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The Ethical Truth of Insider Trading and its Relevance to Singapore
Insider trading traditionally has been deemed as something unethical. Whenever the words “Insider Trading" appears in the media, we often see that the involved parties are portrayed as criminals where they have broken afoul the laws and have unethically committed an act. Critics of insider trading have argued that insider trading goes against the basis of capital markets, that non-insiders are being handicapped, and directors and officers of a corporation have a fiduciary duty towards their shareholders. Although these arguments on surface seem to be valid, rarely has any coverage by the media on the possible positive effects of insider trading been mentioned. Is this due to the fact that it is a political drive by the government to disallow insider trading? Or is this envy and jealousy at work where people who do not have privilege access to this information are resentful of those who could make a fortune with relatively little effort. This paper aims to discover the ethical and unethical truth of insider trading and possibly identify a pragmatic solution. In addition, this paper would also discuss the legal implications and case studies pertaining to insider trading in Singapore.
What is Insider Trading?
The definition of insider trading may vary in different countries or jurisdictions, however in a broader sense, insider trading centers around the generality of buying and selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, non-public information about the security.
In Singapore, the Securities and Futures Act (SFA) passed in 2001 defines insider trading from the “information-connected approach". Insider trading accountability through this approach focuses on the possession of price-sensitive information rather than if the person that has traded with this information is connected to the company. Any person that trades on this price-sensitive information while in possession constitutes insider trading.
Recent Cases of Insider Trading in Singapore
Although currently the limelight on insider trading has been in the U.S market, with the most recent having Ex-Goldman Sachs Group director Rajat Gupta being sued by the Securities and Exchange Commission of U.S. for providing insider information to his friend Raj Rajaratnam who works as a hedge fund manager in Galleon Management , there has also been incidents with regard to insider trading in Singapore.
In May 2009, the Monetary Authority of Singapore (MAS) filed its first civil suit against Kevin Lew Chee Fai, a formal general manager of enterprise risk management at WBL for alleged insider trading. This case involves Kevin selling a total of 90,000 WBL shares at $4.98 per share on July 4, 2007 after he had attended a group management council meeting on July 2, 2007 knowing about the forecasted loss that WBL was going to incur for its third quarter. The trade helped Mr Lew to avoid a loss of approximately $27,000. Subsequently in May 2010, the high court ruled in favour of MAS. Lew was found to have contravened the insider trading provisions of the SFA.
In another case dating back to June 2008, Mr Teo Chuan Teck, a former financial controller of Singapore –listed Cosco Corp was found guilty of contravening the provisions of the SFA. In his capacity as a financial controller, Mr Teo bought Cosco securities five times between January 15 and July 31 of 2007. During this period, Mr Teo was in possession of price sensitive information about his firm. The price sensitive information involved was the securing of ship building contracts by Cosco and its financial results for the 2006 financial year and the first two quarters of 2007.
Ethical Issues Involved in Insider Trading
Most developed countries such as the U.S, Britain, Japan, Hong Kong and Singapore have insider trading laws. The existence of these laws implies that insider trading intrinsically is an unethical behaviour. This begs the question: Why is insider trading unethically and morally wrong?
The prevailing argument against insider trading centres around the misappropriation theory which is currently part of the U.S. law. The misappropriation theory defines the act of stealing or using confidential information of a company with the purpose to use this information to trade and profit on its securities. The rise in prominence in this theory happened when the U.S. Supreme Court convicted of James H.O’Hagan for insider trading. In the case, O’Hagan an attorney himself, traded on insider information with regard to a takeover bid for Pillsbury. It is commonly accepted that stealing is a morally wrong and unethical behaviour, therefore the act of misappropriation in this sense violates the Kantian ethics. Moreover transparency is violated in capital market when stolen non-public information is used to profit from it. In a transparent market where information is distributed and available to its participants at roughly the same time, an investor could only gain advantage over the others by working hard in acquiring skill to analyse the available information. One example is investor guru Warren Buffet where he spends a substantial amount of time going through the fundamentals of a company available to him through his research before he makes any investment. Therefore, in insider trading, trade done is based on non-public information which no matter how hard a person tries to acquire skill and analyse the data available, would be at a handicap compared to someone that has the non-public information. This unfair advantage an insider trader possesses could potentially undermine the basis of the capital market; investors would gradually lose their confidence in the market because of their handicap position in comparison to the insiders and would no longer participate in the market. Lastly, the fiduciary duty argument states that officers and directors have the fiduciary duty to their shareholders by acting in their best interest. Thus, insider trading is unethical when a member of the corporation has a fiduciary duty to its shareholders trades on beneficial insider information in which his shareholders should ought to benefit from as well.
