Insider Trading – Why Is It Unethical?
- Posted on November 12, 2021
The existence of a fair, vibrant and efficient securities market is one of the essential ingredients for economic growth of a country. To instill confidence, trust and integrity in the securities market, the market regulator needs to ensure that there is a fair market conduct, which can be ensured by prohibiting, preventing, detecting and punishing such market conduct which leads to abuse of market. Market abuse includes market manipulation and insider trading that erodes investor confidence which in turn can impair economic growth.
Share trading means buying and selling of shares/securities of companies listed on the stock exchanges with an aim to make profit. Through online share trading account, one can buy or sell shares, stocks, mutual funds, bonds, and other securities easily, without the need of an intermediate broker or agent.
The term “Insider Trading” has been frequently debated in the financial world and is of special importance to the economy during the past few decades because of the series of scams that could help insiders to amass wealth. Insider trading is sale or purchase of securities by corporate insiders (who are privy to the confidential and monopolistic information) to their advantage to make abnormal amount of wealth/money. Monopolistic information is information of privileged nature which are price sensitive and affect significantly the market value of securities of the company or which is likely to be considered by the investors in making investment decisions.
Insiders include the employees, executives, bankers, auditors, financial advisors and their family members and other related parties. It can also include the top management of the company and their close relatives. These categories of persons may sometimes use the price sensitive information illegitimately but successfully for trading on the securities, but manage to hide from being detected by the authorities/regulators. Corporate decisions like bonus issues, right shares, dividend declaration, amalgamation/mergers etc can influence the prices of stocks in the market. Consequently, before making such announcements officially, insiders make profit by trading in the stock. Such trading is considered unethical all over the world and Securities Market Regulators have made strict rules prohibiting insider trading. The mere possession of material non public information does not give rise to a duty to disclose that information. The duty to disclose information or abstain from trading on the basis of the information arises only when a fiduciary relationship or a similar relationship of trust and confidence is involved between parties to a transaction.
Patricia Werhane , Professor of Business Ethics in the University of Virginia in her article “The Ethics of Insider-trading” mentioned that “insider trading is both unethical and inefficient.” Insider trading (by corporate executives) of shares of their own corporate stock is unfair because those executives use shareholders’ property for their private gain. Such trade is unfair, just as all forms of insider trading, because the inside traders use information that, if available to non inside traders, would affect their decision to trade. Such trade gives the outsider an unfair comparative disadvantage that skews competition. Two principles are necessary for competition: An efficient market, where as much complete information as possible is available to everyone, and the ideal of an equal comparative advantage among competitors. Insider trading, by definition, violates the very principles of competition. For all these reasons, stringent regulation is necessary.
George Akerlof, another famous economist in his article “The Market for Lemons” examined and explained how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only lemons behind. Stock market is no exception to this. A market characterized by unconstrained opportunities in the presence of asymmetric information can result in market failure. The market may be narrowed because the super-normal returns gained by the insider traders excluding a large segment of potential investors from the market, undermining investor confidence.He concludes that if insider trading takes place in the primary market, it has no effect on the level of investment, whereas if it takes place in the secondary market, it has a negative impact on investment.
SITUATION IN INDIA
The subject has been widely debated in the press and media in India after the unearthing of several cases of insider trading in our capital market. The following cases/reports reiterate the need for more stringent measures to weed out the anomaly from our economic system.
- Sebi penalises 2 persons for violating insider trading norms in Mindtree case. (Economic Times dated 22.10.2021)
- Sebi confirms ban on 5 persons in Zee insider trading case. (ET dated 28.09.2021)
- Infosys employee banned by Sebi over insider trading. (ET dated 29.09.2021)
- Indiabulls Ventures CEO, 4 others pay Rs 5 cr to settle insider trading case. (ET dated 08.10.2021)
- SEBI bars ex-Infosys, Wipro staffers in insider trading case (ET dated 30.09.2021)
- SEBI levies fine on TITAN employees for disclosure lapses (ET dated 18.09.2021)
- KPMG ousts partner named in MAGMA insider trading case (ET dated 21.09.2021)
In India, the SEBI has the primary responsibility for enforcing insider trading regulations. Although the SEBI typically brings civil charges against a defendant, it may also refer cases to the Judicial forum for criminal prosecution, or if the defendant is a regulated market professional, it may suspend or revoke his or her license. The majority of insider trading cases are civil cases in which the SEBI seeks the return of the insider’s profits, gains or loss avoided, and asks the court to issue an injunction prohibiting further insider trading violations. SEBI (Prohibition of Insider Trading) Regulations, 2015 provide with additional weapons it can use against persons and entities that have violated the provisions of the Acts and the Rules and Regulations promulgated there under.
SEBI in the said Regulations emphasised the duties of a Compliance Officer, in a company, who shall be a senior level functionary, financially literate and is capable of appreciating requirements for legal and regulatory compliance under these regulations. He shall be responsible for compliance of policies, procedures, maintenance of records, monitoring of adherence of rules for preservation of unpublished price sensitive information. He shall also monitor the trades and the implementation of codes specified in these regulations under the overall supervision of Board of Directors/top management of the listed company. As per the said rules, the insider would be required to submit the trading plan in advance to the compliance officer for his approval and such trading plan on approval will be disclosed to the Stock Exchanges, where the securities are listed.
Any person who violates the provisions of these Regulations shall be liable for appropriate penal action under the SEBI Act by issuing any or all of the following orders:
a) Directing the insider or such person not to deal in securities in any particular manner;
b) Prohibiting the insider or such person from disposing of any of the securities acquired in violation of these regulations;
c) Restraining the insider from communicating any person to deal in securities;
d) Declaring the transaction/s in securities as null and void;
e) Directing the person who acquired the securities in violation of these regulations to deliver the securities back to the seller or compensate the seller suitably;
f) Directing the person who dealt in the securities contravening the regulations to transfer an amount equivalent to the cost price/market price of the securities, whichever is higher to the investor protection fund of the recognised stock exchange.
Besides the above the insider shall also be liable to a penalty of Rs.25 crore or three times of the profits made out of the insider trading, whichever is higher. The regulations also provide that the Board may appoint a qualified auditor to investigate into the books of accounts or affairs of the insider or any other person as may be directed by the Board.
CONCLUSION
Currently, regulators are under the assumption that insiders strictly limit their transactions to common stocks, though the scams reported off and on prove otherwise. This is an open research area for future scholars. Future research may also attempt to identify the identities of outside-insiders, the nature of their transactions, and most importantly, how widespread outside-insider trading is. As of today, the volume of aggregate insider trading has not been significantly reduced. This leads us to question of effectiveness of insider trading regulations. Should regulation be redesigned or should taxpayers and investors stop putting their money in a heavy administrative system that has so far provided a questionable return? This warrants immediate attention of our regulators, judiciary and legislature.
The existence of a fair, vibrant and efficient securities market is one of the essential ingredients for economic growth of a country. To instill confidence, trust and integrity in the securities market, the market regulator needs to ensure that there is a fair market conduct, which can be ensured by prohibiting, preventing, detecting and punishing…