Insider Trading: The Bare Facts
Insider trading has always been a point of discussion for investors and regulators. Anthony Fernandes explains what exactly insider trading is and what best can investors do to protect their portfolios from being exposed negatively to such malpractices.
An increase in global economic activity creates one big impact – it also leads to an increase in the buying and selling activity of financial securities. While that in itself is a positive trend, the worrisome factor is that it also leads to a rise in the risks posed by malpractices of all sorts. Indeed, regulators worldwide have a tough task on hand as it is never easy to identify malignant and illegal activity, leave alone proving who the actual beneficiary is. Insider trading is one such illegal activity which provides an edge to a particular investor or a group of investors, leading the opportunist to book abnormal profits in a very short time. Insider trading defies the spirit of the investing game and is a serious punishable offence in several developed and emerging markets.
The New York Stock Exchange (NYSE) is arguably the world’s most efficient market and yet there have been instances of insider trading. Such cases of insider trading are to be found across both developed and emerging markets alike. The ill-reputed Raj Rajaratnam, who was the founder of Galleon Group, was arrested in 2009 by FBI on insider trading charges in the United States. Rajaratnam was accused of earning up to USD 63.8 million between 2003 to 2009 by adopting various illegal insider trading practices and investing in stocks such as eBay Inc., Goldman Sachs Group Inc. and Google Inc., now called Alphabet Inc.
This goes to show that insider trading may happen not only in the low, liquid and micro-capitalised stocks but also in the major ones. In fact, there are several instances of insider trading across all forms of market capitalisation. Investors should take note of this and avoid having a negative bias towards small-caps and micro-caps when it comes to insider trading. So what are the measures that companies take to avoid insider trading? There are five leading methods: 1. Restrict risky trading wherein a list of ‘not to trade’ shares is shared with the employees of the company; 2. Appoint an in-house watchdog; 3. Ensure that all the employees are educated on insider trading; 4. Act quickly to investigate insider trading; 5. Leverage technology to prevent insider trading.
The Securities and Exchange Board of India (SEBI) states, “No insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price-sensitive information. An insider shall be entitled to formulate a trading plan and present it to the compliance officer for approval and public disclosure pursuant to which trades may be carried out on his or her behalf in accordance with such a plan.” Further, SEBI defines an insider as ‘any person including corporate officer, director, employee, friend, business associate, family member and a tipper with inside information that can influence stock prices’.
The following information is considered to be sensitive to stock price movement:
☛ Periodical financial results. ☛ Issue of securities or buy-back of securities. ☛ Declaration of earnings. ☛ Intended declaration of dividends. ☛Expansion plans, related mergers or joint ventures. ☛Operational or top level management changes in the company. ☛Approval or rejection of orders and FDAs.
Insider trading laws prohibit persons who receive or become aware of material non-public information about a public company or other companies that do business with the company from trading in the company’s or such other company’s securities or providing material non-public information to others who may trade in the company’s or such other company’s securities on the basis of such information. Insider trading laws can impose legal liability not only on individuals who fail to comply with these laws, but also on the company.
The Penalties Globally, regulation and enforcement of insider trading laws is important to investors for many reasons. Primarily, investors are likely to be much more confident in the financial statements of companies that operate in countries with strong insider trading laws if such laws are enforced consistently. Additionally, investments within such countries may be viewed as comparatively less risky since the information is considered to be more reliable. Finally, since risk and return on an investment are positively correlated, investments may have a lower required rate of return. According to the SEC, the maximum prison sentence for an insider trading violation is 20 years and the maximum criminal fine for individuals is USD 50,00,000 whereas the maximum fine for non-natural persons such as an entity whose securities are publicly traded is USD 25,000,000. Additionally, persons who violate insider trading laws may become subject to an injunction and may be forced to disgorge any profits gained or losses thus avoided. The civil penalty for a violator may be an amount up to three times the profit gained or loss avoided as a result of the insider trading violation.
The SEBI Act mentions of penalties for insider trading as high as Rs. 25 crore but not less than Rs. 10 lakhs or around three times the amount of profits made out of insider trading, whichever is higher. It also prescribes that insider trading may be punishable with a prison term of up to 10 years but not less than one year. With the rise in insider trading instances, there has also been an increase in the cases under investigation by SEBI. In FY19, SEBI looked into 70 cases, which was a significant rise from just 15 cases in FY18 and 34 in FY17.
