The SEBI in order to revamp the enforcement proceedings under securities law formulated a High-Level Committee under chairmanship of Justice (Retd.) Anil R. Dave. The Committee has proposed legislative measures to introduce, revamp or fill the gaps in current enforcement regime. The Report by the Committee[1] draws majorly from current prevalent practices in USA and UK. Part C of the Report of the Committee deals with ‘Quantification of profit and loss and related issues’ highlighting the importance and manner of quantification of illegitimate profit and loss caused to the investors as a result of a default. Further, in case of insider trading, the Committee discussed different approaches to calculate illicit profits to ensure a sound enforcement regime against insider trading.
In this article we are going to discuss about proposals made for revamp of enforcement proceedings in relation to Insider Trading.
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Modus operandi of Insider Trading
The critical nature of act of Insider Trading is not a secret. Insider trading has a double blow on integrity of the market as not only investors lose their money but they also tend to lose their trust in the market which results in investors pulling out their funds from market, severely hampering liquidity of the markets and hence diluting the very purpose of for which the markets function.
The Insider Trading is carried out by some of the best brains hence it tends to be conducted in various manners and methods, which makes regulating and tracking the transaction of insider trading a tricky task for regulators. In order to understand the legal regime and enforcement procedure of insider trading better, we have analysed the two most common methods of undertaking insider trading as identified by the Committee in its Report:
1. Trading by Insiders
The very basic way of undertaking insider trading is that the person having unpublished price sensitive information (UPSI) directly undertakes the transaction in the securities based on the information he has.
In the case of Martha Stuart and ImClone in December 2001, the Food and Drug Administration (FDA) announced that it would not approve a new cancer drug called Erbitux from the pharmaceutical company ImClone. Because it was expected that this drug would be approved, it represented a major portion of ImClone’s future plan for growth. As a result, the company’s stock dropped rapidly. While many investors experienced losses as a result of the drop, family and friends of the CEO of Erbitux, Samuel Waksal, were unharmed. The SEC later discovered that prior to the announcement of the FDA’s decision, numerous executives had sold their stock based on the instructions of Waksal, who had also attempted to sell his own stock.[2]
This method is seldom used because as the transaction is undertaken by the insiders themselves, tracking such transaction and ascertainment of mens rea is a simpler task.
2. Trading by a tippee
In this form of transaction, the person having UPSI (tipper) passes on such information to a relative, associate or any other person (tippee), who undertakes trading on his own or tipper’s behalf.
In the case of Ivan Boesky[3] , a famous American trader who traded on the basis of UPSI received by him from large corporate leaders, which he deployed to earn large volume of profits by dealing in securities. The people who supplied him information were heavily paid for such information via indirect sources.
This method is used in large portion of Insider Trading violations because-
- It may be difficult to prove the link between such persons;
- Even if the link is proven, the person who actually commits insider trading may be a person of little consequence propped up to bear the blame of insider trading, whereas the real offender simply walks out with profits.
- The inside tipper can always claim to not have ‘benefitted’ from the whole event he tries to appear ‘innocent’ by claiming he has not benefitted.
The Committee has hence focused largely on this method of insider trading while considering the recommendations.
Disgorgement: Current and Proposed
The terms ‘disgorgement ‘
Disgorgement is repayment of ill-gotten gains that is imposed on wrongdoers by the regulatory authorities. Disgorgement in relation to Insider Trading are passed to extract undue wealth gained by the insider through the exploitation of preferential information.
Disgorgement is used as a remedial civil action and not a punitive action and hence the amount of disgorgement shall not exceed amount of gains. The chief reason for disgorgement order is to prevent the wrong doers from profiting from wrongdoings.
Securities Appellate Tribunal in the case of Karvy Stock Broking vs. SEBI[4] explained that, “Disgorgement is the forced giving up of profits obtained by illegal or unethical acts It is neither a punishment nor is it concerned with the damages sustained by the victims of the unlawful conduct.”
Section 11B of the SEBI Act, Section 19 of Depositories Act and Section 12A of the SCRA empowers SEBI to issue an order for disgorgement of the ill-gotten gains against the person who made illegal gains. However, this will save the insider behind the contravention for not earning any direct benefit/ profit from the transaction.
Disgorgement in case of Joint Liability
The committee considered in detail the precedents in US and Indian Law in order to answer the question that whether disgorgement liability should be levied on Tipper where he has not earned any direct benefit, and profit is earned by the tippee and whether their liability shall be joint or on individual basis.
