Table of Contents

Introduction................................................................................................................ 2
Background and Thesis........................................................................................... 3
Literature Review.................................................................................................... 4
Scope of Study........................................................................................................ 5
Methodology............................................................................................................... 5
The Securities and Exchange Board of India (SEBI).................................................6
Some prominent insider trading cases In the India Market.....................................8
Hindustan Lever Limiteds purchase of 8 lakh shares of Brooke Bond Lipton India
Limited................................................................................................................. 8
Palred Technologies Limited...............................................................................10
Conclusion................................................................................................................ 12
Limitations and further research.............................................................................. 13
References................................................................................................................ 13

Introduction
To understand the effect of insider trading on the stock market, we need to first
understand who is an insider, what is stock market volatility and what is insider
trading? Insiders are corporate officers, directors, shareholders owning more than
ten percent and any person having access to or receiving information of a nonpublic
nature on which trading is based for a public company. The United States
government helps facilitate fair-trading through the regulations of the Security
Exchange Commission (SEC), and the implementation of the Securities and
Exchange Acts of 1933 and 1934. The SEC requires every person to file a form
(Form 3) when the individual becomes an insider. Form 3 is the initial statement of
ownership showing all holdings and must be filed immediately upon having insider
status, even if no shares are owned initially. This form verifies the person has
become an insider. Once a person has become an insider, each change of share
ownership must be filed using the SEC Form 4. Form 4 indicates when an insider
has bought or sold shares of their companys stock. Insiders must file electronically
via EDGAR (an electronic filing system used by the SEC at the SEC website) within
two business days of each transaction. Although there is a lag time of two days, this
lag time is more efficient than the old rule stating insiders had until the tenth day of
the following month to file. Information on who is considered an insider is public
information and is available on the SEC website. Insiders are barred from buying
then selling, or vice versa, their stock within a six month period. This rule helps
prevent illegal insider trading from occurring.
Simply put, stock market volatility is when the stock market goes up one day, and
then goes down the next three, then up again, and then down again. A great
example is when car insurance premiums go up along with the likelihood of risky
situations, like a poor driving record. Stock market volatility is a polite way of
referring to investors nervousness who may think volatility indicates a problem, but
to many analysts increased volatility can indicate a rebound. Lee, Jiang, and Indro
(2002) test the impact of noise trader risk on stock market volatility and excess
returns. Using the Investors Intelligence sentiment index, they find that volatility

increases or decreases when investors become more bearish or bullish, hence

supporting the theory of the effects of investors on stock market volatility.
Jennifer Moores article (1990) defines insider trading as the buying or selling of
securities on the basis of material, non-public information and it is popularly
believed to be unethical and illegal. Essentially, insider trading involves the
deliberate exploitation of unpublished piece of sensitive information obtained
through or from a privileged relationship to make profit or avoid loss by dealing in
securities of a company when the prices of securities would be materially altered if
the information were disclosed. To most people, it seems rather unfair that some
speculators are able to make profits at the expense of others who just happen to
know less about any assets in question. A situation quite similar to the attitude
towards insider trading is that of a car dealership selling used cars without
disclosing the past recalls or accidents of their used cars to its buyers. Although,
there are significant economic differences between the used car market and the
financial market, the idea of fairness and unethical is the same. Apart from the
fairness principle, insider trading is assumed to be acceptable as long as the
information obtained is opened to everyone and only if there is a no breach of
fiduciary duty or a breach of trust and confidence (Dennert, 1991).

