Insider trading ¢â¬â some na¯ve thoughts.

Editors place a high store in columns being topical. So, even when I’ve got some issue I’d like to run with in a column, if I can’t think of a way of shoehorning it into topicality I often put it aside for a few weeks, until something comes up that gives me a ‘hook’ with which I can dress it up as a response to issues of the day.

I have a few things I want to write about in my column but no topical ‘hooks’ for them. But one economic topic of the day is insider trading. So I’ve been thinking about it.

The weekend papers are full of Steve Vizard’s misdeeds, and also an investigation proving the obvious by The Age .

The Age cites fifteen recent cases in which insider trading is overwhelmingly likely where share prices moved in advance of an announcement to a value that turned out to be approximately the value the market placed on the stock after a particular announcement was made.

There was a brief discussion on this blog about whether insider trading is that bad. My own presumption is that it is.

To put the argument by way of reference to an unfashionable idea, it seems to me that one of the distinguishing characteristics of civilizations (as opposed to tribal societies) is the idea of formal roles in which people act on behalf of others as opposed to helping out one’s kin and or the local strongman. This is clearly central to the notion of public governance in modern societies whether this is in government, or in the governance of collectively held private assets like shares in a public joint-stock company. Insider trading is a subversion of this idea of people having roles in which they have clear and overriding responsibilities to a well defined collective.

Seen in this way, insider trading is not just like theft in the sense that it relieves people of money that one can argue is rightfully theirs. Insider trading subverts one of the basic institutions that guarantees us our prosperity and our safety.

Insider trading creates ‘insiders’ and ‘outsiders’ with insiders taking advantage of outsiders. In addition to its inequity this is also inefficient as it drives up hurdle rates for the whole market. The vast bulk of money is from outsiders and it needs higher returns to compensate it for the money it is donating to the Steve Vizards of the world whose inside information gives them the edge in trading with outsiders. This is a particular problem with smaller companies, and thus, no doubt part of the reason that small stocks enjoy lower share prices – in other words investors are requiring higher relative rewards to hold them.

Here are some ideas to address these problems. One major part of the problem seems to be that criminalising insider trading necessarily leaves most people out of the net. That’s because one has to prove their guilt beyond reasonable doubt and that’s very difficult. (Why that’s so in the case of Vizard escapes me, but for people who are better at covering their tracks it must be difficult).

Further the culture of insider trading is well ensconced in our financial markets. There is much cultivation of ‘insiders’ in floats. Usually this is informal, but sometimes it’s even instituionalised. Thus for instance as reported by the Age:

Steve Vizard is on a list of Melbourne’s social elite who scored shares in the hard-to-get $2.4 billion Tattersall’s float.

Documents obtained by The Age show that the embattled businessman is joined by former Victorian premier Jeff Kennett, Commonwealth Games boss Ron Walker, Liberal Party powerbroker Michael Kroger, BHP Billiton chairman Don Argus and Collingwood president Eddie McGuire as lucky “winners” of shares in Tatts.

This isn’t insider trading so much as a system of formal rewards for insiders. Insider trading however is very often the product of the informal behaviour of insiders and this makes it virtually impossible to deal with within the criminal law.

As Leon Gettler comments in The Age.

A funds manager said smaller companies were easy pickings. “You’ve got to remember that a lot of smaller companies have very good relationships with particular brokers, and there are opportunities to exploit that.

“From my experience, a lot of the information leaks from the board. That’s the biggest source of leakage, and in many instances, they don’t even do it for their own gain. They will tell someone something for whatever reason, it might be down at the club or after some drinks, and nine times out of 10, it’s not coming for any advantage to themselves. These days, people aren’t stupid enough to trade on the information themselves.”

As today’s Age report shows, the problem is not that that its difficult to detect insider trading, only that its difficult to prove against any one person.

I guess others have written about ideas like the ones I’ve floated below, so if any readers know of these discussions or have criticisms or endorsements of the ideas I’ve proposed, I’d be very grateful if they’d contribute them in comments below.

