Key insights to insider dealing

1. Introduction

Insider dealing is a term that encompasses both legal and illegal activities. The legal version of Insider trading takes place every day in almost all jurisdictions in the world when corporate insiders, for instance when directors and employees trade in securities of their companies complying with regulations governing such trading including sufficient disclosures to the relevant stock exchanges.

However, often the general public associate insider trading with illegal conduct since it is insider trading done illegally which attract criminal sanctions and reported prominently in media.

Generally, illegal insider dealing refers to trading that takes place when those who possess confidential information pertaining to important events about companies use the exceptional advantage of that knowledge to gain profits or avoid losses by trading in the securities of that company to the detriment of the other investors who trade in the shares of that company without the advantage of such “inside” information.

Insider dealing also includes “tipping” such information by insiders to third parties and trading by the person “tipped,” in those securities.

In a nutshell “insider dealing” prohibits insiders of companies from trading in listed securities whilst possessing unpublished price sensitive information or from disclosing such information to third parties who would trade in such listed securities based on such information.

1.1 Arguments for insider dealing

There are two schools of thought as to whether insider dealing should be made a criminal offence or not. Those in favour of insider dealing argue that insider dealing results in more efficient pricing of securities and more efficient operation of securities market. They perceive insider dealing as an indirect means of disseminating market information.

Insiders are the most efficient producers of trading information since they obtain access to information in the least costly way. It is argued that insiders dealing in listed securities of their companies, in substantial quantities, provide an indication of important future events that provides signals for other investors to follow the same pattern.

It is also argued that insider dealing helps a corporate entity to provide some indication to the market about its future prospects without providing specific information which it does not intend to reveal to its competitors.

However, opponents of this school of thought argue that insider dealing does not necessarily produce signals to other investors since insiders could disguise their activities and transactions in numerous ways.

Another argument in favour of insider dealing is that it provides an efficient method of compensating the management of a company by massive profits they may obtain through insider dealing.

Opponents of insider dealing argue that insider dealing is not an effective means of compensating the management since the compensation from insider dealing does not necessarily commensurate the performance or contribution made by the employees.

Further those who oppose prohibiting insider dealing argue that insider dealing is a “victimless offence” since the other party would anyway trade in the securities irrespective of the presence of an illegal insider in the market.

However, this argument overlooks one of the basic elements that should be present in a securities market namely transparency. Further the argument on a victimless offence does not hold true in an options market where professional option writers, write options in response to a particular demand.

A professional option writer is prone to suffer a loss where demand for an option emanates from an insider possessing material price sensitive non public information. It is further argued that enforcing insider dealing cases is not cost effective since proving insider trading cases is difficult and the amount of money recovered by way of imposing fines does not justify the money and human capital spent on investigating and prosecuting insider traders.

On the other hand those who advocate criminalising insider dealing argue that even the few cases where offenders of insider dealing are being convicted is a strong deterrent on possible offenders of insider dealing which would contribute effectively towards ensuring a fair and a transparent securities market. The forgoing makes it abundantly clear most of the arguments in favour of insider dealing does not have a sufficient justification and falls on its own weight.

1.2 Arguments against insider dealing

Prohibition on insider dealing mainly rests on two principals, namely the fiduciary duty of insiders of companies and the maintenance of a fair and transparent securities market. Insiders of a company occupy a fiduciary position in relation to the company in which there are insiders, to the shareholders and to the general public.

They should use such information they obtain as insiders only for corporate purposes and not for their personal benefit. Engaging in insider dealing based on inside information in order to gain a personal advantage amounts to abuse of their fiduciary position.

Secondly, it is essential that there be an equal level playing field in the market for its long term sustainable growth in the market. Information about corporate activities is a very vital commodity in the securities market based on which investors take decisions. Investors will lose confidence in the market as insiders are at an advantage over them due to possession of unpublished price sensitive information.

