Insider dealing: A deep insight

SEC’s mandate is to protect investor interests – Pic by Lasantha Kumara

In Sri Lanka, the securities market is one main forum of commercial existence. In the recent past the regulation of these markets has become imperative. In order to bring such irregularities into the spotlight, this article will provide a specific segment of such market abuse which is left non-probed by the relevant authorities in this country.

Hence, it will be based on the concept of ‘insider dealing’. Insider dealing (used interchangeably with insider trading) is a concept that has evolved several years ago and been implemented in various jurisdictions, whereas in Sri Lanka a lack of monitoring and enforcement is the crucial problem. 

Sri Lanka is an ordinary member of the International Organization of Securities Commissions (IOSCO)1 which is the standard setting organisation for all securities’ regulators and ensures 1. Investor protection; 2. Ensuring that markets are fair, efficient and transparent, and 3. Reducing systematic risk. 

This area was covered under Part V of Companies Act No. 17 of 1982, which now stands repealed. Thereafter the Securities and Exchange Commission of Sri Lanka Act (hereinafter referred to as the ‘SEC’)2 covered this topic under Part IV and applied to only listed companies. This Act prohibits an Insider trading listed securities in Section 32(1), as an individual connected with a company shall not trade in listed securities of that company if he has information which,

He holds by virtue of being connected with the company;

It is reasonable to expect such a connected person by virtue of his position, not to disclose except for the proper execution of his official duties; and

He can reasonably be expected to know is unpublished price sensitive information in respect of those securities.

Similarly, Section 32 (2) also defines a connected person if trading in listed securities in another company.

According to Section 34(1) this connection may be established in two ways. Firstly by being a director of the company (or related) and secondly by being an officer (other than an director) or employee of the company (or related), or by holding a position involving a professional relationship between himself and the first company (or related), where in either case he has access to inside information in relation to either company.

Insider dealing is in essence an offence relating to the abuse of information by giving an unfair advantage to the person in the financial market who is privy to such information undisclosed by the company, in other words it is a “white collar” fraud.

The SEC Act provides for two major types of insiders namely primary insiders and temporary insiders. Primary insiders also known as “corporate insiders” are the true insiders comprising the internal personnel having a better access to the inside information in a company, and generally include members of management and the supervisory and administrative bodies in a company, and sometimes include employees.

A special category of it is temporary insiders. They acquire information as outsiders. These comprise usually the lawyers, accountants, consultants, merchant bankers. They are easily tempted to trade on inside information. In order to mitigate/prevent such activities, professional bodies are welcomed to issue strict codes prohibiting the use of inside information. This is clearly provided for in the 2003 amendment to the SEC Act. 

The second branch of insider dealers are the secondary insiders. They obtain information through an inside person (or someone else). This group consists mostly of tippees. Nevertheless, acquiring information from secondary tippees is not considered illegal.

Theft/abuse of information

Theft or abuse of information is a significant matter to be strictly observed in this information age.

As per the provisions of the Penal Code of Sri Lanka, dealing with offences against property, theft of information has no physical element and therefore not regarded as an offence under the Penal Code. In the popular case of Nagaiah V Jayasekara3 theft of electricity did not constitute a stealing of property.

There are two examples that may illustrate law relating to insider dealing. In Lord Advocate V Mackie4, where a Chairman of a company provided information regarding the approaching problem on profits of the company to a financial analyst, he then handed such information to two of his friends. Similarly, in a famous US Case which was widespread few years ago about the ‘Heard on the Street’ column in the Wall Street Journal5.

In this particular case, if a beneficial remark is made of shares listed in that column it would affect the price positively. The columnist published information to other individuals and resulted in greater profits, prior to publishing it in The Journal. Thereafter in accordance with the applicable US law, the columnist was convicted for insider dealing for having taken confidential information.

Several academics, including Milton Friedman, have argued that insider trading ought to be legal. Several other commentators have renewed that argument in articles over the past year, often citing the recent US scandal of Raj Rajaratnam’s case6. Their arguments are as follows:

It is difficult to prosecute.

It is a victimless crime.

It increases the information in the market, thus increasing market efficiency. This argument requires a bit more explanation. Essentially the idea is that if an insider knows that stock X is severely over-valued, and sells his or her holdings in X, then the price of X will drop, thus more accurately reflecting its value.

It increases incentives for company officers to make profits.

However, the argument stands debatable. Any case of insider trading requires a cost-benefit analysis.

Establishing the connection with the company

The UK Criminal Justice Act (CJA) of 1993 replaced the “connection with the company” test with “access to information”. However, SEC amendment 2003 in Section 34 (1) (c) has imposed liability by “informational advantage” rather than “status”.7

Rule 8.6a of the CSE listing Rules covers directors’ spouse and children under the age of 18 years as a connected person.

However, in Sri Lanka the connection between the person and such information needs to be established. Therefore, anyone outside this connection is an ambiguity in the law.

On the hand, the UK Criminal Justice Act of 1993 replaced the ‘connection with the company’ test with ‘access to information’ but in Sri Lanka, the SEC Act accommodates a provision for an addition into the two fold definition of ‘connection’ a third category of persons. 

This category consists of persons who have access to information in listed securities and has the knowledge that such information is unpublished price sensitive and that it is reasonable to expect him not to disclose such information during the performance of his duties.

