Insider Trading: Evolving a New Standard of Proof

[Shruti Rajan is a Partner at Trilegal. With research assistance from Vidhi Shah, Associate, Trilegal]

A lot has been said (including in this Blog) on the recent Supreme Court decision in the matter involving PC Jewellers (Balram Garg v. Securities and Exchange Board of India, 19 April 2022), where the Court has recast the standard operating protocol used by the Securities and Exchange Board of India (SEBI) to detect and penalise insider trading and market fraud. The case at hand involved trades by relatives of the chairman and managing director of a listed company, PC Jewellers Limited. The allegation was that those who traded in shares of PC Jewellers did so while in possession of unpublished price sensitive information regarding a potential buyback. After SEBI’s stance was upheld by the Securities Appellate Tribunal (SAT), the parties approached the Supreme Court to decide on two key questions of law – one, whether the traders could be presumed to have been tipped off by the chairman and managing director of the company, despite a family separation and estrangement and, second, whether SEBI could prove a tipper-tippee relationship merely on circumstantial evidence. 

While adjudicating on the merits, Justice Saran evolved two principles that have been discussed at length over the past few weeks. SEBI must now gather more evidence while bringing charges of insider trading; mere reliance on “pattern and timing of trades” is not sufficient to discharge its burden of proof. The Supreme Court also holds that frequent communication between persons cannot be presumed and that SEBI cannot rely on the trading pattern alone to demonstrate the same; the record must speak to other circumstances and “produce cogent materials” that can establish possible communication between the tipper and tipper. In doing so, the Court mandates that the SAT must review facts de novo and not rely on SEBI’s factual assessment alone.

Now, herein lies the rub. The tipper-tipper relationship is somewhat of an eternal quandary for enforcement agencies across the world. Proving the passing of information is a critical cog to any insider trading investigation involving multiple parties and there is no perfect way to do so. Direct evidence is almost impossible to procure (especially when the digital age allows for multiple, encrypted modes) and regulators world over rely on fact patterns to glean inferences of market misconduct. Reliance must often (and necessarily) be placed on surrounding circumstances where the occurrence of the trade itself is supported by laying a mosaic and piecing together surrounding facts. The resultant picture that then emerges helps the regulator detect and isolate a possible illegal act.

Of late, SEBI is not the only regulator to be scrutinised in a courtroom for the evidentiary standards deployed in insider trading convictions. The US Securities Exchange Commission (SEC) in the recent case of SEC vs Clark faced a mid-trial dismissal of an insider trading investigation when the court held that the agency failed to present sufficient evidence to prove insider trading. This case involved trades by Clark, allegedly based on tips received from his brother-in-law. To prove this, the SEC brought on record his trading pattern, the repeated communication between the two “in person, phone and on text” as well as evidence that showed their efforts to raise cash in advance of buy trades. Despite this, the US District Judge dismissed the SEC’s case without written reasons even before the defence presented its case, concluding that the SEC had not created a strong evidentiary record and failed to meet its burden of proof. Somewhat similar to Indian jurisprudence on this point, the US court believed that mere familial relationship was not enough to presume communication.

Canada has also seen some interesting jurisprudence develop on this over the past year, with courts challenging circumstantial inferences drawn by the Securities Commission. The 2019 Ontario Securities Commission order in the Matter of Donna Hutchison and Ors makes for a compelling read on this subject. In its order, the Commission emphasizes that circumstantial data fills the “evidentiary gap” often found in insider trading investigations, but inferences should always be “reasonably and logically drawn” from the “combined weight of the evidence”. Given the serious consequences that accompany findings of insider trading, it advocates that the standard of “clear and cogent evidence” must be preserved and that the “judicial test of truth” lies in understanding facts and harmonizing the preponderance of probabilities.

But how does reality stack up against these legal principles and how do regulators sustain insider trading charges in a judicial environment that demands more? Should the decree of law reconcile with the nature of the beast? Practically, the question being asked is what more the regulator can do to meet the yardstick exacted by this case. A quick comparison of the standard of review followed by regulators from different jurisdictions indicates that they all, by and large, follow the same investigative strategy of weaving a pattern of circumstances through timing of trades, calls, emails, funding trails, and the like, to indicate market misconduct. It is a common misconception that the SEC readily gets wire-tap access for every insider trading investigation. It can, of course, obtain access to wire taps but, given the provisions of the US Wiretap Act, such records are primarily used only in criminal market fraud prosecution by the Department of Justice. Here, one would recall the multiple court battles back in 2010 during the Rajaratnam/Galleon case, to allow SEC access to wiretap records.

To say that the PC Jewellers order cripples SEBI’s ability to investigate insider trading is somewhat of an exaggeration and the lingering uncertainty around the efficacy of the regulator’s powers is unwarranted too. But the Supreme Court’s observations do mean that investigations will now take a bit more work. Without entirely dispensing with the use of circumstantial evidence and preponderance of probability, the Supreme Court questions the quality of the body of evidence brought before it (keeping in mind the specific facts) in order to assess if it all stacks up well enough. What this means is that, in its investigations, SEBI will find it difficult to rely on that solitary phone call or meeting, but will still be able to successfully mount charges where an established pattern or series of trades coupled with proximate association can be proven through financial transactions, social interactions, and similar aspects. Reducing the degree of remoteness in facts and minimising the series of presumptions that creep into every step of the evidentiary journey is also critical. The Supreme Court does not demand direct causation through this order, but SEBI will have to become less reliant on indirect associations and assumptions of communication, and bring on board data that displays convincing correlation.

This development gives SEBI the opportunity not only to re-think its investigative and prosecution strategy, but also its penalty imposition system. A large part of the conundrum today is that SEBI deploys an entire arsenal of tools in every single case, by levying market bans, disgorgement and monetary penalties.  This is not to say that smaller instances should go unpunished, but every case does not need a year-long trading ban or an interim order. Penalties should be cut to the size of the problem at hand, reserving a quiver full of arrows only for the instances where brazen and repetitive disregard for the law is observed. Today’s practice of steep penalties, impounding and interim action are also the reasons why courts are so keen to cast such meticulous levels of evidentiary persuasion upon regulators.

Shruti Rajan

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