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Insider Trading in India

Ayan Roy1 INTRODUCTION Insider trading occurs when a corporate insider trades on information before it is disclosed to the general public.2 It is generally thought that such trading gives a premium to the insider that comes from the losses of the general public.3 But because the generic investor tends to be bullish, and the premium causes the information to come to the market sooner, some argue that nothing is wrong with the insider receiving a premium.4 However, financial markets for the most part depend on the investment of the general public, who expect that it will be done on a level playing field with others in the market.5 Without this faith in the market, many investors would not invest.6 It was only about three decades back that insider trading was recognized in many developed countries as what it was - an injustice; in fact, a crime against shareholders and markets in general. At one time, not so far in the past, inside information and its use for personal profits was regarded as a perk of office and a benefit of having reached a high stage in life. It was the Sunday Times of UK that coined the classic phrase in 1973 to describe this sentiment "the crime of being something in the city", meaning that insider trading was believed as legitimate at one time and a law against insider trading was like a law against high achievement. "Insider trading" is a term subject to many definitions and connotations and it encompasses both legal and prohibited activity. Insider trading takes place legally every day, when corporate insiders officers, directors or employees buy or sell stock in their own companies within the confines of company policy and the regulations governing this trading. It is the trading that takes place when those privileged with confidential information about important events use the special advantage of that knowledge to reap profits or avoid losses on the stock market, to the detriment

1 2

The student is a 5th year of School of Law, KIIT University See Twentieth Century Fund, The Security Markets 14 (1935). 3 Ibid 4 Ibid 5 Ibid 6 See Robert C. Rosen, The Myth of Self-Regulation or the Dangers of Securities Without Administration: The Indian Experience, 2 J. Comp. Corp. L. & Sec. Reg. 270-71 (1979) at p.286.

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of the source of the information and to the typical investors who buy or sell their stock without the advantage of "inside" information.

1. INSIDER & INSIDER TRADING DEFINED Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, does not directly define the term "insider trading". But it defines the terms "insider" or who is an "insider; who is a "connected person"; What are "price sensitive information". Obviously an insider, who has deep insight into the affairs of the corporate body and holding knowledge about "price sensitive information" relating to the performance of the corporate body that could have a decided impact on the movement of the price of its equity, is at a vantage position with regards to a prospective trading in the shares of the company to the detriment of the common investors. Taking this fact into account the Regulation prescribes several "do-s" and "don'ts" with reference to these "insiders". The effect of the regulatory measure is to prevent the insider trading in the shares of the company to earn an unjustified benefit for him and to the disadvantage of the bonafide common shareholders. According to the Regulations "insider" means any person who, is or was connected with the company or is deemed to have been connected with the company, and who is reasonably expected to have access, connection, to unpublished price sensitive information in respect of securities of a company, or who has received or has had access to such unpublished price sensitive information; The above definition in turn introduces a new term "connected person". The Regulation defines that a "connected person" means any person who-

