Insider trading is trading of a corporation’s stock or other securities (e.g. bonds or stock options) by the individuals with potential to access to non-public information about company. In most countries, trading by the corporate insiders such as officers, key employees, directors, and large shareholders may be legal, if the trading done in a way that does not take advantage of the non-public information. However, this term is frequently used to refer to practice in which the insider or a related party trades based on the material non-public information obtained during the performance of the insider’s duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company.

In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders (in the U.S., defined as beneficial owners of ten percent or more of the firm’s equity securities) must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While “legal” insider trading cannot be based on material non-public information, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation (broadly speaking) and that their trades otherwise convey important information (e.g., about the pending retirement of an important officer selling shares, greater commitment to the corporation by officers purchasing shares, etc.)

Illegal insider trading is believed to raise the cost of capital for securities issuers, thus decreasing overall economic growth.

Legal insider trading

Legal trades by insiders are common, as employees of publicly-traded corporations often have stock or stock options. These trades are made public in US through SEC filings, mainly Form 4. Prior to 2001, US law restricted trading such that insiders mainly traded during windows when their inside information was public, such as soon after earnings releases. SEC Rule 10b5-1 clarified that the U.S. prohibition against insider trading does not require proof that insider actually used material nonpublic information when conducting a trade; possession of such information alone is sufficient to violate the provision, and SEC would impute an insider in possession of material nonpublic information uses information when conducting a trade. However, Rule 10b5-1 also created for insiders an affirmative defense if the insider can demonstrate that the trades conducted on behalf of the insider were conducted as part of a preexisting contract or written, binding plan for trading in future. For example, if a corporate insider plans on retiring after a period of time and, as part of its retirement planning, adopts a written, binding plan in order to sell a specific amount of company’s stock every month for next two years, and during that period the insider comes into possession of the material nonpublic information about company, any subsequent trades based on the original plan might not constitute prohibited insider trading.

Illegal insider trading

Rules against the insider trading on material of non-public information exist in the most jurisdictions around world, though the details and efforts to enforce them to vary considerably. The United States is generally of viewed as having strictest laws against illegal trading, and makes most serious efforts to enforce that..

Definition of “insider”

In United States and Germany, corporate insiders defined as a company’s officers, directors and any beneficial owners , more than ten percent of a class of company’s equity securities. Trades made by these types of insiders in company’s own stock, based on the material non-public information,they are considered to be fraudulent since insiders are violating the fiduciary duty that they owe to shareholders. The corporate insider, simply by accepting the employment, has made a contract with shareholders to put shareholders’ interests before their own, in matters related to corporation. When insider buys or sells based upon company owned information, he is violating contract with shareholders.

For example, illegal insider trading would be occuring if the chief executive officer of the Company A learned (prior to public announcement) that Company A will be taken over, and bought shares in the Company A knowing that share price would likely to rise.

In the United States and many of other jurisdictions, however, “insiders” are not just limited to the corporate officials and major shareholders where the illegal insider trading is concerned, but it can include any individual who trade shares based on the material non-public information in violation of some duty of the trust. This duty may be imputed,for example, in the many jurisdictions, cases of where a corporate insider “tips”friend about the non-public information likely to have an effect on the company’s share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if he or she trades on the basis of this information.

Liability for insider trading

Liability for the insider trading violations cannot be avoided by the passing on information in an “I scratch your back, you scratch mine” or quid pro quo arrangement, as long as person receiving information knew or should have known that information was company’s property.

For example, Company A’s CEO did not trade on undisclosed takeover news, instead passed information to his brother-in-law who traded it, illegal insider tradingcase would still have occurred.

Misappropriation theory

A newer view of insider trading, “misappropriation theory” is a part of US law. It states that anyone who misappropriates (steals)the information from their employer and it trades on that information in anyof stock (not just employer’s stock) is guilty of it.

For example, if a journalist who worked in Company B learned about takeover of Company A while performing its work duties, and bought stock in the Company A, illegal insider trading might still have occurred in it.. Even though journalist did not violate a fiduciary duty to the Company A’s shareholders, he might have violated fiduciary duty to Company B’s shareholders (assuming newspaper had policy of not allowing reporters to trade on the stories they were covering).

Proof of responsibility

Proving someone has been responsible for a trade can be difficult, because traders may try to hide behind the nominees, offshore companies, and other proxies. Nevertheless U.S.SEC prosecutes over 50 each year, with many being settled administratively out of court. The SEC and several other stock exchanges actively monitor trading, looking for the suspicious activity.

