By Vruti Patel, Gujarat National Law University, Gandhinagar, Gujarat
This paper deals with various regulations prohibiting insider trading in the Indian economy while laying out the legal framework regarding the same in other countries such as the United Kingdom and the United States of America. In the context of insider trading, this paper goes on to discuss the interpretation of the term “legitimate purpose”.
The Securities and Exchange Board of India (“SEBI”) (Prohibition of Insider Trading) Regulations which were implemented in 1992 [the “1992 Regulations”] were one of the first regulatory regimes on insider trading that penalized the offence and several incremental amendments were made to the 1992 Regulations as a result of the findings of the judiciary until then, inter alia.[i] In 2015, SEBI appointed a committee under Justice N. K. Sodhi comprising of 19 members.[ii] They proposed several changes and introduced various new provisions with the benefit of literature published in various jurisdictions such as the United States of America, United Kingdom and European Union.[iii]
The Committee identified the inadequacies of the current regulatory regime and attempted to develop the most appropriate regulatory policy to curb such inadequacies. One of the changes introduced was concerned with the restrictions on communication and trading by insiders.[iv] The 1992 Regulations prohibited communication of insider information that was not available to the general public. The new Securities and Exchange Board of India (“SEBI”) (Prohibition of Insider Trading) Regulations of 2015 [“2015 Regulations”] have introduced three exceptions where such unpublished information can be further communicated without constituting an offence.[v] The concerned Regulation reads-
- (1) No insider shall communicate, provide, or allow access to any unpublished price sensitive information, relating to a company or securities listed or proposed to be listed, to any person including other insiders except where such communication is in furtherance of legitimate purposes, performance of duties or discharge of legal obligations.
Accordingly, the three new exceptions are-
- Legitimate Purpose:
Legitimate means anything that is conforming to the laws or rules.[vi] Hence, a behavior, which is in conformance to the laws, is a legitimate act. Any act done with acceptable principles of reasoning or is sensible and valid and can said to be a legitimate act is an exception to the restrictions on communication and trading by insiders.
- Performance of Duties:
A duty is a moral or legal obligation.[vii] Any task or performance that qualifies as a duty under a person’s course of employment can be an exception to the restriction on communication of information by insiders.
- Discharge of legal obligations
An obligation is something that you must do because of law, rule, promise, etc.[viii] If a person communicates any unpublished information of a company to an outsider as he is bound by the law or a promise, it is an exception to the restrictions introduced in the regulations.
The above mentioned exceptions have been incorporated from various regimes published by different jurisdictions throughout the world. However, the phrase “legitimate purpose” is very vague and ambiguous in terms of what can be regarded as a legitimate purpose while exempting an action concerned with insider trading. The scope of legitimate purpose shall be discussed at length further on below.[ix]
Since the new regulations have recently been established by SEBI, there is little literature on the newly incorporated exceptions in the Indian Judiciary. This memorandum, therefore, to gain some insight into what “legitimate purpose” means, looks at literature and laws in the following jurisdictions:
- United Kingdom;
- European Union;
- United States of America.
The aforementioned jurisdictions have been selected based on the corresponding language in their laws to which a parallel may be drawn to the language used in the 2015 Regulations.
Financial Service and Markets Act (the “FSMA”) is one of the acts that govern Insider Trading and Market Abuse in the United Kingdom.[x] The FSMA came into effect in 2000. Implementation of the FSMA completed vesting of supervisory responsibilities in the regulator, the Financial Services Authority (FSA), the regulatory body under the act, and rationalized and substantially replaced the banking, financial services and insurance companies’ legislation. The FSMA was amended in 2005 including Section 118(5) of the act wherein the amendment incorporated exceptions to insider trading. This Section titled ‘Market Abuse’ contains provisions corresponding to those on insider trading in the Indian regime.
Section 118 (1) and (5) of the FSMA say that:
(1) For the purposes of this Act, market abuse is behavior (whether by one person alone or by two or more persons jointly or in concert) which—
(a) Occurs in relation to—
- qualifying investments admitted to trading on a prescribed market,
- qualifying investments in respect of which a request for admission to trading on such a market has been made, or
- in the case of subsection (2) or (3) behavior, investments which are related investments in relation to such qualifying investments, and
(b) Falls within any one or more of the types of behavior set out in subsections (2) to (8).
