Insider Trading

Types Of Insider Trading:

Insider Trading is of two types. One is illegal insider trading and the other one is legal insider
trading. Both of them are discussed below:

Illegal Insider Trading:

Illegal insider trading is the buying or selling of a security by insiders who possess material that
is still not public. The act puts insiders in breach of their fiduciary duty. As you can imagine, this
is a definite faux pas for anyone closely involved with a company.

A common misconception is that only directors and upper management can be convicted of
insider trading. Anybody who has material and non-public information can commit such an act.
This means that nearly anybody - including brokers, family, friends and employees - can be
considered an insider.

The following are examples of illegal insider trading:

• The CEO of a company sells a stock after discovering that the company will be losing a
big government contract next month.
• The CEO's son sells the company stock after hearing from his dad that the company will
be losing the big government contract.
• A government official realizes that the company will lose a big government contract, so
the official sells the stock.

The Securities and Exchange Commission of Pakistan (SECP) is extremely strict with those who
trade unfairly and thereby undermine investor confidence and the integrity of the financial
markets. Securities and Exchange Ordinance and Rules states in its section 15 A about illegal
insider trading as follows:

Prohibition:

A person shall not deal (directly or indirectly) or cause any person to deal in listed securities,
who has been listed with the company if he has inside information.

Insider Information:

It is the information which:

a) is not generally available;

b) Would, if it were so available, be likely to materially affect the price of those securities;
or

c) relates to any transaction (actual or contemplated) involving such company.

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Consequence of Insider Dealing: (15 B)

Where a person contravenes the provisions of section 15A, the authority may, by a notice in
writing, ask such person to show cause for compensating any person who has suffered loss for
such contravention and initiating prosecution against him.

Withdraw of Notice:

SECP may withdraw the notice if a person to whom the notice has been issued satisfy the
authority that:

a) any dealing on stock exchange or communication of any information was not made with
the intent of making any profit or causing a loss to any person or company; or

b) the dealing on stock exchange or any information was communicated in good faith in
discharge of his legal responsibilities.

Compensation:

If SECP is not satisfied of explanation, it may direct him to pay compensation not less than the
loss sustained. If amount of loss cannot be determined, compensation shall be equal to the gain
accrued or loss avoided.

Imprisonment and Fine:

The Securities and Exchange Commission of Pakistan (SECP) has proposed penalty on persons
indulged in insider trading that is fine of Rs 10 million. In addition to compensation payable the
person in contravention shall be liable to imprisonment up to 3 years and fine up to 3 times of
compensation amount or both. If such person is an executive officer, director, auditor, advisor,
consultant of a listed company, he will be removed from such office by an order of the
Commission and debarred from auditing any listed company for a period of up to three years or
if such person is registered as a broker or agent, be liable to cancellation of registration. Where
an insider person discloses inside information to any other person who is not required to possess
such information for any reason, the insider person shall be liable to fine, to be imposed by the
Commission, which may extend to Rs 30 million.

Recovery Method:

Any compensation payable under this section shall be recoverable as arrear of land revenue.

Insider trading isn’t always illegal:

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There is an important thing to emphasize here: insiders don't always have their hands tied. Legal
trades by insiders are common, as employees of publicly-traded corporations often have stock or
stock options.Insiders legally buy and sell stock in their own company all of the time; their
trading is restricted and illegal only at certain times and under certain conditions.

In SECP there is no such section regarding the legal insider trading but in SEC legal trading is
recognized and they have certain laws for it. The SEC considers insiders to be company
directors, officials or any individual with a stake of 10% or more in the company. Insiders are
required to report their insider transactions within two business days of the date the transaction
occurred (before the 2002 Sarbanes-Oxley Act it used to be the tenth day of the following
month). For example, if an insider sold 10,000 shares on Monday June 12th, he or she would
have to report this change by Wednesday June 14th. Changes in insider holdings are sent to the
SEC electronically as a Form 4, which details a company's insider trades or loans. A Form 14a,
also filed by the company, lists all the directors and officers along with the share interest they
have.

This kind of information is extremely valuable to individual investors. For example, if insiders
are buying shares in their own companies, they usually know something that normal investors do
not. They might buy because they see great potential, a merger, and acquisition or simply
because they think their stock is undervalued. One of the greatest investors of all time, Peter
Lynch, was noted as saying that "insiders might sell their shares for any number of reasons, but
they buy them for only one: they think the price will rise". Insiders are prevented from buying
and selling their company stock within a six-month period: therefore, insiders buy stock when
they feel the company will perform well over the long-term.

