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A Victimless crime?
Securities and Exchange Board of India (SEBI) is again set to tighten the law against insider trading. The law was first passed in 1992 and amended very recently in February 2002. As the amendment is more than ten times longer than the original law, one would have thought that SEBI must have plugged all the loop holes. But one would be wrong; a lot more work is apparently required to banish insider trading from the Indian securities market.
The aim of insider-trading laws is to assure that no one would gain by trading on "insider" or "unpublished" informationinformation that is not available to all market participants. The ultimate goal is equal information to all market participants. The proponents see any inequality of information as unfair.
Those who are more philosophically inclined would immediately see the parallels between the goals of the equality of information and the equality of opportunity. As history has demonstrated, even a totalitarian state is unable to achieve perfect equality of opportunity. What kind of draconian state would be required to implement equality of information?
The countries that have stringent insider-trading laws and stronger enforcement, like United States and Australia, have rather low rates of prosecution and even lower rates of convictions. There have been only six prosecutions in last ten years in Australia. In a recent case, two people purchased shares on the basis of "insider" information, but only one got convicted. This glaring anomaly has made Australian authorities reconsider their insider-trading laws.
Research by Professor Michael Adam of the University of Melbourne suggests that between 5 to 10 percent of securities trading in Australia would be classified as insider trading as per the existing laws and definitions. This high proportion of insider trades and the low percentage of prosecutions and convictions necessitate either even more draconian powers of enforcement or a complete rethink of the policy.
The foremost problem is of definition: Who is an insider, and what counts as inside information? It is not easy to define either--reason why SEBIs amendment is so much longer than the original law. The 1992 law defined potential insider as any director, official, or employee of a company, an official or member of a stock exchange or a clearing house; a merchant banker, share transfer agent, registrar of an issue, debenture trustee, broker, portfolio manager, investment advisor, sub-broker, investment company or an employee thereof, a member of the Board of Trustees of a mutual fund, or a member of the Board of Directors of the Asset Management Company of a mutual fund, or an employee thereof, who have a fiduciary relationship with the company; a member of the Board of Directors, or an employee, of a public financial institution; an official or employee of a Self Regulatory Organisation; a banker to the company, or a relative of any of the aforementioned persons. This long list still left out "temporary or permanent," which was added in the amendment. It also included any person connected in the above capacity "six months prior to an act of insider trading." What kind of insider information is it that a person acts on it after six months?
I save you the torture of reading the definition of insider information. Worlds best rule-making bodies and enforcement agencies cannot possibly cope with these complexities, convolutions, and confusions.
A rethink on insider-trading laws must begin with the recognition that insider trading is mostly a "victimless crime." Our arbitrary sense of fairness has declared insiders as criminals, just as it has labelled prostitutes, scalpers, smugglers, bootleggers as criminals. Without the arbitrary value judgement, all these would be seen simply as providers of services in a marketplace.
The goal of the equality of information is a mirage; some would always be more equal than others. To act on any piece of information requires interpretation of that information, which in turn requires a large number of other pieces of information. An announcement, for example, by IBM that its Q4 profits have risen by 58 percent, doesnt really tell one how to act in the market for IBM securities, whether to buy or sell. This requires one to know what has happened to the profits of other IT companies, companies in other related fields, and so on. Microsofts profits, say, could have risen by 580 percent. One would then sell IBM and buy Microsoft. Or profits of biotechnology companies could have gone up by 1000 percent. One may then sell both IBM and Microsoft. Any single piece of information about a company, however critical it may be to that company and its future, does not in itself provide clear instruction to the investor. Action requires interpretation, which requires wider knowledge.
If insider trading is largely a victimless crime requiring no special laws against it, then what should be done in a few cases where there are identifiable victims? These cases can be dealt under private contracts and civil lawsuits. One reason for low rates of prosecution and conviction under current laws is that insider trading is a criminal and not a civil matter. Criminal conviction requires a far higher degree of proof, "guilty beyond a reasonable doubt." Employment contracts of directors, officials, and employees will specify that any misuse of information acquired during the course of official work would be punishable. If a company or any group of shareholders thought that the official information was misused, they will file a civil lawsuit against individual culprits.
Similar private contracts will apply to merchant bankers and companies that provide specialised professional services. The incentive for these companies to have such contracts with their employees is to attract more customers. If my firm is looking for M&A advice, I am more likely to choose a company that has a contract with it employees that prohibits them from using any acquired information to the detriment of my company. So in cases of identifiable damages, private contracts and civil lawsuits will be more effective and efficient.
(The author is President, Centre for Civil Society)
New Delhi, April 18, 2002