International Securities Markets: Insider Trading Law In China (International Banking, Finance and Economic Law Series Set) 9041125574, 9789041125576

Citation preview

I N T E R N AT I O N A L B A N K I N G

AND

F I N A N C E L AW

SERIES

International Securities Markets: Insider Trading Law in China By Hui Huang

International Securities Markets: Insider Trading Law in China

International Banking and Finance Law Series VOLUME 3 Series Editors Joseph J. Norton SMU Dedman School of Law, Dallas Add Ross Douglas W. Arner Asian Institute of International Financial Law, University of Hong Kong Advisory Board P. Wood (Chair), CCLS and Allen & Overy, London W. Blair, QC, CCLS and 3 Verulam Buildings, Gray’s Inn, London L. Buchheit, Cleary Gottlieb Steen & Hamilton, New York M. Dassesse, McKenna & Cuneo, Brussels S. Gannon, Hong Kong Monetary Authority B. Geva, Osgoode Hall, York University, Toronto A. Halkyard, University of Hong Kong N. Horn, University of Cologne I. Itzikowitz, Edward Nathan and University of the Witwatersrand, Johannesburg H. Kanda, University of Tokyo R. Lastra, CCLS, London S. Seigel, NYU Law School, New York M. Steinberg, SMU Dedman School of Law, Dallas Z. Zhou, Shanghai University of Finance and Economics Editorial Review Board Executive Editors G.A. Walker, CCLS, London C. Hadjiemmanuil, London School of Economics and Political Science J. Winn, Microsoft Center, University of Washington, Seattle B. Hsu, Asian Institute of International Financial Law, University of Hong Kong Associate Editors C. Olive, SMU Institute of International Banking & Finance and Bracewell & Guiliani, Dallas W. Wang, Fudan University, Shanghai M. Yokoi-Arai, CCLS, London

The titles published in this series are listed at the end of this volume

International Securities Markets: Insider Trading Law in China

by

Dr. Hui Huang Lecturer, Law Faculty University of New South Wales

Published by: Kluwer Law International P.O. Box 316 2400 AH Alphen aan den Rijn The Netherlands E-mail: [email protected] Website: http://www.kluwerlaw.com Sold and distributed in North, Central and South America by: Aspen Publishers, Inc. 7201 McKinney Circle Frederick, MD 21704 USA sold and distributed in all other countries by: Turpin Distribution Services Ltd. Stratton Business Park Pegasus Drive Biggleswade Bedfordshire SG18 8TQ United Kingdom

web-ISBN 978-90-411-5539-9 © 2006 Kluwer Law International BV, The Netherlands All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, mechanical photocopying, recording or otherwise, without prior written permission of the publishers. Permission to use this content must be obtained from the copyright owner. Please apply to: Permissions Department, Wolters Kluwer Law & Business, 76 Ninth Avenue, Seventh Floor, New York, NY 10011, United States of America. E-mail: permission @kluwerlaw.com

To My Father and Mother

Table of Contents

Foreword

xv

Preface

xvii

Acknowledgements

xix

List of Selected Abbreviations

xxi

Chapter 1 Introduction

1

Chapter 2 Insider Trading in China: Incidence and Regulations

7

§2.I.

An Overview of the Stock Market A. The Development of the Stock Market B. Features of the Stock Market: Types of Shares 1. A-shares and B-shares 2. Tradable Shares and Non-tradable Shares 3. Other Types of Shares C. The Regulatory Framework of the Market 1. Before 1992: Dispersed Regulatory Regime 2. 1992–1997: Transitional Phase 3. After 1997: Centralized Regulatory Regime

7 7 10 11 13 16 17 17 18 19

§2.II.

The Regulation of Insider Trading A. The History of Insider Trading Regime 1. Before 1999: Governmental Regulations

19 19 19

Table of Contents

viii

§2.III.