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1. (i) is a director, as defined in clause (13) of section 2 of the Companies Act, 1956 (1 of 1956) of a company, or is deemed to be a director of that company by virtue of sub-clause (10) of section 307 of that Act or 2. (ii) occupies the position as an officer or an employee of the company or holds a position involving a professional or business relationship between himself and the company whether temporary or permanent and who may reasonably be expected to have an access to unpublished price sensitive information in relation to that company; WHY FORBID INSIDER TRADING? The prevention of insider trading is widely treated as an important function of securities regulation. In the United States, which has the most--studied financial markets of the world, regulators appear to devote significant resources to combat insider trading. This has led many observers in India to mechanically accept the notion that the prohibition of insider trading is an important function of SEBI. In most countries other than the US, government actions against insider trading are much more limited. Many countries pay lip service to the idea that insider trading must be prevented, while doing little by way of enforcement. In order to make sense of insider trading, we must go back to a basic understanding of markets, prices and the role of markets in the economy. The ideal securities market is one which does a good job of allocating capital in the economy. This function is enabled by market efficiency, the situation where the market price of each security accurately reflects the risk and return in its future. The primary function of regulation and policy is to foster market efficiency, hence we must evaluate the impact of insider trading upon market efficiency. Insider trading appears unfair, especially to speculators outside a company who face difficult competition in the form of inside traders. Individual speculators and fund managers alike face inferior returns when markets are more efficient owing to the actions of inside traders. This does not, in itself, imply that insider trading is harmful. Insider trading clearly hurts individual and institutional speculators, but the interests of the economy and the interests of these professional traders are not congruent. Indeed, inside traders competing with professional traders
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is not unlike foreign goods competing on the domestic market -- the economy at large benefits even though one class of economic agents suffers HISTORY BEHIND THE REGULATORY MECHANISM IN INDIA Insider trading in India was unhindered in its 125 year old stock market till about 1970. It was in the late 1970s this practice was recognized as unfair. In 1979, the Sachar committee said in its report that company employees like directors, auditors, company secretaries etc. may have some price sensitive information that could be used to manipulate stock prices which may cause financial misfortunes to the investing public. The company recommended amendments to the Companies Act, 1956 to restrict or prohibit the dealings of employees / insiders. Penalties were also suggested to prevent the insider trading. In 1986 the Patel committee recommended that the securities contracts (Regulations) Act, 1956 may be amended to make exchanges curb insider trading and unfair stock deals. It suggested heavy fines including imprisonment apart from refunding the profit made or the losses averted to the stock exchanges. In 1989 the Abid Hussain Committee recommended that the insider trading activities may be penalized by civil and criminal proceedings and also suggested that the SEBI formulate the regulations and governing codes to prevent unfair dealings. Following the recommendations by the committees, SEBI has, in exercise of the powers conferred on them by section 30 of the Securities and Exchange Board of India Act 1992, made regulations which are known as the Securities and Exchange Board of India (Insider Trading) Regulations 1992. This regulation of 1992 has prohibited this fraudulent practice and a person convicted of this offence is punishable under Section 24 and Section 15 G of the SEBI Act 1992. These regulations were drastically amended in 2002 and renamed as SEBI (Prohibition of Insider Trading) Regulations 1992. Both the Insider Trading Regulations are basically punitive in nature in the sense that they describe what constitutes insider trading and then seek to punish this act in various ways. More importantly, they have to be complied with by all listed companies; all

