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INFORMATION CONTROL IN MARKET PARTICIPANT FIRMS

REPORT OF AN INQUIRY INTO TRADING IN THE SHARES OF WRIGHTSON LIMITED IN JUNE 2004

PART 3 - MARKET PRACTICE - INFORMATION CONTROL IN MARKET PARTICIPANT FIRMS

Introduction - no insider trading case

60.

Based on the evidence it has about the disclosure of Marathon's intention to accept the RPI offer, the Commission has concluded that:

there was possibly "inside information" as defined in the Securities Markets Act relating to Wrightson (subject to assessments of materiality); but
there was no "insider" as defined in the Securities Markets Act undertaking insider trading or tipping; although
persons with privileged access to non-public information appear to have communicated this to others knowing or believing the recipient was likely to trade or have encouraged others to trade.

61.

We do not consider this is a case in which there are strongly arguable questions of insider trading or tipping within the terms of Part I of the Securities Markets Act. Our analysis of the application of the law to this inquiry is provided as Appendix A.

62.

However, we are of the view that this case raises issues relating to market practices adopted by the firm, in particular the lack of appropriate information control procedures on the part of Craigs.

Information control in broking firms

63.

Many financial services firms offer a number of services to clients, including advisory, broking, investment banking, corporate finance, and market research. The variety of roles that a firm can have makes it essential that there are good procedures in place for controlling the flow of information within a firm, in particular between different business divisions of a multi-service firm. These information controls are commonly referred to as "Chinese walls".

64.

Chinese walls are important in a broking firm for several reasons. One is to help the firm manage conflicts of interest. For example, the firm can continue to provide impartial investment advice about a company in a manner consistent with its duties to its clients while its investment banking department is engaged in a transaction relating to the same company and may be privy to confidential information about the company.

65.

In such cases a Chinese wall prevents the confidential information held by the investment bankers leaking to client advisers. In this way the firm can avoid any breach of confidence to the investment banking client, and can manage any conflicts with duties to advisory clients that could occur if its advisers gave advice that was not supported by the confidential information held by the investment bankers.

66.

Broking firms should also maintain Chinese walls to control the flow of material non-public information, and to limit the likelihood of people trading on the basis of inside or other non-public information. A firm should do this to protect itself from legal liability, and also as a matter of good market practice.

67.

The importance of the Chinese wall to limit liability is recognised in New Zealand's insider trading laws. The Securities Markets Act, which imposes liability for insider trading, contains specific Chinese wall defences. These are available to a firm that:

trades securities or that advises others to trade securities where the firm is in possession of inside information; and
operates arrangements to ensure that no individual who took part in the decision to trade, or the advice given, received or had access to the inside information, or was influenced by any person who had the information.

68.

Markets operate efficiently when information is fully disclosed. This is best done through the market announcement platform of the stock exchange. The Commission is of the opinion that selective disclosure of material non-public information represents a poor standard of market conduct.

69.

In many cases selective disclosure could expose those passing on the information (and, in some cases, also the recipients) to liability for insider trading. Even where it does not, the practice should, in our view, be discouraged as it creates information asymmetries and provides some traders with an advantage over others in the market. It is incumbent upon market participants operating both investment banking and broking activities to ensure this does not occur.

Craigs' information controls in the Wrightson takeover

70.

Craigs was asked to provide information about its role as adviser to RPI in the takeover. The Commission sought information on:

the firm's internal structure;
whether any specific division of its business was responsible for the RPI takeover; and
the Chinese wall policies and procedures within the business.

71.

Craigs' solicitors informed the Commission that the investment banking/corporate finance division was primarily responsible for acting as adviser to RPI although the operations and client services divisions also had responsibilities.

72.

In its submission to the Commission Craigs expressed the view that Chinese wall procedures were not required to be applied to the information received from Marathon. Craigs was of this view because:

the information was obtained in the course of acting for RPI, not as a result of any advice or client relationship with Marathon;
the information was not inside information; and
Craigs' use of the information was consistent with its obligations to RPI. It was in RPI's interests for Craigs to keep its other clients informed of market developments in relation to RPI's offer for Wrightson.

73.

In support of this contention, Craigs' solicitors also informed the Commission that Craigs was required by RPI, as part of its mandate, to communicate up-to-date information on the progress of RPI's offer, in particular the level of acceptances, to market participants and the market generally, by all available means including:

using its network of advisers in its client services division; and
providing regular updates to and receiving them from Forsyth Barr and ASB Securities, the two brokers described as sub-underwriters of the preference share offer.

74.

Craigs submitted that its actions were fully in accordance with its mandate from RPI. The Commission was told that an offeror invariably requires its broking adviser to communicate information about the progress of the offer in the course of a takeover.

75.

In respect of the information about Marathon's acceptance, Craigs submitted that RPI specifically required Craigs to communicate this information to its client advisers so that they could advise their clients. Craigs told the Commission that it also:

communicated the information to the other brokers involved with the offer; and
specifically advised the NZX of the same information prior to the market opening.