2. After 1999: Congressional Legislation B. Features of China’s Insider Trading Law 1. The Willingness to Regulate Insider Trading 2. Importation of Overseas Experience C. Problems with China’s Insider Trading Law

22 23 23 25 26

Incidence of Insider Trading A. Insider Trading Cases 1. Cases Handled by the CSRC 2. Criminal Insider Trading Cases 3. Summary B. The Extent of Insider Trading 1. Empirical Findings of Qualitative Research 2. Analysis of the Empirical Findings a. Insider Trading is Widespread b. Insider Trading vs. Other Types of Misconduct C. Features of Insider Trading Activities in China 1. Likely Insiders 2. Types of Insider Trading 3. Serious Offences but Light Punishment 4. Likely Situations where Insider Trading Occurs 5. Insider Trading Connected with Other Types of Market Misconduct

28 28 28 33 36 37 37 40 40 44 46 46 47 48 50 53

Chapter 3 Why Insider Trading is Widespread: A Cost-Benefit Analysis

57

§3.I.

Introduction

57

§3.II.

Benefits A. Direct Monetary Profits 1. The Heavy Speculative Tint of the Market 2. Empirical Findings: the Importance of Insider Trading for Success in the Market 3. Insufficient Compensation for Corporate Insiders B. Other Benefits 1. Indirect Personal Benefits in cases where Entities Commit Insider Trading 2. Maintaining Good Inter-personal Relationships

58 58 59

68 69

Costs A. Low Operational Costs 1. The Cost of Information a. The Inefficacy of Information Disclosure

71 71 71 71

§3.III.

63 66 68

Table of Contents

B.

C.

§3.IV.

b. Problematic Corporate Governance c. The Porous ‘Chinese Wall’ Procedure d. Capricious Government Policies e. Interpersonal Relationships 2. High Success Rate Low Risks of Apprehension 1. False Trading Names 2. Lack of Informers 3. Evidentiary Obstacles 4. The Ineffectiveness of the CSRC The Low Costs of Penalties 1. Light Legal Liability 2. Low Levels of Damages to Reputation 3. Low Risk of Career Damage

Conclusion

ix 73 74 77 78 78 79 80 81 83 84 87 87 89 91 93

Chapter 4 Effects of Insider Trading: Harmful or Beneficial

95

§4.I.

Introduction

95

§4.II.

Arguments as to the Effects of Insider Trading A. The Beneficial Effects of Insider Trading 1. Compensation to Corporate Executives 2. Enhancing Market Efficiency and Smoothing Stock Price B. The Harmful Effects of Insider Trading 1. Harm to the Market Generally 2. Harm to Listed Corporations 3. Harm to Investors C. Summary

96 96 96 100 102 103 105 106 107

Empirical Findings on the Effects of Insider Trading A. The Beneficial Effects of Insider Trading B. The Harmful Effects of Insider Trading C. Analysis of the Findings 1. Beneficial Effects 2. Detrimental Effects 3. Summary

111 113 116 118 118 119 121

Conclusion

122

§4.III.

§4.IV.

Table of Contents

x Chapter 5 Theories of Insider Trading Liability: A Comparative Analysis

125

§5.I.

Introduction

125

§5.II.

The Regulation of Insider Trading in China: Theory and Problems

125

§5.III.

Insider Trading Regulation Theories: the US Experience A. The Statutory Basis B. The Equality of Access Theory 1. In re Cady, Roberts & Co. 2. SEC v. Texas Gulf Sulphur Co. C. Fiduciary-duty-based Theories: the Classical Theory and the Misappropriation Theory 1. Chiarella v. United States a. Rule 14e-3 2. Dirks v. SEC a. Regulation FD 3. United States v. O’Hagan a. The Misappropriation Theory Prior to O’Hagan b. Adoption of the Misappropriation Theory in O’Hagan

130 131 134 134 135

§5.IV.

§5.V.