Background and Thesis

There has been much argument over the possibility that insider trading could
influence the volatility of the stock market. It is quite known that insider trading is
very common and there is a substantial demand for it in most firms. According to an
article by Josef Lakonioshok and Immo lee (2001), in more than half of the sample
firms they researched, there is at least some form of insider activity in a given year.
In theory, it has been shown that insider trading is likely to have two contrasting
effects on the stock market. On one hand, insider trading may convey insiders
private information to outside investors (Lakonishok and Lee, 2001) and on the
other hand, corporate insiders will have the ability to gain from insider trading
which may in turn induce them to either manipulate or delay value-relevant
information to maintain their informational advantage over outside investors
(Narayannan, 2000; Cheng and Lo, 2006). More recently, Du and Wei (Du and
Wei)have revised the relationship between market volatility and insider trading for a

large list of countries whose data on insider trading is available at the Morgan
Stanley Capital International database. The results of their study suggested that it is
indeed important. The following year, Gerlach (2005) reviewed imperfect
information as the cause of stock market volatility. He concluded that imperfect
information about the growth rate of an asset can produce excess volatility in which
market returns are more volatile than the corresponding full-information asset
returns. In other words, when investors see a change in the dividend growth rate,
they then tend to quickly conclude that the mean growth rate has changed and
their overreaction creates more volatility in the prices than in the underlying
dividend series.
With that in mind, the purpose of this report is to review how these two coincide,
the role of insider trading in explaining the stock market volatility. To do this, we first
consider major factors, like those listed above, other than insider trading that could
also be potential explanations for market volatility, and then proceed for further
analysis.

Literature Review
Petri Kyrlinen (2008) research focuses particularly on the relation between day
trading and stock price volatility from the point of view of individual investors. He
attempt to achieve a more complete picture of the relation between day trading and
volatility, analyzing the trading records of the most important institutional Finnish
investors from both financial and non-financial firms. Kyrlinen also spends time
attempting to answer the question if high share of individual investors day trade
volume are good candidates for high noise-trading stocks and are they a probable
cause for market volatility over information flow? After using a few variables, his
results are conclusive supporting his theory and other previously conducted similar
studies that day training impacts market volatility and noise trading has an effect
on market volatility over informative institutional trades.
In another research examining other factors impacting market volatility, Hasslers
examines the correlation between foreign influence and stock market volatility using
Swedish stock market. His study compares the influence of domestic versus
international news process on the stock market, looking deeply into if greater
international market interdependence may increase or decrease stock market

volatility in a particular country. Using Hamilton regime switching model, Hassler

(1999) is able to show clear evidence of increasing Swedish sensitivity to news from
the world stock market and a positive and significant indication that the foreign
influence is substantially larger during international high volatility period.
Lee, Jiang and Indro (2002) in their research article explain the impact that noise
traders or the sentiments of investors have on the conditional volatility of stock
market prices and the expected assets returns. They discuss the relationship
between market volatility, excess returns, and investor sentiment for three different
market indices, the Dow Jones Industrial Average (DJIA), the Standard and Poors
500 (S&P500) and the NASDAQ, from the beginning of 1973 through October 6,
1995.The authors also utilized the widely publicized Investors Intelligence of New
Rochelle which helped measure investors sentiments and barometer to measure the
temperament of individual investors. The results to their study concluded that
indeed investors sentiments play a significant role in the conditional volatility of the
market and also in explaining the equity on excess returns.

Scope of Study
It has also been argued that allowing insider trading would help mitigate the agency
problem between the management and the shareholders of a company (Padilla,
2002). Agency problem arises when the interests of managers and shareholders are
widely different and managers are driven to act by their own self-interest instead of
the best interests of the shareholders. Shareholders can practice insider trading and
benefit from the same, thereby mitigating agency problems, and increasing the
value of the firm. Also, insider trading is argued to improve informational efficiency
of markets by contributing to the existing information set held by investors (Clacher,
Iain et al., 2009). In this view, insider trading helps in reducing market volatility by
signaling the market to confirm or contradict the information available to the public.
Also, it can be argued that though insider trading may temporarily increase market
volatility in order to correct the price in the market, in the long run it does reduce
the market volatility. The positive effects of insider trading have not been proven so
far, while the negative effects of reducing investor confidence have indeed been
proven and in fact have been experienced by the public at large in number of illegal
insider trading cases.