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market intermediaries (such as brokers) and all advisers (such as merchant bankers, professional firms, etc.). Until these regulations were framed there were no specific provisions in India for the offence of insider trading. Now, by virtue of the said regulations, definitions have been provided as to what is an ""insider", and dealing, communicating or counseling on matters relating to insider trading have been prohibited. Regulation 4 of the said Regulations makes any insider who deals in securities or communicates any information or counsels any persons dealing in securities in contravention of the provisions of the said Regulations a person guilty of insider trading who is liable to be punished with imprisonment for a term which may extend to one year or with a fine or with both under the provisions of section 24 of the Securities and Exchange Board of India Act 1992. In general these are the provisions in India as regards making a family business public and the consequent on-going compliance requirements. Many changes are required to the existing provisions of the Companies Act in India on account of recent liberalization. For the protection of the interests of minority shareholders, the laws governing companies are required to be changed. On October 15, 1996 Mr Ratan Tata, the Chairman of the Tata Group of Companies, announced that the Tatas would levy a charge on group companies for the use of the ""Tata" brand name. This is viewed very seriously and the government-controlled financial institutions who earlier would not have questioned this move of the Tatas have now decided to ascertain officially the details concerning the same from the Tatas and to move further in the matter. This move on the part of the Tatas is considered to be a questionable management practice. In November 1996, the government-controlled financial institutions also announced their decision to seek clarification and, if found necessary, to take remedial measures as regards the recent practice adopted by the family groups of companies in creating cross-holding between the holding company and other group companies. The government-controlled financial institutions have been directed by the Financial Secretary of the Government of India that the nominees of these institutions who are on the board of the company should no longer remain passive watchers. On October 16, 1996, in a meeting held in New Delhi between the Finance Secretary of the Government of India and the heads of the financial institutions, a decision was taken that
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the top 50 family-owned companies should be put on a special watch list and their managements should be monitored by a special task force of the financial institutions' nominees to ensure that they adhere to the norms of ethical corporate governance and that these companies do not compromise small shareholders' interests. A new Companies Act is now being drafted which would permit the formation of ""group resources companies". These group resources companies would enter into contracts with other group companies for lending management expertise for a fee. The proposed change in the new Companies Act is also expected to allow consolidation of accounts in the annual reports. The company which opted for consolidation would have to lift the veil of secrecy that usually surrounds the maze of inter-corporate holdings; because in opting for consolidation of accounts they would be required to declare the accounts of even the closely held companies in which major investments had been made. The Managing Agency System is also sought to be revived under the new Companies Act, though under a different name. The new Companies Act would try to check the areas of misuse under the old system, and it is likely that the group resource companies would be prohibited from charging the management fee linked to the profits of the company under their management. All these would definitely be disliked by the families, but changing times will compel them to comply. SEBI GUIDELINES ON INSIDER TRADING ARE PREVENTIVE IN NATURE The SEBI Act (Insider Trading) Regulations prohibit "insiders" from dealing in exchange-listed securities on his or another's behalf based on unpublished price sensitive information, communication of such information unless in the ordinary course of business, or counseling others based on that information.7 "Dealing in securities" means trading or agreeing to trade either as a principal or agent.8 Liability is not imposed on tippees, persons who have been given information by the insider.9 An "insider" is a person connected to a corporation, and is reasonably expected to have access to, has received, or has previously had access to unpublished price sensitive
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See The Gazette of India Part III (1992), Securities and Exchange Board of India (Insider Trading) Regulations, 1992, under 30 of the Securities and Exchange Board of India Act, 1992, Securities and Exchange Board of India, Bombay, 19 Nov. 1992. 8 See Ibid. 2(d). 9 See Ibid. 2(c).

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information.10 A "connected person" can include directors,11

officers, employees, or

"professionals" who may be reasonably expected to have access to such information. 12 The "professionals" included under this definition include stock exchange members,13 self-regulatory organization (SRO) members,14 and bankers.15 The "information" is any unpublished information that relates to the company that if published would materially affect the market.16 SEBI may delegate an investigative authority if it receives a complaint of insider trading by investors, intermediaries, or others.17 SEBI may also investigate an insider based on supposition arising out of its own knowledge or information.18 The insider must be given notice of the investigation,19 unless public interest dictates that no notice should be given.20 The insider is then required to give reasonable access to relevant records with him or others, such as his stockbroker.21 The authority can interview partners, employees, or members of the insider, and these persons are required to give full assistance to the authority.22 Unlike broker violations, the authority is required to give a report to SEBI within a month.23 The report can also be generated through a qualified auditor, provided that the auditor has the same access to information as would the authority.24 Before taking any action, SEBI must give the insider a statement of its findings and an opportunity to respond.25 The Board can then proceed with criminal prosecution after receipt of the response.26 Other actions the Board can take include injunctions against dealing with

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See Ibid. 2(e). See Ibid. 2(c)(i). 12 See Ibid. 2(c)(ii). 13 See Ibid. 2(h)(ii). 14 See Ibid. 2(h)(v). 15 See Ibid. 2(h)(iii). 16 See Ibid. 2(k). 17 See Ibid. 5(2)(a). 18 See Ibid. 5(1). 19 See Ibid. 6(1). 20 See Ibid. 6(2). 21 See Ibid. 7(1). 22 See Ibid. 7(3). 23 See Ibid. 8. 24 See Ibid. 10. 25 See Ibid. 9(1). 26 See Ibid. 11.