A Proposal for China: the Equality of Access Theory vs. Fiduciary-duty-based Theories A. Fiduciary-duty-based Theories are Unsuitable 1. Problems with the Classical Theory a. Problems with the Fiduciary Duty Requirement b. Problems arising from the ‘Personal Benefit’ Test for Tipping Liability 2. Problems with the Misappropriation Theory a. Dubious Legal Reasoning b. Liability Loopholes 3. The Local Situation of China a. The Undeveloped Concept of Fiduciary Duty b. Ineffective Enforcement Framework B. Adoption of the Equality of Access Theory 1. Parity of Information vs. Equality of Access 2. Common Law Principles 3. The Widespread Acceptance of the Equality of Access Theory a. Blossoming Overseas b. Revival in the US 4. China’s Local Circumstances: the Equality of Access Theory is More Appropriate Conclusion

136 136 141 141 144 146 146 148 151 151 152 152 155 157 158 161 163 163 167 169 170 173 177 178 179 181 183

Table of Contents

xi

Chapter 6 Some Basic Elements of Insider Trading

185

§6.I.

Introduction

185

§6.II.

The Content of China’s Insider Trading Law A. The Overall Framework B. The Short-swing Trading Prohibition

185 186 192

§6.III.

Insiders A. A Critique of the Definition of Insider in China B. A Reform Proposal: the Australian ‘Information Connection’ only Approach 1. The Strengths of the Australian Approach 2. Concerns with the Australian Approach

194 194

Inside Information A. An Overview B. Materiality 1. Standard of Materiality 2. Precision of Inside Information C. When Information Becomes Public 1. Information Disclosure and Dissemination 2. Readily Observable Matter: the Australian Debate

203 203 206 206 210 212 212

Subjective Elements A. Introduction B. Awareness of Inside Information 1. The Scienter Requirement 2. Possession of Inside Information 3. Knowledge that the Information is Inside Information C. Use of Inside Information: the US ‘Possession vs. Use’ Debate 1. The Position of China’s Insider Trading Law 2. Various Approaches to the Debate a. The Strict Possession Standard b. The Strict Use Standard c. The Modified Use Standard d. The Modified Possession Standard 3. The Unsuitability of the Strict Possession and Strict Use Standard a. Arguments against the Strict Possession Standard b. Arguments against the Strict Use Standard

219 219 221 221 223

§6.IV.

§6.V.

197 197 199

215

227 231 231 232 232 234 234 236 238 238 239

Table of Contents

xii

D. §6.VI.

4. The Choice for China: the Modified Possession Standard is Preferable to the Modified Use Standard a. Unclear Proof-Burden-Shifting Effect under the Modified Use Standard b. Problems with the Defences under the Modified Use Standard Conclusion

Securities Covered

243 243 245 249 250

Chapter 7 Private Civil Liability For Insider Trading

253

§7.I.

Introduction

253

§7.II.

The Private Enforcement of Insider Trading in China

254

§7.III.

Different Measures of Damages in Securities Fraud Actions A. Measure of Damages in Face-to-face Transactions 1. The Out-of-Pocket Measure 2. The Modified Out-of-Pocket Measure 3. The Benefit-of-the-Bargain Measure 4. Consequential Damages 5. The ‘Cover’ Measure 6. Rescission, Restitution or Rescissory Damages 7. The Windfall-Profits Measure B. Analysis of the Measurement of Recovery 1. Shifting of Post-transaction Market Risks 2. The Application of Measures of Recovery and the Open Market Problem

256 256 256 258 260 261 262 263 265 269 270

Eligible Plaintiffs A. Various Approaches 1. The Privity Traders Approach a. Fridrich v. Bradford b. The Concurring Opinion of Judge Celebrezze 2. The Contemporaneous Traders Approach a. Wilson and Subsequent Judicial Development b. Codification of the Contemporaneous Trader Approach 3. The Nondisclosure-Period Traders Approach a. Shapiro b. The ALI Federal Securities Code 4. Summary B. Causation: Individual Investors Harmed by Insider Trading 1. Insider Trading: Victimless Fraud? 2. Victims of Insider Trading

274 274 274 275 276 277 277 280 282 282 284 286 288 289 290

§7.IV.

272

Table of Contents C.

§7.V.

