Insider trading: Good, bad or ugly?

By Cassandra Mascarenhas

Bringing to the spotlight an issue that has plagued the Sri Lankan stock market over the past several months, the Institute of Chartered Corporate Secretaries of Sri Lanka and the Securities and Exchange Commission of Sri Lanka in partnership with the Daily FT presented a seminar titled ‘Insider Trading – Good, Bad or Ugly’.

Held earlier this week, the forum featured a number of experts who delved into the finer points of insider trading, discussing its impact on the country’s market and economy and offered up solutions for the way forward and was followed by an interactive session during which the audience raised several key concerns with the experts present.

Let the robber barons come !

The forum commenced with some opening remarks delivered by the Securities and Exchange Commission of Sri Lanka Chairman Thilak Karunaratne who interestingly enough opened his address by citing a rather unexpected quotation on insider trading: “But if insider trading was prohibited, there would not be any trading in the market.”

However, he was quick to point out that though some may gain short term benefits from insider trading, the long terms repercussions would likely to be of a different nature, adding that if insider trading continues unabated, this will result in the loss of investor confidence and market integrity.

“This is why we believe that insider trading should be dealt with rigorous regulatory and enforcement actions. Regulation is essential to retain investor’s confidence and to maintain the integrity of the securities market,” he asserted.

Karunaratne then went on to give a brief overview of the laws governing insider trading in Sri Lanka, stating that the prohibition on insider trading in Sri Lanka is articulated in part four of the Securities and Exchange Commission of Sri Lanka Act No. 36 of 1987. It is noteworthy, he said, that the Sri Lankan law is based on the traditional approach where a connection has to be always shown to an insider in a listed company.

“In Sri Lanka insider trading is defined in the statute books. This means that the SEC has to ensure that, in an insider trading case the accused falls strictly within the prescribed definition given in the law. Whilst in some other countries the offence is not tightly defined and leaves room for interpretation by a regulator or a court of law,” the SEC Chairman noted.

“Whilst corporate insiders are generally thought to be primary candidates for insider trading violations in Sri Lanka, the reality in other countries is that others outside the corporate environment can also be charged with insider trading. It is a significant fact that in the United States only a very few cases involved a corporate officer or a director,” he added. “In contrast, many lawyers, law firms, employees, investment bankers, arbitrageurs, stockbrokers, financial printers, police officers, reporters of ‘Wall Street Journal’ and even a dentist have been charged with insider trading.”

He the felt that it was pertinent to acknowledge that on 22 March 2012, the US senate approved by an overwhelming majority of 96-3 legislation to strengthen ethics rules of insider trading by forbidding lawmakers from buying stocks based on information they gather while performing duties.

The bill also forbids all congressional and White House staff from buying stock products if they have inside information. Elected officials would also have to report any purchases they make on the stock exchange of more than $ 1,000 within 60 days.

“Regulators all over the world are discovering that governments cannot afford to turn a blind eye to insider trading if they hope to promote a lively securities market and attract international investment.

In Sri Lanka, there is renewed interest in business ethics and insider trading. Commentators are beginning to question the ethics, integrity and the goals of those working in the financial markets,” he conceded.

Karunaratne stated that the SEC wishes to have a market where all pertinent information is fully available to all participants and where prices respond immediately and correctly to available information as this would help in creating and maintaining a market in which securities can be issued and traded in an orderly and fair manner.

More Sri Lankans are investing in the stock market than ever before, he pointed out. Sri Lankans now invest several times of the amounts than they have invested in the pre-war era and the SEC believes that these investors will remain in the market only if the trust and confidence is preserved.

“The SEC and the public have raised concerns from time to time that penalties for violating securities laws are too lenient, that imposition of fines are too lenient and that very few cases have been prosecuted to the end. It is also interesting to note that the law does not provide for the restitution of those investors who have suffered losses due to the insider trading activities of some. SEC Sri Lanka too will be looking towards addressing this concern,” he assured.

In spite of the internationally recognised principles to combat insider dealing, certain economic and legal scholars have expressed scepticism about the enforcement of insider trading laws.

They claim that insider trading based on material non-public information benefits investors, in general, by quickly introducing new information into the market.

