Taking on insider trading

On stock markets, Mr Peter Lynch said “In this business, if you're good, you are going to be right six times out of ten. You're never going to be right nine times out of ten”.

The topsy-turvy world of the bourses attracts all, forcing the regulators to provide a level playing field for everyone one of whose limbs is to prevent illegal insider trading — the opposite of legal insider trading when corporate insiders trade in shares as per company policies.

Yet, two high-profile exits in the United States recently prove that despite stringent laws, both varieties of insider trading are not water-tight compartments.

The iconic Mr Rajat Gupta has got himself into a tangle in the US vs Rajaratnam case, having disclosed confidential information to the hedge-fund founder.

His defence is that the information is only “confidential” and not “material non-public” – a key requirement to attract insider trading charges.

One of the top four at Berkshire Hathway, Mr David Sokol, has been forced to seek other opportunities as he left Berkshire leaving a hint of insider trading as he had purchased Lubrizol shares during his employment at Berkshire at around $104 prior to initiating discussions with them to accept a takeover from Berkshire which was settled at $135 per share.

This appears to be more a conflict of interest than insider trading.

Conflict of interest

A very thin line of difference separates cases of insider trading from conflict of interest. In the 1980 case of Chiarella v. United States, the US Supreme Court reversed the criminal conviction of a financial printer who gleaned non-public information regarding tender offers and a merger from documents he was hired to print and bought stock in the target of the companies that hired him.

The case was tried on the theory that the printer defrauded the persons who sold stock in the target to him.

In reversing the conviction, the Supreme Court held that trading on material non-public information in itself was not enough to trigger liability under the anti-fraud provisions and because the printer owed target shareholders no duty, he did not defraud them.

In response to the Chiarella decision, the Securities and Exchange Commission promulgated Rule 14e-3 under Section 14(e) of the Exchange Act, and made it illegal for anyone to trade on the basis of material non-public information regarding tender offers if they knew the information emanated from an insider.

In United States v. O'Hagan, the latter was a partner in a law firm retained to represent a corporation, Grand Met, in a potential tender offer for the common stock of the Pillsbury Company.

When he learned of the potential deal, he began acquiring options in Pillsbury stock, which he sold after the tender offer for a profit of over $4 million.

His main argument in defence was that because neither he nor his firm owed any fiduciary duty to Pillsbury, he did not commit fraud by purchasing Pillsbury stock on the basis of material, non-public information.

The Court rejected his arguments and upheld his conviction on the misappropriation theory.

Unpublished price-sensitive info

In India, the SEBI (Prohibition of Insider Trading) Regulations, 1992 (Regulations) armed the Securities and Exchange Board of India with powers to investigate cases of insider trading.

Any person who is or was connected with the company or deemed to have been so connected and who is reasonably expected to have access or who has had access to unpublished price-sensitive information in respect of securities of a company was termed an insider.

Though cases in India exist, they pale in comparison with the US with Hindustan Lever(HLL) vs SEBI in 1998 probably taking the cake. HLL purchased 0.8 million shares of from Brooke Bond from UTI in March 1996 two weeks prior to the public announcement of the HLL and BBIL merger.

Post-announcement, the price of BBIL's shares shot up thereby causing losses to UTI. HLL was held liable by SEBI for insider trading.

The Securities Appellate Tribunal reversed the order on the ground that the information was not price-sensitive as it was reported in the media and, therefore, was public knowledge.

As a result of this case, SEBI amended the Regulations to specifically provide that speculative reports in the media (print or electronic) would not be treated as publication of price-sensitive information.

Markets are generally stubborn and moody which generally makes any attempt to tame them an effort in vain. With acquisitions and joint ventures becoming a norm, there is bound to be activity in a stock at the time of announcement of a merger.

Despite the existence of trading window, code of conduct and silent periods in insider trading regulations, avoiding being charged under these regulations would depend on the morals and ethics of the entity and the persons who run them.

(The author is a Bangalore-based chartered accountant.)