A Proposal for China: Eligibility to Bring Forward a Private Action 1. Problems with the Privity Approach 2. Problems with the Contemporaneous Traders Approach 3. The Suitability of the Non-disclosure-period Traders Approach

Conclusion

xiii

295 295 298 300 304

Chapter 8 Conclusion

307

Appendix 1 Methodology

311

Appendix 2 The Summary of Reported Insider Trading Cases In China

317

Bibliography

321

Table of Cases

341

Index

347

Foreword

In recent decades China has moved from an incipient player in the world economy to a leader in global capitalism. During this period of rapid economic reform, Chinese securities markets and the corresponding regulatory frameworks, including those designed to prevent insider trading, have undergone an accelerated infancy. Chinese regulators, in working to achieve transparency and fair-trading, are engaged in a project without domestic precedent. International experience has the capacity to provide a range of possibilities. China has shown a clear resolve to open itself to the international environment while making its own decisions on how its capital markets should develop. It is in this context that I commend Dr. Huang’s thoughtful contribution to international scholarship on securities regulation. This book provides an examination of the reasons for the high incidence in China of the kind of market conduct calling for regulation and explains the development of the institutions and regulatory frameworks designed to prevent insider trading. Drawing on extensive interviews with key players and a close examination of the theoretical foundations for regulation, Dr. Huang’s work complements Australian scholarship emerging from institutes such as the Centre for Corporate Law and Securities Regulation at the University of Melbourne and comparable outstanding work at the University of New South Wales (and also at my university, the University of Sydney). Dr. Huang provides valuable insights into the unique characteristics of the Chinese situation and the particular challenges of improving regulation in the context of rapid economic transition, under a civil law system administered by a developing judiciary and regulatory institutions coping with resource constraints. The text tackles the empirical, practical and theoretical aspects of the regulatory project, and presents an informed comparative perspective drawing on Australian, United States and European experience. Dr. Huang presents a program for reform and a compelling case for international lesson-drawing tempered by keen and critical appraisal of the unique features of the Chinese marketplace.

xvi

Foreword

Informed by international experience, Chinese regulators will continue to put into practice specific provisions that advance the philosophy behind insider trading prohibitions. The essential reason for insider trading provisions is to make sure that when there is trading particularly on quoted stock, the trading is on the basis that any price sensitive information that is material is equally available to both parties to the trade. On the one hand this requires a continuous disclosure obligation on the part of the company concerned. On the other, where adventitiously or otherwise an insider has particular information not known to the other party to a trade, it is considered unfair that the party with the inside information should be able to take advantage of the other party. Difficult questions can arise and interested international observers may indeed learn from China as domestic regulators refine and advance the regulatory regime as economic transition continues and new challenges emerge. For example, particular difficulties can arise where one is dealing not with an existing share traded between parties but a new issue of shares. The company must be taken to know all about itself. The shareholder who has access to inside information may take up shares with an advantage over other shareholders, who do not have access to that inside information. There may be an element of unfairness here though not directly as between the company issuing new shares and the shareholder taking them up. Ought insider trading legislation to apply to this situation? These are the kind of issues that we can expect Chinese security law to grapple with over time. What we have in this excellent study is the groundwork for that kind of analysis. This work will prove helpful to many readers, including lawyers, regulators, students and businesspeople interested in the Chinese experience and prospects for reform. As well, for those of us looking internationally, this examination of the Chinese case presents an intriguing exemplar, which may prompt critical reflection on the effectiveness of our own regulatory regimes. The Hon Justice Kim Santow Chancellor of Sydney University Supreme Court of New South Wales Court of Appeal

Preface

This book deals with insider trading in the securities market, taking a comparative perspective to explore ways of improving the regulation of insider trading, particularly in the context of China. The purposes of this book are threefold: 1. to investigate the incidence of insider trading in China; 2. to critically examine the regulation of insider trading in China within the Chinese context; and 3. to set out reform proposals. At present, insider trading is a very serious issue in China as it presents a major obstacle to the development of China’s securities market. This book is therefore of both theoretical and practical significance. Based on both theoretical arguments and empirical findings, this book investigates the extent of insider trading in China, explains why insider trading occurs in China, and examines the harmful and allegedly beneficial effects of insider trading. Insider trading is found to be widespread and widely considered to be harmful in China. This accounts for the fact that China has shown a great willingness to follow the international trend to regulate insider trading. Indeed, with the benefit of overseas experience, China has made a remarkable achievement in establishing its insider trading regulatory regime within a relatively short period of time. Despite this, there are a number of major problems with this regulatory regime, mainly due to the adoption of foreign ideas without due criticism. This is illustrated by various loopholes found in the definition of what is an ‘insider’, which are related to confusion over underlying theories of insider trading liability. The book conducts an in-depth analysis of these theories on a comparative law basis, recommending that the equality of access theory and the Australian ‘information connection only approach’ are better suited to China. The book also examines other basic elements of insider trading, including the concept of materiality, the issue of when information becomes public, and the subjective elements of insider trading. Furthermore, a detailed discussion is carried out concerning the issue of private civil liability for insider trading. It is submitted