(5) The fourth is where the behavior consists of effecting transactions or orders to trade (otherwise than for legitimate reasons and in conformity with accepted market practices on the relevant market) which—
- give, or are likely to give, a false or misleading impression as to the supply of, or demand for, or as to the price of, one or more qualifying investments, or
- Secure the price of one or more such investments at an abnormal or artificial level.
Accordingly, any non-public information that is communicated to any outsider, would amount to insider trading unless it can be proved that it was shared for legitimate reasons.
The scope of the term “legitimate reasons”, has, over the years, been explained through case law and some guidelines, to gauge what can and cannot be a legitimate reason. In the case of 7722656 Canada Inc. (formerly trading as Swift Trade Inc.) v. Financial Services Authority [xi] the engagement of Swift Trade Inc. in the form of a manipulative trading activity known as “layering” was held not to be a legitimate purpose. In layering, the trader places orders with no intention of having them executed but rather to trick others into buying or selling a stock at an artificial price driven by the orders that the trader later cancels.[xii] It was also held that derivatives trading fell within the scope of Section 118(5). It is not necessary that behavior contravening Section 118(5) of the FSMA should be solely behavior of Swift Trade because the opening words of Section 118(1) envisage that the behavior can be that of “one person alone or two or more persons acting jointly or in concert”. “Jointly” means no more than “together with another” and does not require that both parties act with the same ulterior purpose or intention. Therefore, with this concept it can be concluded that Swift Trade Inc. did effect transactions or orders to trade in shares, even though that was done through intermediaries such as Merrill Lynch and Penson.[xiii] In another case, Visser and another v. Financial Service Authority,[xiv] the company concerned had been engaged in market abuse and misleading investors for a prolonged period of time. Visser used legitimate reasons as a defense.
FSA relied upon explanatory expansion of those provisions, which appears in the Code of Market Conduct at MAR 1.6.5E published by the Financial Conduct Authority (“FCA”). The FCA regulates financial firms providing services to consumers and maintains the integrity of the U.K.’s financial markets.
In the opinion of the FCA the following factors are to be taken into account when considering whether behavior is for “legitimate reasons”, and are indications that it is not:
(1) If the person has an actuating purpose behind the transaction to induce others to trade in, bid for or to position or move the price of, qualifying investment;
(2) If the person has another, illegitimate, reason behind the transactions, bid, or order to trade; [Note: Recital 20 Market Abuse Directive[xv]]
(3) If the transaction was executed in a particular way with the purpose of creating a false or misleading impression.
It has been derived from this case of Hobbs v. FSA [xvi] that Mr. Hobbes intended to manipulate the September future prices. His intent was to mislead and thereby influence the behavior of other market participants to gain more profit. Hobbs had conducted proprietary trading for Mizuho in LIFFE (London International Financial Futures and Options Exchange) coffee futures and associated derivatives. It was consequently held that the trading that Mr. Hobbs indulged in was not for legitimate reasons and was not in conformity with accepted market practices.
There are certain articles and papers that have set out guidelines regarding the scope of the term “legitimate reasons”, although it is not exhaustive.One indication that the behavior is for legitimate reasons, for example, is where the transaction is pursuant to a prior legal or regulatory obligation owed to a third party.[xvii]
FCA Code of Market Conduct MAR 1.6.6E sheds light on certain possible circumstances where the term in question is valid.
In the opinion of the FCA the following factors are to be taken into account when considering whether behavior is for “legitimate reasons”, and are indications that it is:
(1) If the transaction is pursuant to a prior legal or regulatory obligation owed to a third party;
(2) If the transaction is executed in a way which takes into account the need for the market or auction platform as a whole to operate fairly and efficiently;
(3) the extent to which the transaction generally opens a new position, so creating an exposure to market risk, rather than closes out a position and so removes market risk; and
(4) If the transaction complied with the rules of the relevant prescribed markets or prescribed auction platform about how transactions are to be executed in a proper way (for example, rules on reporting and executing cross-transactions).
The detection and prevention of insider dealing, market manipulation and other forms of market abuse form a major component of regulatory monitoring, investigation and enforcement activities globally and is expected to remain a central focus. Having discussed the above concepts, India can take assistance from various aspects of U.K. laws in the interpretation of the 2015 Regulations.
The European Union introduced the Market Abuse Directive in January 2003 (“2003 Directive”) on insider dealing and market manipulation. The 2003 Directive is intended to guarantee virtue of the financial markets, incorporate fair practices and increase investor confidence. The objective of the 2003 Directive is to prevent market abuse in order to preserve the smooth functioning of financial markets.