Methodology
Several studies have had different conclusion about insider trading. Though a
majority of these studies concluded that insider trading does indeed result from
insiders and those who have access to inside information benefiting by abnormally
high returns, some recent studies have contradicted that the same is not possible.
Hence, the debate is still on, on this controversial topic. So far, most of the research
on insider trading has been done in developed markets, especially United States of
America, United Kingdom and parts of Europe. Since a detailed analysis of insider
trading has not yet been performed in most under developed markets, such as,
India. This report shall cover insider trading and its effects on Indian market and the
current regulations in place by the regulatory authority, Securities and Exchange
Board of India (SEBI)

The Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India (Prohibition of Insider Trading)
Regulation Act was introduced in 1992. Later on, the Act went under a series of
minor amendments in the years 2002, 2003, 2008, 2009 and 2011. SEBI defines an
insider as any person who is, or was, connected with the company, and who is
reasonably expected to have access, by virtue of such connection, to unpublished
price-sensitive information. The Act clearly prohibits insider trading of any sort. It
specifies that insiders shall not themselves trade nor on behalf of another person,
based on unpublished price sensitive information, nor shall they communicate or
counsel other parties about any unpublished price sensitive information. The
company should be able to defend itself and prove that it is not liable for obligation
of any sort under certain special circumstances or else it would be charged guilty of
insider trading. The Board also has the authority to appoint a qualified auditor, in
the event it suspects insider trading within a company, to investigate into the books
of the company. A compliance officer of senior level has to be appointed by every
company, who reports to the Chief Executive Officer (CEO) of the company. He is
responsible for preserving the price sensitive information until it is made public,
setting rules and procedures in line with SEBI regulations, and monitoring the same.

He should also be familiar with SEBI regulations in order to assist all the concerned
employees within the organization. SEBI also clearly specifies what kind of
information is to be classified as price sensitive information. According to the Act,
the following shall be deemed to be price sensitive information:

periodical financial results of the company;

intended declaration of dividends (both interim and final);
issue of securities or buy-back of securities;
any major expansion plans or execution of new projects;
amalgamation, mergers or takeovers;
disposal of the whole or substantial part of the undertaking;
any significant changes in policies, plans or operations of the company.

There are certain mandatory disclosures to be done as per the Act. SEBI has
formulated a code of internal procedures and conduct to prevent insider trading.
Any person who holds more than five percent shares or voting rights in any listed
company, the number of shares or voting rights will be held by that person, within
two working days of becoming the holder. There are many other disclosure clauses
that follow the above clause including that of disclosure to the stock exchanges, in
which the company is listed. Since Stock Exchange is where majority of trading is
done on a daily basis, and the network of the Stock Exchanges is usually the largest,
this serves the purpose well. These amendments do bring more transparency and
convenience to all investors including that of insiders. Disclosure of information may
be done through various media, so as to achieve maximum reach and quick
dissemination. Company websites may provide a means of giving investors direct
access to analyst briefing material, significant background information, and
questions and answers. Amendments to the act have been made with regards to
disclosure to facilitate faster flow of price sensitive information to the public
whenever necessary, in order to reduce the time gap between the same being
known only to the insiders and being known to the general public. These disclosures
would indeed ensure better market response and hence would reduce the chances
of insiders gaining abnormal returns. The compliance officer has to oversee and
coordinate the disclosure process. The companies should also have to respond to
market rumors accordingly, and disclose or confirm the correct information to the
public to prevent possible frauds. A snapshot of the Bombay Stock Exchange

disclosure (BSE) in the BSE website in the path Home->Corporates->Corporate and

Other Info-> Disclosures->Insider Trading 2015 is shown below.

