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Should Sebi have barred insider trading from consent orders?

The consent order guidelines of 2007 allowed for serious offences like insider trading to be settled by payment of penalty or debarment, with the violator not needing to admit or deny guilt

Shriram Subramanian  |  New Delhi 

Penalties allow offenders off the hook easily, but our legal system may not be evolved enough to guarantee justice

Shriram SubramanianShriram Subramanian
Founder and Managing Director, InGovern Research Services

“Allowing companies involved in to apply for a consent order motivates them to commit such offences and view the penalty as part of regular business costs”

The consent order guidelines of 2007 allowed for serious offences like to be settled by payment of penalty or debarment, with the violator not needing to admit or deny guilt. If were covered under consent orders, it would give insiders the chance to commit an offence, benefit from trading, cause huge loss to other investors and market participants and, if caught, apply for consent, pay a penalty or take a voluntary ban.

However, an offence like insider trading is too grave to be settled through consent. There are many hues of insider trading, with trading done by promoters, senior executives, investment bankers, brokers and so on dealing in confidential and asymmetric information. Insider trading is a clear case of intentional fraud in which the responsibility is abrogated by the perpetrator. The benefits of insider trading and the loss to investors cannot be easily quantified.

A recent case of consent order, passed on May 16, 2012, is that of Educomp Solutions. A show-cause notice was issued by the Securities and Exchange Board of India (Sebi) to Educomp for violations under Code of Corporate Disclosure Practices for Prevention of Insider Trading in Schedule II under of (Prohibition of Insider Trading) Regulations, 1992. Educomp applied for a consent order after which the case was closed after Educomp paid Rs 10 lakh. For a serious case of insider trading, Rs 10 lakh is an insignificant compensation when compared to the likely loss shareholders may have suffered.

Rather than viewing consent orders as a means by which collects penalties for speedy closure of cases, mechanisms should be devised to provide maximum protection to investors and maintain order in capital markets. Public humiliation, fear of incarceration, criminal liability and a stringent penalty not known beforehand should be primary deterrents against insider trading. Settling insider trading cases speedily through a court process is bound to add pressure on companies and insiders, and provide justice to market participants who have suffered loss.

By not admitting or denying guilt, the offender gets away without all the market participants knowing the truth. For example, let us take a situation in which investigates an insider trading case at a leading investment bank and consents to bring the case to a close after the investment bank pays a penalty. Since the investment bank has not admitted or denied guilt, the details of the case wouldn’t come out and market participants would be in the dark about the extent and nature of insider trading. The insider trading case may be symptomatic of poor risk-management and compliance procedures at the investment bank, with potential for a contagion effect across the markets. On the contrary, if details of the case were made public, and market participants were aware of the extent of insider trading, they would be careful in dealing with that particular investment bank.

Allowing companies involved in insider trading to apply for a consent order motivates them to commit such offences and view the penalty as part of regular business costs.

Consent orders only take into account benefits or gains made by the insider and impose a penalty. However, insider trading doesn’t just amount to gain for the trader, but also leads to distortion in market prices, hurts a larger cross-section of investors, leads to loss of investor wealth and, more importantly, leads to loss of investor confidence. In an era in which class action suits are imminent after the Companies Bill, 2011, becomes an Act, consent orders for insider trading cases are not the right solution. Frequent cases of insider trading will tarnish the image of India’s capital markets and regulatory system.

In any event, Sebi has kept the door open for a quicker settlement if the facts and circumstances of any particular case warrant it. The high-powered advisory committee or panel of whole-time members may settle the case.

Sandeep Parekh
Former Executive Director, Sebi & Founder, Finsec Law Advisors

“Contrary to public perception, consent penalties and consent remedies are, in fact, higher than in cases that go through the usual process of enforcement”

The Securities and Exchange Board of India (Sebi) should have allowed all kinds of serious and non-serious violations to be settled through the consent route. Indeed, moral arguments can be made on how a serious violation can be settled. But the settlement process has many benefits, many of which are not fully appreciated.

First, instead of decades of litigation and disputes, amounts can be disgorged from a person. To take just two examples from the arena of fraud, have any investors been compensated for the or the till today? Contrast the lack of compensation to Satyam investors in India, where nothing substantial has even been initiated, with the partial settlement in the US where Satyam securities holders (American depository receipt holders) have settled the case with several of the accused and received compensation. While we have earned a moral victory, the US investors have got real compensation.

Second, litigation in India is particularly long and tortuous. This means few civil litigants see results within a decade or more. This was equally true of Sebi enforcement actions. Weighing complex financial data; gathering oral testimonies, written records and so on from exchanges; and giving a hearing to all parties and often a right to cross-examine can take substantial time. Add to that two appeals and the process is indeed long.

Third, even the guilty party in litigation may get away because a court of law may find the evidence less than watertight. In particular, a situation in which a person is charged with fraud, the burden of proof is extremely high and the guilty party can be set free either on a technicality or on lack of substantial evidence. To take an example, a person accused of insider trading would more likely than not get off scot-free because there is rarely more than circumstantial evidence available. One can rarely prove the conversation that took place inside a closed room with only two people present, particularly when it is in their interest to not disclose the illegality.

Fourth, criminal trials are even worse with a three per cent conviction rate. Most convictions in economic offences don’t even invite a jail sentence. Many invite a penalty of Rs 5,000 on conviction. Compare that against a multi-crore scam and the moral victory doesn’t look like much of a victory.

Fifth, the judicial system can work more efficiently since it gets unclogged owing to settlements. The securities appellate tribunal is perhaps India’s only court or tribunal that has close to zero backlog — this was made possible after the consent mechanism was introduced. The court, with more time, can better appreciate evidence and dispense justice in a time-bound fashion.

Sixth, contrary to public perception, consent penalties and consent remedies are, in fact, higher than in cases that go through the usual process of enforcement. Here an alleged violator gets something and gives up something else. He gets an order that finds him neither guilty nor innocent. And, in return, he must pay a higher penalty.

Seventh, there is no question of lack of guilt. In fact, the condition of settling the case is that a person neither admits nor denies the violation. There have been cases in the US in which people who made a press statement saying they are not guilty had the whole enforcement re-opened against them. Given that the consent orders are in the public domain, and that these need to be disclosed in public documents, there is a sufficient disincentive to commit violations in the future.

Finally, none of this would be possible if serious cases are taken outside the purview of consent. Petty and technical cases are anyway not disputed and don’t clog the system. A broker who sends a contract note a day late will end up paying a small fine, which he will not contest since it is impossible to argue against the violation. I, therefore, believe that serious offences like insider trading should be consentable though they should invite a higher penalty.

First Published: Wed, June 06 2012. 00:15 IST