The Market Abuse Regulation (“MAR”)[xviii] laid down certain guidelines that set out the following circumstances (“legitimate behaviors”) in which a person dealing securities while in possession of inside information shall not be deemed to have engaged in insider dealing, unless a competent authority is able to establish an illegitimate reason for the transaction.
- Market-making, where an acquisition or disposal of financial instruments to which the inside information relates was made legitimately in the normal course of the market maker’s functions.
- Brokerage, where, on the basis of an order authorized by a third party, a person acquires or disposes of financial instruments legitimately in the normal course of his employment, profession or duties.
- Discharge of supervening obligations, where financial instruments are acquired or disposed of in order to satisfy a contractual, legal or regulatory obligation arising in good faith prior to the inside information becoming known to the person concerned.
- M&A, where inside information obtained in the context of a public takeover or merger is used solely for the purpose of that takeover or merger and is made public prior to acceptance of the offer or the approval of the merger. This legitimate behavior does not apply to stake building.[xix]
Legal Standing in the United States of America
The United States has been the leading country in prohibiting insider trading. In the U.S., insider trading is prohibited by the U.S. federal securities laws. Almost all prosecutions for violations of insider trading laws are based on either insider trading where a person purchases or sells securities while he is in possession of non-public information or where a person misappropriates and trades on the basis of confidential information. The Securities Exchange Commission (SEC) and U.S. Department of Justice play a vital role in the regulation of markets. They have expanded the scope and intensity of their enforcement efforts.[xx] The SEC was created by Section 4 of the Securities Exchange Act, 1934.[xxi]
Regulation Fair Disclosure (“Regulation FD”) is a regulation that was promulgated by the SEC in August 2000. The Regulation FD has fundamentally changed how companies communicate with investors by bringing more transparency and more frequent and timely communication. The Regulation FD introduced the concept of “legitimate purpose”. Within the US regime on insider trading, there is a set of Rules called Final Rule: Selective Disclosure and Insider Trading (“Final Rule”) also published by the SEC. The scope of the Final Rule extends to the selective disclosure by issuers of material non-public information; when insider trading liability arises in connection with a trader’s “use” or “knowing possession” of material non-public information; and when the breach of a family or other non-business relationship may give rise to liability under the misappropriation theory of insider trading. The language used in the 2015 Regulations, is akin to that in Rule 100(b) (2).
These exclusions have been mentioned in the II (B) (1) (a) of the Final Rule.
Rule 100(b) (2) – exclusions; this approach recognizes that issuers and the officials may properly share material non-public information with outsiders for legitimate business purposes.
There are no rules that unequivocally clarify the extent of the term “legitimate reasons”. Although, over the course of the years, through case law, what can and can’t be a legitimate reason has been pronounced on. For instance, in the case of SEC v. Lund [xxii] where the issue was whether the information disclosed by Lund was for a legitimate business purpose. Possible investment in a new venture was held to be a legitimate reason for disclosure of information by the court. Lund had purchased stock after receiving non-public information from a corporate insider. The court concluded that the insider had not breached his fiduciary duty because the information was disclosed for the legitimate corporate purpose of a possible investment in a new venture and because disclosure was within the scope of his authority as an officer of the corporation. Consequently, Lund was not liable as a tippee.[xxiii] The Court rejected the notion that sophisticated traders like Chiasson and Newman “must know” that certain information is disclosed in breach of a fiduciary duty, and not for any legitimate corporate purpose. The Court instead concluded that Chiasson and Newman knew “next to nothing” about any personal benefit to the insiders at Dell and NVIDIA and emphasized that companies often authorize employees to “selectively disclose” corporate information for the company’s benefit.[xxiv]
SEC Rule 10b-5, is one of the most important rules targeting securities fraud promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act, of 1934 of the USA.[xxv]
For instance, in the event where an outsider overheard two corporate insiders discussing non-public price-sensitive information at a restaurant or at a sporting event, it has been opined that the two insiders neither knew nor had reason to know that an outsider was overhearing their conversation, which was being held for legitimate purposes.[xxvi] Whether or not the outsider violated rule 10b-5 if traded on this information can be discussed in the context of two sentences of footnote 12 of Chiarella[xxvii] which give conflicting results. The two sentences in the concerned footnote are below. The first reads –
“Tippees of corporate insiders have been held liable under § 10(b) because they have a duty not to profit from the use of inside information that they know is confidential and know or should know came from a corporate insider….“
The tippee’s obligation has been viewed as arising from his role as a participant after the fact in the insider’s breach of a fiduciary duty. The Insider Trading Sanctions Act by reading only the first sentence, the outsider is liable because he should know that he obtained confidential price-sensitive information from corporate insiders. The second sentence, however, states that the tippee is not liable unless there has been a breach by the insider. Since the insiders did not breach any duty, there can be no derivative breach by the outsider. Thus, it has been discussed that even the Supreme Court has sent out conflicting signals through this case.[xxviii]
As with many other securities law issues, also with respect to insider trading, U.S. regulation can be regarded as the “first comer”. The U.S. was the first country engaging in both public and private enforcement of insider trading. Rule 10b-5 is catch-all anti-fraud provisions characterized by a very broad scope of application. The European Union was a relatively “late comer” to the regulation of insider trading. European rules tackle the issue of insider trading more explicitly and directly than their U.S. statutory counterparts, therefore resulting in a clearer, systematic and straightforward approach.