One more important policy that SEBI has formulated is the Chinese Wall policy.
This policy has been incorporated in order to prevent the misuse of confidential
information. As per the act, all companies have to follow this policy. The policy
separates those areas of the organization which routinely have access to
confidential information, considered inside areas from those areas which deal with
sales/marketing/investment advice or other departments providing support
services, considered public areas. According to this policy, the insiders shall not
communicate any price sensitive information to anyone in the public area on the
other side except under specific circumstances when absolutely necessary under
intimation to the compliance officer. A more noteworthy point is that all rules are
being adhered to by the companies and individual insiders. A proof to this is that
companies had approached SEBI with various doubts regarding subsequent
amendments to the act in 2008, to which SEBI released a clarification document in
2009, citing practical yet simple examples. (All Acts can be located on SEBIs
website)

Some prominent insider trading cases In the India Market

Hindustan Lever Limiteds purchase of 8 lakh shares of Brooke Bond
Lipton India Limited
This case of insider trading controversy involves Hindustan Lever Limiteds (HLLs)
purchasing eight lakh shares of Brooke Bond Lipton India Limited (BBLIL) two weeks
prior to the public announcement of the merger of the two companies (HLL and
BBLIL) in March 1996. SEBI, suspecting insider trading, conducted enquiries, and
after about fifteen months, in August 1997, SEBI issued a show cause notice to the
Chairman, all Executive Directors, the Company Secretary and the then Chairman of
HLL. In March 1998, SEBI issued an order charging HLL with insider trading. SEBI
directed HLL to pay the Unit Trust of India (UTI) compensation, and also initiated
criminal proceedings against the five common directors of HLL and BBLIL. Later HLL
filed an appeal with the appellate authority, which ruled in its favor.
Background of the case:
The SEBIs charges arose from HLLs purchase of 8 lakh shares of BBLIL from the UTI
at Rs 350.4 per share prior to the announcement of HLL-BBLIL merger on April 19,
1996. A day after the announcement of the merger, the BBLIL scrip quoted at Rs
405, thereby leading to a notional gain of Rs 4.4 crore for HLL, which then cancelled
the shares bought. According to SEBIs Section 2(e) (insider trading) Regulations,
HLL is an insider in this situation by their definition, thus SEBI argues that insider
trading was committed when HLL bought the BBLIL shares from the UTI. Since HLL
and BBLIL had a common parent company (Unilever) as subsidiaries of the Londonbased $33.52-billion and were then under a common management. Thus, HLL and
its directors had prior knowledge of the merger agreeing that both HLL and BBLIL
are deemed to be under the same management even under Section 370 (1) (b) of
the Companies Act, 1956. HHL argues to this point stating, the transnational
knowledge of the merger was because it was a primary party to the process, and
not because BBLIL was an associate company and maintains that if it had purchased
shares of Tata Oil Mills Co. (TOMCO) before the two merged in April, 1994, SEBI
would not consider it a case of insider trading. (HLL was not associated with the
Tata-owned TOMCO). HLL contends that it purchased the BBLIL shares so that its
parent company, Unilever, could maintain a fifty one percent stake in the merged

entity. Before the merger, Unilever had a fifty one percent stake in HLL, but only fifty
percent in BBLIL. Thus, the HLL management feels that the SEBI should consider if it
had any additional information which it should not, legitimately, have had as a
transferee company in the merger.
HLL purchased the BBLIL shares on the basis of unpublished price-sensitive
information which is prohibited under Section 3 of the Regulations. Section 2 (k) (v)
states that unpublished, price-sensitive information relates to the following matters,
amalgamations, mergers, and takeovers, or is of concern to a company and is not
generally known or published. Only the information about the swap ratio is deemed
to be price-sensitive. And this ratio was not known to HLL or its directors when the
BBLIL shares were purchased in March, 1996. Moreover, HLL argues that the news
of the merger was not price-sensitive as it had been announced by the media before
the companys announcement. HLL points out that it was a case of a merger
between two companies in the group, which had a common pool of management
and similar distribution systems. Therefore, the merger information in itself had
little relevance; the only thing that was price-sensitive was the swap ratio.
In SEBIs charge sheet, HLL did not follow the route of issuing preferential shares to
allow Unilevers stake to rise to fifty one perent in HLL. This step would have
involved various compliances or clearances, and required Unilever to bring in
substantial funds in foreign exchange. Thus implying HLL depleted its reserves to
ensure that Unilever did not have to bring in additional funds. Had HLL followed this
route, it would have had to pay Rs 282.4, instead of Rs 350.4, per share. In other
words, it would have made a profit of Rs 5.41 crore by doing so. HLL states that
while the preferential route would have been beneficial for itself, it would have
diluted shares for other shareholders and resulted in an expanded capital base,
leading to lower earnings per share in the future. HLL was probably worried that the
clearances for a preferential allotment from the SEBI and the Reserve Bank of India
(RBI) would take their time in coming or not be given at all. It had already faced a
time consuming and expensive run in with the RBI during the HLL-TOMCO merger in
1994.
As a result, HLL was found guilty of insider trading and violating the law. Interesting
fact to note is whether the intent behind such a trade is considered by the

