Insider Trading – the column of the blog post

Here is the next exciting installment for those people who read my post of a few days ago on insider trading.

I agonised over whether or not it was worth making the proposal that there be a civil remedy against companies where it can be shown – according to civil standards of proof (ie on the balance of probabilities rather than beyond reasonable doubt) – that a share trader was disadvantaged by a companies neither releasing market sensitive information nor halting trading in their shares.

I think at first blush it is entirely reasonable for there to be such a remedy. The odds are still heavily stacked against the shareholder on account of the scandalously high cost of litigation. The company will almost always be much much larger financially than the shareholder.

Anyway, my old torts teacher and some law professors I spoke to all thought that it was a worthwhile case to make – without saying they agreed with it.

If I’m wrong it will be because, under such a regime company officials are often unsure of whether or not to release some information. It might therefore be appropriate to impose some threshold, so that – for instance – the remedy is only availlable where the information could reasonably be expected to move the market by 10%.

Thanks to James Farrell who suggested I explain insider trading at the outset of the column. I pinched his example without shame, but not without acknoweldgement – at least where it is possible, namely here.

Anyway, for better or worse, here is the column.
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Insider Trading

Imagine if you hired a real estate agent to sell your home and he knew that a coming rezoning would double its value. He doesn’t tell you, but he gets his cousin to buy it. That’s insider trading. And that’s the can of worms that Steve Vizard opened up.

Insider trading is for those privileged few (or is it many?) for whom privilege is not enough unless it is also used as a licence to exploit. Like most duplicitous conduct, it’s a drag on our economy. Stock market returns must be higher increasing businesses’ cost of capital to compensate outsiders for the poor terms on which they trade stock with insiders.

Inevitably some have argued the extreme case for legalising insider trading because it’s so difficult to police and to draw the line between insider trading and legitimate trading by insiders. But securing convictions and/or drawing the line is difficult for most white collar crimes. Should we dicriminalise them all?

Without vigorous attempts to secure market transparency there’d be a huge loss of confidence and so of market efficiency.

There’s also a deeper issue of ethics and expediency. One of the distinguishing characteristics of advanced and prosperous societies its out of fashion to call them ‘civilisations’ as opposed to tribal societies is the distinction between the interests of the ‘office’ and the person holding it.

As an office-holder you incur a duty to act on behalf of others however much you might prefer to advantage yourself or your family. It’s what you know, not who you know. And I’m not just talking about government offices. It’s one of the foundations of our society and of our economic prosperity. Employees act for their employers, school councilors act for their schools. And company officials act for their company and thus for its shareholders.

Of course these responsibilities are often flouted. But they’re honoured in the breach in our outrage and support of legal sanctions for too flagrant betrayals.

There’s an odd paradox though. The ASX knows that a lot of insider trading takes place. It can even tell you when it’s taken place for instance in most cases where share prices in a company move towards the value they will hold as a result of some public announcement before that announcement is made.

But to secure a criminal conviction one must prove wrongdoing by a specific accused person beyond reasonable doubt. Now a lot of trading on insider information is not done by insiders. It’s done by their associates who pick up information at the club and on the golf course. The information might be passed on just to impress, or as part of a rich barter economy of favours. It’s not what they know it’s who they know.

And if an analyst or broker recommends buying a stock, who can prove beyond reasonable doubt that they came to their view by unacceptable means? ASIC says that the difficulty of obtaining a criminal conviction was why it plumped for civil rather than criminal action against the very silly Mr Vizard.

But can we do more? In about a third of recent cases in which price sensitive information was released in a recent informal study of the issue, there was strong evidence of insider trading with share prices moving to reflect information before it was publicly released.

Now companies can suspend trading in their own shares pending release of market sensitive information. If you think about it, if you traded shares at a disadvantage during a period in which the company had inside information which appears to have found its way to market before it was publicly released, then it seems more likely than not (the civil standard of proof) that you’ve suffered from insider trading.

At present you’d fall between two stools. S 1043L of the Corporations Act gives you a civil remedy (attracting the lower standard of proof), but you have to enforce it against the individual who was at fault and if they’re less silly than Mr Vizard you won’t know who they were.

There’s also the common law of negligence. If a firm’s in possession of information which would move its share-price by a substantial margin and it leaks out, then I reckon the company owes you. Now to succeed in an action of negligence, the plaintiff must prove duty, breach and damage. In this case the latter two might be demonstrated. But as I understand the law an individual shareholder could not prove that those in the company had a duty to them only that they had a duty to the company as a corporate entity.

