During May 2011, watchers of stock markets around the globe were keenly awaiting the outcome of the insider trading charges being levelled in the US against Galleon, the hedge fund which controlled assets of more than $6 billion at its peak, run by Sri Lanka-born billionaire, Raj Rajaratnam. The cast also included a number of very successful executives of Indian origin — most of whom have either pleaded guilty and turned approver or have been investigated for their roles by other agencies.
SECURITIES LAWS
Insider trading laws are drawn from one of the most fundamental principles of equity, which translates into the rule that persons in a company, who are in possession of knowledge by virtue of their position, will not make personal monetary gains by trading on the underlying shares, based on such knowledge. The key terms used to describe insider trading are “profiting from material non-public information” and this was important enough to be included as early as 1934 in the US Securities laws.
Utpal Bhattacharya and H. Daouk, in their study on insider trading, state that these laws saw prominence from the 1990s, and out of103 countries reviewed by them, only 81 had insider trading laws, while prosecution took place only in 38 countries.
IMPLEMENTATION
Insider trading laws are one of the most difficult to enforce, and countries around the globe have a poor record in prosecuting such cases. The key to all such cases lies in successfully making the distinction between trades effected on the basis of the maze of legitimate information and research that fund houses and investors rely upon, and trades profiting from illegal information by persons who have a legal responsibility of not abusing their position in relation to such price-sensitive information known to them.
Furthermore, in the US, individuals not connected to a company, but who have traded based on non-public financial information, howsoever obtained, are also regarded as insiders. There is a thin line between researched information based on discussions with company executives and material non-public information obtained from a company. As fund managers and analysts meet company executives all the time, the distinction gets blurred and it gets difficult to prove in a court of law if the fund or its managers profited from such information.
In India, insider trading is rampant but unlike in western markets, where most of the insider trades are done by a company's management or fund managers, such trades are often executed by promoters, who, on an average, hold a majority of the shares. In 2002, Securities and Exchange Board of India (SEBI) brought in more changes to the insider trading laws to make them more effective, but like most Indian laws, the implementation was very poor, though the import of the law was in line with the global best practices. In the 10 years ending 2009, SEBI initiated proceedings on 117 cases of insider trading in India, while in the US, which has a more mature capital market with a stricter code of conduct and prosecution, the Securities and Exchange Commission (SEC) had proceeded against 53 cases of insider trading in 2010 alone.
ECONOMIST'S CONTENTION
The economist's principles and postulates on insider trading are diametrically opposite to the legal agreement, which is based on principles of fairness. In 1966, Henry Manne argued that insider trading made the markets more efficient, as the entrepreneur leads the price discovery process, leading to the actual value of a share, rather than an assumed value. This process makes allocation of resources efficient, as cash and other resources are put into assets almost in proportion to their economic value.
Forecasting the accuracy of a share price is a function of two key factors. One is the amount of information, relating to a firm's future prospects, that exists in the hands of the promoters. The other is the extent to which share price reflects this information. The margin, and hence the motivation to trade, for the insider, lies in the gap of these two factors.
In1985, Frank Easterbrook in ‘Insider Trading as an Agency Problem' contended that “one reason for low implementation of such laws is that insiders might deliberately hide their trading to preserve their informational monopoly. It will be very costly to detect an insider's trades, because he can hide his trading activity. He can buy stock in street names or through nominees (including trusts and family members); he may route orders through a chain of brokers to make tracing difficult; the list of evasive devices is long.”
Many Indian promoters have used such ruses to avoid detection of insider trading and price manipulation, leading to a low level of detection and enforcement.
ENFORCING THE LAW
However, ineffective laws of insider trading or low levels of prosecution may be worse than having no laws at all. In the recent cases of settlement by SEBI through consent orders, the amount to be paid as a fine was very small compared to the amount under dispute, and since there is no disgorgement of profits and large fines or jail terms, the promoter has no disincentive for breaking the law, as the fine may be a fraction of the sums illegally profiteered. We may have borrowed the laws of consent orders and settlement from the US, but in implementation, we may well have made it profitable for insiders to break such laws.
If a vibrant capital market is the barometer of an economy, regulators have a responsibility to enforce laws that maintain the sanctity of such markets. On enforcing insider trading laws, markets create more liquidity and this results in a better share price discovery process. This in turn brings down the cost of capital and improves a country's capital allocation process.
Bhattacharya et all go on to conclude that the cost of equity capital doesn't change merely on the introduction of insider trading regulations, but decreases significantly after the first prosecution. They argue that the factor of strong enforcement alone can result in as high as 7 per cent reduction in the equity costs.
For a country like India, such incremental changes can be transformational, and all we need is some fair and focussed enforcement of our laws. The balance in our favour can easily be tilted. But is anyone listening?
(The authors are founding directors of Thought Arbitrage Research Institute.)