regulators. SEBI is not concerned with the purpose behind the transaction. While
some jurisdictions do take notice of the intent of the transaction there is nothing in
the Indian regulation that would require SEBI to take notice of the intent. Therefore
HLLs contention that the shares were purchased for the specific purpose of
cancellation would not hold water. Regulatory agencies, such as 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.
From this case, it is clear that HLL wanted to transfer majority holding in BBLIL in
the most inexpensive way by identifying a loophole in the then prevailing law. And
needless to say, they would have got away with it, had it not been for SEBI to
identify the above stated violations and laws the company had breached. It would
clearly have swayed the confidence level of the outside investors who had sold their
stake in BBLIL, as well as the general public at large, who did not have critical
information regarding the proposed merger, which was to happen two weeks down
the line.
Palred Technologies Limited
SEBI conducted an investigation into the scrip of Palred Technologies Limited (PTL)
from September 18th 2012 to November 30th 2013 (investigation period), to
ascertain the possible violation of the provisions of the SEBI Act and the SEBI
(insider trading) Regulations. The investigation alleged that Mr. Palem Srikanth
Reddy, who is also the Chairman and Managing Director (CMD) of PLL, Mr. Parani
Amyn Abdul Aziz, Mr. Ameen Khwaja and other parties (mainly accused family
members) had traded in the scrip of PTL during the investigation period, while in
possession of price sensitive information. The investigation revealed that Mr. Palem
Reddy had communicated or counselled, directly or indirectly the unpublished price
sensitive information (UPSI) to one, Mr. Ameen Khwaja, his relative, Ms. Kukati
Parvathy, and others.
Background of the case
Mr Palem Reddy and Mr. Ameen Khwaja were the common directors of one Premium
Online Media Pvt. Limited (Pal). During September 2011 and May 2013, (during the
UPSI period) It was found that Pal had provided services relating to search engine

to PTL. Further, after the slump sale of business by PTL to Kewill group,
discussions pertaining to the merger of Pal with PTL had begun on December 19 th
2013, which later got approved by the board of directors of the company. In view of
the same, Mr. Ameen Khwaja is also alleged to be and insider and connected
person according to the SEBI Regulations 2(e) and (c). Mr. Khwaja appears to have
not traded in the scrip of PT during the period of investigation, but his immediate
family members were found to be trading in the scrip of PTL during the UPSI period
as well. The trading patterns of Khwaja groupd was found to be in clear deviation
from their established trading pattern, raising red flags.
Mr. Parani Amyn Abdul Aziz is also found to be connected to Mr. Khwaja through
mutual friends on Facebook. He was employed with Deloitte Tax Services India Pvt.
Limited, a Company which had conducted its due diligence of PTL during the slump
sale. During the course of investigation, Mr. Parani Aziz failed to reply to the specific
details, as sought by SEBI. His trading patterns were found in deviation from the
established trading pattern. It was found that he had transacted only in the scrip of
Cummins India Limited for a quantity of only three shares for a consideration if
1,330 lakh, which he had purchased and sold during July 2013. Later, he did not
trade in any other scrip since April 2011 except that of investing about 5lakh in PTL
shares from June 2013 onwards. The proportion of his investment in PTL shares
when considered in relation to his income and that too in scrip which was not
frequently traded (during the relevant period), is not commensurate with the usual
investment behavior. On June 25th 2013, he had opened his trading accounts with
HDFC Securities Limited one day prior to his trading in the scrip of PTL. Furthermore,
an analysis of his bank records showed that he had received a series of cash
deposits, prior to each payment to his broker for transacting in the shares of PTL.
Mr. Aziz did not provide the source of each cash deposit raising serious suspicions.
Considering the facts and circumstances of the case, the balance of convenience
lies in favor of SEBI. SEBI has ordered impounding of unlawful gains of over Rs 2
crore from the 15 individuals involved. Below is a snapshot of profit/losses incurred
by the suspected entities during the trading in PTL