xviii

Preface

that the combination of the nondisclosure-period-traders approach and well designed damage caps can best ensure that private actions serve as a necessary and appropriate force in the enforcement of insider trading law. In short, this book evaluates China’s insider trading law, and advices what constitutes insider trading in China, what the consequences of unlawful insider trading might be, and more importantly how to prevent the occurrence of insider trading in the first place. Moreover, the book discusses the relevant political, legal, economic and social context in which the insider trading law operates, so it should serve as a useful source of information about China’s securities market in general. Hence, this book may prove helpful to many kinds of readers, including law students, lawyers, businesspersons and market regulators who want to inform themselves about this important legal issue, and who are interested in the Chinese securties market. Hui Huang Sydney 2006

Acknowledgements

There are a number of people who I would like to acknowledge and thank for the assistance and support they provided me whilst writing this book. I owe the greatest thanks to my supervisor, Angus Corbett, for his valuable support and guidance. Many other colleagues and law professors commented on parts of the manuscript at one time or another, and I am indebted to them all. The contributions of Paul Redmond and Lesley Hitchens were especially helpful. I would also like to thank those people who read and provided insights on those parts of this work which have been submitted to conferences or published in referred academic journals. These people include Professor Donald C. Langevoort (Georgetown University), the anonymous referees for my articles published with the Delaware Journal of Corporate Law (2005) vol. 30 and the Australian Journal of Corporate Law (2005) vol. 17. My gratitude also extends to those people who assisted me during the process of conducting field work in China. A great number of people helped me to organize and conduct the research, granting me access to valuable materials, and taking the time to participate in the interviews. Due to confidentiality reasons, I am unable to list their names here, but their helps are greatly appreciated. I appreciate the publisher’s attention to design and layout. In particular, I am grateful for the considerable thought and efforts of the editor Sasha Radoja. Finally, I must thank my family. This book would not exist without the support from my parents. But the most sustaining and inspiring support was from my dear wife, Wei Li, who freed me from chores and surrendered time together to see this work completed. Her support is its cornerstone, as it is mine. I am grateful for the considerable thought and efforts of the editors Sasha Radoja and Lia Nouwen.

List of Selected Abbreviations

ASIC ASX AUD CAMAC CNY CSRC EU FSA FSC ITSFEA MAS NPC NYSE PRC SCRC SEC SHSE SFCHK UK US USD

Australian Securities and Investments Commission Australian Stock Exchange Australian Dollar Corporations and Markets Advisory Committee (Australia) Chinese Yuan China Securities Regulatory Commission European Union Financial Services Authority (UK) Federal Securities Code (US) Insider Trading and Securities Fraud Enforcement Act of 1988 Monetary Authority of Singapore National People’s Congress (China) New York Stock Exchange People’s Republic of China State Council Securities Commission (PRC) Securities and Exchange Commission (US) Shanghai Stock Exchange Securities and Futures Commission of Hong Kong United Kingdom United States of America United States Dollar

Chapter 1

Introduction

With the growing globalization of the world economy, there is a clear trend towards nations racing to develop their own competitive securities markets to attract muchneeded capital. One critical step to winning the race is to enhance market confidence and efficiency through the prohibition of trading on inside information or so-called ‘insider trading’. ‘Insider trading’ is a term of art that generally refers to unlawful trading in securities by persons in possession of relevant material non-public information. This term is a misnomer, however, to the extent that the insider trading prohibition is not confined to corporate insiders like directors and other senior officers. Rather, the term often means trading by anyone, whether an insider of the company or not, on any type of material non-public information about the company whose securities are traded or the market for its security.1 This book uses ‘insider trading’ in this broad sense. Indeed, insider trading has become a globally debated topic. The decade of the 1990s witnessed an explosion in the number of nations adopting laws prohibiting insider trading. Prior to 1990, just 34 countries had insider trading laws, but by 2000, this number soared to 87.2 It therefore has been said that the world evolved from

1.