Legal Issues Involved in Insider Trading
Not only is insider trading viewed as an unethical behaviour, legal issues are also involved as well. As mentioned, most developed countries such as the U.S, Britain, Japan, Hong Kong and Singapore have laws to prevent insider trading. In Singapore, the Securities and Futures Act governs the prohibition of insider trading. Under the SFA section 218(2), a person that is connected to a corporation (“connected person") must not subscribe, purchase or sell, or enter into an agreement to subscribe, purchase or sell, the securities of such corporation, or procure another person to do so, if he is in possession of inside information. For people that are not connected to the corporation but are in possession of the same inside information, section 219 of the SFA prohibits them from insider trading. A person that is found guilty of contravening either of these two sections could face fine, imprisonment, or both.
Are the Critics for Insider Trading Justified?
According to the arguments presented above, it seems that insider trading is not only an unethical act but a criminal activity as well. In addition, we often see the media portraying insider traders as criminals, where often pictures of them being arrested and handcuffed are published. As a result of this constant media influencing, the society tend to adopt a negative stereotype against these traders. However, in order to arrive at an unbiased conclusion, one has to consider both sides to any story; Is insider trading really unethical? The utilitarian and rights-based approaches would be used in the following paper to explore the other unmentioned side of insider trading.
Under utilitarianism, an act is considered ethical if the result is the greatest good for the greatest number. The efficiency argument which is a modern variation of utilitarianism states that an act is ethical if it increases efficiency. The efficiency argument brings forth the idea that trading insider information allows the market to reflect and influence the share prices in the correct direction sooner than it would have been if insider trading is not allowed. As market prices correct themselves sooner when insider trading is allowed, this increases market efficiency, which under the utilitarian approach would be considered an ethical act. Take for example in Kevin Lew Chee Fai’s case, by selling WBL shares after knowing that WBL was going to incur losses for its third quarter, Kevin has expedited the process of releasing this information to the market before WBL’s formal announcement. One might argue that in Kevin’s case the amount of share traded is too insignificant an amount to affect the market prices. However, in cases where the amount of shares traded are large enough to influence the market, it ts logical to conclude that insider trading would increase the market efficiency. Moreover, it can be argued that the amount of shares an insider trade is insignificant since if financial analysts were to get hold of the information that insiders are trading on their shares, they would provide the same advice to their clients which would in turn gather enough momentum to affect market prices. Judging from the arguments provided, it seems that if the utilitarian view is adopted, insider trading is ethical as it increases the overall efficiency of the market which leads to higher levels of social welfare.
In the rights based approach, an act is considered to be unethical if someone’s rights are violated in the process even though the outcome could lead to an overall higher utility. The premise on why insider trading is ethical under this approach comes from the fact that property owners under the entitlement theory have all the right to use their property which in this case the insider information and as long as no one’s right is violated in the process it is deemed to be ethical. Therefore under this approach, it is valid to conclude that insider trading is ethical.
It seems that what have been presented so far do not provide a distinct answer on whether insider trading is unethical. On one side we have the misappropriation theory, unfair and fiduciary duty argument going against insider trading, while on the other hand, we have the utilitarian and rights-based approaches that favour insider trading. Thus far, the discussion has been centred on two extreme ends of the spectrum where arguments are either in or out of favour for insider trading. However, the approach to the issue of insider trading is of complexity in nature. No one size fits all solution is available to tackle the issue, and therefore the pragmatic approach should be one of a mixture. The following parts of the paper would be my own attempt in accessing these arguments and possibly identify any inherent flaws that are possessed in within so as to derive at a pragmatic conclusion.