In this case, the trading pattern facilitate the investigative case of SEBI, making it
easy for them to pinpoint insider trading, and the fact that multiple family members
were used in this situation made the case obvious. Seen from the figure above, their
trading pattern did have an effect on market volatility and had they had somewhat
of a random trading pattern, the accused parties could have gotten away with the
crime. This case also helps support Cheng and Lo (2006) study that corporate
insiders will have the ability to gain from insider trading which may in turn induce
them to either manipulate or delay value-relevant information to maintain their
informational advantage over outside investors and profit from that information.

Conclusion
Based on previous research conducted in the United State of America, United
Kingdom, and other parts in Europe, it is clear that the United States of America law
or other developed countries are indeed stringent and efficient in bringing the guilty
to justice. Under the presence of such a strong system, investors would definitely
have sufficient confidence to continue trading in the market, hence consequently
reducing market volatility significantly. A perfect example will be the crackdown of
the case on Rajat Gupta for insider trading in the US, has been considered as a

victory for the U.S. Government. While in India, SEBI has been able to crack only a
handful of cases, mainly the big ones. There are not as many insider trading cases
in the India Market as in most more developed markets so one cannot really
conclude as to whether insider trading is rampant in the Indian market, nor can it be
said that SEBI has been completely successful in curbing insider trading.
Nonetheless, the regulations in India over the years have been modified, making
them more stringent, and easy to be implemented and monitored especially after
HLLs case. In an emerging market setting, several factors come into play as cited in
various reports, one of them being the perception of the traders in the market.
Whether they think insider trading is common in the countrys market, and how
much confidence do they have in adjusting to insider trading cases and how much
confidence do they have in the system. For a proper measure of insider trading and
assessing the factors affecting stock market volatility, such qualitative aspects have
to be quantified as Du and Wei (2004)have carried out their research through a
survey, across a country (if not across the globe), and analyzed. Other important
factors like the size of firms and capacity of insiders (Cheng and Lo, 2006) also are
important in an emerging economy where firms and individuals have a wide range
of sizes/capacity to trade. Frino A., Satchell S., and Wong, B (2013) have observed
that the increase in illegal insider trading for increase in certain amount of abnormal
return is less than the corresponding decrease in illegal insider trading for increase
in the same amount of penalty imposed if found guilty. Thus, predicting that more
stringent laws indeed prove to be more effective even with increase in abnormal
profits of the same quantifiable magnitude. Hence, insider trading does affect
market volatility, negatively in most of the cases as it deteriorates investors
confidence (at least as far as an emerging economy market is concerned where the
market is still immature, prices take time to adjust to information flow, and factors
like speculation also sometimes result in high market volatility); but the same
cannot be quantified due to the following limitations of the report.

Limitations and further research

The limitation of this research is that since most of the factors affecting market
volatility cannot be easily quantified, the report is completely qualitative in its

approach. Further research can be carried out by attempting to quantify certain

important variables and arriving at a concrete result.

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