The regulation regarding insider trading in the U.K. is well enforced as insider trading is close to nonexistent. The FSA asserts that past and present regulation has been sufficiently strict and that there have been only a few violations of the trading bans. To conclude, it can be said that the U.K. insider traders are likely to be informative on the day the budget is announced. Some research indicates, “Countries with more prohibitive insider trading laws have more accurate stock prices, and more liquid stock. These findings are generally robust to control for measures of disclosure and enforceability and suggest that formal insider trading laws (especially their deterrence components) matter to stock market development.”[xxix]
SEBI has brought about the abundantly required amendments with an end goal to regulate the illicit transactions in shares of listed firms by administration and “connected persons”. It has widened the concept of “insiders” and “unpublished price sensitive information” subsequently making the act more stringent. The 2015 Regulations have likewise struck a harmony between the restriction of and the requirement to disclose insider information for legitimate reasons, for example, for mergers and due diligence of the issues of organizations.
The laws restricting insider trading in India are significantly more prohibitive in nature than numerous other countries, including the U.S. The 2015 Regulations give the administrative body wide powers to research matters of concern connected with the stock exchanges in the nation. Hence, while the new 2015 Regulations are a much needed development for observing the insider trading movement all the more successfully, a change in the way of implementation of the laws is required like never before. As the history of successful and effective enforcement of the regulations in an extremely dynamic and complex market would benefit much more than a theoretical legislative or regulatory framework, emerging economies such as India has a lot to learn from the more developed economies of the U.S., U.K. and the European Union. Indian courts can take away a few possible things from the various laws and literature of the aforementioned jurisdictions. There have been several instances which have shed light on the scope of the term “legitimate purpose”. In the U.K., it was held that “layering” is not a legitimate purpose for insider trading. Another example of a behavior that does not qualify as a legitimate reason is execution of a transaction in a particular way with the purpose of creating a false or misleading impression.
An action can be considered as a “legitimate reason” if it indicates that the transaction is pursuant to a prior legal obligation to a third party or if the transaction is executed in a manner which considers the requirement for the market or auction platform as to work fairly and productively or when the extent to which the transaction by and large opens another position, so making a presentation to market risk, instead of closing off a position thus removing market risk.
Considering the exponential development of the Indian securities market and its convergence to the U.S., other worldwide economies, which likewise opens India to the unpredictable difficulties in those nations, it is crucial that India must concentrate on setting up a more proficient implementation administration, for example, that of the U.S., rather than presenting or expounding the legislations.
– Edited By Subhashini Narayanan
[i] Ganesh Prasad, Sanjay Khan, “What SEBI’s new insider trading rules mean and where they fall short”, Live Mint (10/03/2015), available at: http://www.livemint.com/Money/qMDHjPWNMJLza41fy8LWBO/What-Sebis-new-insidertrading-rules-mean-and-where-they-fa.html, last seen on 02/06/2015.
[ii] “SEBI Panel proposes stricter insider trading norms”, The Economic Times, (12/12/2013), available at: http://articles.economictimes.indiatimes.com/2013-12-12/news/45081908_1_unpublished-price-sensitive-information-insider-trading-sebi-panel, last seen on 02/06/2015.