They further say that insider trading is a legitimate form of compensation for corporate employees, permitting lower salaries that, in turn, benefit shareholders. It provides an incentive to innovation, by promising huge rewards for developing a plan or product that will lead to a steep rise in the stock.

This argument, however, fails to address the real and significant hazard of creating an incentive for corporate insiders to enter into risky or ill-advised ventures for short term personal gain, as well as to put off the public release of important corporate information so that they can enjoy the economic benefits at the expense of retail shareholders.

There are those who argue that insider trading is a victimless offense and that enforcing insider trading prohibitions is simply not cost effective; the amount of money recovered does not justify the money and human capital spent on investigating and prosecuting insider traders.

This is a one sided argument which lack the merits of a balanced market analysis. We strongly believe that a market cannot be efficient in the long-term, when some investors take a big advantage over the majority of other investors.

“Those who are at a great disadvantage due to insider trading will eventually leave the market because they will lose their money to the unjustly enriched minority. A decreased volume of trading due to fewer investors in the bourse will make the market less efficient because buyers sometimes won’t be able to find sellers, and sellers sometimes won’t be able to find buyers. Market efficiency is an important goal to which we should always aspire to, but not at the expense of fair play,” he noted.

In order to ensure that the Sri Lankan securities market functions efficiently and integrity, time is ripe to borrow from other jurisdictions new ways of dealing with insider trading. He was happy to state that the SEC has embarked on a project to modernise the current securities laws in Sri Lanka and to ensure that we are equipped to face the future challenges.

They are planning to introduce new methods of dealing with offenders of insider trading. With the amended Act, insider trading will not be a compoundable offence and it will enable the imposition of civil sanctions in addition to the criminal sanctions available under the present Act.

“The most challenging task before the public, the market and the SEC today is to be able to distinguish illegal trading from that of permitted trading. So today’s seminar will hopefully contribute significantly towards clearing this fog in the minds of many as to what would actually constitute insider trading,” he said.

He concluded his opening remarks with a quote from the country’s first Executive President.

“In opening up the economy in 1977, he said ‘Let the robber barons come.’ The question now is whether we are now going to emulate him and turn a blind eye to robbers invading the bourse and taking the innocent investors for a ride? The SEC is determined not to do so, and work towards the protection of market integrity.”

What’s so bad about insider trading?

Up next to deliver the keynote address was University of Cambridge Prof. Gishan Dissanaike who delivered a presentation titled ‘What’s so bad about insider trading?’

Insider trading has been around for a long time, he stated, revealing that the world’s first insider trader was William Duer in 1970 who became the assistant secretary of the treasury in the USA and used his position to buy shares in all the banks.

“It has been around for a long time but the regulation of insider trading is comparatively recent. It was only after 1929 that the US brought in statute law to try and limit insider trading but didn’t seek to eliminate it. Since 1960, there has been more aggressive treatment of insider trading. For example, Hong Kong has no laws against insider trading until relatively recently,” he pointed out.

“Insider trading can be defined as trading in securities on the basis of material non-public information. It is important to note that while market manipulation may be related, it’s not the same.”

Dissanaike too stressed on the fact that many significant and important people have expressed scepticism about the enforcement of insider trading. One such person is Henry Manne, an American writer and academic who along with many others, have for many years been arguing that insider trading be encouraged and that all SECs around the world are making a huge mistake by trying to control it.

Manne made two important arguments in favour of insider trading; that it promotes market efficiency and is an important form of executive compensation. Dissanaike then went through the arguments in favour and against insider trading, explaining that when discussing policy making, it is very important to take in all views on the subject.

First taking the point of increased market efficiency, he noted that based on the crucial role that price and markets play in the economy; price is the signal to enable good resource allocation.

“The argument made is that insiders have far more information and so they should be encouraged to trade because then their private information comes out into the open. Insider trading is actually very good for the economy and the country as a whole as the market prices are better signals for market allocation,” the professor stated.

He did point out that this is not always the case and while not everyone agrees with this theory, it is also fair to say that the argument Manne made hasn’t completely gone away but one argument is that insider trading may make the market less efficient especially when inclusive access is limited to a small group of people.

Information must be spread amongst numerous competitors in order for the market to be efficient. If other informed traders like analysts play a very important role and may withdraw from the market as they think the insider traders are running the show which will result in a market that is less efficient.