I find this surprising. In the grand daddy of legal cases, probably the most famous one of them all, a firm was held liable for a dead snail it inadvertently bottled with its ginger beer. Donahue v Stevenson established the proposition that a firm’s customers are, in Lord Atkin’s famous expression the firm’s “neighbours”.

They have a close enough relationship with the firm that they are owed a duty of care – because those in the firm can reasonably forsee the damage their negligence can inflict on them. Now almost all companies have a lot more customers than they have shareholders, but the law holds that their relationship with the company they jointly own is too distant to bring forward a duty of care.

If it became possible for shareholders to sue firms where those firms might reasonably have protected them from insider trading, corporate Australia’s complaisance towards insider trading could take a healthy hit.

It’s no panacea. The principles are harder to apply in the common case where more than one firm has the information, for instance where one company is negotiating a supply contract with another. But a little practice applying them in the simpler cases might help us understand how best to extend them.

It might help us moderate a whole culture of insider benefits.

Indeed Steve Vizard picked up some shares just the other day. He picked up shares in a Tattersalls float for $2.90. It was all perfectly legal. They were a special allocation for special people including former Victorian premier Jeff Kennett, Liberal Party powerbroker Michael Kroger, BHP Billiton chairman Don Argus and Collingwood president Eddie McGuire and lots of others. The shares rose as high as $3.62 on the float and no doubt some of the special people bailed out so they could move onto their next meal.

It wasn’t what they knew, it was who they knew.

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4 Responses to Insider Trading – the column of the blog post

  1. Ken Parish says:

    Nicholas

    Like the legal academics you consulted, I think this is a really interesting idea, and I share your reaction to insider trading abd desire to devise remedies that more effectively sanction it. But despite your acknowledgment of the formidable hurdles a litigant would face in establishing the civil cause of action you propose establishing, I think you might nevertheless be underestimating them.

    A plaintiff wouldn’t have any difficulty establishing a duty to him, because your proposed reform creates it by statute, and wouldn’t have any difficulty proving damage as long as she’s given a right of access to ASX or ASIC data showing a significant price movement prior to the informatin being publicly released. But how does the plaintiff establish, even on the balance of probabilities, that the duty was breached? Even in the simplest of cases, there will be dozens of people legitimately “in the know” and in a position to pass on that information covertly to friends, colleagues etc, only a few of whom we be under the company’s control or direction in any meaningful sense. To prove a breach of duty you would either need to establish which of them passed on the information that was traded (usually almost impossible) or prove that the company failed to take reasonable, prudent steps to prevent improper info leakage. But probably all a company would have to do is to sign up consultants, sharebrokers, lawyers, accountants, geologists etc (i.e. everyone with insider information) on confidentiality agreements, something I suspect many of them already do (and the obligation of confidentialiy will usually already exist in law, so the agreement is merely a further reinforcement). If the company has done this, you are then back to the situation where you have to prove specifically “who dun it” or that there was some further relatively obvious step that the company ought to have take but failed to do. The smarties would soon work out that your reform really didn’t change the existing situation in any significant way. A rampant “rich barter economy of favours” would continue largely unimpeded, with the company itself merely being required to maintain whatever window dressing courts might require to create the impression that they are neither condoning nor colluding in the behaviour and are taking “reasonable” steps to prevent it.

    That said, it may be worthwhile having such a statutory tort for its educational and emphatic value, even if a litigant seldom if ever succeeds.

  2. Robert Patterson says:

    It’s not what you know it’s who you know. This vizard thing is contemptable, but power wins. numbat

  3. John Byrne says:

    Vizard’s only crime is that he broke the 11th Commandment (Don’t get caught)

  4. Thanks for your comment Ken and apologies for delay in replying. I’m being monstered by some philosophers (which is a bit of a worry when the subject is philosophy and you’ve started the fight).

    I was struck by the anti-insider trading paranoia of some merchant banks. They’re paranoid about it because its central to their business. So it seemed to me I wanted to spread that paranoia around a little. So I’d go so far as to at least moot the idea of a (rebuttable) presumption against the company in a range of circumstances.

    There could be some rough justice involved, but it might lead to the issue being taken seriously. I’d add that I suspect (I don’t know) that some companies have a reputation for their prices adjusting before big announcements, whereas with others it’s only a rare thing. So one could apply the presumption where information has leaked with more than an acceptable degree of regularity.

    But I admit this is all kite flying. And I’d be happy to retreat to your position that, like most of the rest of the law of insider trading, we have it for what you call “educational and emphatic value”, even though we don’t secure many convictions (or in this case successful tort actions).

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