When will SEBI have its Rajaratnam moment?

Last year Piramal Healthcare shares rallied 76 percent from Rs 330 to Rs 581 between late January and early May. On 21 May, the company announced that it was selling its generic drugs division to US-based pharma major Abbott.

In the same year, Delta Corp climbed 50 percent in just over a month, before the company announced that it was making a preferential issue of shares to ace proprietary investors, Rakesh Jhunjhunwala and RK Damani.

This year, UTV shares surged - 50 percent in less than two months before Walt Disney’s announcement on 26 July to buy out the remaining equity in UTV Software with Rs 1000 per share as the floor price for the reverse book building issue.

After a near 50 percent drop following the arrest of its managing director on charges of tax evasion and bribery, the Everonn stock rallied on heavy volumes in the week before Dubai-based Varkey group said it was buying a controlling stake in the company at a huge premium to the market price.

In 2007, a reputed Indian metal company acquired an overseas firm for what many felt was an exorbitant valuation. Grapevine has it that one of the bankers advising on the transaction leaked the news to a Middle-East portfolio investor, which then borrowed a sizeable chunk of the Indian company’s stock through the P-note route, and short sold it a few days ahead of the formal announcement. As expected, the stock tanked after the deal was announced, allowing the Middle-East investor to make a tidy profit. The banker’s cut was transferred to an overseas account, and he is said to have used the money to buy an apartment in a luxury housing project in Dubai. This may sound straight out of the pages of a financial crime thriller, but not implausible either.

These are but just a few instances where there have been suspicious activity just before a major announcement. The list, in fact is much longer. It is easy to surmise that some players would have had definite information about the impending development, and taken up trading positions accordingly. But it is not as easy for the regulator in any part of the world to prove that the accused had traded on the basis of unpublished information. There can be plenty of circumstantial evidence to link the transaction to the trader or context.

And while insider trading - unlawful transactions based on unpublished information - is fairly prevalent in markets world over, the conviction rate is low for precisely this reason.

So it was a major triumph for the US Securities Exchange Commission last week when hedge fund tycoon Raj Rajaratnam was sentenced to 11 years imprisonment on insider trading charges, the longest sentence ever in an insider-trading case.

Back home, market regulator Sebi has been pursuing insider trading cases since 1997, when it slapped charges on Hindustan Lever (now Hindustan Unilever) and five of its key officials for the purchase of a large block of Brooke Bond India (BBIL) shares from Unit Trust of India, weeks before BBIL was to be merged with HLL. Others who have been accused of a similar offence include ABS Industries managing director Rakesh Agarwal(buying his stock just before the company’s merger with Bayer), fund manager Samir Arora (for selling Digital Globalsoft shares ahead of its merger with HP), Tata Finance MD Dilip Pendse (for selling shares before the company reported a huge quarterly loss), and former chief financial officer of Wockhardt, Rajiv Gandhi (for selling shares based on unpublished information about the company’s financials). The results have been been far from encouraging. The Securities Appellate Tribunal overruled Sebi’s verdict in the cases against HLL, Samir Arora and Dilip Pendse. Agarwal and Gandhi settled through consent orders, forking out Rs 34 lakh and Rs 5 lakh.

While the quantum of Rajaratnam’s punishment could possibly deter those looking to gain from insider information in the US markets, Sebi is still seeking that one high-profile conviction that could send out a strong message to market participants here.

It is widely acknowledged that foreign portfolio investors prefer India over China when it comes to stock market bets, because the corporate governance and disclosure standards are considered to be much better over here. But there are others who believe the retail investor apathy to equity over the years is the result of a perception that they stand little chance of winning against a system stacked in favour of the institutional players.

The penalty for fraudulent market practices (which includes insider trading) is a penalty of Rs 25 crore or three times the profit made from the illegal trades, whichever is higher. This is in addition to having to forfeit the illegal profit. Market watchers feel this penalty may be big enough for an individual, but not for large companies. Unlike the SEC, Sebi cannot tap the phones of the people it suspects of market manipulation. While Sebi can ask for the call records of the people it is probing for market manipulation, it does not have the power to ask for the recordings of the conversation, or seize records of e-mail communications.

This is often the key to establishing that there was an exchange of confidential information, based on which the transactions were executed. The investigating agencies would not have been able to nail Rajaratnam but for the secret wiretaps that allowed them to record the telephonic conversations between Rajaratnam and those who passed him illegal information. Indian promoters and market operators are known to route orders through a clutch of entities, but it is very hard for the regulator to prove that these entities are known to each other and were acting in concert.

And while the conviction rate may be low, Sebi has been trying to make up for it through monetary penalties under consent orders. In a consent order, the accused pays a fine without admission or denial of the charges. But Sebi’s system of settling market manipulation cases through consent orders has drawn flak from a section of legal experts and market watchers, who feel that it provides an easy escape route to the more powerful offenders. At the time of introducing it, the consent order system was meant to dispose of the less serious transgressions, allowing the regulator to concentrate on the bigger violations.

Insider trading cases are the toughest to prove. So the choice for the regulator is between a long drawn litigation (the influential can always hire the best legal brains and prolong the proceedings) or a penalty that sends out the message that there is a certain cost - reputational and monetary - for wrongdoing. And while the regulator may have collected a tidy sum by way of penalties, it is yet to deal the one knock-out punch that will make offenders - habitual or potential - think twice before breaking the rules. Till then, players will take their chances.

In the backdrop of the Raj Rajaratnam conviction, Sebi’s stance against Reliance Industries in the ongoing insider trading probe will be closely watched. Sebi’s allegation is that entities linked to RIL short sold Reliance Petroleum futures a few days before Reliance Industries sold RPL shares in the open market, and thus gained from the subsequent crash in the price of RPL. According to media reports, Sebi has twice rejected RIL’s offers to settle the case through the consent mechanism, saying the amount was too small in comparison to the gains made by the group.