25 May 2015 22:15 IST

Cracking down on the insider

Only a high-profile conviction with damages slapped on the accused can rein in insider trading

Insider trading is back in the news. India’s stock market regulator, Securities and Exchange Board of India (SEBI), last week indicted A Vellayyan, Chairman of the ₹24,500-crore Murugappa group, one of the country’s well-known business groups, on charges of insider trading. Vellayyan allegedly passed on to a relative price-sensitive information on an acquisition in 2011 of a company called Sabero Organics Ltd. by Coromandel International Ltd., of which he was Chairman. The recipient of the inside information was proved to have traded in the shares of Sabero Organics — which more than doubled in a span of just three weeks when the acquisition was being negotiated — and profited from it.

Consequent to SEBI’s indictment, Vellayyan resigned —he called it “stepping aside” — from the position of Chairman of Coromandel International and EID Parry, listed companies of the group, and also from the group supervisory board. The case will now go on appeal to the Securities Appellate Tribunal.

What it’s all about

What exactly is insider trading and why is it taken so seriously by regulators worldwide? Insider trading refers to trading in a company’s shares with the benefit of unpublished, price-sensitive information, which only the person trading in the share is privy to. And who is an insider? An insider is someone who is/was connected with the company and who has access to price-sensitive information by virtue of such connection.

So, is your head spinning? Not to worry, you are not alone. The complexities of insider trading — and, worse, proving it — has had several heads spinning around the world!

Simply put, insider trading is when you trade in, let’s say, the shares of the company where your father works as finance manager, based on information that he has given you about the company’s impending disastrous financial performance, which only he is aware of.

The results of the company have not been made public yet, so the stock market and investors are not aware of what is in store. Yet, you, thanks to your link to the company, get to know about this early and profit by selling the shares at a higher price. When the information becomes public knowledge, the share price is bound to fall, isn’t it?

Information asymmetry

The above is really a simple explanation. Insiders can be anyone from the company’s promoter to a director, manager, employee or, what the heck, even the auditor. Importantly, it is not necessary that the insider should have profited from the information; just the act of trading on inside information is an offence, irrespective of profit or loss.

Insider trading is harmful because it strikes at the very edifice of the stock market, which is based on symmetry of information. It is assumed that all those trading in shares have recourse to the same information and the differences in their action — buy or sell — stems from the interpretation of the public information they have access to. When someone has recourse to inside dope on a company’s prospects, it creates information asymmetry, helping him get an unfair edge over the others. This is why regulators around the world take a dim view of insider trading and crack down on it mercilessly.

The most celebrated case in recent times was the one involving Rajat Gupta who, it was proved, passed on sensitive information about Goldman Sachs’ finances to his friend and hedge-fund operator, Raj Rajarathinam of Galleon Group, who profited from it. The Securities and Exchange Commission (SEC) of the US found them both guilty of insider trading and they were both convicted.

Poor conviction record

India has a none-too-good record of convictions on insider trading charges. There have been high-profile insider trading cases that SEBI has investigated and passed orders on, such as the Hindustan Lever-BrookeBondLipton case in the mid-1990s and the Reliance Petroleum and Reliance Industries-IPCL cases in the last decade.

Yet, these cases have invariably been overturned on appeal in the Securities Appellate Tribunal (SAT). In the Hindustan Lever case, the multinational was accused of purchasing its subsidiary BrookeBondLipton’s shares a couple of weeks before their common parent Unilever announced a merger of the two companies. Though the case appeared to be a strong one, the multinational managed to get SEBI’s ruling overturned at the SAT through some clever arguments.

Inadequate resources

SEBI’s problem is one of inadequate resources — human and technical — to monitor the market. Though its surveillance systems were beefed up a few years ago, the rising number of trades and the complexity of market instruments make it difficult indeed for the regulator to maintain a watch. It was only a couple of years ago that SEBI was allowed to seek out phone call records while investigating insider trading cases. In contrast, the SEC is allowed to tap phone conversation when it suspects insider trading by an individual. In fact, conversation records from wire-taps constituted prime evidence in the conviction of Raj Rajarathinam and Rajat Gupta.

India is still looking for its equivalent of the Rajat Gupta-Raj Rajarathinam case. We desperately need a high-profile conviction that slaps serious punitive damages on the accused. Only that can rein in the menace of insider trading.