Md. Ziaul Haque Khondker
Recently, the global financial markets have been rocked by conviction in two high profile cases of insider trading. The convictions have relayed a very strong and unequivocal message that the unfair practices and wrong doing in the financial market detrimental to investors and to the market should not go unpunished.
In one case Sri Lanka born Raj Rajaratnam, the head of one of the worlds largest hedge fundsGalleon was convicted of insider trading by a New York court. He faced the music, the toughest punishment for insider trading ever 11 years in jail and a fine of $ 10 million. He was found guilty of fraud and conspiracy on 14 counts. He was accused of making profit of $60 million trading on illegal and insider information. Mr. Rajaratnam and five others had set up of a network of company insiders and consultants to gather material non-public inside information on companies and earn illegal and unfair profit. His hedge fund managed about $ 3.7 billion in 2008. In October 2009, he was the 559th richest person in the world with a net worth of $1.3 billion, according to Forbes Magazine.
In another closely linked insider trading case, India born Rajat K. Gupta, a former director at Goldman Sachs and Proctor & Gamble and former head of Mckinsey and Company, a globally reputed consulting firm, was convicted of securities fraud and insider trading and was sentenced to 2 years in jail and ordered to pay a fine of $5 million. Rajat Gupta, as head of Mckinsey and Company, offered advice to many influential people . Rajat Gupta was involved with Rajaratnam in unfair insider tip and unfair dealings. In one incident Mr. Gupta, who was a director of Goldman Sachs, learnt about investment of $5 billion in Goldman Sachs by the celebrated and successful investor Warren Buffet in a special board meeting in September 2008. He abruptly came out of the meeting and within 16 seconds telephoned Mr. Rajaratnam to inform him of the decision. Mr. Rajaratnam purchased shares in Goldman Sachs, making a profit of more than $8 million in October 2008. Mr. Gupta also gave information to Mr. Rajaratnam about Goldman Sachs unexpected quarterly loss prompting him to sell shares thereby saving a large amount of money. There were allegations that Mr. Gupta had also tipped Mr. Rajaratnam about Proctor and Gambles quarterly sales projections which would be below forecast, helping the latter to speculate on the stock.
These two high profile insider trading convictions are manifestation of US Governments relentless and strong stance against insider trading. US remained most active in tirade against this serious vice in the financial market. In the last 3 years, authorities in the US have brought insider trading charges against more than 100 individuals. One such case involved a former partner of Deloitte and Touche LLP partner, a famous audit firm and his son. They were accused of insider trading in the securities of several of the firms audit clients. Even the famous investment bank, J.P. Morgan was accused of insider trading in 1933 by the counsel of US Senate Banking Committee involving some privileged clients including a former President, a former treasury secretary and CEOs of several famous companies. In Malaysia, an independent director has been charged with insider dealing at a palm oil company.
In the UK, in 2009, two lawyers belonging to two different law firms were charged with insider trading. The insider trading case centered on the famous pharmaceutical company, Novartis takeover of the biotech company Neutec in 2000. It was alleged that the finance director of the acquired company, Neutec conveyed the inside information on the takeover to one of the lawyers, who passed on the news to another lawyer. The two lawyers and Neutec finance director had purchased shares in Neutec on the basis of this insider tip and made gains. In another case of insider trading, a solicitor and his retired father-in-law stood trial in 2009 for allegedly buying shares in a wireless technology firm, TTP Communications a few days before its takeover by US mobile phone company Motorola on the basis of non public insider information.
Simply put, insider trading occurs when someone makes an investment decision based on information/news that is not available to general public, i.e. when someone invests or trades on non-public information. Generally, insider information helps investors getting the information to make unfair gains. It also helps to avoid or reduce loss. In other words, insider trading is a trade which has been influenced by the privileged possession of corporate information that has not yet been made public. As other investors do not have access to such information, an investor using such knowledge is conspiring to gain unfair advantage over the rest of the market.
Relying on non-public information or news for trade violates the principle of fair practice and transparency, the cornerstones of stock market. This kind of trading is disruptive of proper functioning of the stock market and investors lose confidence in the market.
