UK paper on insider trade can guide Sebi

WITHOUT CONTEMPT

A thought provoking and seminal paper on the insider trading titled "Measuring Market Cleanliness" was published last week by the Financial Services Authority (FSA) in the UK.

The paper says stringency of securities law may have had little deterrent impact on the insider trading in the UK (www.fsa.gov.uk). The paper holds out a few lessons for securities regulation in the Indian capital market.

The paper shows with statistical basis that the insider trading in the UK has not declined because of the introduction of the stringent Financial Services and Markets Act (FSMA) in 2001.

The paper concludes that informed trading is indeed taking place, (over 30 per cent of announcements are preceded by informed price movements), and around M&A announcements, informed trading may have actually increased.

Before the FSMA, the toughest penalty for breaching the listing regime prescribed by the FSA was only public censure. Although the insider trading has been a criminal offence since 1985 in the UK, criminal prosecution requires a charge to be proved "beyond reasonable doubt". But after 2001, the FSA can punish market abuse by imposing civil penalties, which arguably require a lower burden of proof for a successful prosecution.

Contents of the FSMA were public since 1998. The law was passed in 2001 and the first enforcement took place in February 2004. The paper notes that the penalties imposed under the new law have so far been relatively small.

The FSA listing regime imposes an obligation on every company to publicly announce material information as soon as possible. In cases where information cannot be made public (say, material contracts under negotiation), companies are obliged to keep the information confidential.

The paper picks up price movement around every such statutory announcement, and statistically determines if such announcements were preceded by "informed price movements" i.e. whether the insider trading occurred before the official announcement.

All insider trading need not have a price impact and every significant price movement need not necessarily mean there is an insider trading, but by using statistical tools and elimination thresholds, the report assert that the abnormal price movements preceding official announcements hint at insider trading.

To arrive at the findings, the authors deal with all announcements made in respect of all stocks comprising the FTSE 350 index (since all these stocks are liquid) and the price movements in these stocks for 1998-2000 and 2002-2003 (i.e. leaving out 2004, when the FSMA was legislated). But all M&A related announcements and related data relating to 2000 and 2004 have been analysed including those relating to stocks outside the FTSE 350.

The authors have considered the price behaviour in the stocks for two trading days preceding the actual announcement and for the two trading days after the announcement including the date of the announcement.

The paper computes an "expected return" in a stock by studying the price behaviour during a period of 240 days ending 10 days before the date of the actual announcement. These returns are adjusted to eliminate any increase or decrease in price arising out of overall upward or downward movement in the rest of the market.

To infer whether an announcement was significant and whether the price movement before a significant announcement was an "informed price movement", the price behaviour in the four days around the announcement was compared with 10,000 randomly-selected four-day price movements picked up from the 240-day period.

If the returns in the four-day price movement around the actual announcement was greater than (in the case of positive news) or lower than (in the case of adverse news) the 50th most extreme positive or negative return from the simulated 10,000 random four-day samples by more than one per cent, it was concluded that the announcement was significant.

If the price movement in the two days before the announcement was greater than or lower than the 500th most extreme positive or negative return out of the 10,000 random four-day samples by more than 10 per cent, an inference of an "informed price movement" was drawn.

Similarities with India are striking. Pursuant to a clamour for more powers by Sebi, which pleaded powerlessness to prevent the 2001 securities scam, the Sebi Act was made stringent in 2002. Civil penalties rose from Rs 5 lakh to the higher of Rs 25 crore, or three times the gain made. Criminal penalties too have been hiked to Rs 25 crore and to a 10-year prison term""a marked increase from the one-year jail before 2002.

Just as the authors note that there is no case law yet to conclude that severe civil penalties can be imposed with a lighter burden of proof against the accused, the Securities Appellate Tribunal has been grappling with the standard of proof to be applied in appeals relating to civil penalties.

The FSA has been candid in publishing this controversial paper, which suggests that just a stringent law will make no impact. Perhaps, it would be a good measure for Sebi to apply this test to stocks comprising the BSE Sensex, and the NSE's Nifty, to see how India has fared since 2002.

(The author is a partner of JSA, Advocates & Solicitors. The views expressed are personal.)

somasekhar@jsalaw.com