See Donald C. Langevoort, Insider Trading: Regulation, Enforcement, and Prevention (West Group) (looseleaf) s 1.01, pp. 1–6 (stating that the term ‘insider trading’ potentially reaches anyone who has access to privileged information); See also William K.S Wang and Marc I. Steinberg, Insider Trading (Aspen Publishers, 1996), pp. 1–2; Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991), vol. VII, pp. 3448–3449; Henning, ‘Between Chiarella and Congress: A Guide to the Private Cause of Action for Insider Trading Under the Federal Securities Laws’ (1990) 39 U. Kan. L. Rev. 1, 1. 2. Utpal Bhattacharya & Hazem Daouk, ‘The World Price of Insider Trading’, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id
200914 , at 3 (last visited on 8 February 2005).

2

Chapter 1

a situation, at the start of the 1990’s, in which the majority of countries with stock market did not prohibit insider trading, to a situation where the overwhelming majority of countries with stock markets had adopted such a prohibition by the year 2000.3 China has followed this international trend. As a result of economic reform and opening-up policy, the Chinese economy has experienced rapid growth. It now has one of the strongest economies in Asia and is a major source of international economic dynamism. In the past decade, as the world’s fastest growing economy, China’s average Gross Domestic Product (GDP) growth was 8.2%; China became the world’s 7th largest economy, and the largest recipient of foreign direct investment in the fiscal year ending in May 2003.4 China’s 2001 World Trade Organization (WTO) accession now exerts important and growing influence on world trade.5 China’s foreign trade volume has grown rapidly in recent years, from joining the world’s top ten of trading nations in 1997, to the top seven in 2000, and entering top four in 2003; China has recently become the world’s third-largest trading nation, following the United States and Germany, with its foreign trade value hitting a record high of USD1 trillion in the first 11 months of 2004.6 Due to China’s continuing economic development and its membership in the WTO, China is becoming an increasingly attractive investment destination. The securities market is an important channel for foreign investment in China, and it is needed for China’s industries and enterprises to grow.7 As a condition of that growth,

3. Franklin A. Gevurtz, ‘The Globalization of Insider trading Prohibitions’ (2002) 15 Transnational Lawyer 63, 65–66. Although the significant increase in the number of countries with stock markets in the 1990s may have contributed to the growth of insider trading laws, this is not the principal reason. In fact, the number of nations with insider trading laws grew clearly out of proportion to the increase in the number of nations with stock markets. Before 1990, just over half of the developed countries with stock markets chose to prohibit insider trading, while 39% of countries with emerging markets did. By 2000, in contrast, all of the developed countries and 80% of the countries with emerging markets chose to do so. See Utpal Bhattacharya & Hazem Daouk, ‘The World Price of Insider Trading’, available at http://papers.ssrn.com/sol3/papers.cfm? abstract_id
200914 , at 10 (last visited on 8 February 2005). 4. See Robert Sutter, ‘Why does China Matter’ (2003–4) 27(1) The Washington Quarterly 75, 78; Department of Foreign Affairs and Trade (Australia), ‘Australia-China Free Trade Agreement Joint Feasibility Study’ (2003) available on http://www.dfat.gov.au/geo/china/fta/china_fta_study_ brochure.pdf (last visited on 30 March 2005). 5. China is one of the founding members of the General Agreement on Trade and Tariffs (GATT), which was succeeded by the WTO. See Karen Halverson, ‘China’s WTO Accession: Economic, Legal and Political Implications’ (2004) 27 Boston College International and Compara. tive Law Review 319, 321. On 12 December 2001, then as the world’s tenth largest trading country, China officially entered the world trade body. See e.g., ‘Entry to WTO Benefits Foreign Trades’, 11 December 2002, Zhongguo Ribao [China Daily], 2002 WLNR 7703459; Joseph Kahn, ‘World Trade Organization Admits China Amid Doubts’, N.Y. Times, 11 November 2001 at 1A.16. 6. ‘Foreign Trade may hit USD 1.1 Trillion’, 1 November 2005, Zhongguo Ribao [China Daily], 2005 WLNR 403023; Julie Walton, ‘WTO . . . Year 4’ 32(1) 1 January 2005 China Bus. Rev. 24, 2005 WLNR 886785 (stating that China is now a leading trading nation). 7. Stephen C. Thomas and Chen Ji, ‘Privatizing China: The Stock Markets and Their Role in Corporate Reform’, 31(4) 1 July 2004, China Bus. Rev. 58, 2004 WLNR 11626777. For more account of this, see below §2.I.A.

