22 November 2004	Monday	09 Shawwal 1425

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The public outrage at several successive stories of "insider trading" in equities that were picked up by the press, has forced the chief corporate watch dog not simply to bark but also to bite.

Although there is hardly any 'price sensitive material information' that some people do not have before the rest of the stock market does, the SECP has groped and finally managed to find one high profile insider case.

Pakistan Kuwait Investment Company (PKIC) was fined Rs 0.536 million for insider trading in shares of Fauji Fertilizer Company Limited (FFC). That, somehow, looks like the work of an institutional director who sits on the Board of both PKIC and FFC. Should then the company pay for an alleged irregularity to which it never was a party? But that argument could generate another controversy, which had better be avoided at this time.

In the cosy offices of the SECP in Islamabad, heads have perhaps been put together and the realization is dawning that the responsibility to curb insider trading is basically that of the chief regulator. And that it is not the law that is lacking but the capacity to enforce it and a strategy to make it all work. Latest among the rules released by the SECP are the 'Proprietary Trading Regulations, 2004'.

These provide that every broker, agent or an associated person should maintain separate accounts and books for money received or paid to on account of each of his clients and person's own account.

Every broker, who is engaged in proprietary trading, has been asked to maintain separate accounts in the name of the broker, agents or an associated person. The account(s) shall be used for all transactions involving proprietary transactions.

Earlier on March 27, 2001, SECP had imposed the Listed Companies (Prohibition of Insiders Trading) Regulations, 2000. Other great ideas have also been pressed forward from time to time. These include 'The Stock Exchanges Members (Inspection of Books and Records) Rules, 2001', which empowers SECP to order inspection of books and record of any member of the stock exchanges.

These rules were thought to help regulators monitor brokers and strengthen SECP's surveillance capabilities. Then there are the 'Brokers and Agents Registration Rules, 2001', which were enacted with the noble objective of exercising direct control over brokers and agents and act as 'a safeguard for investors'.

But what is the 'insider trading' about which there is so much hullabaloo? Insider trading 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, non-public information about the security. Insider trading violations may also include "tipping" such information to a person who trades in securities on the basis of such 'tip'.

In relation to a listed security, material price sensitive information means any information which relates to the following matters or is of concern, directly or indirectly, to a company, and is not generally known or published by such company for general information, but which if published or known, is likely to materially affect the price of securities of that company in the market.

The following are examples of such unpublished material price sensitive information: Unpublished financial results of the company; Intended declaration of dividends (interim and final); Information on shares issued by way of rights, bonus, etc; Major expansion plans or execution of new projects; Strategy on amalgamation, mergers and takeovers; Exit strategy for either the entire company or a part thereof; Any information that may affect the earnings of the company; and Any changes in policies, plans or operations of the company.

Insider trading refers to transactions in the securities of a company executed by the company insider. Although a company insider might theoretically be anyone who is in possession of "unpublished price sensitive information" about the company, in practice, the list of company insiders are thought to include sponsors of the company, chief executive, directors, corporate officers, managing agents, chief accountant, secretary, auditors and lawyers & investment bankers that may be temporarily retained by a company but have access to material non-public information.

Insiders could also include friends, business associates, family members, employees of law, banking, brokerage and printing firms who were given such information to provide services to a company.

Government employees who learned of such information because of their employment by the government and other "tippers" of such officers, directors, and employees, who traded the securities after receiving such information.

A "tipper" could be the spouse of a CEO who goes ahead and passes on to his neighbour inside information about the company. If the neighbour in turn knowingly uses this inside information in a securities transaction, he or she is guilty of insider trading.

Insiders also could be Ministers, MNAs, Senators and MPAs, who trade in shares acting on early knowledge they may have regarding what legislation will be passed when; which companies will be awarded big contracts, and and particularly the proposals in budget and any new tax measure.

Under the Code of Corporate Governance, the Audit Committee of a listed company normally reviews financial results of the company prior to being presented at the board of directors meeting.