Hence in order to create and sustain investor confidence it is pertinent that every investor knows the rules of the game in advance and is able to trade in an equal level playing field. The justification for the prohibition on insider dealing by tippees of insiders rests on the above since on the one hand trading by tippees of insiders amounts to misappropriation of inside information and on the other hand runs counter to an equal level playing field.

2. Legal framework governing insider dealing in Sri Lanka

Provisions relating to insider dealing are found in Part IV of the Securities and Exchange Commission of Sri Lanka Act No. 36 of 1987 as amended1 (“Act”). These provisions prohibit connected persons of companies, takeover bidders and their tippees from engaging in insider dealing2. Also the provisions prohibit abuse of information by public officers obtained in official capacity.

Whist the Act does not define the offence of insider dealing, the provisions relating to the offence of insider dealing as embodied in the Act, reveals that the provisions are premised on the generally accepted concept of insider dealing. Hence in terms of the provision of the Act in order to constitute the offence of insider dealing the securities transaction should be performed by an insider of a company whilst in possession of unpublished price sensitive information.

2.1 What constitute unpublished price sensitive information?

Section 34 (2) of the Act interprets “unpublished price sensitive information” in relation to any listed securities as information which:

a. relates to specific matters relating, or of concern (directly or indirectly) to that company that is to say, if not of a general nature relating or of concern to that company; and

b. 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.

In effect in order to constitute insider dealing the information should be of following nature.

1. Information which relates to specific matters relating to a company but not general matters;

2. It must relate to or be of concern to that company

3. It’s not generally known to persons who are accustomed or would be likely to trade in those listed securities, relating to that company

4. If it was generally known to them, it would be likely to affect materially the price of those securities

Often insider dealing takes place when insiders trade on information which is out of the ordinary or unusual events relating to corporate activities such as mergers and acquisitions, changes in investment, management changes, a bonus or a rights issue.

These are information which requires public disclosure since such information cannot be reasonably contemplated by investors although they have a bearing on the prices and investment decisions of investors.

2.2 Who are insiders?

In its simplest form insiders are those who have intimate knowledge of information relating to a company. Traditionally a board of directors of companies and employees are considered insiders since they are presumed to have access to information about a company before any other. However definition of insiders in practice is not so simple and encompasses a large variety of categories within its ambit.  It is important to distinguish between insiders who are privy to inside information about a corporate entity and those who make forecasts relating to companies based on thorough study and analysis of activities of a company. It is argued that an individual with a good analytical mind who closely monitor the activities of a company and the related environment within which a company operates would be able to make reliable forecasts of a company and know virtually as much as the insiders or even better. Hence studying a company and making good forecasts of the company does not make those involved in such activities insiders.

There are two categories of insiders.

i. Primary Insiders

ii. Secondary Insiders

2.2.1 Primary Insiders

Primary insiders are those persons who would have access to information by themselves. There are 03 types of such persons.

i. Individuals who are connected with a company.

Who is a person “connected”  with a company?

In terms of the Act3 an individual is considered to be connected with a company, if:

(a) he is a director of that company or a related company; or

(b) he occupies a position as an officer (other than director) or employee of that company or related company or a position involving professional or business relationship between himself (or his employer or a company of which he a director) and the first company or a related company which in either case may reasonably be expected to give him access to information which, in relation to listed securities of either company, is unpublished price sensitive information and which it would be reasonable to expect (a person in his position not to disclose except) for the proper performance of his functions; or

(c) he has access to information in relation to listed securities, which he knows, is unpublished price sensitive information and which it would be reasonable expect him not to disclose except in the course of performing his duties.

From the above it is clear that not only directors and employees of a company could be held liable for insider dealing but also persons who have a business or professional relationship with the company such as lawyers and consultants so long as they have access to such unpublished price sensitive information due to their position and would be reasonable to expect them not to disclose such information except for the proper performance of their functions.

ii. Takeover bidders

As per section 32(4) of the Act persons who are contemplating or who have contemplated to make a takeover offer for a company which constitute unpublished price sensitive information are considered insiders.

iii. Public servants

In terms of Section 33 of the Act a public servant or a former public servant who obtains unpublished price sensitive information by virtue of that position are also regarded as insiders if it is reasonable to expect that such person would not disclose such information except for proper performance of the functions attached to that position.

