Profit motive: a sine qua non for liability under insider trading laws?

Introduction

Recently, in the landmark case of Securities and Exchange Board of India v. Abhijit Rajan [2022 LIVELAW (SC) 787], the Supreme Court has ruled that mere possession of price-sensitive information and trading based on it is insufficient to prove insider trading charges. The ruling stated that it is also equally critical to establish that the transaction’s intent was to profit from the said insider information. Such a ruling from the apex court is likely to affect the insider trading cases pending before the regulatory system and will have implications that will influence the way in which SEBI, courts and tribunals will deal with such cases.

The background facts of the case are as follows: The respondent herein was the Chairman and Managing Director of a company named Gammon Infrastructure Projects Limited (GIPL) till September 20, 2013. In the year 2012   GIPL was awarded a contract by the National Highways Authority of India. For the execution of the project, GIPL set up a special-purpose vehicle called Vijayawada Gundugolanu Road Project Private Limited (“VGRPPL”).

Similarly, another company named Simplex Infrastructure Limited (SIL) was awarded a contract by NHAI in Jharkhand and West Bengal. For the execution of the project, SIL set up a special-purpose vehicle called Maa Durga Expressways Private Limited (MDEPL). GIPL entered into two shareholder agreements with SIL. Under these agreements, GIPL was to invest in MDEPL and SIL was to invest in VGRPPL for their respective projects. The mutual investments were to be made in such a manner that GIPL and SIL would hold a 49% equity interest in each other’s projects.

However, on September 8, 2013, the Board of Directors of GIPL passed a resolution authorising the termination of both shareholders’ agreements. On 22.8.2013, the respondent sold about 144 lakh shares (approx.) held by him in GIPL, for an aggregate value of approximately Rs.10.28 crores, and the same was disclosed to the stock exchanges a week later. This was the case’s Unpublished Price Sensitive Information (UPSI). He was suspected of having violated rules 3(i) and 4 of SEBI (Prohibition of Insider Trading) 1992 (PIT Regulations, 1992).

SEBI, after completing its investigation, held the respondent liable. Dissatisfied with the SEBI order, the respondent filed an appeal at SAT ultimately leading to the apex court. The respondent argued that he sold about 70% of his shareholding in GIPL along with other assets to raise money for the corporate debt restructuring (CDR) package of the company and save it from bankruptcy, which makes it a case of “distress sale’. He further pointed out that the sale was made before the information could have had a positive impact on the price of the shares, thus excluding him from any liability.

The Supreme Court exonerating Abhijt Ranjan held that, “While it is true that the actual gaining of profit or sufferance of loss in the transaction, may not provide an escape route for an insider against the charge of violation of Regulation 3, one cannot ignore normal human conduct. If a person enters into a transaction that is surely likely to result in loss, he cannot be accused of insider trading.

In other words, the actual gain or loss is immaterial, but the motive for making a gain is essential.” It further held that: “an attempt by the insider to encash the benefit of the information is not exactly the same as mens rea. Therefore, the Court can always test whether the act of the insider in dealing with the securities, was an attempt to take advantage of or encash the benefit of the information in his possession”.

The legal position in the United States

The United States has been the gold standard in terms of laws relating to securities markets. Most developing countries use their adaptation of U.S. laws to regulate their securities markets. Thus, in the present context, it is crucial to analyse US laws.

The US started regulating its securities market post-Great Depression. The Securities Act of 1933 and the Securities Exchange Act of 1934 were the first steps towards regulation. As per the Securities Exchange Act, to be held liable for the violation of Section 10(b) (responsible for regulating insider trading) defendant’s action must be expressly considered to constitute a “wilful violation” of the securities crimes under Section 32(a) of the Act.

Thus, it implies that the presence of mens rea is an essential ingredient to being held criminally liable for insider trading. Rule 10b-5 further engages with the requirement of mens rea by making the wilful violation a pre-condition to being held liable for fraud or misrepresentation in connection with the purchase or sale of securities. Thus, the statutory provisions in the U.S. have clearly included mens rea as an essential ingredient in cases of insider trading.

Judicial developments have further clarified the requirement of mens rea. In the case of United States v. Chiarella [445 U.S. 222 (1980)], the federal court held that silence in connection with the purchase or sale of securities could have been fraud under Section 10(b). In this case, the court propounded the misappropriation theory. The Court held that mere trading on material, non-public information per se is not punishable. For insider trading to be illegal and punishable, there must be a pre-existing fiduciary relationship that imposes an obligation to abstain from misuse of such information. If such a fiduciary relationship does not subsist prior to or at the time of such insider trading then, such trading could not be held to be unlawful under Section 10(b).

In this particular case, the defendant worked as a financial printer in the petitioner’s firm. He misappropriated the information handed to him, without disclosing this information, he traded according to the information. Court held his silence or concealment of information prior to the purchase as not being fraudulent under Section 10(b) as he was not under any fiduciary relationship with the sellers.

