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Insider Trading Law and Practice

REPORT ON QUESTIONS ARISING FROM AN INQUIRY INTO TRADING IN THE SHARES OF FLETCHER CHALLENGE LIMITED IN MAY 1999

SECURITIES COMMISSION
WELLINGTON, NEW ZEALAND

PART 4 - COMMENTS ON THE LAW

  1. The primary purpose of the Commission's inquiry was to consider whether there was any insider trading by any person in terms of the Amendment Act. However the inquiry has raised questions about the policy of laws regulating behaviour of traders in quoted securities. The particular questions are:

    1. Whether liability under Part I should always be absolute with regard to the tipping provisions and whether liability should always fall on the insider tipper;

    2. Whether liability as a secondary insider should be extended beyond the people covered by sections 3(1)(c) and (e); and

    3. Whether a person who has received or obtained inside information from an insider should be free to trade on that information when it was not initially communicated in confidence or when it was taken without the knowledge of the source.

  2. The question is also raised whether our laws should expressly prohibit any forms of manipulative conduct in respect of stock prices and stock markets. This is addressed in Part 5 of this report.

Liability for tipping

  1. We have commented that on the facts available to us AB may be liable under section 9 of the Amendment Act because, while she was an insider, she communicated inside information to another person knowing or believing that that person might thereby be induced to buy securities.

  2. We have queried such an outcome where a person in the position of AB appears to have believed that the information she passed on was not inside information and she did not gain by her actions.

  3. While the nature of liability has not been fully examined in relation to sections 7 and 9 of the Amendment Act the Court of Appeal indicated in the Wilson Neill case that it sees liability as being absolute, with no room for a defence of absence of fault.

  4. When the Court made this observation its judgment mentioned the statutory exceptions from liability available under section 7 and 9. It stated "In such a legislative scheme there is no room for the principle applied in Civil Aviation Department v MacKenzie, [1983] NZLR 78...[which concerns a 'no fault' defence for strict liability offences]".15 The Court referred to the "Chinese wall" exceptions available in sections 8 and 10, and the exception, available under section 8(1), for company officers who buy or sell securities in accordance with a procedure approved by the Securities Commission.

  5. Applying absolute liability for insider trading has a pragmatic justification. The experience overseas has been that it can be very difficult to prove a person's motive when bringing an action for insider trading. Imposing absolute liability where a person has suffered a loss or been deprived of the opportunity to make a gain allows an action to be determined on the basis of more readily discoverable facts.

  6. In addition however absolute liability can be justified as a matter of principle. While the insider trading action remains a civil matter the basic liability of a trader to make good the losses incurred by his or her counterparties may be viewed, quite apart from questions of moral opprobrium, as a matter of restitution for unjust enrichment. The insider who has benefited from the trade is required to forfeit the profits, irrespective of fault.

  7. The public interest in securing judgment in appropriate cases might be seen to favour restitution where a person, viewed objectively, has acted with benefit although without fault.

  8. On the events described in this report we doubt that the restitution approach works so well in relation to liability for tipping because the tipper (insider) may be liable to counterparties of the tippee for losses incurred where the tipper did not receive any gain. On the policy of this legislation we query whether an innocent tipper who receives no gain should be required to restore the losses suffered by any counterparty of the tippee.

  9. Two options present themselves to remedy this. Taking the approach that the primary liability provisions of our law seek to restore losses suffered by counterparties, it may be that it is the person who trades to an advantage as a result of the tip who should be liable to his or her counterparty for the losses. Alternatively, liability on an insider to account for losses arising in a transaction to which the insider's tippee is a party might be confined to situations where the insider tipper cannot establish that he or she acted without knowledge of the nature of the information.

    Liability on the tippee

  10. The question of a remedy for the losses of a counterparty in cases of tipping will involve balancing a number of factors. These include the possible inequity of permitting the recovery of losses from a person who entered into a bargain in good faith, the desirability of allowing restitution for counterparties, and the desirability of achieving certainty in stock market transactions (where no insider is involved in the transaction).