Research:

Nejat Seyhun, a renowned professor and researcher in the field of insider trading at the
University of Michigan found that when executives bought shares in their own companies, the
stock tended to outperform the total market by 8.9% over the next 12 months. Conversely when
they sold shares, the stock underperformed the market by 5.4%.

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Arguments For Legalizing Insider Trading:

Some economists and legal scholars (e.g. Henry Manne, Milton Friedman, Thomas Sowell,
Daniel Fischel, Frank H. Easterbrook) argue that laws making insider trading illegal should be
revoked. They claim that insider trading based on material nonpublic information benefits
investors, in general, by more quickly introducing new information into the market.
Milton Friedman:
Milton Friedman, laureate of the Nobel Memorial Prize in Economics, said: "You want more
insider trading, not less. You want to give the people most likely to have knowledge about
deficiencies of the company an incentive to make the public aware of that." Friedman did not
believe that the trader should be required to make his trade known to the public, because the
buying or selling pressure itself is information for the market.
Other Critics:
Other critics argue that insider trading is a victimless act: A willing buyer and a willing seller
agree to trade property which the seller rightfully owns, with no prior contract (according to this
view) having been made between the parties to refrain from trading if there is asymmetric
information.
Legalization advocates also question why activity that is similar to insider trading is legal in
other markets, such as real estate, but not in the stock market. For example, if a geologist knows
there is a high likelihood of the discovery of petroleum under Farmer Smith's land, he may be
entitled to make Smith an offer for the land, and buy it, without first telling Farmer Smith of the
geological data. Nevertheless, circumstances can occur when the geologist would be committing
fraud if he did not disclose the information, e.g. when he had been hired by Farmer Smith to
assess the geology of the farm.
Advocates of legalization make free speech arguments. Punishment for communicating about a
development pertinent to the next day's stock price might seem to be an act of censorship. If the
information being conveyed is proprietary information and the corporate insider has contracted
to not expose it, he has no more right to communicate it than he would to tell others about the
company's confidential new product designs, formulas, or bank account passwords.
There are very limited laws against "insider trading" in the commodities markets, if, for no other
reason, than that the concept of an "insider" is not immediately analogous to commodities
themselves (e.g., corn, wheat, steel, etc.). However, analogous activities such as front running are
illegal under U.S. commodity and futures trading laws. For example, a commodity broker can be
charged with fraud if he or she receives a large purchase order from a client (one likely to affect
the price of that commodity) and then purchases that commodity before executing the client's
order in order to benefit from the anticipated price increase

Global Prospective:
The US and the UK vary in the way the law is interpreted and applied with regard to insider
trading.

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In the UK, the relevant laws are the [[Criminal Justice Act 1993]Part V Schedule 1 ] and the
Financial Services and Markets Act 2000, which defines an offence of Market Abuse. It is also
illegal to fail to trade based on inside information (whereas without the inside information the
trade would have taken place). The principle is that it is illegal to trade on the basis of market-
sensitive information that is not generally known. No relationship to the issuer of the security is
required - all that is required is that the party guilty traded (or caused trading) whilst having
inside information.
Japan enacted its first law against insider trading in 1988. Roderick Seeman says: "Even today
many Japanese do not understand why this is illegal. Indeed, previously it was regarded as
common sense to make a profit from your knowledge.
In accordance with EU Directives, Malta enacted the Financial Markets Abuse Act in 2002,
which effectively replaced the Insider Dealing and Market Abuse Act of 1994.
The "Objectives and Principles of Securities Regulation" published by the International
Organization of Securities Commissions (IOSCO) in 1998 and updated in 2003 states that the
three objectives of good securities market regulation are
(1) investor protection
(2) ensuring that markets are fair, efficient and transparent
(3) reducing systemic risk.
The discussion of these "Core Principles" state that "investor protection" in this context means
"Investors should be protected from misleading, manipulative or fraudulent practices, including
insider trading, front running or trading ahead of customers and the misuse of client assets."
More than 85 percent of the world's securities and commodities market regulators are members
of IOSCO and have signed on to these Core Principles.
The World Bank and International Monetary Fund now use the IOSCO Core Principles in
reviewing the financial health of different country's regulatory systems as part of this
organization’s financial sector assessment program, so laws against insider trading based on non-
public information are now expected by the international community. Enforcement of insider
trading laws varies widely from country to country, but the vast majority of jurisdictions now
outlaw the practice, at least in principle.

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