Almost eight years ago, India's capital market watchdog – the Securities and Exchange Board of India organised an international seminar on capital market regulations. Among others issues, it had invited senior officials of the Securities and Exchange Commission to tell us how it tackled the menace of insider trading.
Insider trading is about profits made through trades based on confidential information which is not known to other investors. It usually involves corporate directors, government officials, lawyers and accountants who are privy to corporate plans well before they are ready to be made public. It is also notoriously impossible to prove because "insiders" are usually smart enough never to trade on their own account. Because such trading undermines investor confidence in the fairness and integrity of the securities markets, preventing it is an important part of any regulatory system.
Just before the session started, the SEC official casually asked me how prevalent insider trading was in India. Those were the days prior to screen-based trading and automated tracking of trades. My answer was, that almost all trading in India is "insider" trading, because even the last sucker in the market believes he has a hot tip. The official gave me a disbelieving look and went on to take his place on stage.
Ironically enough, the first speaker, a former president of the Bombay Stock Exchange began his speech by making the exact same observation – "that there is no other kind of trading in India, but the insider variety". It is another matter, he said, that by the time the retail guys get the "hot tip" the real operators are already dumping their holding.
Fast-forward to 1997-98. SEBI is now a statutory watchdog mandated to protect investors. The markets have metamorphosed, trading is fully automated and protected through trade guarantees, the standards of disclosure and accounting have been drastically improved, and there are rules in place to cover everything from disclosure standards, accounting, advertising, takeover and acquisition, price manipulation and insider trading. The composition of market participants is also different – there are more corporate brokers, mutual funds (Indian and foreign) and trading is largely dominated by Foreign Institutional Investors with deep pockets.
Yet, one thing remains the same. The extent of insider trading in the market. Institution investors now cover their deal making by having research reports churned out with at frequent intervals, but it is not for nothing that a broker calls the shots in the market today. He cannot be as invincible as he appears, or earn the nickname of 'pied piper' unless he has a whole range of 'insiders' acting in concert with him. These include politicians, company managements, fund managers and large investors.
After insider trading was been declared illegal in India a few years ago, corporate managements, their law firms and chartered accountants have turned more cautious. Can they be caught if they route deals through friends and relatives? It is difficult.
Last week SEBI released draft guidelines which are aimed at tightening existing Insider trading rules and plugging loop holes. SEBI also has shifted the onus for monitoring insider trading onto compliance officers which each company is expected to appoint. These officers are to report directly to the managing director. It is indeed true that making an insider responsible for preventing insider trading will have a deterrent effect on the employees. But the broker-promoter--politician-fund manager nexus which these days accounts for the biggest chunk of insider trading cannot be caught.
Already, SEBI has botched up its credibility on the insider trading front by going after Hindustan Lever's top executives, one of India's best companies, for what I personally believe was not insider trading at all. Its efforts to tighten the rules will hopefully help put the HLL issue behind it (even thought it is still in court) and begin all over again.
But it still remains stuck with some serious handicaps. It has no power of search and seizure. Unlike the powerful Securities and Exchange Commission of the US, which files criminal prosecution in concert with the department of justice, in India there is only antagonism and rivalry between the various regulators – SEBI, department of company affairs and the Reserve Bank of India.
One of SEC's biggest tools is its power to reward informants with a bounty of up to 10 per cent of the money disgorged through an insider trading action which is successful. This is an important incentive for people to speak up against colleagues and senior officials.
It also allows the SEC to spread its dragnet wide enough to nab a curious assortment of insiders. For instance, an insider trading action by the SEC for trading ahead of IBM's takeover of the Lotus Development Corporation (illegal profits $ 1.3 million), led the trail to a doctor, an engineer, school teacher, printer repairman, Deli and a Pizza shop owner who were among six tiers of illicit traders unearthed by it. The originator of the leak was an IBM executive's secretary.
In India, SEBI has not even bothered to penetrate the first and obvious tier of insiders – promoters-brokers and fund managers. In the most notorious case of price rigging and insider trading of 1998, which a known scamster openly pushed the price of Sterlite, BPL and Videocon, SEBI has been dawdling on investigations.
Over the last year, the prices of some telecom and software stocks have not only been pushed up with impunity, but the broker-promoter nexus has been routinely reported in the stock market columns of the business newspapers. SEBI has not even announced an investigation.
Even if it does manage to gather adequate evidence to launch an action, SEBI is handicapped by the rules. In the US even civil penalties are linked to the size of the profit made or loss avoided (penalties can be up to three times such a profit). The SEC is also allowed to let the offenders simply pay up without admitting to an offence but merely by publishing the settlement. This too is an important deterrent, which prevents every case being locked up in court. In contrast, the maximum penalty allowed to be imposed by SEBI is a paltry Rs 500,000. Since the profits through insider trading usually run into tens and hundreds of million rupees, the penalties are never even a good slap on the wrist. Plea bargaining and compounding of offences are not even on the cards.
Clearly, preventing insider trading is not about a set of rules or alleged loopholes. It is about a determination to go after illicit trades and the power to punish offenders. Until SEBI shows it is serious about checking insider trading, the activity will continue to thrive unchecked.