August 12: Reports of insider trading make newspaper headlines anywhere in the world. It was, therefore, no surprise to notice that the recent insider trading controversy involving Hindustan Lever Ltd (HLL) was the talk of the town. This immediately raises an issue. How would the US Securities and Exchange Commission (SEC) react to the HLL transaction involving the purchase of eight lakh shares of Brooke Bond Lipton India Ltd (BBLIL) two weeks prior to the merger announcement of the two companies?

The Securities Exchange Act of 1934 empowers the SEC to ensure that the markets remain honest in order to promote investor confidence. Section 10(b) of the Act provides:

"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange--(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the (Securities and Exchange) Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors."

The Commission, pursuant to its section 10(b) rulemaking authority, has adopted Rule 10b-5, which provides:

"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange...

(a) To employ any device, scheme, or artifice to defraud...(or)(b) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security."

The arms of the SEC are wide enough to catch any person who had taken advantage of inside information.

In fact two theories of insider trading liability exist. Under the "traditional" or "classical theory" of insider trading liability, section 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, non-public information.

In the case of Chiarella Vs United States (445 US 222-1980), the Supreme Court stated that "a relationship of trust and confidence (exists) between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.

"That relationship" gives rise to a duty to disclose (or to abstain from trading) because of the "necessity of preventing a corporate insider from taking unfair advantage of uninformed stockholders."

The classical theory applies to officers, directors and other permanent insiders of a corporation as well as to those related to the corporation in their capacity as attorneys, accountants, consultants. It also extends to others who temporarily become fiduciaries of a corporation.

Earlier, only corporate insiders and those in connection with the corporation in the manner described above could be hauled up for insider trading offenses. Later, the reach of the SEC was widened.

On June 25, 1997, the US Supreme Court, in the case of United States Vs O'Hagan (1997 WL 345229) expanded the SEC's enforcement power to curb insider trading by validating what has come to be known as the "misappropriation theory." The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction and thereby violates section 10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.

The misappropriation theory premises liability on a fiduciary- turned-trader's deception of those who entrusted him with access to confidential information. Such a person may have come across confidential information in the most innocuous manner, yet he can be held liable.

The two theories are complementary. The classical theory targets a corporate insider's breach of duty to shareholders. On the other hand, the misappropriation theory outlaws trading on the basis of non-public information by a corporate `outsider' in breach of a duty owed to the source of the information and not to a trading party. In a nutshell, that is where the current stride, a broad stride one might add, of US insider trading law stands.

While the HLL transaction involving BBLIL may not strictly come within the statutory framework of section 10(b) and Rule 10b-5, the SEC would certainly react in a similar vein as the Securities and Exchange Board of India (SEBI). The fact remains that the HLL directors knew of the forthcoming merger with BBLIL and, based on that material, non-public information, they engaged in the block purchase of the latter's shares.

Regulatory agencies such as the SEC and the SEBI do not concern themselves with the motives behind such transactions. And rightfully so, as their primary concern is to promote investor confidence and they should not be distracted from pursuing that goal.

Neither the investing public, in general, nor the shareholders of the two companies had any idea that a merger was impending. As such, there seems to be ample evidence that there was a breach of a fiduciary duty owed to the shareholders by the directors.

Furthermore, only HLL was privy to this material, non-public information. Thus, no other outsider could have participated in acquiring shares of BBLIL at that particular time, at that particular price. An outsider privy to such information could have bought the shares to prevent HLL from acquiring a majority block.

Arguably, HLL did in fact profit from the transaction by potentially avoiding a loss in the future. HLL management may have assumed that it would be costlier to buy the necessary shares after the merger, anticipating a rise in BBLIL's share price once the merger was formally announced. If the sole intention of HLL was to acquire a controlling block of the merged company, it should have purchased the shares after the merger.

Alternatively, if it wanted to acquire the shares prior to the merger, it should have notified the market of its intentions. One might argue that since BBLIL's share price stabilised rather quickly after just a brief increase, HLL could have bought the shares after the merger. It did not do so for strategic business reasons, whatever they may be. That is a feeble defence because, in hindsight, we would all do things differently. Furthermore, HLL had no way of knowing that the BBLIL share price would in fact stabilise at such a pace. If it did, it would also have anticipated this groundbreaking inquiry launched by the Sebi.

In fact, insider trading laws anywhere in the world should be continuously strengthened to enable the regulatory authorities to boost investor confidence.

(The author is a law student at American University. This article is part of a recent project at Nishith Desai Associates, international legal and tax consultants.)

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.