Generally, any company related information, which if made public, would be likely to have significant impact on the price of the companys securities, is regarded as material price sensitive information. Such information can take many forms such as major new developments, schemes, products, change in companys financial condition or business performance, declaration of benefits i.e. dividends, changes in capital structure etc. Sometimes such information may be company or sector specific. In particular, a company should be able to ascertain whether an event or information would be material i.e. would have a significant impact on current and future earnings, earning per share, borrowings or other potential determinants of a companys share price as well as returns to the investors.
While dealing with insider trading, the definition of insiders has been subject of debate as there had been different interpretations of insider, from time to time and from case to case. Generally, directors and officers and other officers of a company are regarded as insider in so far as they have access to material information bearing on price and trade of a stock. However, in practical terms, many other individuals can have access to such material information in course of various contacts, contracts and assignments. For example, statutory external auditors, legal retainers and advisors, marketing agents in case of outsourcing, may be in possession of insider information.
Then again, some individuals who are not insiders may be in control of material non-public information and news in various situations. In addition, certain individuals may also come to know of material information, which are not public, in course of contact and association with the above insiders, such as close relatives. Some insiders may ignorantly divulge such information to relatives, friends and others. As such, insider definition has been extended to wives, siblings and other close relations of core insiders i.e. the employees of a company, though opinions differ in this regard. If such individuals exploit the information/news and undertake trade in the relevant stocks, they can be treated as insiders.
As a result, the phrase insider trading thus includes a wide range of individuals who trade in a companys stock on the basis of material information not known by the public at large.
But what is at stake is insider trading i.e. trade based on non-public material information. A very important collateral issue is the scope and timing of trade by insiders. Can the insiders trade in their companys securities? If so, when can they do so? Here, there are several dimensions. Insiders who do not possess (or do not use) material non-public information may trade freely. Nevertheless, many countries have adopted measures to pre-empt scope of trading by employees including those who do not have access to material information as well as by directors. One such measure is the prohibition of trading by employees/directors covering a specific period including date of closure of accounting period and the date of declaration of material/piece-sensitive decisions. However, this aspect becomes tricky when an insider simultaneously trades with the public disclosure of the material/price sensitive information and news in his/her possession or knowledge. In such cases, the insider may only trade after information in question has been made public. But is mere disclosure sufficient? Here the question arises whether or not the information in question has been adequately disseminated with enough time to reach the broad investors. In this respect, it is pertinent to refer to a famous insider trading case.
Texas Gulf Sulphur (TGS), a mining company, in Canada, carried out, between March 1956 to April 1964 survey drillings, chemical assay etc. leading to discovery of significant ore in Ontario. The president of the company instructed the exploration group and the other persons involved, not to disclose the news, not even to other directors. Rumors swirled several times but the company denied the rumors. But the company finally disclosed its discovery in a press conference in April, 1964. But by that time, TGS insiders bought stocks of the company. Some outsiders also gained access to the information in the period from November 1963 to March 1964.
The discovery was first announced by a press release to the Canadian news media distributed at 9:40 a.m. on April 16, 1964. A news conference with American media was arranged at 10 a.m. on the same day. The news showed up on the Dow Jones ticker tape at 10:54 a.m. that day. But TGS director Francis G. Coates left the April 16th news conference to call his broker son-in-law to buy 2000 shares. But the broker, in addition to executing Coates order also purchased 1500 shares for himself.
Coates admitted that he traded the TGS stocks while in possession of material information on the discovery of ore but claimed that information/news had been effectively disseminated to the public before his trades was executed implying that information/news was no longer non-public. But the court differed and contended that before insiders and others may trade on the basis of non-public material information, the information must have been disclosed in a manner that ensures its availability for all investors. Just waiting for a press release for the reporters is not enough. The information/news must have been widely disseminated to reach the general investors.
The court further observed that, at a minimum, insiders wait until the news would reasonably be expected to appear over the Dow Jones ticker tape suggesting that a large number of investors receive the news to take decision whether to invest or not. The basic logic is that all investors trading on impersonal exchange must have equal access to material/price sensitive information and news. In other words, all investors should be subject to identical risk and equal opportunity which are the foundations stock market efficiency and transparency.