Introduction

3

both domestic and foreign investors must be confident that adequate measures are in place to protect the integrity of the market. It has therefore become crucial for China to establish a regulatory regime over the securities market that would be basically consistent with the international norm. The securities market is certainly a product of China’s economic reforms. After 1949 when the People’s Republic of China (PRC) was established, all pre-existing financial centers were dismantled as China moved into a centrally planned socialist economy.8 For better or worse, a national distaste for securities which were regarded as ideologically undesirable, characterized national policy for about thirty years. The economic reforms in the late 1970’s challenged these taboos, and attempted to transform China into a market economy under an increasingly capitalist interpretation of ‘socialism with Chinese characteristics’. In order to more effectively allocate capital to business and facilitate greater overall economic efficiency, China’s securities market was brought back to life. China’s securities market has seen remarkable progress in a relatively short period of time after the initial economic reforms, and is playing a more and more important role domestically and internationally. Securities gradually returned to Chinese economic life in the 1980s, and securities markets developed accordingly, culminating in the establishment of the Shanghai Stock Exchange and the Shenzhen Stock Exchange in the early 1990s. The securities market has grown rapidly: the market capitalization at the end of 2001 was CNY 4,352.21 billion (roughly USD 528 billion), almost 42 times the figure in 1992; the ratio of market capitalization to GDP rose sharply from 3.93% in 1992 to 45.37% in 2001.9 However, there are many remaining problems with China’s securities market that need to be addressed. The Chinese securities market is charged with the task of building a bridge between domestic enterprises and sources of capital, and must efficiently manage the exchanges in order to shore up confidence in the Chinese capital markets as a whole. Not surprisingly, the challenges of regulating these markets are great: under-trained and under-staffed government regulators must tackle such problems as inadequate information disclosure, insider trading, market manipulation, and shareholder rights in a precedential vacuum. In addition, the Chinese markets must study and quickly achieve the standard of transparency and equitable operation that the major world markets have developed over decades and centuries. The problem of insider trading is an excellent example of the difficulties that Chinese regulators must confront. At the present time, insider trading appears to be a very serious problem with China’s securities market, and is widely thought to be very prevalent.10 Generally speaking, China has been quick to react to the problem of insider trading. Insider trading has been deemed harmful to market fairness and efficiency in China, with the Chinese government regulating insider trading at almost the same time the stock market was established. 8. See below §2.I.A. 9. China Securities Regulatory Commission, Zhongguo Zhengquan Qihuo Tongji Nianjian [China Securities and Futures Statistical Yearbook] (Beijing, Baijia Publishing House, 2003), p. 18. 10. See below §2.III.