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securities,27 prohibition of disposal of securities,28 and the restraint of communication or counsel to deal in securities.29 An insider may appeal to the Central Government if the Board sanctions him.30 The recent draft guidelines issued by SEBI for public discussion are the latest of the developments in India in this direction. Earlier, one would recollect the 1992 regulations, which, at best, would be described as a sleeping beauty (or a sleeping giant) since they did not appear to be aggressively pursued or enforced. In this article, the latest guidelines as proposed have been discussed. The importance of these guidelines cannot be understated. The insider trading regulations are basically punitive in nature in the sense that they describe what constitutes insider trading and then seek to punish this act in various ways. The new guidelines are basically preventive in nature. More importantly, they will have to be complied with by all listed companies; all market intermediaries (such as brokers) and all advisers (such as merchant bankers, professional firms, etc.). These guidelines require that each of these entities should take steps in advance. The guidelines provide for very detailed procedures that each of such entities would have to follow. In a sense, this approach makes sense since such offenses are easier to prevent but far more difficult to prove and prosecute. Even the classic cases in the west such as the celebrated Dennis Levine case in the United States shows the vigorous and extensive efforts the authorities had to take including pressurizing so-called tax havens to reveal information when such havens are otherwise known for their strict confidentiality. Such cases do serve as an example for those who may think of carrying out such acts. But preventive measures are likely to substantially reduce such acts as also educate the innumerable insiders of the law relating to insider trading. Interestingly, SEBI has sought to delegate most of the procedures almost up to the last stage on the entity concerned and usually it will be up to the entity to carry out initial investigation for final submission to SEBI for taking punitive action. Further, such entities have been required to provide for internal punitive measures such as monetary penalties, forfeiting Esops, etc. The
27 28

See Ibid. 11(a). See Ibid. 11(b). 29 See Ibid. 11(c). 30 See Ibid. 12.

