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Regulating insider trading

By Alex Tawanda Magaisa

IN the past five years there have been numerous reports of and corporate suspensions from the Zimbabwe Stock Exchange (ZSE) on the basis of insider trading.


<
FONT face=”Verdana, Arial, Helvetica, sans-serif”>Insider trading occurs when a person holding confidential and price-sensitive information about a company trades securities in the company thereby obtaining an unfair advantage over counterparts in that transaction who do not have access to that privileged information.


Insider dealers may engage in large-scale stock sales when they know of the company’s impending problems thereby avoiding losses or they may purchase large stock knowing that there will be an immediate disclosure of information that will boost the company’s share price.


In both cases the use of confidential information places insiders at a distinct advantage by comparison to the public investors without access to that information. In most countries, such as the USA, UK and a number of emerging economies, insider trading attracts severe criminal and civil sanctions. The proposed Securities Bill in Zimbabwe will hopefully create sufficient mechanisms for dealing with this problem, which is by no means restricted to the small developing markets.


Problems


Insider trading is a problem for two principal reasons:

Reduces investor confidence in the capital markets and

Affects the efficiency, fairness and transparency of the capital markets


First, investors place their money on the market in the expectation that they will gain benefits when the companies in which they have invested do well.

People invest on the basis of the information that is publicly available on the market. The availability of information gives investors and their advisors the tools to make informed choices. That is why the price that any company that wishes to attract investments on the public market is greater disclosure.


All over the world, public companies are obliged to continually disclose information to the market. While the investors expect good news, it is possible that bad news might arise. Either way, he needs to know so as to make choices. If everybody had the same access to information investment on the stock markets would be a near perfect and fair gamble.


But then, other people are corporate insiders and they know more than others in the market do. If insider dealing were to flourish, the public would retreat from the market because of the unfairness of the market.


Indeed the insiders would freely exploit inside information to enrich themselves at the expense of those that have no access to privileged information. In a way insider-dealing laws give an incentive to the companies to disclose information as much as possible so that the public are kept in the know.


The other danger is that capital might become expensive for the companies on the public market. Investors will know that there is a greater inherent risk in holding securities and they will include the risk in their investment decisions, which may lead to a reduction in the price that they are prepared to pay for the securities.


Capital becomes expensive because companies have to issue securities on less favourable terms to accommodate the higher risk factor. So in reality it is in the company’s interest to ensure that this unethical conduct is minimised.


Insider trading reduces the efficiency of the capital markets because it causes distortions of stock prices. An efficient securities’ market should reflect the true performance of the company through for example the share index. That is what investors use to measure the performance of the company and make investment decisions. When insider dealing occurs, the price reflected on the stock market sometimes does not reflect the true performance of the company.


Who are insiders?


The definition of insiders is a wide net that covers both those within the company and those outside the company. Therefore in addition to directors, executives, employees within the company, corporate advisors, lawyers, accountants, auditors, government regulators, family members, club-mates and colleagues may all be caught within the net.


The key is that those who receive inside confidential information from an insider or from privileged documents become insiders for the purposes of the laws. Thus for example, an official at the RBZ has confidential knowledge of the information that Faith Bank’s request for funds from the Troubled Bank Fund will be accepted.


Knowing that the publicity of this information will boost the share price of Faith Bank, he will before the public disclosure, make a huge share purchase in Faith Bank at the current low price knowing that once the publicity is made the next day, he will have gained enormous value. He is engaging in insider trading even though he has not received the information from an insider in the bank.


Similarly directors and executives may supply information to their friends and relatives who then proceed to trade in the securities of the company.

Arguably, insider trading attracts some of the most intelligent crooks that always try to stay ahead of the laws. Where regulation is poor but the corporate sector is closely-knit, such as in Zimbabwe at present, the probability of insider trading is high.


Legal sanctions


The problem with insider trading is that it is notoriously hard to police largely because detection is difficult. This is coupled with the fact that in most common law jurisdictions, the doctrine in the famous case of Percival v Wright makes it practically difficult to ensnare errant directors or officers who do harm to the company. In that case it was decided that directors owe a duty to the company only and not to individual investors.