The committee with an emphasis stated that “It would make little sense to allow insider to escape disgorgement when he gives away not the proceeds of a trade predicted on his insider knowledge, but knowledge itself to other who will spin the information into gold, trading on it themselves.”
Further, the Committee also considered that in the case of United States vs Alcan Aluminium Corp[5] the US court held that, “When apportioning liability among multiple tortfeasors, it is appropriate to hold all tortfeasors jointly and severally liable for the full amount of the damage unless the liability is reasonably apportioned. “Where joint tortfeasors cause a single and indivisible harm for which there is no reasonable basis for division according to the contribution of each, each tortfeasor is subject to liability for the entire harm.”
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The Committee has further on the above ground recommended that – Though it is clear that the liability of Disgorgement shall be joint, however for sake of clarity it may be considered, the existing explanation in respect of disgorgement in section 11B, be amended for the sake of clarifying any doubts in respect of joint and several liability, as follows, – “Explanation.—For the removal of doubts, it is hereby declared that the power to issue directions under this section shall include and always be deemed to have been included the power to direct jointly and severally, all or any of the persons, who made profit or averted loss by indulged in any transaction or activity in contravention of the provisions of this Act or regulations made thereunder, to disgorge an amount equivalent to the wrongful gain made or loss averted by such contravention.” |
The above recommendation of the Committee, once made effective, will allow SEBI to enforce disgorgement on joint and several liability basis, irrespective such person has actually received any illegal proceeds.
Disgorgement Action by Employer against Employee for violation under Insider Trading
The Committee had noticed that some employers had taken action against their employee for violating the organisations Code of Conduct for Insider Trading pursuant to [*]. The companies had along with action such as wage freeze had also taken disgorgement action against their employees
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The Committee has recommended that – The Board may consider issuing a circular to all employers who are required to frame a code of conduct under the 1992 or 2015 regulations relating to insider trading, to, in case of sanctions have been imposed by an employer in the nature of disgorgement under the 1992 or 2015 regulations relating to insider trading prior to the issue of the Circular, the monies so disgorged shall be deposited in the SEBI IPEF within 30 working days; and Further, the Board may consider amending the 2015 insider trading regulations to clarify that the employer cannot impose a sanction against an employee, if such sanction would amount to disgorgement of profit resulting from insider trading. |
Except in case of contra trades, there is no clear provision under [*PIT Regulation or IPEF Regulation] in regards to liability of companies in respect of depositing disgorged amounts to the IPEF, Therefore, it has been observed that companies have taken advantage of this situation and kept the amount with themselves instead of depositing them with the IPEF. I personally found this as mockery of law, as clearly companies are unjustly enriching themselves with amounts disgorged because it pertained to unjust enrichment.
Penalties in case of Insider Trading
Current Enforcement Provisions for Insider Trading
In order to safeguard the integrity of the market, the Insider Trading transaction are prohibited. The principal legal text dealing with Insider Trading is the SEBI (Prohibition of Insider Trading) Regulation, 2015(2015, Regulation). The 2015, Regulation not only prohibits trading on basis on UPSI but also sharing of UPSI. The code provides for a framework to be followed by listed entities in order to defer Insider Trading in their securities as well as in securities of the company, whose UPSI are available with the functionaries due to some business or other transaction.
Regulation 10 of the 2015, Regulation provides that any contravention of these regulations shall be dealt with by the Board in accordance with the SEBI Act, 1992. Further Section 15G of the SEBI Act, provide following penalty for Insider Trading-
15G. If any insider who, –
- either on his own behalf or on behalf of any other person, deals in securities of a body corporate listed on any stock exchange on the basis of any unpublished price-sensitive information; or
- communicates any unpublished price-sensitive information to any person, with or without his request for such information except as required in the ordinary course of business or under any law; or
- counsels, or procures for any other person to deal in any securities of any body corporate on the basis of unpublished price-sensitive information,
shall be liable to a penalty which shall not be less than ten lakh rupees but which may extend to twenty-five crore rupees or three times the amount of profits made out of insider trading, whichever is higher
However, it shall be noted that Supreme Court in the case of Chairman of SEBI vs. Shriram Mutual Fund[6] held that mens rea is not a prerequisite in levying penalty under a civil Act hence penalty under SEBI Act can be levied without consideration of mens rea.
The section 15G is quite clear in terms, that it provides for penalty on both tipper and tippee and also hold them jointly liable for the act. Further it provides for penalty which can extend upto thrice the amount of profits earned which is in line with general understanding that penalty should be more than amount of illegal gains, especially in case where disgorgement action is not taken.
