[Peeyush Agarwal and Zarnaab Aswad are both 5th year law students at Dr. Ram Manohar Lohiya National Law University, Lucknow]
Introduction
Consider this: X is an employee of Y Corporation, which is a leading steel manufacturing company whose scrips are listed on stock exchanges. X, being an employee gets to know that Y Corporation has just discovered huge deposits of iron ore that, if extracted, will increase the total supply of steel, thus influencing the steel price (downwards) in the commodities market while possibly increasing the prices of the scrip of Y Corporation in the stock market.[1] Assume that this information is not yet disclosed to the public. So, X decides to exploit this informational advantage. He knows that his position as an employee of Y Corporation makes him an insider, so if he takes a position in securities of Y Corporation, he may be subjected to charges under insider trading regulations. To avoid those complications, he instead shorts on steel futures in the commodities derivatives market, and consequently books huge profits. X gained on account of exclusive access to superior information; the nature of his trade undermines the integrity of the market, although it would escape the clutches of insider trading regulations (or even anti-fraud regulations) of the Securities and Exchange Board of India (“SEBI”).
The apparent anomaly is the focus of this post. It seeks to suggest that though it may be more difficult to draw lines with respect to insider trading in commodity derivatives, the solution requires acknowledgement of the mischief at the very least.
Insider Trading Regulations of SEBI and its Applicability to Commodity Derivatives
“Securities” in the SEBI (Prohibition of Insider Trading) Regulations, 2015 (“Insider Trading Regulations”) means “securities” as defined in section 2(h) of the Securities Contract (Regulation) Act, 1956 (“SCR Act”) which, pursuant to the Securities (Amendment) Act, 2015, covers commodity derivatives within its ambit. However, an overall reading of the Insider Trading Regulations would suggest that they deal with the prohibition of insider trading only in corporate securities. To illustrate, unpublished price sensitive information (“UPSI”) has been defined under Regulation 2(1) (n) of the Insider Trading Regulations as:
“unpublished price sensitive information” means any information, relating to a company or its securities, directly or indirectly, that is not generally available which upon becoming generally available, is likely to materially affect the price of the securities…”
[Emphasis added]
The relevant operative provision to the facts at hand, namely regulation 4(1) of the said Regulations reads: “no insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information.” It is also relevant to note that “insider” under the regulations means any person who is: (a) a connected person (in relation to a company); or (b) in possession of or having access to UPSI. On this, there can be two possible interpretations. First, that X’s trade on the facts stated above would fall under Regulation 4(1) as he possessed UPSI and, being an insider, he traded in securities (steel futures) when in possession of such UPSI. Second, that X’s trades do not fall under the scope of Regulation 4(1) because: (1) he is not an “insider” for the purposes of steel futures, since his connection to Y Corporation as an employee of Y Corporation would not be relevant to his trade in commodities; and (2) the information that he possessed is not UPSI under the Insider Trading Regulations because UPSI can only be an information relating to a company or its securities that can affect the prices of the company’s securities only (and not that of commodities). Further, section 15G of the SEBI Act also prescribes punishment for dealing in “securities of a body corporate” on the basis of UPSI.
In the absence of specific norms, investor protection is left to the overbroad canons of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market) Regulations, 2003 “the “PFUTP Regulations”).
Insider Trading in Commodities Market: An Existential Debate
Arguments against
As mentioned above, insider trading as a concept has only been associated with corporate securities. Professor Andrew Verstein, in his paper on the same topic,[2] lists out the common arguments made against the application of insider trading regulations to commodities:
1. Any information influencing commodities price is inherently public: For instance, if the monsoon fails, it would be common knowledge that harvest of a given commodity may be affected.
2. It is also argued that in commodities, no fiduciary duty is owed to anybody; there are no shareholders to betray. This is to say, X, in the abovementioned proposition did not owe a fiduciary duty to steel as a commodity, because it is inconceivable that steel can have an insider.
3. It has also been argued that commodities market participants would rationally prefer a regime of unlimited trading, given their sophistication and the need to hedge. This argument does not hold well in India because the basic intent of the Central Government for merger of the Forward Markets Commission with SEBI was to invite wider participants of end users-farmers, manufacturers, promoters, etc. within the overall framework.
Arguments for
On the other hand, it is not a stretch to imagine scenarios where exclusive nonpublic information, obtained by a person due to his unique position, can be abused. Consider the following:
1. Knowledge of government research or decision-making can give a trading advantage on non-public information. For instance, In India, the Commission for Agricultural Costs and Prices determines the minimum support prices of agricultural commodities, which certainly has a bearing on prices of their contracts on exchange platform. If one gets access to its report before it is made public, one gets an informational advantage over other participants.[3]
2. Financial Benchmarks providers and their tippees know important data long before the public does. These summary statistics are of enormous importance in all markets, but they are particularly meaningful in commodities markets.[4] Producers of benchmarks know before the market what the benchmark will report, and they can trade on this information or sell it to those who will.
