Insider Trading In United States

Posted in Finance Articles, Total Reads: 1528 , Published on 09 October 2012
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An insider can be defined as a person who is connected with the company (director, officer, employee and those in professional/business relationship with the company) and has had access to unpublished price sensitive information. Most investors generally associate the term insider trading with illegal conduct. However, it includes both legal and illegal activity. Legal insider trading is when officers, employees and directors trade stock of their own companies and report their trades to the regulatory authority (SEC in U.S.A. and SEBI in India).

Illegal Insider Trading, as defined by SEC; refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

Insider Trading is as old as the markets itself. However, its recognition as a crime against shareholders and enforcement of regulations took force in the 1980s after the cases against Michael Milken and Ivan Boesky in the U.S.

United States of America has one of the world’s largest and most developed capital markets. It ranks first in the world by market capitalization of listed companies and is just behind Hong Kong in total value of stocks traded as % of GDP. The transparency and strict regulatory framework adopted by the SEC is one of reasons for the high investor confidence in US markets. Enforcement of laws against insider trading forms an important part of keeping the markets free, fair and open for all investors.

To quote former chairman of the SEC Arthur Levitt:  “Honest trading, and equal access to material information.  It's simply a question of integrity. As long as the rules of the game are fair to all, investors' confidence will remain strong.”This is a major factor behind the thriving markets.

In the next part of the paper, we explore the important events in the history of American insider trading, before moving to the case of Rajat Gupta.

The year 1909 saw the first crackdown against insider trading in the US; when the director of the Philippine Sugar Estates Development Company was convicted of fraud for buying stock in his company without sharing information with the seller that soon increased its value.

Lax regulations and few rules on insider trading were one of the many reasons which caused the stock market crash of 1929. This resulted in the birth of the Securities and Exchange Commission to restore investor confidence and faith in the financial sector.

The following years saw enactment of a number of legislations to regulate the sector:

  1. Securities Act - to ensure more transparency in financial and to establish laws against misrepresentation and fraudulent activities in the securities markets.
  2. Securities and Exchange Act of 1934 - to provide governance of securities transactions on the secondary market and regulate the exchanges and broker-dealers in order to protect the investing public.
  3. Insider Trading Sanctions Act Of 1984 - allows the SEC to seek a civil penalty, of up to three times the amount of profit or loss, from those found guilty of using insider information in trades, as well those who provided information not generally available to the public
  4. Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA) - to increase the liability penalties to all involved parties to insider trading. This act was established due to the increase in high profile insider trading cases, as well as the increase in monetary values of the trades.

The enforcement of all of these acts was left to the SEC.

Overview of important sections of the SEA, 1934-

  1. Section 10(b) of the Securities and Exchange Act of 1934- the disclose or abstain rule and the misappropriation theory. Section 10(b) makes the employment of any device, scheme to defraud or making an untrue material statement or omission of a material fact unlawful.
  2. Rule 14 e-3 – proscription of insider trading involving information relating to tender offers
  3. Section 16(b) of the SEA, 1934 applies to corporate insiders (directors, officers and principal stockholders). The beneficial stockholder (holding more than 10% shares) shall not engage in short swing profit transactions (period less than six months).

The famous SEC vs Texas Gulf Sulphur Co. case ended with the conclusion that “All investors must have relatively equal access to material information and anyone in possession of material inside information must either disclose it to the public or abstain from trading the securities while such inside information remains undisclosed.

"If you don't tell, you can't sell," Colleen A. Conry, a Washington-based Justice Department prosecutor, told the jury in her closing argument.

Liability for Tipping:

Tipper liability refers to the disclosure of material non-public information in breach of a fiduciary duty and receipt of a personal benefit as a result of the disclosure

A tippee can be liable if the tipper breached a fiduciary duty and the tippee knew or had reason to know that the tipper was breaching the duty.

Both the classical and misappropriation theories of 10b-5 liability also extend to cases in which the insider does not personally trade, but reveals material, nonpublic information to another individual who does trade. The purpose of so-called “tipper-tippee” liability is to prevent insiders from circumventing securities laws by giving inside information to individuals who are not restrained by fiduciary obligations to a company’s shareholders.

Rajat Gupta

Brief Profile: Co-founder of the Indian Business School, Hyderabad;

Former Director and Senior Partner, McKinsey;

Board Member, Goldman Sachs; Former Director, P&G

By the virtue of being a director/board member at Goldman Sachs and P&G, Rajat Gupta had access to a range of material information before it was made public.

Summary of the civil insider trading suit filed by SEC in October, 2011:

  1. Sept. 23, 2008: Berkshire Hathway invested USD 5 billion in Goldman Sachs. This investment was aimed at raising confidence in the venerable Wall Street firm at the height of the financial crisis. In addition, Goldman Sachs raised the size of its common stock offering to USD 5 billion.

These decisions were discussed in a board meeting on Sept. 23, 2008, whereby Rajat Gupta conveyed the information to Mr. Rajaratnam( a hedge fund manager). The hedge fund (Galleon) made a profit of USD 840000 according to government claims.

  1. Q2FY2008: It was also alleged that he passed on information about the positive quarterly results of Goldman Sachs to Rajaratnam before they were announced to general public.
  2. Q4FY2008: Gupta passed on tips regarding negative financial results to Rajaratnam; who subsequently liquidated his holdings and avoided losses of more than USD 3.6 million
  3. Gupta disclosed information about P&G’s impending financial results for the quarter ending December, 2008 on the basis of the draft of the earnings release received in an email; two days prior to the release of the results. The hedge fund made profits of nearly USD 570000 by short selling P&G shares on the basis of inside information about organic sales being lower than expectation

The SEC previously charged Rajaratnam and others in the widespread insider trading investigation centering on Galleon, the multi-billion dollar New York hedge fund complex founded and controlled by Rajaratnam.

Mr. Gupta did not trade on any of the information himself; however he failed in his fiduciary duty to the shareholders to not disclose any material information to outsiders (Mr. Rajaratnam) who traded on these pieces of information in order to earn handsome profits. The tipping off was attributed to the shared business interests and friendship between the two.

Conclusion:

Mr. Gupta was convicted on three counts of securities fraud and one count of conspiracy for passing along confidential boardroom information about Goldman to a hedge fund that earned millions of dollars trading on his tips. He was acquitted of two counts of securities fraud, including the only one relating to P&G.

The case of Rajat Gupta has brought insider trading into the limelight once again. Insider trading, simply put is seen as a form of cheating which is economically dangerous, morally wrong and legally forbidden.The conviction holds lesson for the Indian markets to curb the practice of insider trading more actively if it wants to attract the small investor and move beyond mere two percent of the population.

This article has been authored by Prashant Sahni from XLRI.

Image: FreeDigitalPhotos.net


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