  11. The chain of tippees whose trading can incur liability for an insider tipper currently extends for two removes from the insider, both where the insider tips by passing on information and by giving advice or encouragement. The tippee may not know about the inside nature of the information at issue. If there were a cause of action against the tippee the counterparty would have a claim against the person who actually profited from the trade.

  12. The Australian Corporations Law provides a civil remedy where an insider trades or procures another person to trade. This civil action allows the counterparty to this trade to recover losses from "the insider, the other person, or any other person involved in the contravention". It appears that this provides a right of action against a tippee for losses sustained as a result of action taken by an insider. Under this provision the insider must have acted with knowledge of the nature of the information, but there is no "no-fault" defence available for the tippee.

  13. It might be argued in the New Zealand context that this would produce a harsh result for a tippee who enters into a transaction in good faith expecting to achieve a final settlement, at least where that person entered into the trade without knowledge that information on the basis of which the trade was undertaken was inside information. It may be appropriate to limit any claim against a tippee to those occasions on which the tippee knew or ought to have known that the transaction was tainted.

    Knowledge of the insider

  14. Similarly it might be appropriate to consider whether to limit recovery against the insider tipper for losses caused by tipping to those situations where the insider acted with knowledge that the information in question was inside information, or alternatively where the insider is unable to establish that he or she acted without knowledge. Knowledge that the information is inside information is a requirement in all the overseas jurisdictions that we have observed, and has been raised in the discussion paper on insider trading published by the Ministry of Economic Development in September.

  15. As is the case at present, the option of holding the tipper liable for losses of the tippee's counterparty involves compensation or damages for losses suffered (to a third party) rather than restitution for money paid. The argument in favour of a knowledge requirement for this is that an award of damages (rather than restitution for money paid) against a person who has not transacted should usually be made only where a wrong can be established.

  16. Conversely, a knowledge requirement could make it more difficult for counterparties to recover their losses. For this reason we raise for discussion whether placing the onus on an insider to show lack of knowledge would lessen this burden.

    Penal provisions

  17. Whether or not any recovery of losses can be obtained from a tipper or a tippee, any further penalty should be considered in the light of the ethical nature of the insider's actions (including disqualification from management of a company under the Companies Act - the Commission has previously recommended to the Government that the law be amended so that disqualification is at the discretion of the Court). This was signalled by the Court of Appeal in the Wilson Neill case, where it commented that "absence of moral fault would clearly be important on any question of penalty and also on an application for relief from disqualification [from managing a company]...".16 This discretion on the part of the Court provides a valuable safeguard, and would perhaps be important on the facts of the present matter.

  18. We consider that the insider tipper should remain liable for pecuniary penalties and disqualification from management of a company, as these can be identified as remedies going to the nature of the insider's actions. It will be a matter for the courts to determine the circumstances in which these further penalties should be imposed. Under either option discussed in paragraphs 164 to 170, the tipper can be liable for these penalties whether or not any gain is made, but conversely the innocent tipper who makes no gain should incur no liability.

  19. Against this background it is clear that disqualification from management of a company as a result of liability for insider trading should be at the discretion of the Court. This is a penalty relevant to the ethical nature of the insider's actions. It does not fit well with the restitutory nature of the primary non-discretionary remedies.

Secondary insiders - the "length of the chain"

  1. This section refers to people who are insiders by reason of the receipt of inside information rather than by reason of a pre-existing relationship with the public issuer. In the context of this report, we have commented that we do not consider that either CD or EF was an insider of FCL. It appears that EF took advantage of information that was inside information. It is not clear from CD's statements whether or not he could be said to have taken advantage of the information (see paragraph 63). This information, we consider, should reasonably have been known by both of them to be inside information at the relevant times. EF and CD both gained from trading on this information.

  2. Liability arising from the receipt of inside information does not extend further than two removes from the primary source, nor was it intended to.

  3. The proposals for the Amendment Act stopped the chain of insiders at two removes from the public issuer because the intention was to prevent insider trading near the source of the information. However, the recommendations also acknowledged "logic suggests that a sequence of confidences could reach to infinity, and that all in a sequence, however extended, should be regarded as insiders" 17.

  4. The question arises whether the chain of insiders under section 3(1)(e) should extend more than two removes from the primary source of the information.