History of insider trading: Broadly speaking insider trading history dates back to 1789 1792 period. In that period William Duer, the then assistant Secretary of US Treasury was the first individual to use information gathered in his official position for speculative trading. In effect, he was the first insider trader. He speculated in the newly issued debt of the newly born US Government. His speculation did not work and he went bankrupt when the debt bubble burst. In 1800, a US senator and some others profited from short sales of railroad stocks taking advantage of privileged position and information. In 1869, a former US President Ulysses S. Grants sisters connection was used by two well-known manipulators to make unfair and illegal profit from trading in the gold market. But the President realized this intention and took corrective actions which led to gold market crash on Friday, 24th September, 1869 which is known as Black Friday.
Insider trading gives rise to various negative implications, such as
Price distortion: Financial theories postulate that price of stock in an efficient market is fairly determined when material information is available to all investors at the same time. This is because of optimum supply-demand match. Though efficient markets are rarely found, nonetheless, insider trading does distort stock prices harming general investors. One study reveals that insiders on average outperform the market more than 7%, which means that profit earned by insiders is 7% more than that of other investors. Price distortion by insiders jeopardize systematic price discovery sought by investors.
Damage to company reputation: Some contend that insider trading by directors/officers tarnish a companys reputation and sour shareholder relations. This reputational damage could raise the cost of raising equity capital. This usually happens when a company exposed to insider trading issue right shares or issue debts but the investors demonstrate reluctance to subscribe. Some people go as far as to argue that even lenders may also express concern, and demand additional guarantees while processing loans to a company subject to intense insider trading.
Delay in decision making: Some employees who engage in insider trading may delay transmitting material information to their superiors for personal gains, exerting negative impact on companys operations.
Before the establishment of Securities and Exchange Commission in US, the largest stock market in the world in 1934, there was very little or slack regulation of the stock market. Consequently, detection of insider trading was difficult and even when it was identified that there was not much legal force to bring the insider trades to task. In a landmark insider trading case in 1926 to 1933 period involving a mining company, an experienced geologist with knowledge of mineral deposits was accused by another shareholder of insider trading in stocks of company. But Massachussets (USA) Supreme Court ruled in 1933 that no wrongdoing was committed. The court further ruled that the accused merely had exercised a perk (benefit) of being an insider. For about next 30 years, insider trading cases generally followed this court ruling.
Prosecution of insider trading case was not common until the second half of the present century. Since 1961, insider trading laws and regulations became tougher through adoption of a host of cases and interpretations.
In USA, the Securities and Exchange Act of 1934, its amendments and additional legislations passed in subsequent periods dictate the legal basis for indictment of insider trading. Among all the codes, the broad language in the relevant sections which bans insider trading are any manipulative or deceptive device used in connection with the purchase or sell of any security. This statement has been widely applied in curbing insider trading and in banning insider trading and in prosecuting insider trading indictments.
The American SEC prosecuted a broker accused of insider trading for the first time in 1962. His punishment was a fine of $ 3000 and suspension of his brokerage from New York Stock Exchange for 20 days. But insider trading now invites severe punishment. Three of the worlds most notorious and much publicized insider trading cases involved, Dennis B. Levine, Ivan Boesky and Michael Milken. Dennis B. Levine, an investment banker was at the centre of insider trading in the 1980s. Over the years, he built up a network of professionals at several Wall Street firms who engaged in insider trading. Members of the network exchanged non-public material information on mergers and acquisition and engaged in insider trading to earn illicit profits. He pleaded guilty to insider trading. His penalties were two years in federal prison, $ 362,000 fine, and $ 11.5 million in disgorgement, life ban from the securities industry. Subsequently, Levine directly implicated a powerful stock market player in mid 1980s, Ivan Boesky. Revelations by Boesky also implicated another prominent actor in the mergers and acquisitions field, Martin Siegel. Boesky paid both Levine and Siegel for pre-takeover news and information on the basis of which he traded in stocks. But when Boesky made big gains in almost every deal in 1980s such as Nabisco, Gulf Oil, Chevron, Texaco, USA, SEC became suspicious leading to unearth of the insider trading case. He pleaded guilty to insider trading and agreed to pay a fine of US $ 100 million and to cooperate with US SECs investigation. Due to Boeskys confession and testimony, SEC, USA indicted some of the worlds famous financiers including Michael Milken, known as the Junk Bond King. Milken was not accused of insider trading but he pleaded guilty to securities fraud and reporting violations. He was sentenced to 10 years in prison and was permanently banned from the securities industry by SEC. He also agreed to pay $ 600 million in fines.