2.2.2 Secondary insiders

Those who obtain or have reasonable cause to believe that they have obtained unpublished price sensitive information either directly or indirectly from primary insiders, constitute secondary insiders and are generally referred to as “tippees”. As per the act tippees of individuals connected with a company, takeover bidders and public servants become secondary insiders.4

E.g: Mr. “X” a director of company gives inside information about a bonus issue to his brother Mr. “Y”. In this instance Mr. “Y” becomes a secondary insider and is prohibited from trading in securities of that company before information relating to such bonus issue is disclosed to the public.

In order to become a secondary insider that person should know that the price sensitive information came from an insider although it is not necessary to know who the primary insider is. Further it has to be a person who has obtained such information. However the term “obtained” does not restrict the scope of secondary insiders to those who obtained information on their own volition but also to extend to those who obtained unsolicited information.

Insider information can be obtained either directly from a primary insider or indirectly.

E.g: If Mr. “X” a director of a company who is a primary insider gives insider information about a possible bonus issue to his brother Mr. “Y” and if Mr. “Y” in turn gives such information to his neighbour Mr. “Z” then such communication of unpublished price sensitive information makes Mr. “Z” a secondary insider.

2.3. Prohibited transactions that constitute insider dealing

Both primary and secondary insiders who are in possession of unpublished price sensitive information cannot engage in the following activities:

i. Trade in listed securities, in relation to which they hold unpublished price sensitive information.

ii. Counsel or procure any other person to trade in listed securities in relation to which they hold unpublished price sensitive information.

iii. Communicate unpublished price sensitive information to any other person.

2.3.1 Prohibition on insiders trading in listed securities

Prohibition on individuals connected with a company:

Section 32(1) prohibits a person who is connected with a company and has unpublished price sensitive information, from trading in securities of that company of which he is a connected person.

E.g.: Mr. “A” is a director of company “Y” and the directors of company “Y” decides to declare a bonus issue. Mr “A” who is also a shareholder of company “Y” buys shares of company “Y” before the company makes a public announcement relating to the “bonus issue”. This act of Mr. “X” constitutes insider dealing.

Section 32(2) on the other hand prevents any individual who is connected with a company from trading in listed securities of any other company if he holds unpublished price sensitive information in relation to those securities of that other company by virtue of being a connected person of the first mentioned company.

E.g.: There are two companies, “X” and “Y” producing drugs for AIDS which compete with each other and “A” is a scientist of company “X”. Suppose company “X” invents a new drug for the first time in history which can cure AIDS and is contemplating to obtain a patent over the new drug. “A” being a scientist of “X” company knows about this new invention and knows that once this drug is introduced to the market it will wipe out the demand for drugs from company “Y”. A shareholder of company “Y” knowing that the profits of company “Y” will drop drastically in the future sells the shares in company “Y”. This constitutes an act of insider dealing.

Contd. on page 13

(The writer is the Director General of the Securities and Exchange Commission of Sri Lanka and the comments are his personal views.)

Key insights to insider dealing

Prohibition on tippees of connected parties:

Section 32(3) prevents tippees or secondary insiders who obtained price sensitive confidential information from a connected party of a particular company from doing the following:

(i) Trading in listed securities of that company

E.g.: Mr. “X” a director of company gives inside information about a bonus issue to his brother Mr. “Y”. In this instance Mr. “Y” becomes a secondary insider and is prohibited from trading in securities of that company before information relating to the bonus issue is disclosed to the public.

(ii) Trading in listed securities of any other company if he knows that the information is unpublished price sensitive information in relation to those securities.