Under the fairness argument presented above, insider trading is unethical because traders possess an unfair advantage when they trade on insider information which outsiders would not be able to get hold of. It is logical to assume that having a level playing field for all participants is ethical. This example is often seen in sporting events where all competitors compete fairly. For example, soccer teams have the same amount of players, athletes run the same amount of distance and participants are prohibited from taking any performance-enhancing drugs. However the concept of fairness becomes tricky when applied to insider trading. To begin with, there are certain things in life that are unfair to begin with. Not all of us are born equal, some are born poor but some are born rich. Some are born with a better appearance but some are born ordinary. Therefore it is hard to rectify this inherent fairness, it would be absurd to ask those who are born with the better appearance to destroy it and those who are born rich to have their fortunes taken away. In the very same sense it would be unfair to ask insiders to divulge their insider information which they have every right to so as to trade in the market. The asymmetry information that a insider trader possesses that leads it to an unethical act during a transaction is another premise on why people argue against insider trading. However by analysing this issue in depth, asymmetric information is part of the business world. In a transaction, it is most likely that a party knows more than the other. For example, an investment banker that is dealing with a merger and acquisition has more information with regard to the underlying value of the company compared to retail investors. A property investor that buys over a property from its existing owner probably knows more about the potential gain in value of that particular property than its owner. Therefore, the asymmetry disparity that happens in insider trading is just a reflection of this real world phenomenon. Moreover in a transaction, it is logical to believe that the parties gain more than what they have exchanged, in essence it is a win-win situation. Thus, the notion of unfairness doesn’t seem to be valid in insider trading.
The utilitarian view that suggests insider trading should be allowed as it increases the efficiency of the market and therefore the welfare of the society could be misleading at times. This lies from the fact that efficiency should not be replaced with ethics. If one were to blindly adopt this approach, it could be said that during wars, killing would have been ethical if countries had found a more efficient way of doing it. Similarly, the seizure of an individual’s property and wealth could become ethical if it leads to a more efficient economy. However we know both are untrue because the act of killing is immoral and unethical by nature and the seizure of one’s property is a violation of an individual’s right which is also an unethical act by the rights-based theory. This observation does not mean that one should totally discount the utilitarian argument. In certain cases it is apt to apply this theory. For example, it is understood that wasting resources is unethical by nature. Therefore if there are ways to use resources more efficiently and yet we are not adopting it, then it is considered unethical. Lastly although the utilitarian view is a simple yet effective approach, it is hard to implement. This comes from the fact that it is hard to measure or quantify the gain in efficiency the market will experience as compared to the loss in confidence by investors towards the market due to insider trading. Therefore it seems like the inherent structural flaws of the utilitarian approach makes it hard to implement with regard to insider trading.
Although the fiduciary duty argument seems logical, it is incomplete in establishing whether insider trading is unethical. This is because as mentioned above, the fiduciary duty argument only involves directors and officers and does not consider outsiders, employees and non employees who do not have any fiduciary duties to the shareholders.
Approaches to Adopt
Given the arguments up till this point, it seems that insider trading can be ethical or unethical depending on the context. This section will propose the approaches one could adopt to determine when insider trading is ethical or unethical. As mentioned, the utilitarian view which states that insider trading is ethical as long as the gain in market efficiency outweighs the cost of market participants is a very simple and yet elegant approach to use in theory. However, the inherent structure deficiency of quantifying the gain and loss makes the utilitarian view hard to adopt in reality. Thus, the use of utilitarian ethics is not a very pragmatic approach to determine ethical issues in insider trading.
With regard to the fairness argument, it does not provide a strong case in justifying whether insider trading is ethical. Similar to the utilitarian ethics, the fairness argument is hard to apply. This lies in the fact that by trying to level the playing field, the informational rights of the insiders would be violated. Violation of the insiders’ informational rights and punishing them for having the comparative advantage they possess is unethical. The basis of comparative advantage works around the fact that through specialization, and allowing individuals to concentrate on their talents, the economy on the whole would be far more efficient. By trying to impose a level playing field, rights would be violated and inefficiency arises. Therefore the fairness argument is also not a pragmatic approach to determine ethical issues in insider trading.