My proposed remedies focus on civil remedies, rather than criminal ones, and for that reason I think they can more successfully address some of the problems. But I envisage them as being in addition to existing criminal penalties where criminality can be proven to an acceptable standard of proof.

1. The thought experiment begins with this rule which is then watered down and varied in subsequent suggestions. Instead of having the market open most weekdays, open it say in the last week of each month or each couple of months. Wherever possible, financial announcements which could affect share prices would have to be made when the shares were not trading.

My guess is that there are more costs than benefits with this suggestion. It would not work where information arrived in the marketplace during the trading time which would be the case where international developments or some physical or technological development occurred within the company.

Presumably there are benefits from the ongoing liquidity that an open market provides. It would also presumably add risk. There would be anxious moments when markets opened and stocks ‘gapped’ towards their new values. Stop loss orders would be less effective at covering risk, as the market would ‘gap’ between values when it opened. I could go on.

2. A watering down of this experiment might be to have periods of a two or three weeks once or twice a year during which financial reports would be compiled and trading was halted. But perhaps one would need longer periods than this taking one back toward the first suggestion.

3. Here is a more organic process by which my objectives might be achieved. As I understand it, whenever board members are in possession of privileged price sensitive information they must desist from trading. Why not require the company to cease trading whenever such information has gone to the board, until some public announcement is made?

Further, the decision to cease trading can be up to the board, but the company itself could be made liable to compensate or partially compensate anyone who lost money as a result of insider trading. There would be a rebuttable presumption that this had happened wherever prices changed by more than a certain amount and these changes were subsequently ‘ratified’ by the market when the new information was released. Such a rule would give the company a strong incentive to cease trading until it had got sensitive information to market.

The advantages of this is that it begins to bring the company management and board on board in trying to combat Insider trading. As a threat to the company it would begin to be treated seriously within the corporate culture. But perhaps comments will reveal it to be unrealistic.

4. One might also adopt some kind of probabilistic rule along the lines of Oscar Wilde’s comment about losing one’s parents. Losing one looks like a misfortune, losing both looks like carelessness. Accordingly one might have a rule in which insider trading once detected then pushed the company involved into a zone in which any further such events triggered rule three above, and/or triggered progressively higher levels of indemnity for those who had lost from insider trading.

Comments, links or other ideas please.

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Robert Merkel
2021 years ago

To somebody not involved in the share trading game, I have to agree with Nick about the dubiousness of the process of allocating shares in hot IPOs to favoured “insiders”. Isn’t something like Google’s IPO auction an inherently fairer way to conduct an IPO? Why aren’t more IPOs done this way?

Slightly less seriously, why not make live audio feeds from microphones placed at every lunch table in the Melbourne Club (and whatever the trendy lunch spot the rich and powerful are eating at in Sydney this week) available free to the public? Should even out the information gap nicely… ;-)

Nicholas Gruen
2021 years ago

It has always been a mystery to me why floats are managed the way they are, and why there are not more floats onto the exchange a la Google.

Fyodor
2021 years ago

Nicholas,

Regarding your suggestions:

1) Illiquidity cost (i.e. the inability to sell or buy shares when you want to) would be extraordinarily high in the periods when the market was closed. You would create a significant incentive for “grey” (i.e. non-standard or even illegal) markets, open at more convenient times, to develop. Insider trading would be an even greater problem in grey markets, which tend to be lightly regulated and thoroughly dominated by insiders.

2) see 1) above.

3) board members are almost always in possession of some price-sensitive information. The proposal is impractical, ambiguous and arbitrary.

4) we only hear about a small fraction of actual cases, and usually only where trading volumes are of such magnitude and/or direction that they are hard to ignore. I suspect, and I’ve heard it said many times, that most insider trading is small-scale and not detectible. Thus we are not going to know whether or not a company has been affected in most cases. It also penalises a listed company even when the incidence of insider trading is not its own fault.

Insider trading is rife, and it is a problem. Unfortunately I don’t have any better solutions – the punitive approach taken by ASIC pour encourager les autres seems to be the only option at the moment.