E.g: Company “A” and Company “B” are two companies in the hotel industry. The Board of Directors of Company “A” decides to make a voluntary offer to company “B” and informs their decision to the Mr. “X” the Chief Financial Controller of company “A” in order to calculate an appropriate offer price. Mr. “X” a primary insider of unpublished price sensitive information relating to the offer tells about the voluntary offer to one of his friends Mr. “Y” who is a shareholder of company “B”. Mr. “Y” becomes a secondary insider by virtue of having information relating to the takeover and starts buying shares of Company “B” in order to sell them at a higher price to company “A” once they make the offer. This act amounts to insider dealing.

Prohibition on takeover bidders:

Section 32(4)prohibits an individual contemplating a takeover offer for a company in a particular capacity from trading in listed securities of that company in another capacity if he can be reasonably expected to know that the information about the takeover offer is unpublished price sensitive information.

E.g.: a strategic investor contemplates to make a takeover offer to company “X”. He cannot trade in the listed securities of company “X” as long as the information relating to the takeover remains as unpublished price sensitive information.

Prohibition on tippees of a takeover bidder:

An individual who has obtained information about a takeover from an individual who contemplates or completing a takeover offer, is prohibited from trading in the listed securities of the offeree company.5

Prohibition on public servants and their tippees:

Part IV of the Act prohibits a public servant or a former public servant who has unpublished price sensitive information of a particular company by virtue of his/ her position and which is not expected to be disclosed except for the performance of those functions, from trading in the relevant securities of that company. 6

E.g.: An employee of the SEC have access to information due to the regulatory requirements and is considered as an insider as far as such information is concerned and are prohibited from trading in the securities of such companies.

It also prohibits a tippee of a public servant or a former public servant who has unpublished price sensitive information of a particular company from trading in the relevant securities of that company if he knows that this information was derived by the public servant in his official capacity.

2.3.2 Prohibition on insiders counselling or procuring any other person to trade

Prohibition on individuals connected with a company and their tippees, takeover bidders and their tippees:

Any individual who is prohibited from trading in listed securities namely individuals connected with a company and their tippees, takeover bidders and their tippees are prohibited from counselling or procuring some other person to trade in such securities.7

Prohibition on public servants and their tippees:

Section 33(3) (b) prohibits a public servant or a former public servant who has unpublished price sensitive information of a particular company by virtue of his/her position and which is not expected to be disclosed except for the performance of those functions from counselling or procuring any other person to trade in such securities. The said section prohibits a tippee of a public servant or a former public servant who has unpublished price sensitive information of a particular company from counselling or procuring any other person to trade in any such relevant securities.

2.3.3 Prohibition on communication of inside information

Prohibition on individuals connected with a company and their tippees, takeover bidders and their tippees:

In term of the Act, an individual who is prohibited from trading in listed securities by reason of having any information, namely individuals connected with a company and their tippees, takeover bidders and their tippees, is prohibited from communicating that information to any other person if he knows or has reasonable cause to believe that person will make use of that information for the purpose of counselling or procuring any other person to trade in such listed securities.8

Prohibition on public servants and their tippees:

A public servant or a former public servant who has unpublished price sensitive information of a particular company by virtue of his/her position which is not expected to be disclosed except for the performance of those functions is prohibited from communicating to any person the information held or obtained if he knows or has reasonable cause to believe that such person will use that information for the purpose of counselling or procuring any other person to trade in such securities.

The said section prohibits a tippee of a public servant or a former public servant who has unpublished price sensitive information of a particular company from communicating to any person the information held or obtained if he knows or has reasonable cause to believe that such person will use that information for the purpose of counselling or procuring any other person to trade in such securities.9

3. Exceptions to insider dealing10

According to Section 32 (8) (a), doing any particular thing otherwise than with the view to making of a profit or for the avoidance of a loss, whether for himself or for another person by the use of information will not constitute insider trading. In terms of this section the mere fact of having confidential price sensitive information does not prohibit an individual from trading in securities if it is done without a view of making a profit or to avoid a loss.

