The Concept of Insider Trading - Essay Example

Insider Trading Introduction This present essay mainly focus on the concept of insider trading, which has in the past come into sharp focus because of high profile business figures been accused of trading with an added advantage compared to other traders at the financial market. This unfair advantage always enable the traders to make more gains or evade incurring losses unlike other traders who do not have the advantage of knowing about a confidential information concerning a company, which potentially affects it share prices. However, it is important to note that insider trading is not only limited to the stock market. This is because Seyhun (2000) stated that another example of insider trading is when a business approaches another business for takeover or merger and it has prior knowledge about the long term status of the company, which could indicate that it is either going to collapse or make major profits in the near future. Williams (2005) noted that this is also another form of trading with an additional advantage, which is bound to benefit the party with the insider information and therefore, transaction do not always have to be carried out via the financial market for the concept of insider trading to be considered. According to the studies conducted by George (1970), he interlinked the concept of insider trading to the concept of efficiency market, which states that a financial market is efficient in respect to information item, if the new information item has full influence on the market prices. Karjala (1982) stated that under the efficiency market concept, there are three different hypotheses that have been formulated to try to explain market prices, in respect to what kind of information is availed to the market. Jensen (1969) and Scholes (1972) stated that each of these hypotheses has different impact on how the financial market operates and it is further stated that market participants have rational expectations. This is to say that when new information is availed, the market participants are expected to change their expectations in line with the new information. According to Samuelson (1965), the strong form efficiency market relates with the concept of insider trading because it states that prices in the financial market are a full reflection of the information that is already known to the market participants or the prices in the financial market are a reflection of insider information. However, Williams (2011) and Harris (2003) stated that there is substantial evidence against the strong form of empirical market hypothesis because of current legal laws that prohibit confidential information becoming public. Insider trading can be analysed from a financial perspective as well as a legal perspective, in this present essay the concept will be discussed from a legal perspective drawn from a case scenario that will be summarised in the first part of the essay. The main objective of the essay will be to discuss the mentioned scenario with critical analysis case laws and legislations that addresse insider dealing with particular emphasis on the rationale behind the recent high profile cases brought about by the Financial Services Authority against personalities such as David Einhorn, James and Miranda Sanders, and the Ali Mustafa’s group. Before the discussion of the rationale behind the recent high profile cases, the essay will first critically discuss all the legal concepts that relate or touch on insider trading from the legal definition of an insider trader to the legal consequences of those found guilty of insider trading. Case scenario The case scenario used in this essay stipulates that Patricia is a student on placement in a firm of accountants. Whilst working with Buck, one of the senior partners, she overhears his conversation with Huang, the Managing Director of Ningbo plc. She becomes aware from that conversation that Ningbo plc are about to make a takeover bid for the share capital of Xiamen plc. As soon as she gets home that day Patricia tells her father Marcus about confidential information he had his bosses sharing. Marcus the father of Patricia is a stockbroker who operates on the London Stock Exchange and in addition, he is a director of a small company. He immediately buys options on the market to acquire Xiamen plc shares at £1 each, and this was motivated by the confidential information that her daughter disclosed to her. Three days later Ningbo plc makes its bid public to buy Xiamen plc shares and the share price for Xiamen plc shares shots up to £4 per share. Marcus exercises his option over Xiamen plc shares and resells them in the market, thus making a £3 per share profit. From the case scenario, it is evidently clear that Marcus expectations changed in line with the new information that her daughter gave him, as it is suggested under the efficiency market theory (investors change their expectations in line with new information). From the case scenario, it is also evidently clear that Marcus had unfair advantage over the other shareholders of Xiamen plc because of the prior knowledge he had about the targeted company and therefore, he was able to make a substantial amount of profit solely based on the confidential information given to him by her daughter. Critical analysis of legislation affecting insider trading Under this section, the essay will look into some of the legislations that are spelt out by the United Kingdom’s constitution, which touch on or govern the issue of insider trading. The critical analyses of the legislations are aimed at providing background knowledge about the entire concept of insider trading and provide a basic framework for making a judgment on the case scenario mentioned above. First, it is important to note that in the UK’s constitution, insider trading is covered under the criminal justice act of 1993; this is according to Cole (2012). This act stipulates the offences under insider trading and the defenses that can be applied. Additionally, Wang and Steinberg (2010) and Bainbridge (2007) noted that the act also stipulates securities that fit to be mentioned under insider trading, secondly, it elaborates on what ‘dealing’ in securities actually mean, what inside information actually means, who are the insiders, and what is information ‘made public’. Thirdly, Lukeman (2003) stated that the act further stipulates the penalties and prosecution for those found guilty of insider trading, the jurisdiction of the offence of insider dealing, and limitations of section 52 of the act. Muzea (2004) and Taylor (2012) stated in their writing that according to the criminal justice act of 1993, the offence of insider trading is defined as committed by someone who has privileged information as an insider. The insider uses this information to deal in securities whose price is shaped-up or influenced by other factors including the information held by the person privileged to have the insider information. Roth and Zabel (2012) stated that a person is guilty of insider trading if he or she persuades a third party to deal with the securities that are bound to be affected by the information while knowing well how the dealings will proceed in respect to the information. This is regardless of whether the third party is fully aware of the potential of the information given to him or her. Secondly, Briese (2008) stated that a person is guilty of insider trading if he or she discloses confidential information in a manner that is contrary to the proper conduct of his or her profession or office. It is of essence to note that the circumstances above apply only when the dealing occurs in a regulated market, and the person dealing is a broker in the market or relies on a broker to handle the transaction. In reference to the writings by Passarelli (2011), Altenburg and Julian (2008), they stated that a person is innocent of insider trading if he or she can prove that while dealing in securities at that time he was not aware that the dealing will generate profits because of the inside information he knew. Secondly, Bainbridge (2012) stated that a person is not guilty of insider trading if he or she can prove that at the time of dealing in securities he or she had reasonable facts to believe that many people knew about the privileged information. Therefore, no one taking part in the dealing would be prejudiced for the lack of the privileged information. Thirdly, Manna (2011) stated that a person is not guilty of insider trading if he or she can prove that the dealing would have been the same in a scenario whereby he or she did not have access to the privileged information. It is significant to note that these three exceptions also apply to a person who encourages a third party to deal in securities. Ali and Gregoriou (2008) further added that a person is not guilty of insider trading by the mere fact of disclosing information if he can prove that he did not expect the third party to deal in the associated securities based on the confidential information provided. Secondly, if he can prove that he was not aware that dealing in the associated securities at that time would have resulted in profits because of knowledge of the confidential information he gave out. Roth and Zabel (2011) noted that under the criminal justice act of 1993, the term securities as used in part V of the act refers to what falls under paragraph of schedule 2, which include investment instruments that are negotiable and non-negotiable and are sold and purchased in the financial market such as warrants, shares, notes, debentures, and bonds. On the other hand, Margaret (2007) noted that the criminal justice act of 1993 defines dealing in securities as the act of agreeing to buy or sell a security or signing a contract that creates a security or conclude a contract that created the security. Additionally, a person dealing with securities is a person acting on his own or through a broker or nominee in respect to sale and purchase of securities. It is critical to note that under the criminal justice act of 1993, the term ‘inside information’ is used to refer to information that relates to a specific security or a specific party that issues securities. The critical features of inside information are that they are specific, confidential, and they have the potential of affecting the prices of the related security once they are made known, this is according to Kabir and Vermaelen (1996) and Karmel (1993). However, information can be regarded as ‘made public’ if it is available to everyone who is likely to deal with the related security, or it is kept in records that are open for public inspection. On the other hand, Bazley and Haynes (2006) stated that an insider is a person who has information that he or she is aware is an inside information, that is obtained from an inside source. Secondly, a person is an insider if he or she access the inside information by the virtue of be being a director, shareholder, or an employee of the company issuing securities. Additionally, a person has inside information if he directly or indirectly acquires the inside information from any of the three parties mentioned above. According to the writings by the Financial Service Authority (2007), it is noted that the criminal justice act of 1993 prescribe the penalties and prosecution for parties found liable for insider trading and summarily the conviction stipulates that such parties shall be imposed with a fine that is limited to the statutory minimum. Alternatively, Ferran et al. (2001) noted that they may be imprisoned for duration not exceeding six month, or they may be penalized as well as convicted. Upon conviction on indictment, either the guilty offender can be subjected to a fine or he may be imprisoned for period not exceeding seven years. Case laws In this section, the essay will critically analyse certain cases that were brought about by the Financial Service Authority, which were based on insider trading, and basing on these cases the essay will further seek to establish the rationale used to determine the judgment and then possibly apply the same rationale to this essay’s case scenario. The James and Miranda Sanders’ case The first case example is the James and Miranda Sander case on insider dealing. According to Neville (2012), the Financial Service Authority brought charges against the couple for engaging in insider dealing and benefitting from the deals. James Sanders was an investment banker at Blue Index who made extreme gains relying on inside information from his sister in-law, Annabel McClellan whose husband was a partner at Deloitte’s mergers and acquisition department. The Financial Service Authority