The issue of insider trading is as old as trading on equity markets itself. In all developed markets around the world it is seen as the biggest offense against the ethics of business and is also seen as a potential destroyer of public confidence in the stock exchange. Therefore should be legally regulated. This does not mean that insider trading is always associated with illegal conduct.
Legal and illegal insider trading
We also recognise legal forms of insider trading. The legal situation appears when corporate insiders as employees, officers and directors buy or sell stocks in their own company. Insider trading is legal once the decisive information has been released to the public, at which time the insider has no direct advantage over any other investor. When these insiders trade with their own securities, they must report their trades. However, the Author in this essay deals with the illegal aspects of this phenomenon.
Insider trading as defined by the Black’s Law Dictionary is: „The use of material non public information in trading the shares of the company by a corporate insider or any other person who owes a fiduciary duty to the company”.
Just imagine one possible situation, where a director of a company whose shares are traded on the stock market. This director has from his position access to information about the ground-breaking innovation of the products the company makes, which will lead to improvements and competitive products made by the other companies, may not be able to compete with this company. Such price-sensitive information, when it becomes publicly known, causes an increasing interest in the stocks of the company and thus also increasing their value. The model director then buys (or advises his friends to buy) shares before any price-sensitive information is published and then, after the stock value rises, sells them at a profit.
Information, which is not publicly accessible, does not need to have a positive impact on a stock’s value. The negative impact can have, for example, the news on the upcoming criminal prosecution of a member of the Board or the Supervisory Board. If our director in such a situation would sell his shares in time, i.e. before information will be disclosed, his „profit“ would be tantamount to the loss he would suffer and which thus he avoided by an early sale.
But, it is not only a problem of the company itself. Aside from the moral or ethical reasons for this conduct, no less important is the economical aim to protect the market in the respective country as a whole. If the behaviour described above, would not been prohibited, the interest of investors in such securities market would probably be jeopardised. The subject of this essay will confront the views on the merits of regulation of the transactions outlined above. The transactions using non-public information that might, after becoming well known, affect the rate or yield on a security.
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, which is non-public information about the security. Insider trading violations may also include „tipping“ such information, securities trading by the person „tipped,“ and securities trading by those who misappropriate such information
As we can see todayand could see through history, stock markets prices are subject of a speculative manipulation. This manipulation creates prices of stocks which does not reflect their real value and represents disadvantage for those, who are not aware of this manipulation.
It took several decades to introduce a legal regulation of insider trading. Until the end of World War II, it was not anything special that members of a company – directors, officers or employees – were selling and buying shares and stocks of „their” company on the basis of information that was not known by a public. This conduct was considered as legitimate, common and widespread. After the end of World War II, until the late 1950’s, it started to be considered as unethical to make a private profit at the expense of the main body of shareholders. Surprisingly, at the 1960’s and at the beginning of 1970’s, the practice of insider trading was widespread once again. Insider dealing was even described by the Financial Editor of the Sunday Times in 1973 as the „crime of being something in the City“.
This situation in 1973 forced the Stock Exchange and the Takeover Panel to issue a „joint statement” which called for criminal sanctions. The term insider trading (or dealing) has been used in British law since 1980. After several aborted tries to pass legislation through the Parliament, on 23 June 1980, sections 69-73 contained in the Part V of the Companies Act 1980 came into force and made „insider dealing” a criminal offence. Later on this was re-enacted in the Company Securities (Insider Dealing) Act 1985. After suggesting the reform of law, dealing with the investment industry in a White Paper], insider trading was amended by the Financial Services Act 1986.
Regulation of insider trading in many other countries with similarly developed capital markets is not much older. Even in relatively recent times could be argued quite convincingly that the only country with relatively functional and enforceable regulations is the United States of America, where the roots of legislations are in the beginning of the 1940’s and a wider application by the courts has begun in the early 1960’s. The approach of the U.S. regulator, the United States Securities and Exchange Commission (SEC), is sometimes with a little exaggeration deemed to be thus; „that people who engage in insider trading should be left naked, homeless, and without wheels”. This approach has been seen for a long time as extreme when compared with the most other countries, which, with some exceptions, did not punish insider trading at all or existing rules were rarely enforced.
