So, you can be a college-mate-turned-confidante of the chairman of a conglomerate, his advisor for new ventures, director in his companies and still buy shares of a group company just days before it makes a major announcement without fear of being called an ‘insider’.

Strange, yes? But that is precisely the gist of the Securities and Exchange Board of India’s (SEBI) order in the insider trading case against Manoj Modi, advisor and friend of Reliance Industries Chairman Mukesh Ambani.

Mr. Modi and his wife bought shares of Indian Petrochemicals Corporation Ltd. (IPCL), a Reliance group company, just days before a board meeting that was called to discuss its merger with Reliance Industries (RIL); and to consider an interim dividend. They bought a total of 1,00,000 shares of IPCL on February 28, 2007, March 1 and March 2 valued at Rs.2.57 crore.

On March 2 afternoon IPCL announced to the stock exchanges that its board would meet on March 10 to consider declaration of interim dividend. Further, on March 7, IPCL informed the exchanges that the same board meeting would also consider amalgamation of the company with RIL. The merger was finalised at the meeting with an exchange ratio of one share of RIL for every 5 shares held in IPCL; an interim dividend of Rs.6 a share was also declared. Thus, Mr. Modi and his wife together were richer by Rs.6 lakh in dividend and 20,000 shares of RIL (exchanged for their IPCL shares).

SEBI’s investigating officer was convinced that Mr. Modi was a ‘connected person’ and, therefore, an ‘insider’ as per the SEBI (Prohibition of Insider Trading) Regulations and that he was also in possession of unpublished price sensitive information concerning the proposed amalgamation and dividend declaration.

Mr. Modi’s defence was that he and his wife were long-term traders in the market and that they bought IPCL shares based on fundamental factors backed by analyst reports. The information on dividend and amalgamation was known to only four top people in the two companies, including Mr. Ambani.

Mr. Modi also held that IPCL was not the only company that declared interim dividend; 180 others had done so in March 2007 to avoid a higher dividend distribution tax that kicked in on April 1. His role in the Reliance group was limited to advising Mr. Ambani on new business ventures, and had nothing to do with day-to-day running of the group companies and, therefore, he had no access to price sensitive information.

Not an ‘insider’

All these defences proved unnecessary because the officer adjudicating the case in SEBI was not convinced in the first place that Mr. Modi was an ‘insider’; mere professional relationship with Mr. Ambani was not enough to prove that Mr. Modi was a ‘connected person’ as per SEBI’s insider trading regulations. He needed to have a ‘connection’ with IPCL to be termed so. And Mr. Modi had no ‘connection’ with IPCL. He also had no professional or business relationship with RIL and so he could not be expected to have access to unpublished price sensitive information from the company, ruled the adjudicating officer.

And so, yet another case put up by SEBI’s investigation department failed for want of adequate evidence. The Adjudicating Officer applied the letter of the law as well he should, though in practical terms it was well known that Mr. Modi was a powerful advisor and aide to Mr. Ambani. It is also believable that he knew of IPCL’s proposed merger with Reliance but SEBI’s problem is one of proof.

Indeed, the regulator, which has made a world of difference in various aspects of the stock market in the two decades of its existence, has been unable to make a mark in the difficult area of insider trading. Its two best known insider trading prosecutions — Hindustan Lever-Brooke Bond Lipton (1998) and Samir Arora of Alliance Capital (2003) — were both overturned by its own appellate authority for inadequate proof and defective interpretation of rules. While the Lever case is now pending with the Bombay High Court, the other is in the Supreme Court.

Overhaul insider trading rules

The larger issue here is whether the insider trading law as it exists needs a re-look. It is just over a decade since the regulations were tweaked following the setback in the Hindustan Lever case but then the markets have evolved tremendously since, and the regulator needs to be in step. It is just as well, therefore, that SEBI has recently constituted a committee to review its insider trading regulations.

The committee should go beyond the structure of the rules to look at the most difficult aspect of insider trading prosecution: gathering evidence and proving the offence. In the recent U.S. case of Raj Rajarathinam, the clinching evidence came from wiretaps which SEBI is not permitted to do.

The point is that proving insider trading has not been easy across the world. Often, if not always, investigators can get no more than circumstantial evidence to prove their cases and though it’s a civil offence, they have found it difficult to convince appellate authorities and courts to go by such evidence. That is the reason for SEBI’s poor record in securing convictions in insider trading cases until now.

More bite, less bark

So, the committee should take a bold view on extending the powers of the regulator to the electronic realm, as, for instance, securing and examining call records, emails and so on.

The aim should be to empower SEBI to carry out electronic surveillance such as wiretaps, for instance, to gather incontrovertible evidence. The markets have moved on from a decade ago when the regulations were last amended and with more business done through electronic devices such as phones and computers, it is only natural that the evidence and the process of gathering it, also turns electronic.

Along with this, we also need a redefinition of the terms ‘insider’ and ‘connected person’ to make them wider. A ‘connected person’ should not be merely seen as someone either working for the company or consulting for it; it can be anyone who is in a position to get a tip on a corporate action. A holistic re-look at the regulations appears in order here.

Insider trading is the most common form of malpractice in the market, and is also the most insidious as it leads to information asymmetry, often, if not always, to the detriment of the small investor. It’s time that we took this crime seriously and strengthened SEBI’s hands.

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