For instance an insider, who is a Trustee, who is legally bound to protect the interest of the beneficiaries of the trust trading in securities, is not considered as an act of insider dealing.

Section 32 (8) (b) exempts a liquidator, receiver or trustee from entering into a transaction in the course of the exercise in good faith of their functions.

Section 32(8) (c) exempts stock broker or a stock dealer from doing any particular thing if the information was obtained by him in the course of the business and if the information was of a description which it would be reasonable to expect him to obtain in the ordinary course of that business and if he does that thing in good faith in the course of that business.

In terms of Section 32(9) an individual shall not, by reason only of having information relating to any particular transaction, be prohibited;

a. by the provision of subsection (2), paragraph (ii) of subsection (3), subsection (4) or subsection (5) of Section 32 of the Act from trading in listed securities; or

b. by the provisions of subsection (6) or subsection (7) from doing any other thing in relation to listed securities which he’s prohibited from trading in by any of the provisions referred to in paragraph (a) of that section, if he does that thing in order to facilitate the completion or carrying out of the transaction.

In brief section 32(9) (a) exempts trading in listed securities by insiders (as enumerated in sections 32(2), 32(3)(ii), 32(4) or 32(5)) who have information relating to any particular transaction from the offence of insider dealing if they trade in such listed securities in order to facilitate the completion or carrying out of that particular transaction. Further section 32(9) (b) exempts doing any other thing in relation to listed securities by insiders (as enumerated in sections 32(6) and 32(7) ) who have information relating to any particular transaction if they do such any other thing in order to facilitate the completion or carrying out of that particular transaction.

The above section deals with a particular transaction. A transaction where the mere fact of that a person having information relating to a transaction does not prohibit such person from carrying out the completion of that transaction in relation to which such person had such information.

E.g. Mr. “Y” an investor may decide to takeover company “X”. According to the strategy adopted by the investor, he will first try to increase his share ownership in the company to 30% of the voting rights since in terms of the Takeovers and Mergers Code of Sri Lanka, anybody who acquires 30% or more of the voting rights of a company is required to make a mandatory offer to the remaining shareholders of the Company. The fact that Mr. “Y” is going to takeover company “X” is unpublished price sensitive information and Mr. “Y” becomes an insider since he is in possession of such information. However in order to carry out the takeover he has to first increase his stake in the company up to 30% by purchasing shares in company “X”. The above exception allows Mr. “Y” to purchase shares in the market in order to increase his share ownership in Company “X” to 30% since he is merely carrying out a transaction in relation to which he has information. However Mr. “Y” cannot trade in the shares of Company “X” in a different capacity.

4. Penalties for insider dealing11

Section 33 A of the Act specifies the punishment relating to insider dealing. According which any person who engages in insider trading shall be guilty of an offence and shall:

(i) On conviction after summery trial by a Magistrate be liable to a fine not less than Rs. 1 million.

(ii) Liable for a sentence of imprisonment of either description, which may extend to a period of not less than two years and not exceeding five years.

(iii) Or both such fine and imprisonment

The Securities and Exchange Commission of Sri Lanka in terms of Section 51 (a) of the Act is also empowered to compound the offence of insider dealing to a value of up to one-third of the maximum imposable fine, which amounts to approximately Rs. 3.3 million.

1 Amendment by Act Nos.26 of 1991, 18 of 2003 & 47 of 2009 of the SEC Act

2 Section 32 (amended by Act No. 26 of 1991) of the SEC Act

3 Section 34 (1) of the Sec Act

4 Section 32 (3) of the SEC Act

5 Section 32(5) SEC Act

6 Section 33(3) (a) SEC Act

7 Section 32 (6) SEC Act

8 Section 32 (7)

9 Section 33(3) (c) SEC Act

10 Sections 32(8) and 32(9)

11 Section 33A of the SEC Act