Further impulse for the next reform in the UK came in 1989, in order to comply with European Community Directive 89/592/EEC (Insider Dealing), which was aimed to co-ordination of the insider trading in the member states. The Companies Securities (Insider Dealing) Act 1985 was repealed and replaced on 1 March 1994 by Sections 52 to 54 of the Criminal Justice Act 1993, implementing the above mentioned Directive. At the time the Directive was passed, four of the 12 members of the European Community – West Germany, Belgium, Italy and Ireland – had no insider trading legislation on the books and the remaining eight members – France, England, Luxembourg, the Netherlands, Denmark, Greece, Portugal and Spain – had widely varying statutes. Nowadays in the UK, Part V of the Criminal Justice Act 1993 deals with Insider Dealing, wherein are contained several forms on insider trading which makes them criminal offences.
Financial Services and Markets Act 2000 and FSA’s model code
As we can see, the problem of insider dealing is contained in criminal law and can also be sanctioned by civil law under the control of the Financial Services Authority (FSA). The FSA is an independent and non-governmental organization, whose authority is based upon Part VI of the Financial Services and Markets Act 2000 (FSMA). The FSMA introduces the broader offence of market abuse, which includes „insider dealing“, „disclosing inside information“, „dissemination of false“ and „misleading information“, and „employing fictitious devices“. All of these offences are included in the term “insider dealing”.
The FSA is a securities regulator, focused on the companies which issue the securities traded in financial markets. It is a limited company by guarantee and financed by the financial services industry. The FSA’s model code, which is adopted in chapter 9 of the Listing Rules and contains „discharging managerial responsibilities”, which listed companies are required to adhere. This is a model, which all listed companies have to adopt as they are required to take „all proper and reasonable” actions to meet criteria contained in the model code. The model code is not directly binding for directors of a listed company, but the company has to adopt this code. Possible breach of the adopted code is a breach of the duty owed by the director to the company, not to the FSA. The duty owed by the company to the FSA is to adopt the code itself.
Increasing activity of the FSA can be demonstrated at the last year when a series of highly publicised arrests by the City of London Police in connection with FSA investigations into insider dealing has caught the attention of both the press and city institutions. The high water mark of the year, in the FSA’s drive against market abuse, may very well be its successful prosecution in March 2010 of Malcolm Calvert, a retired partner of Cazenove, on five counts of insider dealin
Mr Calvert, 65 years old, was sentenced for 21 months after being found guilty of five counts of insider trading in three companies (in pharmaceutical company Vernalis, in road construction firm Johnston Group Plc. and in water firm South Staffordshire Plc., all between 24 June 2003 and 18 October 2005) ahead of public takeover announcements. He was also ordered by the judge to pay more than half a million pounds in confiscation and costs. The judge added: „It should be said the case has been investigated very thoroughly and efficiently. The FSA decided to do a proper job and should be commended for that.”
The main restrictions included in the model code are:
- A director must not deal in securities within a period of 60 days preceding the preliminary announcement of the final results. Similar rule applies for half-year and quarterly results.
- A director must not deal at any time when he or she knows price sensitive information, which has not been published. The price sensitive information is any information, which is able after the publishing to have a demand on the value of the respective securities.
- A director must seek clearance from the chairman (or other director designated by the board for this purpose) prior to entering into the transaction.
- Clearance to deal in any securities must not be given during a prohibited period; it is during a period when price sensitive information is unpublished but is known.
The Model Code also contains detailed definition of the term „dealing“.
Criminal Justice Act 1993
Protection under the Part V of the Criminal Justice Act 1993 consists of three criminal offences, which can commit an individual are described in Section 52.
- An insider who disposes of information is guilty of insider dealing if, under the specified circumstances, he deals in securities, and provided that the information is made public, would then have had a significant effect on the price of the securities (price-affected securities).
- An insider encourages another person to deal in such securities, knowing or having reasonable cause to believe that the other would do so
- An insider discloses the information, beyond that of the proper performance of the functions of his employment, office or profession, to another person
In the accordance of these three offences, an insider can be sentenced up to seven years imprisonment and can be also fined.
In the section 63 (2) is stated that, no contract shall be void or unenforceable, because of the fact that an offence was committed. The contract is unaffected, as in the controversial case Percival v Wright, where the judge held that: “the directors of the company are not trustees for individual shareholders, and may purchase their shares without disclosing pending negotiations for the sale of the company’s undertaking”.
The decision remained for almost a century without being overruled in the UK, and not being followed elsewhere in the Commonwealth, except at first instance in the case Coleman v Myers. The court held that the controversial decision from Percival v Wright should be ignored as it was wrong and argues by fiduciary duties between directors and shareholders.
