Not easy to pin down insider trading

The term ‘insider trading’ arouses more interest than all the other dull and boring corporate frauds thanks to the vivid image it invokes — that of someone closely connected to the company snooping around for information and then stealthily trading in stock markets to rake in the moolah.

Such trades — based on material information not available to other investors — are quite common but they are also very hard to control. The task of market regulators, including the Securities and Exchange Board of India (SEBI), has been made even more difficult by a recent verdict of a US appeals court.

The court reversed an order by a US district court that held two portfolio managers, Todd Newman and Anthony Chiasson, guilty of insider trading charges. The reasons given for this decision has now made implicating people for insider trading extremely difficult.

The ruling has implications for India as well. The set of laws dealing with insider trading in India is still evolving and is reviewed and revised frequently, with the most recent changes made this November. As the US and other countries migrate to these stricter norms, India could also follow suit.

What was this case all about? A group of analysts from various hedge funds and investment firms had obtained from insiders in Dell and NVIDIA, the companies’ earnings number before they were publicly disclosed.

These analysts shared it amongst each other and then passed it on to portfolio managers at their companies. Newman, portfolio manager at Diamondback Capital Management, LLC, and Chiasson, portfolio manager at Level Global Investors, LP, were charged for trading on information obtained by their analysts and making a profit of $4 million and $68 million for their respective funds.

The appeals court overruled the conviction based on two facts. First, there was insufficient evidence to show that the company insider had received any personal benefit in exchange for the information he leaked.

Second, it was not proved that Newman and Chiasson were aware that they were trading on information obtained from a company insider who had benefited in some manner from sharing the information.

Insider trades are not always illegal. In the legal form of insider trading, the company insider trades in the shares of the company after making the necessary disclosures to the stock exchanges.

In its illegal form, an insider in possession of unpublished price sensitive information either trades in shares or communicates the information to some other person who trades based on that information, in breach of a fiduciary duty or other relationship of trust and confidence.

So far, it has been sufficient to hold anyone guilty if it could be proved that he/she had traded based on insider information.

But after the ruling, it has to be proved that the insider giving out the information has done so for personal benefit and that the person trading with insider information was aware that the information had been obtained after giving some benefit to the insider.

In cases where the company insider executes the trades directly or if the person receiving the insider information puts through the trades, proving guilt will be easy. But if there are multiple layers between the insider and the person executing the trades, proving guilt is going to get onerous.

Let us test these regulations on some of the famous insider trading cases in recent times.

In the case involving Rajat Gupta and the Galleon hedge fund manager, Raj Rajaratinam, the former was the insider since he was privy to the information revealed in the Goldman Sachs and Procter and Gamble board meetings, among others. Gupta passed on the information to Rajaratinam so that Galleon could profit from it.

Since Gupta had investments in Galleon, the benefit that he derived from passing on the information is not disputed. Also since the information was passed to Rajaratinam directly, it cannot be said that he was unaware that he was accessing confidential information. If the regulations are revised according to the appeals court verdict, Gupta and Rajaratinam would still be found guilty.

Let’s examine another insider trading case in India — the allegation that Satyam’s promoter Ramalinga Raju and other top executives including Vadlamani Srinivas and G Ramakrishna sold shares worth ₹4.5 crore between 2003 and 2008, even as they were aware of the company’s deteriorating financial position.

Here too there would be no problem in ascertaining illegal insider trading. Here the company insiders have themselves traded on unpublished information instead of passing it on to others to profit from it.

However, all insider trading cases will not fit the requirements of the US court of appeals that easily.

Once the number of layers increases, establishing guilt will get difficult.

The recent instance of Factorial Master Fund, a Cayman Island-based hedge fund, was alleged to have traded in the shares of L&T Finance Holding based on unpublished information on the floor price of the company’s offer for sale is one such case.

Here the identity of the person who leaked the information is not yet revealed. So it cannot be established whether the person leaking the information benefited from the act or not.

Whether the employee of Factorial who put in the trade was aware of the benefit gained by the insider will also be hard to pin down.

All in all, we have interesting times ahead of us in future insider trading cases.

COMMENT NOW