Insider trading may also drive up the cost of capital and that has economic importance. It is the enforcement of laws that matters. It is interesting to note, Dissanaike said, that the cost of equity was lower by around five per cent in countries where insider trading laws were enforcement. Looking at the market efficiency argument, we cannot completely dispel Manne’s theory but we cannot be very sure about it either, the professor summed up.

The second argument however has come under much more fire. It states that by providing executive compensation for entrepreneurs, it’s a way to save on payroll costs, does not cost the company anything and only involves allowing an inside executive to use information for insider trading for personal gain and in turn adds value to the firm.

“Executive compensation has serious limitations. While it accurately measures the value of the innovation, the insiders’ innovation will be limited to the number of shares the person buys and so is not based on the returns itself but also depends on the limits of his or her wealth. There is also the difficulty of restricting trading to those who actually created the value. There may be employees who create value but the insider trading benefits may be shared by those who had nothing to do with raising the value,” he pointed out.

Furthermore, managers may be able to profit even when the company is doing badly. An incompetent manager can make profits if he short sells the stock. Dissanaike added that Manne himself in a recent article accepted that the argument is no longer as strong.

Dissanaike then went on to list out five reasons in favour of regulation; that it simply is not right, that it is immoral to make large profits with very little effort, the need for a level playing field, fiduciary duty and misappropriation and property rights. Choosing to focus on the last three reasons given, he noted that the playing field cannot be level when some enjoy informational advantages over others. On the other hand, it has to be recognised that asymmetric information is often present in business transactions as one party in a business transaction will obviously have more information about the transaction than the other party. Therefore a simple reliance on a level playing field argument may not be enough.

“I think that the fiduciary responsibility argument is one of the strongest that can be made against insider trading but that too cannot be used in cases where it is an outsider who trades in the securities unless he is a de facto and an extension of the insider,” he stated.

The professor pointed out that the argument would be difficult to apply in a case where a journalist who works for a financial newspaper trades on the basis of information that has not been published in the paper yet.

“But we could say that he has a fiduciary duty to the company he is working for but does that mean then that the newspaper could have traded? What if we say that the newspaper didn’t get the information from an insider and got it instead from heavy research? That’s not necessarily insider trading,” he said. “So a journalist who goes out and trades without the permission of the newspaper may be breaking the terms of his fiduciary duty to the newspaper but if the newspaper does it, that’s another question depending on how the information was acquired. It must be acknowledged that some people can do more with certain information than others.”

Fiduciary responsibility covers most cases of insider trading but not all. It also cannot be used when an insider sells to someone who was not already a shareholder. Furthermore, it does not apply if an insider buys or sells corporation bonds as bond holders are creditors although the person may owe his shareholders some information that he is investing in bonds as the bond market may have an effect on shareholders as it has an effect on equity.

Finally there is the argument of misappropriation which is increasingly being used in the US. It basically states that the information used by insiders belongs to someone else and therefore results in the misuse of property rights but again is not applicable in cases where someone trades on information that they are legally or morally allowed to trade on.

“We need to review the arguments both for and against regulation. Often in policy discussions, the arguments for insider trading are not mentioned which I think is a mistake and we need to be careful that we do not completely kill innovation and information generation when imposing regulations,” Dissanaike cautioned. “A pure market solution is unlikely to work and the same applies to a pure regulation approach. Markets are not perfect but regulatory regimes are not perfect either. We must try to find that optimal level of regulation which is very hard to define – cases of clear insider trading are discouraged but neither do we want to kill the innovation and gathering of information that is very necessary for the economy.”

Self regulation is actually very important and should go hand in hand with official SEC regulations. The largest banks, largest fund managers have a role to take on and acknowledge what a problem insider trading is. Self regulation can be very effective hand in hand with more compliance that way. It is never going to be perfect but there is a role for self regulation here, he stressed. Dissanaike concluded with an interesting insight into insider trading - that most insider trading investigations are started many years after the event and trigger for this is mostly from ex-employees and ex-wives.

Insider trading or outsider trading?

Laugfs Holdings Chairman W.K.H. Wegapitiya then addressed the gathering on ‘risk and reward.’ He noted that for quite a long time entrepreneurship literature has made risk taking the central theme. The main reason for this is that engaging in risky activities has been consistently been on the list of activities of entrepreneurs.