In the case Brunninghausen v Glavanics the judge held that “the general principle that a director’s fiduciary duties are owed to the company and not to shareholders is undoubtedly correct, and its validity is undiminished”. The judge then went further and asked himself a question “whether the principle applies in a case, such as the present where the transaction did not concern the company, but only another shareholder.” At the end, the judge concluded that “the decision of a high judge in Percival v Wright should not stand in the way of the recognition of … [a] fiduciary duty owed by directors to shareholders where there are negotiations for a takeover or an acquisition of the company’s undertaking [that] would require the directors to loyally promote the joint interests of all shareholders. A conflict could only arise if they sought to advance their personal interests beyond the joint interest”.
The wording of s 63 (2) of the Criminal Justice Act 1993 is different from its predecessor in the 1985 Act which provided that no contract was to be void or voidable as a consequence of an offence. Thus the courts were able to hold that a contract was nevertheless unenforceable by the insider. That is no longer possible so that in theory at least a criminal will be able to enforce a contract which was the subject of his crime.
In the accordance with the Criminal Justice Act 1993, a person has information as an insider if it is, and he knows that it is, inside information from an inside source; if he has it through being a director, employee or shareholder of an issuer of securities or having access to the information by virtue of his employment, office or profession. A person deals in securities if he; acquires or disposes of the securities, whether as principal or agent; or he procures, directly or indirectly, the acquisition or disposal of the securities by any other person.
The clear statement has been made by the Lord Justice in the case R. v McQuoid about the insider trading: „Those who involve themselves in insider dealing are criminals: no more and no less. The principles of confidentiality and trust, which are essential to the operations of the commercial world, are betrayed by insider dealing and public confidence in the integrity of the system which is essential to its proper function is undermined by market abuse. Takeover arrangements are normally kept secret. Very few people are permitted to have advance knowledge of them. Those who are entrusted with advance knowledge are entrusted with that knowledge precisely because it is believed that they can be trusted. When they seek to make a profit out of the knowledge and trust reposed in them, or indeed when they do so recklessly, their criminality is not reduced or diminished merely because they are individuals of good character.”
Criminal Justice Act 1993 v Financial Services and Markets Act 2000
The definition of insider dealing as the criminal offence under Criminal Justice Act 1993 is very similar to the definition of insider dealing as the civil offence under the Financial Services and Markets Act 2000. There are only some minor differences in the wording. Anyway, both of them contain the rules which must be taken into account when considering if insider trading has occurred.
The Criminal Justice Act 1993 contains criminal liability for insider trading. But, on the other hand does not contain a civil remedy for the company or an outsider dealing in bona fide. The FSMA, especially its Part VIII, have been enacted to supplement the criminal liability of insider trading contained in the Part V of the Criminal Justice Act 1993.
The Financial Services and Markets Act 2000 contain a substantially wide regulation for financial services in the UK. The FSMA established civil sanctions to supplement the criminal sanctions contained in the Part V of the Criminal Justice Act 1993. Difficulties during prosecuting individuals accused of insider trading, under the regime of the Criminal Justice Act 1993, led the government to introduce a civil offence containing insider trading in the FSMA.
If the FSA is assured that an individual is engaging in, or has engaged in, insider trading, or has required or encouraged another individual to do so, it may assess an unlimited civil fine. The FSA may also issue a public announcement that the individual has engaged in insider trading or require the payment of compensation to victims of insider trading
A somewhat problematic moment in the British legal regulation may be the fact that laws against insider trading are usually very general. Due to the common law system there are “gaps” in the legislation detailed supplemented with many cases. This process is often very slow and until the higher courts confirm the legality of the interpretation, it is not entirely clear whether the lower court’s opinion should be fully respected.
Nowadays, most major elements regarding the issue of insider trading are developed by case law sufficiently and it is not very difficult to find and apply relevant higher courts’ decision to the chosen issue.
Further development of the prohibition of insider trading can be predicted only in silhouette. History has shown that legal regulation is usually one step behind- it is a response to adverse business practices that have occurred in the capital market. A massive expansion of the internet usage in the early 21st century led to a substantial acceleration of transfers of electronic information which are able to affect the price of securities almost in a real time. The Author assumes that there is a space for further development of legal regulation of this new phenomenon. Based on the existing historical evidence, the Author believes that the only truly effective tool for reducing the level of insider trading in the stock market is the immediate duty to disclose all inside information.
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