Fyodor
2021 years ago

Robert and Nicholas,

Few business decisions are as complex, risky and nerve-jangling as listing your company. The only transactions that come close are large mergers and acquisitions. This tends to make company owners and managers very risk-averse about the process.

It’s easy for Google to announce the intention to float and wait for the bids to roll in – it’s an Internet leviathan, an iconic brand with global appeal. It’s not so easy for Joe Bloggs Engineering Ltd to drum up the same level of frenzied interest. That’s why investment bankers and stockbrokers, the slutty midwives of capital markets, are paid to manage the process. It’s corrupt and byzantine, but it tends to work OK in most cases.

Nicholas Gruen
2021 years ago

If its so nerve-jangling to list your company why not just list a few shares, and sell a few more into the market as you feel comfortable doing so, until you have sold down the number of shares you want?

Fyodor
2021 years ago

That’s what most owners do. Most IPOs are of family-owned companies where the founding family retains control. The IPO raises capital by selling new shares into the market, thereby diluting the holdings of the original owners. In fact it’s relatively common for existing shareholders to place their own holdings in escrow for a period. It’s extremely rare for a company to be “sold” in its entirety to the market – it’s usually taken as a huge negative by prospective investors if the existing shareholders want to exit entirely: “why should I buy shares in the company if the insiders want out?”.

The nerve-jangling has more to do with submission to unbelievably onerous regulation and compliance – both formal (i.e. the stock exchange you list on, government regulators) and informal (i.e. the various predators circling your particularly floaty in the great ocean of capital) – and public ownership itself, i.e. losing total control of your own company.

James Hamilton
James Hamilton
2021 years ago

I’ll only speak generally but I for one would like to see those individuals involved in laws relating to purchase & selling of stocks, anti – competitive behavior etc really cop a pounding from the courts and society in general.

On the topic of free trade I have had many a heated arguement with farming friends of the operation of markets. My position is stop squawking about the dairy industry – they can’t compete with Victoria or New Zealand then stiff cheese. Argentine beef – if it’s as good and cheaper then ditto.

They come back with a very valid responses – what has happened to the price of milk on the supermarket shelves? and they are paying more for qld & south american beef than local prices to pressure suppliers.

I say these are seperate issues that need to be addressed. The transparent and clean operation of markets is the basis of our well being (and the best chance we have of world peace btw) – crimes against it are serious. We must have faith in the operation of these markets.

Wealthy criminal business types like Vizard and many others are scum. More significantly they are dangerous scum. They should be treated as such by the courts and by the community.

An acquaintance sheepishly confessed to screaming obscenities at Alan Bond in a populated public beachfront. Hardly a mature act but as he said “well, fuck it”

Mork
Mork
2021 years ago

I think Fyodor has hit a number of nails on the head, but let me take a crack at one more: the Google auction was widely regarded as a failure because, for some reason, the institutional investors that drive the price in IPOs were not particularly enthused and the final offer price was well below expectations. The subsequent performance of the stock tended to bear out the view that the owners of Google left a lot of value on the table by taking that approach. (That said, one of the reasons that they reportedly chose the auction mechanism in the first place was the perception that the post-listing “pop” experienced by a lot of IPO companies, particularly during the internet bubble, represented value that the companies could have got their hands on themselves had the investment banks managing the deals been less conflicted and more aggressive.)

But I think Fyodor’s main contention is the right one – listing, and finding buyers for a big chunk of equity are pretty complex processes. There may be a fair amount of bullshit and mystique peddled by the i-bankers about just how complex it is – particularly the bookbuild process – but nevertheless, it’s way beyond the capabilities of most companies to manage that process by themselves.

As for your other suggestions, Nicholas, I’m afraid that you might be right about them being a little naive. The whole purpose of the stock market is to provide constant liquidity. The economic consequences of insider trading (which, when it’s all said and done, are probably close to non-existant in most well-regulated markets) would be dwarfed by those of reduced liquidty. And the result would simply be the creation of new, less well regulated trading systems.

