Insider Trading and The Unfair Trade Practices

Insider Trading and The Unfair Trade Practices

Author: Sharyu Rumde, School of Law, Mumbai University.

Abstract

Insider Trading is an Unfair Trade Practice which has caused quite a stir all over the world. Many public entities are deceived by a trader who deals with diverting information to gain illegal profits. This article talks about the laws enacted by the countries to deal with the situation and how the authorities are functioning with accordance to these laws.

How often do we come across people taking advantage of our situation and fooling us into doing something we don’t want to? As much as we hate to admit it, such situations take place almost on a day to day basis. Some people even end up getting fooled, which makes us question about the fairness of the situation. However, if we think about it, there is a motivating factor behind the commission of such practices. A factor which makes people blind to their misconduct to such an extent that they feel no shame in doing it again and again. Money is that factor. People have been fooled to no bounds just because someone wanted to earn quick money. We have been fooled by a shopkeeper to buy something at a higher price or by an agent who guaranteed doubling our money and at times even by someone we were familiar with who fled away after borrowing our money. This fraudulent practice isn’t just limited to people we come across in our day-to-day life but is even seen amongst big multinational companies and traders. We do suffer a loss when we are deceived by someone but it is nothing in comparison to the unfair practices taking place a higher level. These businessmen are the big players as the profit they earn by their fraudulent act is in millions and billions of dollars.

A businessman who looks forward to earn profits isn’t in the wrong as that is how a business works, but cheating to earn his way to the top? That’s not just unethical but a gross violation of consumer rights. The person is deceiving others and using unfair methods to achieve his goals. This wrongdoing is called as an Unfair Trade Practice.

Such practices are becoming very common in today’s world as it is easier to gain profits in a lesser amount of time. One such practice being Insider Trading. With the flourishment of industrialization and globalization, the market boomed. The change in economy was seen at such a massive scale that a few years back, one would have found it hard to imagine such prosperity in the world of commerce. However, any form of development comes at a cost. As the trade started growing, people started finding ways to misuse it for their personal benefit. Similarly, as companies started soaring new heights, some people found their way to trick others to earn quick money. In Insider Trading, people started to trade nonpublic information of their own company to affect the future decisions revolving it.

These practices were being committed at a global level. The need for a law was recognized. The governments understood the seriousness of the situation and formulated laws governing the unfair practices.

Insider Trading

When a public company’s stock and securities are purchased and sold on the basis of material information which is not yet public is called as Insider Trading. Material information refers to any and all information that may result in a substantial impact on the decision of an investor regarding whether to buy or sell the security.[1] In a public company, the securities traded is in no ordinary amount, hence if any inside information is being shared, it is evident that the person is able to influence the decision of an outsider. If this practice is carried out with a treacherous intention, the insider is able to earn illegal profit out of it. However, if this practice is carried out with an honest intention, there is nothing to worry as a valuable information shared by the directors or employees can be for the benefit of the organization. 

Insider Trading is both legal as well as illegal. Though many countries consider insider trading as an illegal activity, there are certain provisions which specify what doesn’t classify as illegal insider trading, so if any form of trading is done in accordance with those provisions an insider will be able to trade within the purview of law. But not many countries have classified the term ‘insider trading’ as a legal practice, so it is usually forbidden.

Legal Insider Trading

The United States of America is one of the few countries that considers some form of insider trading as legal. In the country, when an officer buys and sells stocks in his own companies, the trade is considered to be legal. This trading is carried out by many public companies. However, it has to be reported to the Securities and Exchange Commission by filling Forms 3, 4 and 5 which deals with statement of ownership, change of ownership and reporting of transactions accordingly. The United States law permits insider trading as long as it is not fraudulent, and done in a period of time where it is not affecting the decisions of outside traders. If a person adheres to the provisions of Rule 10 b-5 of the Securities Exchange Act, 1934 which prohibits any act amounting to deceit but doesn’t expressly prevents Insider Trading, he can do so with no fear of being held liable under the law.

This enactment by the United States government is a fresh change as opposed to the laws of other countries, the country encourages legal insider trading and highlights the positive side of it. Many experts have argued over the legality of insider trading as the states simply don’t consider it as a viable option. It is very true as the United States law focusses on both the legal and illegal aspect of it unlike the other countries. The intent of the wrongdoer should be a deciding factor rather than the whole practice. Many companies in the US fill the necessary documents and legally trade within the law. The illegal trade is and should be prohibited as the consequences following it are dire but at the same time legal insider trading should be well acknowledged and encouraged by nations all over the world.