Their ability to take risk marks the difference between ordinary people and entrepreneurs, asserted Wegapitiya. He also pointed out that there is a correlation between risk and reward; the higher the risk, the higher the reward expected.

Wegapitiya then took the theoretical aspect of risk and reward and pitted it against what happened over the last nine months in the financial market.

When it comes to virtues commonly found in entrepreneurs, ambition has been ranked first and perseverance second. The capacity of risk taking has been commonly shared by all entrepreneurs – risk taking reinforced by ambition, commitment and various other sub-components, he defined.

“However there is a missing link when it comes to the theoretical market and what happened in the CSE over the last nine months was that someone else took the risk and someone else took the reward. So many were reluctant to talk about it and get involved in trading on the CSE,” he stated.

Wegapitiya defined risk as a potential hazard that may arise due to a present or future event. It is usually mapped based on the probability of the hazard occurring combined with a believable scenario consisting of risk, rewards and regrets and is assessed into a financial amount.

“Many people who are capable of taking that risk essentially get the reward. There was a missing link – your controllability. Most involved in trading activity were very ambitious people but many didn’t have the ability to control that risk. If you have that ability, then your probability of getting a reward is decided,” he explained.

Unfortunately what took place over the past several months was not just insider trading, Wegapitiya said. Robber barons probably allowed a certain party to take a risk and took the reward and the other party had no control over it. What happened was not insider trading but outsider trading. They were not worried about the insider information. In fact some didn’t even know what companies they were buying into but were led into it and now innocent people are suffering while those who led them to it gained and then vanished.

“A set of individuals got hold of some easy stock, shared some information and encouraged people to buy. Those who initiated it then vanished with rewards but innocent people were left with pain. It is not about taking risks; there are enough and more people who are willing to take risks. In the case of the CSE, the controllability was not there for those who invested and that’s the main reason why people are discouraged to invest and get involved in the CSE.”

Swings between Greed and fear

Heraymila Securities Limited Director/CEO Ravi Abeysuriya addressed the topic by making an assessment of how greed and fear play into investor emotions by delivering a presentation titled ‘The swings between greed and fear in the Sri Lanka stock market’.

After showing the audience short clips from the movies ‘Wall Street’ and its sequel ‘Wall Street: Money Never Sleeps,’ Abeysuriya noted that the entire finance industry in the US was on the verge of collapse, the primary cause being that people in financial institutions made very bad decisions because they got greedy.

He then drew upon the example of Raj Rajaratnam who was the richest Sri Lankan-born in the world with an estimated net worth of $1.5 billion but was sentenced to 11 years of jail and fined with a civil penalty of $92.8 million for insider trading in 2008.

Looking at what drove the Sri Lankan stock market; Abeysuriya noted that like any other stock market, it is driven by two emotions: greed and fear. He pointed out that in Sri Lanka, there is more information driven short-term retail trades without fundamental research and institution play.

“This get-rich-quick mentality makes it hard to maintain gains and keep to a strict investment plan over the long term. Although Heraymila said that our market is grossly overvalued and is poised for a correction, the market continued to rally until June 2011 because investors under the influence of delusion and greed took greater risks to make profits in the shortest possible time span,” he explained.

In reality, the price of a stock should depend on expected fair value of the underling company. However, as the price of a stock moves further and further away from the fair value of a company, a profitable trade could only happen as long as there are more gullible investors lured by the prospect of huge profits and willing to pay an inflated price, he went on to say. In this backdrop, companies came into the market by way of IPOs and share introductions and took advantage of the investor hype.

“In Sri Lanka, we have rules against market manipulation and insider trading but they only bind those who care to be bound by them. We have had only a few prosecutions and I have not heard of anyone going to jail for these crimes. Our stock market is dominated by retail investors who are punting on penny stocks that have low liquidity and it is greedy advisors who have allowed investors to buy stocks at these prices. Professionalism, ethics and discipline in providing investment advice is the only way to go,” Abeysuriya expressed strongly.