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guidelines provide for a set of procedures and code of conduct for those entities whose employees; directors and owners are most likely to be in a position to take advantage of inside information for personal gain. These guidelines are separately prescribed for listed companies, market intermediaries and professional firms. Quite expectedly, the guidelines for listed companies are given the most attention and place more responsibility on such companies. Before we go further, it is necessary to first understand what the offense of insider trading is. For this purpose, one has to understand two important terms. The first is the term "insider". This term is very broadly defined and all those who have access to unpublished price sensitive information in one way or the other are included. The other term is "unpublished price sensitive information", that is, that information relating to the company, which is unpublished, and with respect to which the market price of the share is very sensitive. To give an example, if it is known that a company is being merged with another company at very favorable terms, it is information that the market price of the company can be quite sensitive about. If a person, who has access to information that is not published, such as a director, trades in the shares of the company on the basis of such information, he would be deemed to have committed the offense of insider trading. Note that it is not necessary that the person should have traded in the shares. He may have communicated such information to another person so that such other person makes use of such information. This also constitutes insider trading. Other similar acts are also covered. The insider trading regulations are the parent regulations in this respect. The guidelines now proposed are expected to serve the function of percolating down to the level of those entities where such acts actually occurred. The broad pattern of these guidelines and features common to all groups of entities covered can be first reviewed. The first step that an entity needs to take is to lay down and declare a policy relating to insider trading. It also involves the basic step of providing copies of the statutes to all concerned. The second step is to create a compliance department. This department is to be headed by a compliance officer who should report to the chief executive of the entity. The compliance department would have a great responsibility in this matter and it is submitted that there is overkill in this regard. So much responsibility and requirements have been placed on the compliance department as well as the compliance officer, apart from too many procedures, that it
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is likely that this department and the compliance officer may be drowned in paperwork. The important concept of materiality and exception reporting has not been applied. For example, every executive has been required to first clear and report his share transactions with the department. Further, they are also required to give monthly reports. Further, it would have been better if a cutoff point in this regard could have been laid down so that small transactions in shares need not be reported. Of course, this is not to encourage small offenses but there could be separate procedures for such acts. Similarly, a reporting should be only by exception and thus only where a person actually trades in the shares that he should report or clear such transaction. Presently, it appears that all listed companies, all market intermediaries and all professional firms having some connection to listed companies will be required to follow the same procedures and guidelines. It may be worthwhile to consider whether some cut off can be made so that companies and firms below a certain size are either exempted or can follow alternative summary procedures. Since the requirements are quite detailed (perhaps the largest of companies and firms have also been kept in mind), not all such entities can afford or even require such detailed procedure and infrastructure such as an elaborate compliance department headed by a compliance officer. Nor would it be possible for professional firms in all cases to have the socalled Chinese walls. Incidentally, to explain the term Chinese Walls, it means those physical and intangible barriers created between departments of a firm whereby those departments having access to such inside information of companies are separated with other departments which have no concern with such information or who may misuse such information. It may also be not out of place to mention here that the success of maintaining Chinese Walls in controlling insider trading is at best mixed in the West. The Securities and Exchange Board of India's (SEBI) new regulations on insider trading has made it mandatory for investors to disclose their holding in a company beyond five per cent, for every additional two per cent stake acquired. In addition, any fall in the holding below five per cent will also have to be disclosed mandatory, according to the new guidelines. Earlier regulations had provision for disclosure just after crossing the five per cent for the first time and there was no provision for disclosure if the holding falls below the five-per cent limit. The new
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regulations come into effect from February 20. The regulations follow the final recommendations of the SEBI Insider Group headed by Mr Kumarmangalam Birla on March 31, 2001, that was approved by the SEBI Board on May 14, 2001. According to the Section 13 of the Insider Trading Regulations, any person who holds more than five cent shares in any listed company shall disclose to the company the number of shares held and change in shareholding, even if such changes result in shareholding falling below five per cent. If the holding falls below five cent, it has to be disclosed if there has been change in such holdings from the last disclosure which has been made. Investors will have to continuously disclose acquisition of additional shares every time such acquisition rises by two per cent above the threshold limit of five per cent. In its bid to tighten insider-trading norms, the SEBI group has prescribed a code of internal procedures and conduct for listed companies and for entities associated with the capital market. In an informal chat with the media, the Senior Executive Director of SEBI, Mr L.K. Singhvi, said these guidelines are being prescribed to create an internal framework of compliance at every level in order to prevent or minimize insider trading. Once approved by the board, the SEBI Insider Trading Regulations of 1992 would be amended to incorporate these guidelines. ``Internal enforcement of this is mandatory'', Mr Singhvi added. He, however, clarified that compliance with this prescribed code does not mean that you cannot be proceeded against under the main regulations. `These guidelines provide a supplementary framework and are to serve as a preventive measure. This will also put the onus of responsibility on corporate and other entities like broking firms, merchant bankers etc., to create an atmosphere of compliance internally,'' Mr Singhvi said. The code also stipulates mandatory disclosures on two counts. One, with respect to disclosure of interest/holdings by directors and other officers who are insiders in the company and thereafter accumulating continuously for every 5,000 shares or shares worth Rs 5 lakh, whichever is higher. Two, shareholders or those holding at least five per cent stake in a company and thereafter accumulating every additional two per cent. These disclosures will initially be made at the company level, which would then inform the stock exchanges. The objective is to preserve the confidentiality of information, prevent its misuse and ensure commitment to transparency,'' Mr Singhvi explained. The code of internal procedure and conduct for listed
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companies will broadly detail what would be violation of the insider trading code, what is pricesensitive information etc. It also stipulates that every company must have a compliance department, which would serve as a nodal agency to collate information, specify policy requirements etc. It suggests following the principle of `need to know' with regard to unpublished information. Access should be limited to those who need it. To prevent misuse of information, it has been suggested that companies provide a trading window during special events, whereby trading in those shares would be curtailed. In this case, we are talking of events like declaration of dividend, company results etc.,'' he said. The trading window would thereafter be opened a day or two after information is made public. The code also prescribes mandatory pre-clearance of trades and reporting to compliance officer. Further, it prescribes a minimum holding period of one month for directors, officers and designated employees. Violation or non-compliance of this would attract a penalty. The code of procedures and conduct for intermediaries or entities associated with capital markets includes stock exchanges, legal firms, professional firms, depositories, and associations such as AMFI, AMBI etc. DUTIES/ OBLIGATIONS OF THE COMPANY Every listed company has the following obligations under the SEBI(Prohibition of Insider Trading)Regulations , 1992 To appoint a senior level employee generally the Company Scecretary , as the Compliance Officers; To set up an appropriate mechanism and to frame and enforce a code of conduct for internal procedures, To abide by the Code of Corporate Disclosure practices as specified in Schedule ii to the SEBI (Prohibition of Insider Trading)Regulations , 1992 To initiate the information received under the initial and continual disclosures to the Stock Exchange within 5 days of their receipts; To specify the close period; To identify the Price Sensitive Information
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To ensure adequate data security of confidential information stored on the computer; To prescribe the procedure for the pre- clearance of trade and entrusted the Compliance Officers with the responsibility of strict adherence of the same.