established that Arnold McClellan used to give the Sanders inside information through her wife on companies that planning on making bids or takeovers and were been advised by Deloitte. Neville (2012), wrote that upon receiving the inside information, James Sanders as well as a colleague used to rapidly increase their personal as well as the company’s shareholding in the company which was being targeted for takeover and once the news went public they earn huge profits from the increased share prices. Neville (2012), stated that James Sander was sentenced for four years for inside trading, while his wife Miranda and a colleague of Mr. Sander, James Swallow were both sentenced to ten months in prison. Mrs. McClellan was sentenced for eleven months for her part in providing inside information to James Sanders. Mr. David Einhorn’s case The second case example is the David Einhorn case on insider dealing that was also brought by the Financial Service Authority. In this case, the Financial Service Authority (2012) fined Mr. David Einhorn who was the president of Greenlight Capital Inc £3,680,000 for engaging in insider dealing. Mr. Einhorn was found guilty of avoiding losses that his fund could have otherwise incurred if he was not privy to the inside information given to him. The inside information, made Mr. Einhorn aware that Punch Taverns Plc was planning on making a public announcement about its plans to issue new equity in order to be able to repay back its convertible bond and create headroom. After receiving the inside information from the management of Punch Taverns Plc, Mr. Einhorm issued a directive for the sale of entire shareholding of Punch, which the Greenlight Fund held. The Financial Service Authority (2012) established that Mr. Einhorn directive was issued entirely based on the inside information that he had obtained from the management of Punch. Following the public announcement by Punch on their intended plans, its shares dropped by 29.9% meaning that by Greenlight Capital Inc selling some of its shareholding in Punch, it was able to evade making loses amounting to £680,000. With reference to the studies conducted by Cohen (2012) and Moreland (2000), it can be stated that, Mr. Einhorn was guilty on the basis that he exploited confidential information that was price sensitive and he acted at an unfair advantage compared to other shareholders of Punch Taverns Plc. The case of Ali Mustafa’s group The Financial Service Authority filled charges against Ali Mustafa, Mitesh Shah, Bijal Shah, Truptesh Patel, Pardip Saini, Netan Shah, and Paresh Shah for insider dealing. The seven men were accussed by the Financial Service Authority of making profits of more than a million pounds based on inside information they acquired illegally. It was established that the seven used confidential bank documents to purchase shares in companies, which had been targeted for takeovers and after the takeovers were made public, the share prices recorded increased profit thus enabling the seven to earn huge profits. The seven men used to acquire inside information from unpublished reports that contained information that were price-sensitive. They acquired these reports from printers contracted by J P Morgan Cazenove, which is a brokerage firm and the Swiss bank UBS. Conclusion Under this section, the essay will provide a judgment for the case scenario that was used and this judgment will be substantiated with facts presented under the section that analyzed legislations governing insider trading and specifically the criminal justice act of 1993. Secondly, the essay will provide judgment for the case scenario based on the rationale that were used to determine the cases discussed in this essay, which were also based on insider trading. First, in relation to the case scenario it is significant to note that the insider is Patricia who acquired information by the virtue of his employment/ placement at Ningbo Plc offices. Secondly, the inside information was that Ningbo plc were planning on a takeover bid for the share capital of Xiamen plc, this information was specific, it had not been made public, and it had the potential of influencing the share prices of Xiamen plc. Equally, from the case scenario, the second insider was Marcus, whom according to the writings by Macey (1991) was well aware that the information that she was given by her daughter was an inside information by virtue of being a stockbroker at the London Stock Exchange. Secondly, Marcus was the insider because he knew he had an inside information from an inside source who was her daughter. Moreover, Grechenig (2006) noted that a person has information from an inside source if the direct or indirect source of the information is a shareholder, employee, or director of a company issuing securities. First, Patricia will be found guilty of disclosing confidential information, which to begin with, she acquired illegally by eavesdropping on a private conversation and then giving the inside information to her father whom she was well aware was a stockbroker, and hence it can be assumed that she was aware the information was price sensitive. Equally, Patricia conviction can be related to the conviction of Mrs. Annabel McClellan who was imprisoned for disclosing inside information to James Sanders and his wife. Secondly, from the legislations or laws pertaining to insider trading, it can be asserted that Marcus is also guilty of insider trading because he went ahead and bought options at the market to acquire Xiamen plc share at £1 each being fully aware that the information he had was capable of influencing the share prices of Xiamen plc. Additionally, he was fully aware more so being a stockbroker that the share prices of Xiamen plc are likely to experience a sharp rise once the takeover bid was made public. The conviction of Mr. Marcus will resemble the conviction of Mr. Einhorn and the group of Ali Mustafa who were jointly convicted because of using insider information with knowledge that it was insider information for their personal benefits while other market participants did not have same privilege they did because of the inside information they had. References Ali, P. and Gregoriou, G. (2008). Insider Trading: Global Developments and Analysis. US: CRC Press Altenburg, S. and Julian. 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