In the cases of Cady Roberts & Co. [40 S.E.C. 907 (1961)] and Dirks. v. Securities and Exchange Commission [463 U.S. 646 (1983).], the court devised the test of personal benefit. As per this test, a trade was an instance of illegal insider trading only when it was intended to defraud, deceive, or manipulate shareholders accompanied with the intention of gaining some undue personal benefit, either direct or indirect.

Further, in the case of US v. Newman [456 F.2D 668], the court noted that the existence of some improper purpose is a must to hold a person liable for insider trading. Thus, in the U.S, judicial opinion on the matter is in harmony with the statutes. This provides clarity to the investors.

 The legal position in India

As far as insider trading is concerned in India, there is no statute or regulation that specifically defines or states what Insider Trading is. Neither the SEBI (Prohibition of Insider Trading) Regulations of 1992 nor the PIT Regulations of 2015 state what Insider Trading is.

However, the Patel Committee in its report, gave the following definition of insider trading, “Insider trading generally means trading in shares of a company by the persons who are in the management of the company or are too close to them, based on undisclosed price-sensitive information regarding the working of the company which they possess but is not available to others.”

Section 2(e) of the 1992 PIT Regulations defines an insider as a person connected or deemed to be connected to the company, reasonably expected to have access to UPSI relating to the company’s securities due to the person’s position, and has actually had access to UPSI.

“Price sensitive information” has been defined under Section 2(ha) of the 1992 regulations as follows: “price sensitive information” means any information which relates directly or indirectly to a company and which, if published, is likely to materially affect the price of securities of that company.

The explanation for this section provides the following seven different kinds of information, which are deemed to be UPSI. These are financial results of the company, dividend declarations, buyback announcements, announcements of expansion plans, amalgamations or mergers, disposal of shares by a major investor, and anything else that is likely to materially impact the share prices.

Regulation 3(1) and Regulation 4 prohibit an insider possessing UPSI regarding a company that is listed or proposed to be listed on a stock exchange, from communicating or providing it to any person and trading in a security listed on a stock exchange using that UPSI respectively. These regulations empower SEBI to investigate cases of insider trading and penalise people indulging in this malpractice.

As far as the defences which are available to the accused in insider trading cases are concerned, Regulation 4(1)(i) and Regulation 4(1)(ii) come to the rescue of the accused as they provide a list of defences that can be availed by the accused. However, what is relevant to the discussion is the note attached to Regulation 4, which clearly states that mens rea, or motive of the act, shall be irrelevant while assigning liability under Insider Trading. The authors of the Consultative Paper issued by SEBI in 2008 also clearly opined that ‘intent’ shall not be considered as a relevant criterion for determining liability in Insider Trading.

However, other jurisdictions do consider intent or motive as a relevant factor for assessing liability in insider trading. The Indian jurisprudence too contains cases, where the Adjudicating authority established the need for evaluating insider trading cases from the lens of the intention of the accused.

In this context, the case of Rakesh Agarwal v. SEBI [(2004) 49 SCL 351 (SAT)] holds great significance. In this case, the SAT, drawing reference from foreign jurisdictions, held that if dealing in securities was not done with the purpose of misusing the information, unfairly gaining from using the information, or of making a profit, then the act would not be covered by Regulation 3.

The Tribunal, adopting a dynamic approach to the interpretation of the law and the regulatory framework, was of the view that the intention or knowledge of the accused must be taken into cognizance while adjudicating insider trading cases even though the statute doesn’t explicitly provide for it. This judgment was in line with the laws and jurisprudential framework of the United States and the United Kingdom.

The case was however later overruled by the Apex Court in SEBI v. Shriram Mutual Fund [2006 TIOL 72 SC SEBI] in 2006 where the judges adopted a strict “plain language” interpretation of the Regulations and held that intention as an element is irrelevant and stated that penalty was to be attracted as soon as contravention of the statutory obligation was established. This view was further cemented by the Bombay HC in the case of SEBI v. Cabot International Capital Corporation.

Conclusion

Just like any other market, the securities market also thrives on the grounds of fairness. To ensure this, specific statutes and clear judicial positions are a sine qua non. Thus, any form of vagueness on the stance on the issue of the requirement of mens rea as an element in cases of insider trading is harmful for the market. This vagueness might in turn erode the faith of the stakeholders in the absolute fairness of the market.

Thus, the decision of the court in the present case is a stitch in time. The decision is also welcomed because it ushers Indian security market regulations towards the worldwide accepted norm of taking mens rea as an important element in cases of insider trading. Such consistency with international standards would encourage other investors to invest capital in the Indian market.

This article has been authored by Ayush Upadhyay and Shubham Sharma, a student at Chanakya National Law University, Patna.