PENALTIES Following penalties /punishments can be imposed in case of violation of SEBI (Prohibition of Insider Trading) Regulations , 1992 SEBI may impose a penalty of not Rs 25 Crores or three times the amount of profit made out of insider trading; whichever is higher. SEBI may initiate criminal prosecution. SEBI may issue orders declaring transactions in securities based on unpublished price sensitive information. SEBI may issue orders prohibiting an insider or refraining an insider from dealing in the securities of the company.

CONCLUSION The importance of policing insider trading has assumed international significance as overseas regulators attempt to boost the confidence of domestic investors and attract the international investment community. Reports from the international press confirm a proliferation of law-making and regulatory actions within just the last several months in countries across the globe aimed at curbing insider trading. For example, in 1998 alone: Hong Kong regulators unveiled new measures to combat insider trading, including the introduction of new electronic surveillance capability31. Malaysia amended to its securities laws, for the first time giving investors a private right of action against insider traders32. In its efforts to curb insider trading, the Securities and Exchange Board of India enacted regulations requiring that corporate deals be

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Stewart Oldfield and Sauw Yim, Regulators Aim to Hit Market Regulation, South China Morning Post, July 22, 1998, at 1. 32 Munir: Amendments to Promote Transparency, New Straits Times-Management Times, June 17, 1998.

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reported to stock exchanges within 15 minutes of finalizing33. Vietnam announced a decree establishing its first public securities market, which includes prohibitions on insider trading34. The government of Egypt announced that it is working on a comprehensive reform of its regulation of the Cairo Stock Exchange, to bring it into line with world standards 35. The Netherlands Securities Board announced that it is launching an investigation into whether the Amsterdam Exchanges have sufficient systems in place to detect and investigate insider trading36. These developments herald a new era of universal recognition that insider trading, in the words of the SEC's Chairman Levitt, "has utterly no place in any fair-minded law-abiding economy37." The new 2002 regulations in India have further fortified the 1992 regulations and have increased the list of persons that are deemed to be connected to Insiders. Listed companies and other entities are now required to frame internal policies and guidelines to preclude insider trading by directors, employees, partners, etc. In the past, it has been observed that insider trading legislation is ineffective and difficult to enforce and has little impact on securities markets. Low enforcement rates and few convictions against insiders have been cited as evidence of this ineffectiveness. Irrespective of whether or not the SEBI was bestowed with wide ranging powers, it has been a clear failure when it came to the task of administering the law. The importance of policing insider trading has also assumed international significance as overseas regulators attempt to boost the confidence of domestic investors and attract the international investment community. So, SEBI now should take the role of a regulator only. Special Courts could be set up for faster and efficacious disposal of cases.

33 34

Indian Watchdog Makes Negotiated Deals More Transparent, Asia Pulse, August 13, 1998. Jonathan Birchall, Hanoi Decree on Exchange, Financial Times, July 15, 1998. 35 Global Regulations: Financial Reforms in Germany, Egypt, Philippines, EIU ViewsWire, April 9, 1998. 36 Netherlands Securities Board to Investigate Amsterdam Bourse Systems, AFX News, July 22, 1998. 37 Arthur Levitt, A Question of Investor Integrity: Promoting Investor Confidence by Fighting Insider Trading, Address Before the "SEC Speaks" Conference, February 27, 1998.

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