Trading on information in general

Not all trading is illegal inside trading, however. For example, while dining at a restaurant, you hear that CEO of Company A at next table telling CFO that the company’s profits will be higher than expected, and then you buy stock, you are not guilty of insider trading unless there was some closer connection between you and company, or company officers. However, information about a tender offer (usually regarding a merger or acquisition) held to a higher standard. If this type of information obtained (directly or indirectly) and there is a reason to believe it is non-public, there is a duty to disclose it or abstain from trading.

Tracking insider trades

Since insiders are required to report their trades, others often track these traders, and there is school of investing which follows lead of insiders. This is of course subject to risk that an insider is making a buy specifically to increase the investor confidence, or making a sell for reasons unrelated to health of company (e.g. a desire to diversify or pay a personal expense).

December 2005 companies are required to announce times to their employees as to when they can safely trade without being accused of trading on inside information.

American insider trading law

The United States has been leading country in prohibiting insider trading made on basis of material non-public information. Thomas Newkirk and Melissa Robertson of U.S. Securities and Exchange Commission (SEC) summarize development of U.S. insider trading laws.

Common law

U.S. insider trading prohibitions are based on English and American common law prohibitions against fraud. In 1909, well before Securities Exchange Act was passed, United States Supreme Court ruled that a corporate director who bought that company’s stock when he knew it is about to jump up in the price committed fraud by buying while not disclosing his inside information.

Section 17 of the Securities Act of 1933 contained prohibitions of fraud in the sale of securities which were greatly strengthened by Securities Exchange Act of 1934.

Section 16(b) of the Securities Exchange Act of 1934 prohibits the short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibits the fraud related to securities trading.

The Insider Trading Sanctions Act of 1984 and Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for the illegal insider trading to be as high as three times profit gained or the loss avoided from illegal trading.

SEC regulations

SEC regulation FD (“Fair Disclosure”) requires that if company intentionally discloses material non-public information to the one person, it must simultaneously disclose information to the public at large. In case of an unintentional disclosure of material non-public information to the one person, company must make a public disclosure “promptly.”

Insider trading,and other similar practices, are also regulated by SEC under its rules on takeovers and tender offers under Williams Act.

Court decisions

Much of development of insider trading law has resulted from court decisions.

In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court stated ,that anyone in the possession of inside information must either disclose information or refrain from trading.

In 1984, Supreme Court of the United States ruled in case of Dirks v. SEC that tippees (receivers of second-hand information), are liable if they had reason to believe that tipper had breached a fiduciary duty in the disclosing confidential information and tipper received any personal benefit from disclosure. (Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.)

The Dirks case also defined concept of “constructive insiders,” who are lawyers, investment bankers and others who receive the confidential information from a corporation while providing services to corporation. Constructive insiders are also liable for insider trading violations if corporation expects information to remain confidential, since they acquire the fiduciary duties of true insider.

In United States v. Carpenter (1986) U.S. Supreme Court cited an earlier ruling the while unanimously upholding mail and wire fraud convictions for defendant who received his information from journalist rather than from company itself. The journalist R. Foster Winans was also convicted, on grounds that he had misappropriated the information belonging to his employer, Wall Street Journal. In that widely publicized cases, Winans traded in the advance of “Heard on the Street” columns appearing in Journal.

The court ruled in the Carpenter: “It is well established, as general proposition, that a person who acquires the special knowledge or information by the virtue of a confidential or fiduciary relationship with the another is not free to exploit the knowledge or information for his own personal benefits but must account to his principles for any profits derived there from.”

However, in the upholding securities fraud (insider trading) convictions, justices were evenly split.

In 1997 U.S. Supreme Court adopted the misappropriation theory of the insider trading in 1997. O’Hagan was a partner in a law firm, representing Grand Metropolitan, while it was the considering a tender offer for the Pillsbury Co. O’Hagan used this inside information by buying calls option on Pillsbury stock, resulting in the profits of over $4 million. O’Hagan claimed neither he nor his firm owed the fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing the Pillsbury options.

The Court rejected O’Hagan’s arguments and upheld his conviction.

The “misappropriation theory” holds that person commits fraud “in connection with” the securities transaction, and thereby violates 10(b) and Rule 10b-5 , when he misappropriates the confidential information for trading purposes, in breach of a the duty owed to source of the information. Under this theory, fiduciary’s undisclosed, self-serving use of principal’s information to a purchase or sell securities, in breach of duty of loyalty and confidentiality, defrauds principal of exclusive use of the information. In the lieu of premising liability on a fiduciary relationship between the company insider and purchaser / seller of the company’s stock, misappropriation theory premises liability on fiduciary-turned-trader’s deception those who entrusted him with the access to confidential information.