Although the fiduciary duty argument is incomplete, it is apt in applying to directors or officers of corporations. Thus, under the fiduciary duty argument an insider trade would be considered ethical if the trade leads to increase in shareholders’ value. For example, if a director knows that they is a certain news or information that would lead to a favourable rise in the share prices, by trading on this information or by sharing it with financial analyst, the market would react to this positive news and share prices would increase. Thus, this would result in a general increase in the share prices of the corporation. Therefore, under the fiduciary duty argument, the director has not been unethical towards its shareholders. However if the director knows that a certain news would lead to a decline in the stock prices, he then should not trade on this insider news. This is unethical as the trade would have prevented a loss for the director but not the shareholders. This is in breach of his fiduciary duty as he is supposed to act in interest of his shareholders and not against it.
Misappropriation theory is also an approach we could adopt in deciding the ethical issues involved in insider trading. It is clearly unethical to trade on stolen information. For example, if a lawyer acting on a company was specifically told in his contract that he is not allowed to trade on any information that is deemed confidential in his course of work, then clearly it is unethical to trade on any information pertaining to the company because he is ethically and legally binded by his contract.
Lastly, the rights-based approach is a pragmatic approach in defining ethical issues in insider trading. This comes from the fact that insiders have every right to trade on information that they have rights to. By ruling that insider trading is unethical by implementing the fairness argument is a violation of rights to the insider. Therefore judging from this aspect, insiders should have the rights to conduct insider trading.
Concluding Remarks and Relevance to Singapore
All in all, we have seen that insider trading is a complicated and complex issue. There is no distinct approach where one could adopt. To a certain extent, it could be considered very subjective in nature. However what this paper has proposed is to provide a systematic way for readers to apply when confronted with this issue in the future.
The first thing when one encounters this is to ask oneself if he has broken any fiduciary duties to his shareholders. Next he should ask himself if he is misappropriating the information. Were there any clauses in his contract that specifically directed him not to trade on non-public information? Following, he should adopt the rights-based approach in determining if he has the rights to the information that is going to be traded. Lastly, and the most important of all after passing all the criteria mentioned, is that if one is violating any insider trading laws in its jurisdiction.
Linking it back on how this proposal could be applied in the Singapore context, the 2 insider trading cases mentioned earlier would be used as an example. In Kevin’s case, it is clear that Kevin has violated his fiduciary duties towards his shareholders. This comes from the fact that Kevin knows that WBL is going to incur a loss in the third quarter. Thus, by selling his shares off through this insider information, it has helped him prevented a loss of approximately $27,000. In this scenario, Kevin acted on his own interest instead of his shareholders. Had the shareholders known about this information, they would be better prepared for the impending drop in share prices and act accordingly. Moreover, Kevin has violated the SFA. Thus, knowing what he was up against, Kevin should not have proceeded on with the trade. In Chuan Teck’s case, it appears that he did not act unethically. This is because the price sensitive information that Chuan Teck possessed was in favour of increasing the share prices. Thus, through trading on this positive news that Cosco had secured ship building contracts, Chuan Teck has indirectly helped his shareholders to gain value because of his trade. However, given the limited information, we do not know if Chuan Teck has misappropriated this information and whether he has any rights to this price sensitive information. Moreover, even if his act was ethical, the SFA deemed that he had violated the insider trading provisions.
It seems that the SFA is quite stringent and restrictive in a sense. Although according to this paper’s proposal, Chuan Teck mostly likely did not act unethically, the SFA deemed that he has contravened the insiders trading act. One could then question if the SFA is effective in punishing insider traders. In the spirit of capitalism, transaction between parties should be legal and unregulated. Only when rights are violated and fiduciary duty has been breached should then the laws come in to punish the perpetrators. Therefore, legislators should perhaps revisit the SFA to identify any flaws and rectify it so that Singapore could remain competitive in the financial world.