Regulations in India

Insider trading has been practiced in India for the last 50-60 years. Two expert committees
namely the Patel Committee in 1985 and the Sachar Committee in I 987 had made
recommendations to curb such type of trading. However, no such concrete steps were ever
been taken by the government in this direction prior to the formation of SEBI. Securities and
Exchange Board oflndia was set-up as the apex investor protection body in the year 1992. It
framed regulations on insider trading named SEBI, Securities and Exchange Board of India
(Insider Trading) Regulations, 1992. But these regulations suffer major drawbacks in respect
of curbing insider trading and protecting investors. In the year 2002 they have thoroughly
revised these Regulations. An important example of this revision is, prior to amendment,
Regulation 2. clause (k) defined 'unpublished price sensitive information' under 8 parameters.
After amendment, clause (ha) has been inserted to define 'Price Sensitive information' and
clause (k) has been amended to define the word 'unpublished' .The amendment seeks to take
away the defence which was provided by the definition earlier i.e. any information ~hich is
generally in the media or otherwise, cannot qualify as 'unpublished price sensitive information'.
This defence was relied upon by the Directors of MIS Hindustan Lever Ltd. (HLL) when they
were charged with the offence of insider trading in connection with the merger of MIS Brook
Bond Lipton India Ltd. (BBLIL) with HLL.
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Conclusion
If insider trading is a notorious practices in the stock market then how can it be determined
whether there is insider trading or not? It is mostly admitted that behind almost all big scams
and scandals in the stock market all over the world, for all the time, insider trading played a
villainous role. The problems for which the stock market of a country fails to attain the critera
of an efficient stock market. Though there are valid reasons behind legal insider trading,
ultimately it does hurt the market sentiment, which needs to be curbed.

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