This means that except in very limited circumstances only the company can take action for wrongs committed against it. Other than protecting personal interests, the fear that such litigation may bring the company into disrepute usually dissuades them from taking much action. It is therefore imperative to have outside legal regulation to deal with cases of insider trading.


Whereas various jurisdictions have taken the routes of criminal sanctions or civil, regulatory sanctions against insider trading culprits or both, the three key aspects are detection, investigation and enforcement of the laws. The detection mechanisms need to be properly formulated to suit the circumstances of each country’s market.


The British Financial Services Authority (FSA) has developed three mechanisms, which are also used in the US and other countries with variations. These are supervision market surveillance and whistle blowing.

Supervision may take both formal and informal means whereby the regulatory authority discovers irregularities during its regulatory duties.


This method has proved to be hard under the informal systems used in the UK, as internal compliance officers are less likely to notify authorities.

Matters would rather be resolved from within and sometimes this information is therefore not brought to the attention of the supervisor. The scope however remains for co-ordination with other regulatory authorities such as the central bank to uncover and share information on possible irregularities.

Indeed the ZSE can also play a part to assist the SEC in the supervision to detect irregularities.


Market surveillance is more sophisticated and probably effective way of detecting insider dealing. However it requires computerisation and expertise but even so it can be cost effective by comparison to manual monitoring mechanisms. Marker supervision involves monitoring and supervising the exchanges including those peripheral markets like derivatives.


In London, the LSE surveillance team is responsible but it rarely discloses its mechanisms to avoid informing potential fraudsters who may exploit weaknesses. As in London, the US also uses computerised systems such as the Intermarket Surveillance Information Systems (ISIS) and the Auto Search and Match System (ASAM).


The ISIS records details of all trades in securities carried out on all exchanges in the US. The ASAM is used to identify chains or links of insider dealers through cross-referencing the jobs, clubs or other possible connecting points of the market players. These systems enable large and suspicious transactions to be brought to the attention of regulatory authorities.


So like the NYSE or the LSE the ZSE can assume this role in more sophisticated and effective ways to assist the proposed SEC to detect irregular activities.


Whistle blowing can be used as a method to promote accountability from within. It is very common in the US where the legislation allows the SEC to pay large amounts of rewards to informants. While the UK has not followed the US system of paying bounty to informants, the FSA has nonetheless encouraged whistle blowing. It may be necessary to enact legislation to protect employees who might be victimised by their employers for divulging information.


In the UK the Public Interest Disclosure Act (1998) protects employees who report matters of public interest. It has been said that in the US the system has depended much on unhappy employees, estranged spouses jilted lovers and indeed jealous compatriots. One must be careful however, when dealing with information coming from bitter parties, as it might falsely tarnish the image of otherwise clean men and women.


Whistle blowing therefore needs to be carefully handled so as to protect the rights of the accused.


There is general agreement that despite early voices of support, insider trading is a cancer that needs to be minimised in the market. It is important for purposes of protecting investors, companies’ interests and the integrity of the markets. There are greedy hounds within the markets, which are always on the look out for key confidential pieces of information to further their individual interests at the expense of others.


The market requires fair play and transparency. Insider trading is serious unethical conduct that goes to the very heart of poor corporate governance.


Given the suspensions that have taken place over the years, there is no doubt that such practices are commonplace in Zimbabwe. Limiting the number of corporate boards on which a single director may sit will be a key rule as will the improvement of surveillance and clear policies if whistle blowing is used.


However, at the end of the day, the investigation and application of the laws and sanctions will fall to regulatory and police authorities that need to be equipped with the infrastructure and expertise to effectively deal with the problems. Detection without enforcement will render the SEC a toothless watchdog, which can be dangerous for the market.


Alex Tawanda Magaisa is Baker & McKenzie Lecturer in Corporate & Commercial Law at the University of Nottingham. He can be contacted at alex. magaisa@nottingham.ac.uk

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