[iii] N. K. Sodhi Committee (High Level Committee), Government of India, Report to Review the SEBI (Prohibition of Insider Trading) Regulations, 1992, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1386758945803.pdf, last seen on 01/06/2015.
[iv] Section 2(1)(g), Securities and Exchange Board of India (“SEBI”) (Prohibition of Insider Trading) Regulations of 2015, Insider is defined as “any person who is: i) a connected person; or ii) in possession of or having access to unpublished price sensitive information”.
[v] Menaka Doshi, “The 5 Big Changes to Indians Prohibition of Insider Trading Regulations”, Money Control, (19/11/2014), available at: http://thefirm.moneycontrol.com/story_page.php?autono=1233159, last seen on 03/06/2015.
[vi]Oxford Dictionary of English, 3rd ed., Oxford University Press, 2010, also available at: http://www.oxforddictionaries.com/definition/english/legitimate?q=legitimate, last seen on 09/06/2015.
[vii]Ibid also available at: http://www.oxforddictionaries.com/definition/english/duty?q=duties.
[viii]The Merriam-Webster Dictionary, Merriam-Webster, 2009, also available at: http://www.merriam-webster.com/dictionary/obligation, last seen on 09/06/2015.
[ix] Aparajita Shanu. Regulating Insider Trading: An Overview, The Libertatem Magazine (25/05/2015), available at: http://mylibertatem.com/regulating-insider-trading-an-overview/, last seen on 02/06/2015.
[x] The other Act governing Insider Trading in the U.K. is Criminal Justice Act, 1993.
[xi]All ER (D) 266, [2013, Upper Tribunal (Tax and Chancery Chamber)].
[xii] SEC Charges N.Y.-Based Brokerage Firm with Layering, U.S. Securities and Exchange Commission, available at: http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171484972, last seen on 04/06/2015.
[xiii] Supra 11.
[xiv] All ER (D) 56 [2011, Upper Tribunal (Tax and Chancery Chamber)].
[xv] Directive of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation (market abuse) (No 2003/6/EC).
[xvi] All ER (D) 369 [2012, Upper Tribunal (Tax and Chancery Chamber)].
[xvii] Sweet and Maxwell, Compliance Officer Bulletin, 7 (Issue 118, 2014).
[xviii] Regulation (EU) No 596/2014 of the European Parliament and of the Council of April 16, 2014 on market abuse.
[xix] MAD II Adopted by European Parliament and Council, Alter Memorandum- Clearly Gottlieb, July 1, 2014, available on: http://www.cgsh.com/files/News/b50f94c4-82e5-4ce4-9b87-6a2d8c9de4a8/Presentation/NewsAttachment/907ed507-44ad-4c02-bdc4-6f7585627df3/European%20Union%20Overhauls%20Insider%20Dealing%20and%20Market%20Abuse%20Regime.pdf, last seen on 10/06/2015.
[xx] Noam Noked, Differences between U.S. and U.K. Market Abuse Regimes, Harvard Law School Forum on Corporate Governance and Financial Regulation, available on: http://corpgov.law.harvard.edu/2012/04/07/differences-between-us-and-uk-market-abuse-regimes/, last seen on 08/06/2015.
[xxi] “Role of SEC” available on: http://investor.gov/introduction-markets/role-sec, last seen on 03/06/2015.
[xxii] SEC v. Lund, 570 F. Supp. 1397 (1983, United States District Court, C.D. California)
[xxiv] USA v. Todd Newman, 13‐1837‐cr (L), (2014, United States Court of Appeal, Second Circuit) Chiasson and Newman were arrested for allegedly trading Dell and NVIDIA stock based on material nonpublic information that originated from insiders at those companies. Their hedge funds were alleged to have reaped $72 million in illicit profits, which made the case one of the largest insider trading prosecutions to date.
[xxv] 15 U.S.C. S.78j (b) (United States).
[xxvi] Michael Karsch, The Insider Trading Sanctions Act: Incorporating a Market Information Definition, 6 J. Int’l L. 283, University of Pennsylvania (1984).
[xxvii] Chiarella v. USA, 445 U.S. 222 (1980, Supreme Court of the United States).
[xxviii] See Michael Karsch, Supra 26.
[xxix] Laura Nyantung Beny, Do Insider Trading Law Matter? Some Preliminary Comparative Evidence, 7 AM. L. & ECON. REV. 144, 144 (2005).