The committee further contested that the concept of joint liability should be extended to include employer specifically, where there is a failure on employers’ part or the systems of employer to prevent Insider Trading are found to be weak.
The committee has recommended inclusion of a concept of “Liability of Controlling Authority” which is similar to that found under Section 20 of Securities Exchange Act of 1934 in USA.
| The Committee recommended insertion of following section-
(1) Every person who, directly or indirectly, controls any person liable under any provision of this Act or of any rule or regulation made thereunder, shall also be liable jointly and severally with and to the same extent as such controlled person in any action brought under this Act or any rule or regulation made thereunder, unless the controlling person acted in good faith and did not directly or indirectly induce or enable the act or omission constituting the violation or cause of action. Explanation 1. – No person shall be liable as a controlling person solely by reason of employing another person, but the liability of such employer may be subject to sub-section (1) where he is under a duty to control but intentionally or by gross negligence fails to exercise control. Explanation 2. – In this section ‘control’ includes direct and indirect positive acts or omissions that amount to control. (2) It is hereby clarified that it shall be and always has been unlawful for any person, directly or indirectly, to do any act or thing which would be unlawful for such person to do under the provisions of this Act or any rule or regulation made thereunder, through or by means of any other person. (3) Any person who knowingly or in absence of good faith provides substantial assistance to another person in violation of a provision of this Act, or of any rule or regulation made thereunder, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided. Explanation. – For the purpose of this section, nothing is said to be done in “good faith” which is done without due care and attention. |
The recommended provision applies to all kinds of violations, not just Insider Trading and focuses on imposing the liability of such persons who controlled them. The Board would then be free to concentrate its enforcement action against the main persons- persons who employed others and those who provided substantial assistance i.e. the ‘smart’ enforcement through action on the main accused and enforce securities laws in a time bound manner to protect the interest of investors rather than expend its limited resources and time on pursuing the entire chain of defaulters.
However, the perusal of the proposed section, reveals two points that are not abundantly made clear in the proposal –
The definition of “Controlling Authority” – as the committee proposes to take controlling authority in the ambit of penalties the definition of controlling authority become very important as leaving the term undefined may lead to either arbitrary action by the officers of SEBI or may consume a lot of working hours of court as every relation may need a judicial interpretation that is it a controlling authority or not.
It shall however be noted that the explanation given in the section proposed define control as ‘control’ includes direct and indirect positive acts or omissions that amount to control. Hence giving a broad ambit to cover and is not restricted to having any prescribed relationship like, Shareholding or voting power as given in definition of control under Companies Act, 2013.
The above definition might benefit in a way that it would cover all sort of control and avoid corporates from setting up corporate structures just to avoid the scope of control, however the stance of courts as well as SEBI while deciding scope for inclusion in the term “controlling authority” would be very crucial.
Secondly the term “Substantial assistance” is not made clear as what is meant by substantial assistance. Further this term would decide the scope of the proposed section to an extent. The term is not defined in rigid sense in the report or in Securities Exchange Act in USA.
Conclusion
India is one of the largest stock markets around the globe. There are around 7800 companies listed in India on NSE alone. In FY 2019 alone SEBI undertook investigation of around 141 companies[7] in Insider Trading despite all these standing and action against Insider Trading in India is considered weak and deficient. The law is not at par with the current market practices and does not meet the level that a country like India should have.
The proposal of committee are in line with current practices in global legal regime and also address the concerns and points lacking in India law. The proposals are made after considering practical cases around the globe which to an extent provide for an assurance to their success. The regulation to control Insider Trading by tipper-tippee method can prove to be a fruitful measure. The changes if implemented have potential to curb Insider Trading in India.
[1] https://taxguru.in/sebi/report-measures-strengthening-enforcement-mechanism-sebi-incidental-issues.html
[2] https://www.sec.gov/news/press/2003-69.htm
[3] https://en.wikipedia.org/wiki/Ivan_Boesky#Career
[4] https://www.sebi.gov.in/enforcement/orders/dec-2019/order-in-the-matter-of-karvy-stock-broking-limited-representations-by-banks-and-nbfc_45319.html
[5] https://www.leagle.com/decision/19921216964f2d25211183
[6] https://www.sebi.gov.in/sebi_data/attachdocs/oct-2017/1509173631627.pdf
[7] https://economictimes.indiatimes.com/markets/stocks/news/sebi-investigated-an-unprecedented-number-of-alleged-insider-trading-violations-in-fy19/articleshow/73762248.cms?from=mdr
Author Bio
Excellent article. Bright future for the professional who attempts first but the best. Informative and instructive. Best wishes
Subramanian CPA