76.

Craigs said that the steps taken accordingly involved no breach of any duty by Craigs to RPI. According to Craigs there was therefore no requirement for the information relating to any increase in the level of acceptances to be kept confidential on one side of the Chinese wall between Craigs' divisions. Rather, Craigs said it was required by its client (RPI) to communicate the information to its clients.

Information controls - Chinese walls

77.: In the Commission's view, the flow of information between the investment banking/corporate finance division and the client services division of Craigs raises issues relating to the existence, implementation and applicability of Chinese wall procedures in relation to investment banking activities undertaken by market participants.

Did adequate systems exist to address issues relating to information control and how were these implemented?

78.

Craigs has an Investment Banking Operations and Compliance Manual that sets out the processes and procedures in which the investment banking/corporate finance division operates, including the Chinese wall procedures. The Commission received a copy of this manual.

79.

This manual recognises the need for Chinese walls within the firm and requires them to be implemented. The existence of a detailed compliance manual with Chinese wall procedures indicates that Craigs has provisions for the systems and policies expected of any investment banking firm.

80.

The manual also recognises the several purposes of Chinese walls, setting out the following explanation in its Policy section:

Chinese walls are established management and control structures, policies and procedures which separate the different business activities of the Company and control the flow of information between those activities. These procedures generally enable the private client advisory areas of the Company to continue to engage in transactions or recommend securities even where the corporate side of the Company possesses material or confidential information about these securities or their issuer. These procedures also serve to avoid the risk that clients' interests may be prejudiced as a result of conflicts of interest between the Company and its clients and between clients themselves.

81.

The manual goes on to state that the purpose of a Chinese wall is to:

prevent the improper use or disclosure of information, which is confidential to a client or other person;
provide evidence that information has not been improperly disclosed or used; and
prevent the attribution of information to all parts of a business.

82.

The manual also states:

A Chinese wall can also provide a defence concerning insider dealing and maximises the Company's ability to take up business opportunities it is offered. It is therefore vital to the Company that Chinese wall policies and procedures are observed strictly.

83.

The Compliance Issues part of the manual indicates the circumstances in which Chinese walls may be used. The section entitled Compliance Issues - Conflicts of interest states:

AAC's Corporate Finance will try to avoid conflicts of interest. Where conflict does arise AAC's corporate staff must ensure fair treatment to all clients by maintaining internal rules of confidentiality, observing the Chinese Wall policy, by disclosure, by declining to act or otherwise. If a conflict of interest emerges during the course of a transaction, Senior Management must be contacted. The Corporate department will seek advice from Senior Management as to how the conflict can be managed.

84.

According to the manual, senior management would decide on how to deal with a situation in which conflict of interests arose. In the current matter Craigs has informed the Commission that it did not consider there was any conflict of interests between RPI's objectives in the takeover and the interests of clients serviced by the client advisory division. Its legal adviser submitted that:

Our client's use of the information was consistent with its obligations to RPI. It was in RPI's interests for ABN AMRO Craigs to keep its other clients informed of market developments in relation to RPI's offer for Wrightson Limited.

Were Chinese wall procedures required to be applied?

85.

As discussed above, Craigs expressed the view that the Chinese wall procedures were not required to be applied to the information received from Marathon as:

the information was obtained in the course of acting for RPI, not as a result of any advice or client relationship with Marathon;
the information was not inside information;
use of the information was consistent with its obligations to RPI. It was in RPI's interest for them to keep their other clients informed of market developments in relation to RPI's offer for Wrightson; and
Craigs was specifically required by RPI as part of its mandate to communicate up-to-date information on the progress of RPI's offer, and in particular the level of acceptances, to market participants and to the market generally by all available means including, specifically:

(i)
using its network of advisers in its client services division; and

(ii)
providing the regular updates to and receiving them from Forsyth Barr and ASB Securities, the two brokers described as sub-underwriters of the preference share offer.

86.

The Commission considers that Craigs' submission as outlined above is misconceived in respect of the purpose of Chinese walls. An important function of information controls is to manage conflicts of interest. However, this is not their only purpose. Craigs' compliance manual explicitly recognises the importance of Chinese walls to regulate flows of material confidential information between investment banking and client advising divisions of the firm. This is important both as a risk management tool to reduce the chances of inadvertent corporate liability for insider trading and, in the Commission's view, as a matter of good market practice to discourage selective disclosure of material market information.

87.

In this case, relevant information about the takeover was given to a few market participants. This was not consistent with Craigs' mandate to inform the market generally of the level of acceptances. It appears to have led NZX to impose a trading halt on Wrightson shares.

88.

In announcing the halt to the market, NZX stated:

NZX advises that it has placed a trading halt on WRI securities on the basis that the market may not be equally informed in relation to the Takeover Offer for WRI.