  5. One way to achieve this would be to define an insider by reference to the receipt in confidence of inside information from any insider (including another person who is an insider under section 3(1)(c)). Sections 3(1)(e) and (f) would become redundant.

  6. Adoption of this proposal would mean that the concept of insider could be extended, consistent with the concept of breach of confidence, as far as the string of confidences might go (so long as the information is still not publicly available, because it would then not be inside information).

  7. A similar approach is found in the Ontario Securities Act, which provides for liability where a person in a "special relationship" with a reporting issuer trades in securities of that issuer "with knowledge of a material fact or material change with respect to the reporting issuer that has not been generally disclosed." The categories of people deemed to be in a "special relationship" with a reporting issuer include:

    1. A director, senior officer, affiliate, or associate of:
      1. the reporting issuer or a subsidiary; or
      2. a person or company (listed or unlisted) that is proposing to make a take-over bid for the reporting issuer or proposing to become a party to a merger or other reorganisation with the reporting issuer; or
    2. A substantial shareholder in the issuer; or
    3. A person that is engaging or proposes to engage in any business or professional activity with or on behalf of the reporting issuer or with any person described in paragraph (a)(ii) above; or...
    4. A person who "...learns of a material fact or material change with respect to the issuer from any other person or company [in a special relationship with the issuer], including a person or company described in this clause, and knows or ought reasonably to have known that the other person or company is a person or company in such a relationship".

  8. This legislation maintains the concept of "special relationship" for disclosure to any degree from the primary insiders (up until the point that the information must be regarded as generally disclosed).

  9. The Ontario law adds a requirement that the person receiving the information knows of the nature of the information and its source. We consider the requirement under our law that the insider is a person under an obligation of confidence adequately addresses this point.

Receipt in confidence

  1. We have discussed above (paragraphs 129ff) that our insider trading laws are based on theories of breach of confidence. If this basic notion is to be preserved then there must be an obligation of confidence arising from the receipt or possession of information. Further, unlike liability arising at equity for breach of confidence, the source of an insider's information is vital under our insider trading law at present. People can be liable as insiders only if they receive the inside information from a "primary" insider (one who is an insider under sections 3(1)(a) or (b)) or from a person who is an insider under section 3(1)(c) or if they are themselves "primary" insiders.

  2. The Commission's 1987 recommendations to the Government that led to the enactment of the Amendment Act stated:

    "Our principal advice is that statutory causes of action should be established to enable companies and persons who deal with insiders to obtain, by means of civil proceedings, redress for the mis-use of information that is held in confidence" 18.

  3. We think this statement sums up the policy intent of this legislation. It is common sense to infer an obligation of confidence in respect of CD's possession of the inside information following his receipt of the phone call from AB and in respect of EF's taking of the information that he believed he should not have. We think that such an obligation would be inferred in equity.

  4. We do not consider it is consistent with this policy that a person is spared from liability who misappropriates inside information knowing it to be confidential, while the person who receives in confidence the same information voluntarily given attracts liability as an insider. We do not believe such a distinction is warranted or desirable.

  5. We consider that if the legislation is unclear on this point it should be amended. One way to achieve a satisfactory outcome on this and the point discussed above might be to amend section 3(1)(c) to include as an insider under that provision any person who obtains or receives inside information from an insider (including a person who is an insider by reason of section 3(1)(c)) and who holds that information in circumstances importing an obligation of confidence in respect of the information.

  6. Amending the law in this way would introduce the broader concept of "obligation of confidence" and leave the precise details of this to be decided by the courts. If a similar approach were taken to that used in equitable actions to restrain mis-use of information and to prevent breach of confidence then we are confident that such an obligation will be found to arise in appropriate circumstances even where the information concerned was taken without the knowledge of the person from whom it was obtained, or when an obligation of confidence, objectively assessed, arises in respect of the information after receipt of the information.

Footnote(s):

15
Above no. 4 at 162

16
Above no. 4 at 162

17
Insider Trading - Report to the Minister of Justice by the Securities Commission, Securities Commission, 1987, Volume 1 p 49

18
Above no. 17 at p 73