Nicholas Gruen
2021 years ago

Mork,

You may be right about the efficiency tradeoffs of lower liquidity – though I wouldn’t have thought that the third proposal would be all that disruptive to liquidity.

But I think you’d need to argue the idea that “new, less well regulated trading systems” would be created rather than just assume it. I would have thought that part of the point of the regulation to prevent trading during designated periods would be to criminalise, or at least render legally unenforcable arrangements that sought to effectively trade when a stop had been placed on trading.

Mork
Mork
2021 years ago

Nicholas – I still think your proposal 3 would have a big impact on investors’ expectations of liquidity. Moreover, it would affect different companies quite differently. For example, a company that always has a couple of potentially significant deals in the works, any of which may or may not come to fruition, would be more or less permanently suspended (and believe me, there are Australian companies that fit this mould). It would also discriminate against companies based on their governance practices in a may that may be inimical to effective supervision: ie, wouldn’t it tend to discourage lengthy contemplation of signficant transactions by the board … at least, there would be a strong incentive to delay briefing the board on a potential transaction until the last possible moment, in order to shorten the period of any suspension.

On the alternative trading platform point, well, I guess that depends how draconian you want to make the regulatory regime. It’s one thing to say “the ASX must suspend trading in this stock in these circumstances”. It would be quite another to say “holders of this stock cannot dispose of it at all in these circumstances”. And if you’re not going to do that latter, then what are you going to do if a bunch of institutional investors get together and set up a wholesale market on which they can trade with other institutional investors when the ASX is closed. After all, if THEY are prepared to take the risk of trading in an unregulated market, what is the government’s interest in stopping them?

You would also need to consider the accelerating internationalisation of the capital markets. For example, many Australian companies have offshore listings. If trading is going to be regularly suspended on the ASX, why wouldn’t it just shift offshore, and why wouldn’t MORE Australian companies add offshore listings to ensure liquidity for their investors? Similarly, many institutional investors are now multinational and have no trouble shifting their holdings around the globe for various reasons, including regulatory.

But I think the key reason why no dramatic change is warranted is that it is just not that big a deal. It’s morally offensive, to be sure, and we can all cheer when some greedy fool gets caught, but it’s really only a big problem if it occurs at a level that drives away capital. I don’t see any evidence that the level at which it’s held by the current regime has any such effect.

blank
blank
2021 years ago

Buying our beef from Argentina, or our cheese from NZ, or even your stawberries from WA if you live east of Kalgoorlie, always assumes that the goods are always going to get to market – that transportation will never be interrupted.

Perhaps that is a dangerous assumption.

Robert Merkel
2021 years ago

Mork, Fyodor: I understand that drumming up interest in an IPO requires a good deal of salesmanship, but why couldn’t you pay them fees to drum up interest in stock sold through a process that doesn’t favour the well-connected?

Nicholas Gruen
2021 years ago

I guess that part of the way they get people in – get them to buy up stock that’s an unknown quantity is to give them the feeling that they’re getting a special deal. The promise of a special deal necessarily implies insiders.

(I’m thinking aloud here. I wish it were not true. But the fact that Google may have left a lot of value on the table by not using investment bankers is sobering. If Google can’t do it, who can?)

Fyodor
2021 years ago

Robert,

The well-connected are usually also rich investors, and therefore “High-Value Clients” for the broker. They stump up money for IPOs on the understanding that they get looked after by the broker, i.e. get preferential allocation. The broker looks after them because: a) he has to find investors anyway; and b) he knows the HVC will keep coming back in future, for both primary (i.e. IPO) and secondary (i.e. normal, on-market) trading.

The result? Company obtains new investors; broker does his job and collects a fat wad of fees; broker’s clients make some easy money. Everybody happy, except the poor schmucks who think the market is fair and are disappointed not to get set in the IPO.

The world turns and another day begins.

Nabakov
Nabakov
2021 years ago

Two great lines about the stockmarket.

“If you can’t spot the sucker, it’s you.”

“Where are the customers’ yachts?”

Or to paraphrase M. Fyodor, the sun churns and burns, and so does everything under it.