Case Studies
1. The insider trading scandal at ImClone Systems, a biopharmaceutical company dedicated to developing biologic medicines in the area of oncology, was revealed when its stock price fell sharply towards the end of 2001 after its experimental monoclonal antibody drug ‘Erbitux’ failed to receive the required Untied States Food and Drug Administration (USFDA) approval. ImClone System’s founder, Samuel Waksal, was accused of insider trading charges for tipping off friends and family to sell their stocks along with attempting to sell his own before the news of USFDA’s rejection was made public since it was obvious that the news would drag down the stock. The scandal also roped in Waksal’s Merill Lynch broker Peter Bacanovic for further tipping their mutual friend Martha Stewart, a well-known American retail entrepreneur. Stewart was quick to dispose all her shares in ImClone Systems. Consecutively, Waksal was sentenced to seven years and three months in prison and ordered to pay more than USD 4 million in fines and back taxes whereas Bacanovic was also convicted of federal charges and sentenced to prison term. Although Stewart maintained her innocence, she was found guilty and sentenced on July 16, 2004 to five months in prison, five months of home confinement, and two years probation for lying about the stock sale, conspiracy and obstruction of justice.
2. In India, there is the case of Indiabulls Ventures Ltd. (IVL). According to SEBI, Pia Johnson, the non-executive director of IVL and Mehul Johnson, her husband, traded the scrip of IVL when in possession of unpublished price-sensitive information about the company. The said information was about the sale of India Land and Properties Ltd. (ILPL) to Indiabulls Infrastructure Ltd. (IIL), an investment of IIL into ILPL. It was observed that Pia Johnson traded 5.5 lakh shares while Mehul Johnson traded around 3.38 lakh shares, thus collectively making alleged gains of Rs. 69.09 lakhs. Reacting to this stock movement, SEBI intervened and penalised the duo an amount of Rs. 87.21 lakhs while directing banks and depositories to ensure that no debits were made without the regulator’s permission.
3. The insider trading case of India’s ace investor Rakesh Jhunjhunwala is quite recent. It is said that he first bought the shares of Aptech in 2005 at Rs. 56 per share. Since then, his stake along with his other family members has risen nearly to 49 per cent with a market value of around Rs. 690 crore as of end of January 2020. It is the only investment where he wields management control. As on September 7, 2016, the shares of Aptech Limited hit the upper circuit at Rs. 175.05 after the investor’s brother and wife bought 7,63,057 shares in the IT firm through block deals. Thus, SEBI examined a timeframe of February 2016 to September 2016 for irregular trades, which it suspects were done on the basis of insider information, post which the investor will be paying Rs. 2.48 lakhs as settlement for the case.
Protection Possibility So, how can investors protect themselves from the effects of insider trading? When it comes to convictions against insider trading, as compared to global regulators, SEBI’s presence isn’t feared as much since its regulations allow for settlement of insider trading violation cases through payment of charges without admitting or denying the findings of fact and conclusion of a legal trail. Most firms prefer ‘settling’ the case. Hence, it is the responsibility of investors to verify the status of the company whose stocks they intend to buy. A company which follows good corporate governance practices can safeguard the trust of investors. It is commonly believed that blue chip companies are structured well and ensure proper practice of corporate governance so as to boost the interest of investors and thereby expand their business. However, it should not be concluded that all the large companies are immune from such malpractices and that the smaller capitalised stocks are more vulnerable.
Conclusion As equity markets expand and grow in volumes, the challenge to keep them safe and tamper-proof also increases. No matter how strict the regulator can be and despite the preventive measures a company may take at the corporate level to prevent insider trading instances, investors have to factor in the risks of such malpractices while deciding to take exposure to equity asset class. While it is almost impossible to predict which company is susceptible to insider trading, investors can hedge themselves to a great extent by following some basic portfolio management practices. Investors need to focus on sustainability and corporate governance more than they are used to in order to prevent the portfolio from such contingent events.
Some of the basic steps that investors need to adopt include having a diversified portfolio, hedging portfolio from market risks, and always conducting quality analysis and research. It is often seen that retail investors do not allocate their portfolio in diversified manner while leaving it non-hedged. Often investors are caught unaware of market risks and lack the knowhow on hedging the portfolio risks. '
When a contingent event such as insider trading impacts stock prices, an investor may get panicky and take irrational decisions. If the tenets of portfolio management are adhered to, tackling such contingencies would be manageable for investors.