Illegal Insider Trading

Illegal Insider Trading is considered as a serious offence and has been criminalized in many countries. The trading usually affects the stock market as the public companies are constantly buying and selling their shares and the information influences their trading behaviour. To better understand the concept, we can refer to the legislation of countries with the leading stock exchange markets.

United States of America

The country has two of the largest stock exchanges in the world namely New York Stock Exchange and National Association of Securities Dealers Automated Quotations Exchange (NASDAQ). As the securities are traded at a great scale, the insider trading laws have been formulated to supervise these trades.

The first known case of insider trading was from the year 1909 when the Supreme Court decided that a director who decided to act in a way which can affect the value of shares cannot use that knowledge to acquire shares from outsiders.[2] Later, the enactment of Securities Exchange Act, 1934 brought forward the provisions relating to prohibition of insider trading done with a malicious intention.

As per the Act:

Rule 10 b-5 prohibits any acts or practices that can amount to fraud or deceit on any corporate person, in relation to the sale or purchase of securities.

Rule 14 e-3 prohibits insider trading done by a person in possession of non-public information relating to the commencement of a tender offer which should not be public.

Section 16 (b) prohibits short swing profits from purchases and sales that occur within six months.

Furthermore, the Act has given power to the Securities and Exchange Commission to regulate the trading activities of the public companies and govern the market by creating and enforcing rules. The SEC has successfully filed suits against many corporate entities and individuals who have gained profits by disclosing confidential information.

The penalties are quite hefty which can be observed in the following case, Former hedge fund manager of the Galleon Group who was convicted on 14 counts, including 9 counts of securities fraud and 5 counts of conspiracy was sentenced to 11 years of imprisonment alongwith a fine amounting to $10 million and forfeiture of $53.8 million in profits. In a civil case brought by the Securities and Exchange Commission (SEC), the manager was ordered to pay a fine of $ 92.8 million.[3]

China

The Shanghai and Shenzhen Stock Exchanges are two of the major stock exchanges in the world. The insider trading carried out in the country was no meagre issue which resulted in the formulation of the China Securities Regulatory Commission (CSRC). The trading was first made illegal in the year 1993 with the introduction of the Establishment of Securities Companies with Foreign Equity Participation Rules.

In the year 2005, the Commission made shares accessible publically as opposed to the private nature of earlier times, however the companies were given a deadline to convert these shares which resulted in many people committing illegal insider trading to gain profits. Since then the country has seen a rise in cases.

The imposition of penalties is as strict as the US as in a recent case, Shanghai entrepreneur Wang Yaoyuan and his daughter Wang Chengcheng were fined 2.72 billion Yuan for using inside information to punt on the shares of Joincare Pharmaceutical Group on the city’s stock exchange. Their net gains of 906.4 million Yuan earned from the doubling in Joincare’s stock price were confiscated. In total their penalties amounted to 3.6 billion Yuan.[4]

United Kingdom

The vital provisions relating to insider trading are found in Section 52, Section 56(1) and Section 57 (1) of the Criminal Justice Act, 1993 (CJA) which deal with defining the type of offences, definition of insider information and the person considered as an insider accordingly and the Financial Securities and Markets Act, 2000 (FSMA). The 1993 Act follows the European Community Insider Dealing Directive which states that insider dealing is an abuse of the market rather than breach of the insider’s fiduciary obligations with the company. Section 1195 of the FSMA requires the Financial Services Authority (FSA) to issue a Code of Market Conduct that provides guidance to determine what kind of behaviour amounts to market abuse. The FSA regulates securities trading and aims to ensure that the stock markets are orderly and fair. A person convicted of insider trading is liable on conviction of indictment to a fine or imprisonment for up to seven years or to both.

While discussing Insider Trading in the case of R. v McQuoid[5], the Lord Justice stated that, “Those who involve themselves in insider dealing are criminals: no more and no less. The principles of confidentiality and trust, which are essential to the operations of the commercial world, are betrayed by insider dealing and public confidence in the integrity of the system which is essential to its proper function is undermined by market abuse. Takeover arrangements are normally kept secret. Very few people are permitted to have advance knowledge of them. Those who are entrusted with advance knowledge are entrusted with that knowledge precisely because it is believed that they can be trusted. When they seek to make a profit out of the knowledge and trust reposed in them, or indeed when they do so recklessly, their criminality is not reduced or diminished merely because they are individuals of good character.”

Japan

The Tokyo Stock Exchange is one of the leading stock exchanges in the world which makes Japan prone to insider trading. The trading is monitored by the Market Surveillance and Compliance Department as all the important corporate information is examined by them alongwith the buying and selling pattern of the public entities. Insider trading is prohibited under Article 166 and Article 177 of the Financial Instruments and Exchange Act (FIEA).[6] The criminal penalties are imposed under Article 197-2(xiii) against violations of the insider trading laws including a maximum penalty of imprisonment up to five years and a fine up to JPY 5 million.