Does insider trading take place in the time lag between the meeting of the audit committee and that of the board? Since that is a possibility, it wouldn't be a bad idea to suspend trading in a company's share during this time lag. And then it is the directors of listed companies, who receive agendas for Board meetings, which include the Profit and Loss account, earning per share and appropriation of profit, a week in advance of the board meeting, following which the information is make public.

It would do less harm to keep such 'price sensitive information' away from directors to prevent direct or indirect insider trading. And how about the statutory auditors? The partner incharge of the audit knows how much dividend the company proposes to pay. Disclosure of such information to the audit firm is not only unnecessary, but simply adds to the list of potential insiders.

NIT has major shareholdings in scores of companies on which its representatives sit as directors. Could NIT be at an advantage of an early knowledge of price sensitive information, such as dividend payouts? Since insider trading takes advantage not of skill but chance, an insider may outperform skilled investment strategists of a mutual fund. Private Mutual Funds would be within their rights to demand a level-playing field.

But to be fair to our market makers, it has to be conceded that insider trading is not of our own making. It has perhaps been in existence ever since the birth of the first equities market in the world.

The US Securities and Exchange Commission (SEC) have tried to prevent insider trading in U.S. securities markets since the depths of the Great Depression in early thirties. There are rules against such insider trading in most jurisdictions around the world, though the details and the efforts to enforce them vary considerably.

In a well regulated market such as the U.S. and U.K. even though there are violations of insider trading laws from time to time, majority of insiders or would-be insiders are deterred from engaging in such activity. In Europe, the extent of enforcement differs across countries. For example, Italy is perceived to be a place where insider trading is relatively common.

One reason that insider trading is considered a menace is because it undermines investor confidence in the fairness and integrity of the securities markets. If people fear that insiders will regularly profit at their expense, they would be more inclined to stay away from the market. Efficient securities markets require a "level informational playing field".

Using non-public information for making a trade violates transparency, which is the basis of a capital market. Rampant insider trading also sends negative signals to foreign investors, who may be compelled to shun a stock market even when it offers attractive stock valuations.

Although insider trading is a global phenomenon, according to a recent study published by International Monetary Fund, it is relatively high in countries like India, China, Russia, Venezuela and Mexico. The central finding of the study is that countries with more prevalent insider trading do have more volatile stock markets.

For example, the Chinese and the Russian markets, respectively, are nearly 600% and 800% as volatile as the U.S market. No one disputes the fact that a certain degree of market volatility is unavoidable, even desirable, as one would like the stock price fluctuation to indicate changing values across economic activities so that resources can be better allocated. But too much of everything is too bad. A recent report of the experts committee on demutualization of the Pakistan's stock exchanges suggested that it is not investment but speculative activity that dominates the trading and liquidity is highly concentrated. The equity market has been distorted by Badla financing. Due to excessive speculation, concentration and Badla financing the market is exceptionally volatile, laments the report.

The main problem with tackling insider trading is that it is very difficult to prove. Even in the USA, the Securities Exchange Commission was unable to fix insider trading charges in case of 99 per cent of the cases it investigated. But in our markets, there have been innumerable less complicated cases that have gone unnoticed. A three-day delay in release of information about Hubco's faulty transformers and the extra-ordinary gain in PTCL accounts that changed the face of its Profit and Loss account are perhaps the most recent happenings.

SECP promises to do all it can to eliminate the illegal 'insider trading' activity through effective surveillance and investigation. The Regulator has said it would look into the possibility of insider trading emanating from leaked agendas of the Privatisation Commission (PC) and the privatization status of listed state-owned firms.

Are the penalties against 'insider traders' adequate? It is being argued that the fine amounting to Rs 0.536 million being two times the amount of gain accrued to PKIC in this case are not a penalising sum and may be too small to put fear in the hearts of the insiders. In India, the penalty for insider trading has recently been made harsher and the concerned person has to pay a fine of up to Rs.25 crore and\or undergo 10 years imprisonment.

In South Africa, maximum insider trading fine goes up to 25 times or imprisonment for a period not greater than 10 years, or both. In US, the Insider Trading Sanctions Act of 1984 provides penalties for up to three times the profit gained or the loss avoided by the insider trading. But perhaps it is not so much a loss of money as the bad publicity that such companies attract, which hurts them the most.

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