Other countries are also adopting tougher stands against insider trading. There are several reasons for the crusade against insider trading. The rise in the incidents of market irregularities and market abuse has impelled the regulators to crack down on insider trading. Increase in cross border listings have pushed regulators to become much more agile to ward off market abuse and unfair practices. Strengthening of market integrity, thrust on investor protection and on fair dealings has received intense focus and deep attention due to mergers between stock exchanges, including the cross border mergers. Loss suffered by the investors, especially institutional investors, has alerted them making them much more vocal against insider trading. The significant rise in shareholder activism across the world, mostly in Europe and USA, has helped to take steps to curb ill practices in the market including insider trading.
The big stock markets such as USA, UK and Hongkong have reinforced their battle against insider trading. Developing countries in their bid to attract foreign investment, more so foreign portfolio investment, have initiated policies aimed at combating insider trading.
The following table shows the position of insider trading laws and actions in some markets:
Source: The Economist
In India, the Securities and Exchange Board of India (SEBI) introduced insider trading regulation in 1992. Sebi can impose a penalty upto Rs 250 million or 3 times the gains made from such insider trading. Till 2011, a total of 57 cases relating to insider trading were investigated and 28 were settled. There were suspensions and punishment. Some warnings were issued. In some case Sebi ordered the disgorgement of the profits arising out of insider trading. But nobody was sent to jail. Sebi has been mulling actions for tougher measures. After Raj Rajaratnam’s conviction in USA recently, it has approached the government for power to tap phone calls for suspected insider trading, which was declined. But there are possibilities that Sebi may have access to phone call records of suspected insider traders and other unfair practices relating to insider trading.
High frequency trading, alternative trading platforms and enlargement of the stock exchanges and other developments have led to sharp rise in the average daily turnover in several stock exchanges, especially the major exchange which has made difficult the task to detect insider trading. For example, in USA, average daily trades increased to 12.1 billion in 2008 from 1.6 billion in 2003. High frequency trading, in which computers make elaborate decisions to initiate orders based on information received electronically before human traders are able to process the information they observe has resulted in a dramatic transformation of the market microstructure.
Prof. Frank Partnoy of the University of San Diego says, ‘’Before you were trying to find a needle in a haystack ………… Now you have to find a needle in a million haystacks! ‘’
The sharp escalation in the average trades tended to make it difficult to detect insider trading. But regulators have responded by upgrading the surveillance and monitoring systems. In August, 2011, UK’s financial regulator, Financial Services Authority (FSA) launched a ‘more intelligent’ monitoring system to detect market abuse, called Zen system. This system is based on a new transaction reporting data base and abuse detection system using Aii (Alternative instrument identifier). All UK investment managers and brokers are required to report comprehensive transaction data to FSA the day after a trade is completed, allowing FSA to detect any irregularity, potential market abuse, insider trading or market manipulation. Trading patterns precedent to and after price sensitive/material information and news and corporate events such as dividend declaration earning news, takeovers, new products etc. are regularly scrutinized by regulators.
In Bangladesh, there are adequate regulations for prohibition of insider trading, given the present market structure. The 2[wmwKDwiwUR I G·‡PÄ Kwgkb (myweav‡fvMx e¨emv wbwl× Kib) wewagvjv] 1995] clearly spells out the definition of insiders. Information which is price sensitive/material is also outlined in the regulations.
Insider trading is, without doubt, very sinful for a stock market. Not only does it subvert market integrity and fair dealings, but it also shatters investors’ trust and confidence thereby disrupting systematic expansion of the market. Insider trading has the tendency of becoming pervasive because of the apparent short-term benefits. Without any action to suppress this market abuse, the damage to entire market would be substantial. For all these reasons, regulators worldwide pursue a zero tolerance policy in combating insider trading.
The writer is former chairman, Securities & Exchange Commission