He then took a look at what drives the Sri Lankan stock market at present, noting that with the stocks suffering huge losses, the market has become overwhelmed with fear. In a bid to stem their losses, investors have moved out of stocks in search of less risky fixed deposits and this mass exodus out of the stock market shows a complete disregard for a long-term investing plan based on fundamentals. “Being too fearful can be just as costly as being too greedy. Now that the bubble has burst and investors have lost lots of money, they have become overwhelmed with fear and are vulnerable to their emotions, often resulting in very costly mistakes,” Abeysuriya pointed out. “The advisors and analyst communalities are responsible for the present predicament of the market.”

The way forward

The final speaker of the forum, Nithya Partners Partner Attorney-at-Law Arittha Wikramanayake, summed up the evening’s proceedings by sharing some thoughts on the way forward.

He began by noting that that there appears to be widespread agreement that the problem of insider dealing has become a serious drawback to the growth of this market, by having severely undermined its credibility. Many serious investors are opting to stay out of the market, as a result of their concern that it does not offer a level playing field. One must bear in mind, he said, that the stock market is but one other avenue for investment, and that investors have options. Credibility of markets is therefore crucial for the developments of the stock market.

“At the same time, I also believe that it is virtually impossible to make an objective assessment on how much insider dealing actually takes place in this market but, we have to concede that no matter how deep or shallow the problem lies, perceptions matter in capital markets, and that even mere perception can bog down or even kill a market – as it seems to have happened to a large extent in Sri Lanka,” he observed.

The good, bad and ugly coexist together on the stock market and Wikramanayake stated that the existence of these three categories of market players means that there should be a multi focused approach to deal with the issue.

As far as the “good” are concerned, the primary task is to focus on education and awareness so that they are kept that way.

“No one can deny that the laws and concepts on insider dealing are hugely complex, and not easy to understand. This is not necessarily so only in Sri Lanka, but also in developed markets. Sometimes, one even finds that certain interpretations are not even available in the practices of developed markets. The fact that these situations exist highlights the need for education and public awareness,” he stressed.

Wikramanayake pointed out that the main approach in dealing with insider dealing, has, by and large, been in focusing on catching those who have involved in insider dealing - the trader.

He believes that it is equally important to create a culture within public quoted companies and boards, that they are equally bound to prevent insider dealing on their securities by implementing more meaningful rules on block outs; confidentiality agreements; restrictions on circulation of information – that is in dealing with the tippers.

However, education does not always work. There will be, and always continue to be, those who will be driven by greed, the attorney acknowledged. Insider dealing will continue in some degree, like in all other markets.

“That does not mean that we should sit on our hands and do nothing. We have to continually build deterrents, or what are commonly referred to as ‘fences’ which will make the commission of the offence expensive; and, so that even if it does not result in hordes of persons being jailed, those who commit the offense will not be blatant, and certainly not dare to stand in public and declare with impunity that they engage in insider dealing. To create these deterrents would primarily require sound laws, effective surveillance and enforcement.” In his opinion, the laws in place are certainly not inadequate. In fact if one examines our law, it is so wide that it can catch virtually anyone engaged in insider dealing, whether they be tippers or tipees, he said. The weakness is clearly in surveillance and enforcement.

“As we all know, surveillance, investigation and enforcement of insider dealing cases is not easy – even in highly sophisticated markets. It requires tons of expertise, tact, and hard work. The challenge is, no doubt, immense, but has to be taken head on. Remember, our markets are no longer infant or nascent markets, the regulator being in existence for over a quarter of a century,” he added.  Access to information itself is not enough. One has to build capacity to decipher raw information and extract material to commence investigations. It is imperative that the regulator builds public confidence and networks with the market.

 A good way to start building such networks might be by building confidence that leads will be pursued: and pursued discreetly, maintaining confidentiality, he said. Investigations should not be amateurish or frivolous. We also read of countless investigations that have been embarked on, usually finding their way to the press through undisclosed sources. The fact of the matter is that these unfinished investigations do more harm than good.

Enforcement is also key, in moving forward towards successfully combating insider dealing. The fact of the matter is that we have had little or no success in enforcement of such cases, he said, but it needs to be done. “We have to accept the fact that insider dealing cannot be totally eradicated. The reality is that insider dealing, being driven by greed or ignorance, will continue to happen, and is more akin to a cancer. Having accepted that reality we have to be equally dogged, continue to create deterrents, make the commission of such offences expensive, and above all create a perception that the market is relatively well regulated.”

 – Pix by Upul Abayasekara