India

India has two major stock exchanges namely the Bombay Stock Exchange and the National Security Exchange of India. The Security and Exchange Board of India (SEBI) regulates the insider trading law in the country. SEBI (Insider Trading) Regulation, 1992 framed under the Section 11 of the SEBI Act, 1992 has the authority to prevent the illegal trading of securities. The Act doesn’t define the term but Section 12A prohibits activities that primarily include manipulative trades, insider trading activities and substantial acquisition of securities. The penalties are quite hefty as under the SEBI (Amendment) Act, 2002 any person found trading unpublished information, price sensitive information or illegal dealing in securities of a published information can be fined for an amount of Rs. 25 crores or 3 time the profit made by him, whichever is higher.[7]

As stated earlier, the laws differ from country to country but nevertheless one thing remains the same, illegal insider trading is considered as an offence of serious nature and the punishment is severe. The countries have set up a specific Commission or Department to deal with issues relating to this trading. Even the penalties are strict in nature. However, the authorities still lack in making the full use of the prescribed laws. Many people continue to trade illegal information and escape the legal liability. The trading is considered to be done on a regular basis but the culprits are not caught that frequently. On the other hand in many countries the legislative process is slow which is also considered an important reason for the lack of proper justice. Though the amount of penalty is hefty, very few people have been made to paid that amount, others escape the liability with a meagre amount of fine. Despite having serious provisions, the execution isn’t up to the mark. The culprits need to be properly charged for their offences.

Unfair Trade Practice

The deceptive and fraudulent practices committed by business owners which involves the use of unethical methods like misrepresentation, false advertising, deceptive pricing, etc. to obtain their  business goals against their consumers is called as unfair trade practice.[8] These practices are so common in nature that the governments have enacted various laws in order to stop the exploitation. Insider trading is a classic example of Unfair Trade Practice as the trading is done with a malicious intention for that person’s own benefit. The unfair trade practices has engulfed the entire world as many countries are seen violating the trade laws enforced by the World Trade Organization. The people on the opposite side of these deceivers are affected to a great extent as their rights are grossly breached and they are robbed of their desired services. This gross violation has been happening for ages and even though the laws are enforced, such practices continue to take place. Right from a local shop owner to a businessman trading all over the world, the product and services right of a person is compromised to a great extent.

Conclusion

Insider Trading is a very important legal issue in today’s world. The traders are using it positively as well as negatively, however the negative aspect triumphs as many people are keen to make illegal profits in a short amount of time. However, there is still a need for better understanding of the topic. Many companies have simply discarded the notion that legal insider trading exists and have simply categorized it as an illegal activity. The proper classification of the term needs to be done.

At the same time, we are in no place to ignore the negative impact of insider trading. Many businessmen have made an insane amount of profit out of it. While doing so, they have cheated the other parties by making them believe a diverting information. Many companies have ended up losing a great amount of money due to this misrepresentation. While we classify many things under Unfair Trade Practices, we don’t talk enough about Insider Trading. This trading is a perfect example of a fraudulent practice and such trades happen very frequently all over the world.

While the laws are strict, the implementation is severely lacking in many places. The governments need to enforce stricter laws to effectively stop this illegal trade. The judiciary needs to deal with the cases more efficiently in order to make sure that the culprit is charged at the right time and with the right punishment. Insider Trading is an unfair trade practice happening all over the world and it needs to be stopped. These unfair practices are committed for a selfish motive which is all the more reason for the laws to be stringent. A society can only be developed when everyone is equally benefitted out of something.

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[1] Insider Trading, Corporate Finance Institute, https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/what-is-insider-trading/

[2] Strong v. Repide, 213 U.S. 419 (1909)

[3] Raj Rajaratnam American investor, Britannica, https://www.britannica.com/biography/Raj-Rajaratnam

[4] China’s regulator gets tough on insider trading as it metes out record penalty on wrongdoers in the financial markets, South China Morning Post, https://www.scmp.com/business/companies/article/3090564/chinas-regulator-gets-tough-insider-trading-it-metes-out-record

[5] R. v McQuoid, [2009] EWCA Crim 1301; [2009] 4 All E.R. 388.

[6]About Unfair Trading (Market Manipulation/ Insider Trading), Japanese Exchange Group, https://www.jpx.co.jp/english/regulation/ensuring/preventing/about-unfair-trading/index.html

[7] Section 15G of the Security and Exchange Board of India (Amendment) Act, 2002.

[8] Unfair Trade Practice, Investopedia, https://www.investopedia.com/terms/u/unfair-trade-practice.asp