Court specifically recognized that corporation’s information is its property. “A company’s confidential informations…qualifies as property to which company has a right of exclusive use. The undisclosed misappropriation of information in violation of fiduciary duty…constitutes fraud akin to the embezzlement – the fraudulent appropriation to one’s own use of money or goods entrusted to one’s care by another.”

In 2000, the SEC , which defined trading “on basis of” inside information as any time person trades while aware of material nonpublic information – so that it is no defense for one to say that she would have made trade anyway. This rule also created affirmative defense for pre-planned trades.

Security analysis and Insider trading

Security analysts gather and compile the information, talk to corporate officers and other insiders, and issue recommendations to the traders. Thus their activities may cross legal lines if they are not especially the careful. The CFA Institute in its code of the ethics states that analysts should make every effort to make all reports available to all the broker’s clients on a timely basis. Analysts should never report material non public information, except in an effort to make that information available to general public. Nevertheless, analysts’ reports may contain a variety of information that is “pieced together” without violating the insider trading laws, under mosaic theory. It may include non-material nonpublic information as well as material public information, which may increase in the value when properly compiled and documented.

In May 2007, a bill entitled the “Stop Trading on the Congressional Knowledge Act, or STOCK Act” was the introduced that would hold congressional and the federal employees liable for stock trades they made using the information they gained through their jobs and also regulate analysts or “Political Intelligence” firms research government activities. Bill has not passed.

Argument for legalizing insider trading

Some economists and legal scholars (e.g. Henry Manne, Milton Friedman, Thomas Sowell, Daniel Fischel, Frank H. Easterbrook) argue that the laws making insider trading illegal should be revoked. They claim insider trading based on the material nonpublic information benefits investors, by more quickly introducing new the information into market.

Milton Friedman, laureate of Nobel Memorial Prize in Economics, said: “You want more insider trading, not less. You want to give people most likely to have knowledge about the deficiencies of company an incentive to make public aware of that.” Friedman did not believe that trader should be required to make its trade known to the public, because buying or selling pressure itself is information for market.

Other critics argue insider trading is a victimless act: A willing buyer and a willing seller agree to the trade property which seller rightfully owns, with no prior contract (according to this view) having been made between parties to refrain from trading if there is asymmetric information.

Legalization advocates question why activity that is similar to the insider trading is legal in other markets, such as real estate, but not in stock market. For example, if a geologist knows there is a high likelihood of discovery of petroleum under Farmer Smith’s land, he may be entitled to make Smith an offer for land, and buy it, without first telling Farmer Smith of geological data. Nevertheless, circumstances can occur when geologist would be committing fraud if he did not disclose information, e.g. when he had been hired by Farmer Smith to assess the geology of farm.

Advocates of the legalization make free speech arguments. Punishment for communicating about a development pertinent to next day’s stock price might seem to be act of censorship. If information being conveyed is proprietary information and the corporate insider has contracted to not expose it, he has no more right to communicate it than he would to tell others about company’s confidential new product designs, formulas, or bank account passwords,

There are very limited laws againsts “insider trading” in commodities markets, if, for no other reason, than that concept of an “insider” is not immediately analogous to commodities themselves (e.g corn, wheat, steel, etc.). However, analogou activities such front running are illegal under U.S. commodity and futures laws. For example, commodity broker can be charged with fraud if he or she receives the large purchase order from a client (one likely to affect price of that commodity) and then purchases the commodity before executing client’s order in order to benefit from anticipated price increase.

Legal difference amongs jurisdictions

The US and UK vary in the way the law is the interpreted and applied with regard to the insider trading.

In UK, relevant laws are [[Criminal Justice Act 1993]Part V Schedule 1 ] and Financial Services and Markets Act 2000, which defines an offence of Market Abuse. It is also illegal to fail to trade based on inside the information (whereas without inside information trade would have taken place). The principle , it is illegal to trade on basis of market-sensitive information that is not generally known. No relationship to issuer of the security is required to – all that is required is that party guilty traded (or caused trading) whilst having inside information.

Japan enacted its first law against the insider trading in 1988. Roderick Seeman says. “Even today Japanese do not understand why this is illegal. Indeed,they previously it was regarded as the common sense to make a profit from your knowledge.”