3. Multi-national conglomerates gain informational advantage that are not available to a solitary market analyst. For example, when a bank is a large shareholder of a commodity-related enterprise, the bank could gain special information from its board seats,[5] e.g. Goldman Sachs.[6]
The Law Regulating Insider Trading in Commodities in Other Jurisdictions
Western jurisdictions seem to be waking up to the reality of unfair trading practices in commodities derivatives amidst popular denial. It is pertinent to observe the legal developments in European Union and United States.
European Union
The European Union (“EU”) was the first to introduce regulations prohibiting insider trading in commodities in the form of wholesale energy market integrity and transparency (REMIT), in 2011.[7] The latest Market Abuse Regulation[8] in the EU clearly proscribes insider trading[9] and read with articles 7 and 8, includes insider trading in commodity derivatives as well. The policy statement attached to the Regulation states: “Inside information in relation to a derivative of a commodity should be defined as information which both meets the general definition of inside information in relation to financial markets and which is required to be made public in accordance with legal or regulatory provisions at the Union or national level, market rules, contracts or customs on the relevant commodity derivative or spot market”.
USA
While, the case of Texas Gulf Sulphur[10] set the hardline approach against insider trading in securities with the pronouncement of the “equal access theory”, no such need was felt to regulate same in commodities derivatives. In fact, apart from some restrictions on government and exchange officials,[11] the Commodity Futures Trading Commission (“CFTC”) actively resisted any effort to introduce insider trading regulations in commodity derivatives.[12] But, the change in policy stance is apparent especially after financial crisis of 2008.
The Dodd-Frank Wall Street Reform and Consumer Protection Act,[13] signed into law in 2010, amended the Commodity Exchange Act and strengthened several aspects of the CFTC regulatory and enforcement powers. With respect to insider trading, the Dodd-Frank Act (i) granted the CFTC authority to promulgate such “rules and regulations as … are reasonably necessary to prohibit … [any] trading practice that is disruptive of fair and equitable trading”[14] and, (ii) made it unlawful to violate the CFTC anti-manipulation and antifraud regulations.
The CFTC subsequently promulgated a new Rule 180.1 that significantly expanded the scope of its anti-manipulation regulations. Rule 180.1 is expressly modeled on Rule 10b-5 under the Securities Exchange Act of 1934, which is the foundation of many insider trading actions in the securities markets. The CFTC views Rule 180.1, like Rule 10b-5, as prohibiting “trading on the basis of material nonpublic information in breach of a pre-existing duty (established by another law or rule, agreement, understanding or some other source) and trading on the basis of material nonpublic information that was obtained through fraud or deception”.
To date, the CFTC has secured two settlements in insider trading actions brought under Rule 180.1, In re Motazedi and In re Ruggles, both of which involved allegations of employees trading for personal accounts on the basis of their respective employers’ proprietary and confidential trading and portfolio information.
Conclusion
In August 2017, SEBI constituted the Committee on Fair Market Conduct under the Chairmanship of TK Vishwanathan that recently submitted its report reviewing and suggesting changes to the existing anti-fraud and insider trading regulations. However, the Committee failed to address the absurdity arising out of application of the Insider Trading Regulations to securities like commodities, currency derivatives, unlisted equity shares, etc. On this, Professor Sandeep Parekh suggests that the Regulations should have limited applicability over listed equity, their traded derivatives, and in some narrow circumstances listed debt securities.[15] He suggests that mischief in other securities would be covered by anti-fraud law of SEBI. However, such an approach would continue to absolve market participants like X of any liability, since his trade is neither insider trading nor fraudulent.
– Peeyush Agarwal & Zarnaab Aswad
[1] See, Matt Levine, Lending Money to Bet on Default: Also Commodities Insider Trading, Tesla and Lottery Tickets, Bloomberg, June 12, 2018; SEC v. Texas Global Sulphur, 401 F.2d 833 (2d Cir. 1968).
[2] Verstein, Andrew, Insider Trading in Commodities Markets, 102 Virginia L.R. 447 (2016).
[3] See, Eddie Murphy Rule of the US Commodity Futures Trading Commission.
[4] Andrew Verstein, Benchmark Manipulation, 56 B.C. L. Rev. 215 (2015).
[5] Permanent Subcommittee on Investigation, Wall Street Bank Involvement with Physical Commodities, U.S. Senate (Nov. 20-21, 2014) at 144.
[6] Marcus Stanley, The Goldman Sachs Guide to Manipulating Commodities, US News, July 24, 2013.
[7] Maytaal Angel, Emma Farge, EU Close to Agreeing Rules for Insider Trading in Commodities, Reuters, June 14, 2013.
[8] Regulation (EU) No. 596/2014.
[9] Market Abuse Regulation, art. 14.
[10] SEC v. Texas Gulf Sulphur Company, 401 F.2d 833 (2d Cir. 1968).
[11] Barring Insider Trading by Members of CFTC and their Staff, 7 U.S.C. § 13(c), (2012).
[12] Andrew Verstein, note 2 above.
[13] Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), Pub. L. No. 111-2031, § 753, 124 Stat. 1376 (2010).
[14] Commodity Exchanges, Prohibited Transactions, 7 U.S.C. § 6c(a)(6) (2018).
[15] Sandeeep Parekh, Fraud, Manipulation and Insider Trading in Indian Securities Market (Wolters Kluwer, 2016).