89.

This indicates that the unequal information available in the market (contributed to by Craigs' disclosure to its client services division and other select market participants) may have compromised effective price discovery in the market. The selective disclosure of this information appears to have disrupted the smooth functioning of the market.

90.

Because of the extent of legal risk to which the firm and clients can be exposed, Chinese wall procedures should be applied to confidential and potentially price sensitive information received in the course of investment banking assignments. Decisions which relate to the application of the Chinese wall should be properly documented and communicated to staff involved with these transactions. For the same reason the Commission is of the view that market participants should give a high priority to ensuring that their personnel are adequately trained in the firm's information control procedures.

91.

Craigs has policy arrangements, set out in its compliance manual, for ensuring that price sensitive information was not passed between business divisions. However, it did not use them. It was of the view that it did not need to. In the Commission's opinion, this view was misguided, and the selective disclosure of the information was poor practice on the part of the firm. The information should not have been passed on to selective recipients before it was released to the market.

92.

The actions of Craigs contrast with the prompt measures taken by ASB Securities to refrain from speaking to additional clients until further clarification was received from NZX about the status of the information, and also Forsyth Barr's decision to not disclose the information about Marathon's intention until this was publicly available. The Commission also notes RPI's efforts to keep NZX informed of the developments in the takeover offer. The Commission is of the view that RPI, ASB Securities, and Forsyth Barr acted appropriately in this matter.

NZX Participant Rules

93.

As an NZX Participant, Craigs must comply with the NZX Participant Rules. The NZX Participant Rules provide guidance on the standards of market behaviour expected of NZX Participants. The NZX website describes the NZX Participant Rules as follows:

The NZX Participant Rules set the standard of conduct required by participants in NZX's securities markets. The rules are designed to protect the interests of investors and market participants and promote market integrity.

94.

Participant Rule 3.23 requires every person who seeks to be designated as a market participant to provide an outline of that person's Chinese wall procedures.

95.

Section 8 of the Participant Rules sets out the general obligations of all market participants and advisers. Rule 8.1.1(b)(ii) states that each market participant and each adviser must at all times:

Refrain from any action, conduct, matter or thing which is, or is reasonably likely to be a discredit or bring generally into disrepute NZX, any Market Participant and/or any Advisor.

96.

All market participants are required to observe "good broking practice". This is defined in the Participant Rules as meaning:

Conduct that is, at the discretion of NZX, in the wider interests of the markets provided by NZX, the New Zealand securities markets and investors and which complies with the spirit and intent of the practices, procedures and requirements as set by NZX in:

these Rules; and

any Guidance Notes, documents, policy statement or direction issued from time to time by NZX.

97.

The Commission considers that the actions of Craigs' representatives contributed to a situation where potentially price sensitive information was selectively disclosed to Craigs' clients and to a few market participants. This appeared to create uncertainty in the market and resulted in NZX having to declare a trading halt in shares for Wrightson.

98.

The Commission is of the view that NZX acted correctly in imposing the brief trading halt. Nonetheless, any trading halt may constrain participants' ability to execute their investment strategies, particularly during a takeover offer. In the present case this could conceivably have adversely affected the interests of the parties involved in the takeover offer, as well as ordinary investors in shares of Wrightson. The Commission does not consider that actions such as those of Craigs which required a trading halt to be imposed are in the best interests of the market.

99.

Craigs submitted to the Commission that its actions were not in breach of any specific NZX Participant Rule, Guidance Note, directions, or operational requirements of NZX, and so cannot be considered to be in breach of good broking practice. It relied in this respect on Rule 8.5.1, which states that:

... for the purpose of the Participant Rules, each market participant or advisor will discharge its Good Practice obligations by meeting the requirement of the Participant Rules, any Guidance Notes, directions and/or operational requirements given from time to time by NZX.

100.

Craigs submitted also that the selective receipt and disclosure of information is a widespread feature of market practice, apart from a limited range of circumstances in which the law expressly requires uniform disclosure. We have noted already that Craigs' actions in this matter can be contrasted with those of the other two market participants who received this information. We have noted that we do not agree that selective disclosure of potentially material information can be considered to be good market practice. In any event, we note that Participant Rule 8.5.2 states that:

... for the avoidance of doubt, common industry practices and/or historical practices, especially in areas where no policy statement has been issued by NZX, do not necessarily constitute good broking practice.

101.

It is not for the Commission to interpret the NZX Participant Rules or to express any view as to whether Craigs' conduct in this matter should be considered to be contrary to those rules, and we do not do so. The Commission does consider, in light of the submissions put forward by Craigs, that the actions detailed in this report raise questions under the NZX Participant Rules, including the application of those rules to the use of information controls by broking firms. The Commission refers this report to NZX to consider whether it wishes to take any action in the matter, including by way of providing any policy statement or guidance to market participants concerning the purpose and use of Chinese walls.

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