In accordance with the EU Directives, Malta enacted Financial Markets Abuse Act in 2002, which effectively replaced Insider Dealing and Market Abuse Act of 1994.

The “Objectives and Principles of Securities Regulation” published by International Organization of Securities Commissions in 1998 and updated in 2003 states that three objectives of good securities market regulation-

(1) investor protection,

(2) ensuring markets are fair, efficient and transparent, and

(3) reducing the systemic risk. The discussion is “Core Principles” state that “investor protection” means “Investor should be protected from the misleading, manipulative or fraudulent practices, including the insider trading, front running or trading ahead of customers and misuse of client assets.” More than 85 percent of world’s securities and commodities market regulators are the members of IOSCO and signed on to these Core Principles.

The World Bank and International Monetary Fund now use IOSCO Core Principles in reviewing financial health of different country’s regulatory systems as a part of these organization’s financial sector assessment programs, so laws against insider trading based on the non-public information are now expected by international community. Enforcement of insider trading the laws varies widely from the country to country, but vast majority of jurisdictions now outlaw practice, at least in principle.

Larry Harris claims that the differences in the effectiveness with the which countries restrict insider trading help to explain differences in executive compensation among that countries. The U.S, has much higher CEO salaries than do Japan or Germany, where insider trading is less effectively restrained.


HLL case highlights need to clarify insider trading norms

The Securities and Exchange Board of India’s (SEBI) decision to prosecute country’s second largest corporate, Hindustan Lever, and its five senior directors has brought into the sharp focus that grey areas of insider trading laws as well as absence of any corporate transparency and governance among the Indian companies.

With SEBI, HLL, former justices (hired by multinational), and corporate lawyers interpreting `insider trading’ to suit their requirement, it has confused common investors and shareholders who have been witnessing insider trading almost on the daily basis on Indian bourses.“SEBI and HLL have interpreted term `insider’ in their own ways. There seems to be a grey area in the insider trading laws in the country.

SEBI should think of banning share transaction by senior officials or the company itself before then sensitive decision is taken,” said a senior corporate lawyer, who preferred anonymity.

Brokers point out that in HLL case; nobody has made any monetary gain by selling shares acquired by the company from the Unit Trust of India. It was a negotiated deal at a price higher than then prevailing market price.UTI also did not make any complaint, but deal helped Unilever to retain 51 per cent equity stake in HLL after merger with Brooke Bond Lipton India.

While Sebi says HLL acted as an `insider’, former chief justice P N Bhagwati says it is not so.In fact, SEBI can take some help from the US Securities and Exchange Commission (SEC) which has bought numerous civil actions in federal courts against persons whose use of material non-public information constituted fraud under the securities laws. In US, the insider trading prohibitions are designed to curb misuse of confidential information not available to the general public. Examples of such misuse are buying or selling of securities to make profits or avoid losses based on the material non-public information or by telling others of the information so that they may buy or sell securities before such information is made to the shareholders. The US Insider Trading Sanctions Act, signed into a law in August 10, 1984 allows imposing fines upto three times the profit gained or loss avoided by use of such material non-public information. Significantly, the SEC’s Section 16 of the Exchange Act, requires all officers and directors of a company and beneficial owners of more than 10 per cent of its registered equity securities to mandatorily file an initial report with the commission, and with the exchanges on which the stock may be listed, showing their holdings of each of the company’s equity securities.

Thereafter, they must file reports for any month during which there was any change in those holdings. In addition, the US law provides that profits obtained from purchases and sales or sales of such securities within any six-month period may be recovered by the company or by any security holder on its behalf.

Such `insiders’ are also prohibited from making short sales of their company’s equitysecurities. A similar system would certainly help to inculcate more transparency among the Indian corporate sector and its leaders. As of now, there are no such clear-cut guidelines and it’s a free-for-all situation.

As per SEC, “insider trading” refers generally to buying or selling a security in breach of a fiduciary duty or other relationship of trust and confidence, while in possesion of material, non-public information about the security. Insider trading violations also include `tipping’ such information, securities trading by the person tipped and securities trading by those who misappropriate such information.

Insider trading is nothing new to Indian markets. It is very common to see a big spurt in the share prices when companies plan bonus issues or major decisions like takeovers and sell-outs. The sudden jump in the share price of Merind one day before the Tatas announced the sell-out of their stake to Wockhardt is another case of blatant insider trading.