Price sensitive information

Section 34 (2) of SEC Act defines “unpublished price sensitive information” as relating to any listed securities of any company is a reference to information which relates to specific matters relating, or of concern, (directly or indirectly) to that company that is to say, is not of a general nature relating or of concern to that company; and is not generally known to those persons who are accustomed or would be likely to deal in those listed securities but which would if it were generally known to them be likely to affect materially the price of those securities.

The law has broadly defined the parameters where the information must relate to “specific” matters, as opposed to “precise”. 

This definition is very vague as compared to Section 58 of CJA UK. The CSE listing rules of 2009 has framed the boundaries of “Price sensitive information”8, due to the fact that the sensitive periods in trading of shares are vulnerable for market manipulation9. 

The primary features of price sensitive information are it should be of material and confidential nature that if made public, will influence the shares critically. It is noteworthy that confidentiality arises when information is obtained from an insider. The Takeover and Mergers Code of 1995 requires a company to make announcement in situations where there is some unpleasant movement in its share price. But this code covers SEC members during the offer period. Therefore, Takeover Code10 applies for them and prohibits divulging information that is privy to confidential price sensitive information.

In SEC V Texas Gulf Sulphur Co.11 TGS discovered about a substantial mineral in Canada, but TGS did not release such information. However, the TGS employees knowing about it purchased TGS stocks, but did not disclose the mineral discovery. Therefore, the employees act amounted to insider trading.

However, Section 33 of the SEC Act contains a provision which exposes public servants or former public servants to liability for insider dealing. This provision does not extend to members, officers and servants of the Securities and Exchange Commission of Sri Lanka as they are simply not ‘public servants’.

A serious deficiency in the SEC Act is the glaring omission to provide against the use of price sensitive information gathered in the course of the discharge of their duties by the members, officers and servants of the Securities and Exchange Commission.

Penal sections

As per Section 33A, any person found guilty of insider trading shall be liable on conviction after summary trial by a Magistrate, to a sentence of imprisonment of either description for a period not exceeding five years or to a fine not exceeding Rs. 10 million or to both such imprisonment and a fine.

The Commission may, according to the circumstances in which the offence was committed, compound such offence for a sum of money not exceeding one-third of the maximum fine imposable for such offence and all such sums of money received by the Commission in the compounding of an offence shall be credited to the Compensation Fund established under SEC Act. However it is of great public concern that the penalties for violating securities laws are too lenient, that imposition of fines are too lenient and also a very few cases have been prosecuted to the end

The Takeover Code12 does not expressly provide for any defences, however the SEC Act provides for possible defences under Sections 32(8) and 32(9). Alternately the defence of ‘non-use’ of inside information is provided in the jurisdictions of UK and South Africa, which can also be used in Sri Lanka despite it not having been applied in the Sri Lankan courts13.

However the basis of the non-success of the SEC provisions on insider trading is due to the issue of a non-availability of a proper law enforcement framework.

Recommendations

The New Securities Exchange Bill14 provides the necessary legal framework for curbing market misconduct and providing protection for whistleblowers. In terms of the proposed draft Bill, the offences of market misconduct, insider dealings, operating a stockbroking or market research firm without a license, and misleading investors to buy, hold or sell stocks will attract hefty fines of up to Rs. 100 million, or up to three times the illegal profit made or loss avoided for insider trading. 

Offences will no longer be compounded under this proposed new Act. Criminal proceedings will be filed at the Magistrate’s Courts for serious violations such as market misconduct, if not then civil action will be heard by the Commercial High Court.

The proposed new law will eradicate financial irregularities beginning within the listed companies and therefore the Auditors will play a vital role in revealing any information regarding such irregularities. Auditor oversight will be introduced with it, wherein no auditors will be on the board. The loophole is that unlisted markets are not regulated (Over-the-Counter transactions).

The words “having access to intentions or likely intentions of a person” are added to insider information, which will be proved by showing that the person (someone) benefitted from the information or knowledge that which was not public at that time. Market intermediaries should exercise due diligence prior to offering investment advice, whereas others who give such advice has to prove a reasonable basis for such decisions.

Therefore, anyone aggrieved by the decision of SEC can seek redress from courts, while the checks-and-balances are inherent judicial power. Investigations will be taking place on the past six years offences. Judicial activism is essential in this spectrum.

However, this draft 2017 Bill has not yet been passed. The proposed new Act will alleviate investor confidence when it becomes law. SEC’s mandate is to protect public investments.

Conclusively, it is indisputable fact that if insider dealing is prohibited, there would not be any trading in the market.

(The writer is an Attorney-at-Law.)

Footnotes

1 http://www.sec.gov.lk/wp-content/uploads/speech-26-Mar-23rd.pdf 4

2 Securities and Exchange Commission of Sri Lanka Act No. 36 of 1987 as amended by Act No. 26 of 1991, Act No. 18 of 2003 and Act No. 47 of 2009

3 Nagaiah V Jayasekara (1927) 28 NLR 467

4 Lord Advocate V Mackie (1994)

5 The famous film titled “Wall Street”

6 Financial Times 22nd November, 2009

7 UK Act of 1993; extension of European Council Directive (89/592/EEC) Article 2 and 2(1).

8 See: Close period rules

9 Rule 8.1

10 Take over and Mergers Code of 1995

11 https://casetext.com/case/securities-and-exchange-comn-v-texas-gulf-sulphur

2 Take over and Mergers Code of 1995

3 see section 32(8) and 32(9) of the SEC Act

4 https://www.casrilanka.com/casl/images/stories/2017/2017_pdfs/draft_securities_and_exchange_commission_bill.pdf