The optical illusion of failure

Sebi’s record in tracking insider trading is much better than is believed

Insider trading has been a hot topic of discussion worldwide. It has been no less interesting in India, but chiefly because a large number of US cases of insider trading in the past three years involved people of Indian or Sri Lankan origin. The most high profile of the lot, Rajat Gupta, was recently sentenced to two years of imprisonment. Gupta who was born and mainly educated in India, earlier headed blue-blooded McKinsey & Co and sat on various boards including that of Goldman Sachs. His fall from grace from one of the most high profile and respected individuals to one of shame and criminal conviction will probably give rise to several books on the subject.

However, this piece is not about us looking outside at Western systems, but looking inwards at the Indian system and how it engages with, and fights insider trading. Here, I have a contrarian view. A view which few people will agree with at first blush. In my view the problem of insider trading in India is of a far less serious degree than in many western countries. This is not to say that it is not widespread — it may be. I'll explain my position shortly in case you are bewildered by this assertion. First let us restate a commonly held view of insider trading in India.

Attend any dinner conversation, and any discussion of corporate ethics will invariably have a mention of how rampant insider trading is in India. There will also be an invariable comment on how efficient the US system is in punishing such trades and how everyone gets away with such trades in India. There will also be accompanying snorts and chuckles to support this universally acknowledged truth. To be sure, there has been some statistical evidence of insider trading before a market event. So there is no denying the fact that there is insider trading activity going on — possibly based on some tips by employees of the company to friends and relatives.  

However, the data on enforcement actions against classic insiders, like promoters and senior management and their relatives, points in a different direction. A vast bulk of the enforcement actions taken by Sebi relates to insider trading of merely one to five thousand shares. There are also cases involving a few hundred shares. There are some examples of much larger numbers, but most of them have either not been upheld by SAT (a recent order), relate to outsider trading (Hindustan Lever — where trades occurred in a target companies shares rather than where the inside information arose i.e. the acquirer) or are cases of front running, a different offence.  

This data is surprising, but not inconsistent with the widely held belief of widespread insider trading. In other words, there appears to be many people doing low level insider trading, or even digging out some informational advantage even without any illegality. But few, if anyone, is doing insider trades in millions of shares or even a fraction of that number. And I can think of two reasons which come to mind why this is the case in India. First, we don’t have the class of investors who exist in the US, classic hedge fund managers who have a strong incentive to beat the index return. Since it is difficult to beat the market, and since the managers get to keep 20% of the profits of investors’ money there is a strong incentive to commit insider trading. With the size of the funds which many of these managers invest running into billions of dollars, they can’t possibly do insider trading in a few thousand shares — they must necessarily do it in very large numbers. Thus the chance of getting caught also increases substantially. Second, the Indian system is far more transparent and the audit trail is very clear. As opposed to more opaque systems of holding in ‘street names’ for instance in the US where brokers hold shares  on behalf of investors in their own name, in India every investor buying a single share must provide an income tax PAN card number and shares must be held in their own name. The complete trail of purchase of securities and transfer of funds ensures that promoters and senior management are either not committing  illegalities or are doing it by dividing it through dozens of other people, each one buying not more than a few hundred or thousand shares. Given the easy access to phone records (not phone taps) it is not impossible to connect the dots between these people. 

Since insider trades occur at these small numbers, catching such persons is far more difficult as it is easier to merge with the crowd and assert lack of any access to inside information. Also, connecting a person who bought a 1,000 shares with the actual insider through phone call records may not be sufficient
evidence as a judge is likely to ask why a person who had access to inside information profited only in such a limited manner. In other words, short of access to the actual phone conversation, it would be difficult to prove that the trade occurred based on the access to privileged inside information.

Even though Indian law is strict and imposes a deemed insider status on a variety of people who can be expected to have access to information — like lawyers, auditors or relatives of senior management, courts have not imposed the standard strictly. This is natural because the deeming provision imposes harsh standards of ‘guilty till proven innocent’ and judges are naturally averse to such an inverted frame of evidentiary law. Particularly so when the numbers traded are small.

Third, insider trade tips occur in the privacy of a room or on a phone conversation, where both sides are interested in not disclosing the illegal event.  Thus the evidence gathering is fairly difficult and must usually be by way of gathering circumstantial evidence. Given the serious nature of the violation, insider trading is seen as a type of fraud; judges often apply standards of evidence closer to those applied in criminal convictions rather than those of
civil suits. 

Lastly, Sebi has limited staff. Compared to an enforcement staff of over a thousand professionals in the SEC, twice the entire strength of Sebi, clearly the evidence hungry insider cases will be fewer in number than in the US. Last year, according to the Sebi annual report (2011), the regulator tracked around 30 new cases of insider trading. The relevant enforcement staff of Sebi would be under a dozen people working on such cases. Compared to the staff strength in enforcement, Sebi actions are actually quite large compared to their US counterpart’s trading of 57 cases of insider tracking (source: annual report of the SEC, 2011) with an enforcement staff strength which is almost a hundred times larger.

Therefore, in my view, there clearly are challenges in catching insider trading in India, because there are many people doing it and because they aren’t doing too much of it at the same time. At the same time the opportunity costs of not pursuing other violations which may be easier to prove because of direct evidence must not also be discounted. That is not to say such cases should not be pursued with greater force, which they must. But whipping Sebi for not doing much about curbing insider trading is not accurate.