The Merind scrip had shot up by 9.94per cent to Rs 191.30 from Rs 174 on the Bombay Stock Exchange on February 24. In fact, the share sale was announced by Wockhardt and the Tatas only on February 25. Then how did the scrip which was normally a laggard spurt by nearly 10 per cent one day before the sell-out was announced? Only a detailed investigation can reveal the parties who benefitted from the share spurt.

Similarly, lack of transparancy in the Lakme sellout to Levers is another example why Indian corporates need a crash course on corporate governance.Stock-brokers, on their part, consider it privilege to get exlcusive information related to a company. Most of the companies have a network of brokers to support their share prices and other market operations. “Almost 90 per cent of companies which came out with premium issues in the last three years rigged up their share prices prior to the launch of issues. Investors were thus lured to such issues. Now look at the prices of these shares they are quoting below the face value,” said amarket source.

In fact, there is no law in Indian markets which keeps track of share transactions of top officials of Indian companies or companies themselves. India which boasts of a stock market tradition of over 100 years and listed companies of over 6,000, formulated insider trading regulations only three years ago. Before the HLL case, nobody had heard of any known case of punishing a party for insider trading. Legal experts argue there is a need to redefine insider trading laws in India. Loopholes need to be plugged. And there should be clarity in rules and definitions of terms like `insider’.

In order to get more information on insider trading, the SEBI can take help from the public or any one who can provide leads and in quid pro quo give rewards for such leads as is the practice in the United States.

Vodafone Accused of Insider Trading

The Dutch shareholders association, Vereniging van Effectenbezitters (VEB) says that it has asked Amsterdam public prosecutor to the investigate a claim of insider trading by Vodafone during its current bid for remaining shares in its Dutch subsidiary Libertel.

On 13 January 2003 Vodafone announced a public bid. Initially, Board of Executive Directors and the Supervisory Board considered bid too low, but it was still carried through the unchanged by Vodafone – without explicit support of Libertel. The transactions in the Libertel shares that have been made public, show that between 13 January 2003 and 7 February 2003 (termination of negotiations between Vodafone and Libertel) almost 21 million Libertel shares had been additionally purchased by or on behalf of Vodafone. Subsequently, shareholding was increased via transactions on stock exchange, on 12 February up to 82.4% and on 26 February up to 83.5%. In that period up until 4 March – the date of publication of offering memorandum – Vodafone bought at least another 0.3%. The intention is to acquire via public bid – the application term for which will, for time being, end on 27 March 2003 – at least 95% of all issued shares. After this, listing would be terminated.

In opinion of the VEB the Vodafone Group in period between 13 January and 4 March acted with inside the information. This insider trading probably extends to period preceding the announcement on 13 January, 2003. During this period Vodafone knew that much more about Libertel than other shareholders did. For:

• Vodafone consolidated results of Libertel in its own annual accounts;

• Libertel has been fully integrated into the Vodafone’s management information system, as a result of which operational data (user numbers) and the financial data (sales, costs, development of ARPU, cash position, et cetera) are at times known by Vodafone;

• the executive directors of Libertel are appointed on recommendation of Vodafone;

• of five supervisory directors of Libertel, four are (in)directly linked to Vodafone.

However, VEB says that this is only tip of the iceberg. Examples of other (potential) sources of insider trading by the Vodafone include:

• the internal transfer prices for the services performed by Vodafone for Libertel and which are charged by the Vodafone to Libertel accordingly;

• the sale of Vizzavi Nederland by Vodafone to theLibertel;

• the “specific internal financial reports, budgets and estimates” (offering memorandum) as drawn uptil 3 March 2003 by the Board of Executive Directors and Board of Supervisory Directors of Libertel and provided to ABN Amro – Vodafone’s financial advisor – in the connection with valuation of the Libertel share.

Finally, VEB says that it is possible that the Vodafone, also before 22 November 2002, acted on basis of insider trading concerning Libertel and that as a result more (legal) persons have committed (incitement to) insider trading.

It is the opinion of the VEB that on the basis of foregoing the law has been violated. Vodafone has much more information about Libertel than it is willing to share with its co-shareholders and, according to the VEB, in this kind of situation Vodafone is to abstain from purchasing additional Libertel shares.”

Barclays Settles SEC Insider Trading Case

Insider trading can happen in lots of different ways, and Barclays Bank PLC chose an interesting one: using information from creditors committees of bankrupt companies to trade in their debt securities. Steven Landzberg, a defendant in case along with Barclays, was the bank’s representative on the creditors committees for the six different companies, and as a member received private information about financial condition of the debtors.