4

Chapter 1

Indeed, with the benefit of overseas experience, in a relatively short period of time, China has made a remarkable achievement in setting up its insider trading regulatory regime. As the underlying securities market progresses, China’s insider trading regulation has developed in an incremental, yet rapid and impressive, manner. It started with exchange-level regulations, followed by two successive waves of governmental regulations with nationwide application; the Securities Law of the Peoples’ Republic of China built on these experiences, marking the era of regulating insider trading in a rule-of-law based approach.11 However, the task of regulating insider trading is difficult for China in its current climate of rapid and somewhat chaotic economic transformation. Even though the Chinese securities law has made a quantum leap in the area of insider trading, China’s efforts to combat insider trading are far from satisfying. There have been a very limited number of insider trading cases so far, contrasting strikingly with the perceived prevalence of insider trading activities in the market.12 Of course, there are an array of reasons behind this imbalance. One of the most important reasons, among others, is that in some respects, China has been too ready to import ideas from foreign sources, without adequately assimilating them into the local context.13 This has resulted in serious problems, which have significantly affected the efficacy of the Chinese law of insider trading. The purpose of this book is therefore to deal with the issue of insider trading in China within its context, critically examine China’s insider trading regulation and, based upon this examination, set out reform proposals. This book will explore in detail the issue of insider trading in China on a comparative law basis, in an effort to improve the effectiveness of China’s insider trading regulatory regime. Moreover, in order to gain a first-hand understanding of the context in which the law operates, interviews were conducted with various stakeholders in China.14 This book is comprised of eight chapters. Chapter 1 introduces the topic and states the objectives of the study. Chapter 2 presents the background of the regulation of insider trading in China, including an overview of China’s securities market, a discussion of the historical development of China’s insider trading regulation, and the current situation of insider trading activities in China. Chapter 3 looks at why insider trading occurs in China using a cost-benefit analysis, and further sets up the context in which insider trading is discussed. Chapter 4 explores the effects of insider trading both theoretically and empirically. It answers the question of whether insider trading should be regulated in China. The following chapters, including Chapters 5, 6 and 7, move on to discuss how to more effectively regulate insider trading in China. Chapter 5 deals with the rationale underlying the prohibition of insider trading in China. It provides a blueprint for

11. See below §2.II.A. 12. See below §2.III.A. 13. Hui Huang, ‘The Regulation of Insider Trading in China: A Critical Review and Proposals for Reform’ (2005) 17(3) Australian Journal of Corporate Law 281. 14. For more information on conducting of the field work, see Appendix 1: Methodology.

Introduction

5

the design of insider trading regulation. Chapter 6 examines in detail some basic elements of insider trading regulation, including the notion of insider, the scope of inside information, subjective elements, and transactions covered. Chapter 7 focuses on some key issues concerning private civil liability for insider trading, including the measurement of damages and the standing requirement. Chapter 8 contains a concluding remark. Before moving into the substantive discussion, I would like to make the following notes: 1. In order to avoid ambiguity and ensure uniformity, all authors’ names are provided with given name first and surname last, regardless of the custom in the language of the thesis cited. 2. Footnotes are numbered consecutively per chapter. 3. Cross-references use heading numbers, with the first number indicating the chapter. Thus ‘§5.III.B.1’ is a reference to heading III.B.1 in Chapter 5 of the book. 4. At the final stages of manuscript preparation, China significantly revised both the Securities Law and the Company Law on October 2005, and those revisions came into effect on 1 January 2006. However, this revision effort does not make any significant changes to the insider trading provisions as it should in the way suggested by this book. Thus, the analysis in this book applies with equal force to the insider trading regime after the revision. The statutory references have been updated and some discussions revised to reflect the two new laws. 5. The book has used gender neutral language where possible.

Chapter 2

Insider Trading in China: Incidence and Regulations

§2.I.

AN OVERVIEW OF THE STOCK MARKET

A.

THE DEVELOPMENT OF THE STOCK MARKET

Historically, it was not until after the Opium War in 1840 that China began implanting the western way of fundraising, namely the shareholding system.1 Despite the political chaos and a series of governmental replacements thereafter, this economic model continued to exist and develop in the reigns of successive Chinese governments before 1949 when the People’s Republic of China (‘PRC’) was established. For example, in 1927, there were forty joint stock companies in China.2 In correspondence with this, several stock exchanges appeared, the first of which was the Waishang Shanghai Zhongye Gongsuo, formed by foreigners in Shanghai as early as in 1891.3 In 1918, the Beijing Stock Exchange, the first stock exchange established by Chinese citizens, began its operation. This was followed by a string of Chinese-founded stock exchanges in other cities. For instance, in Shanghai, the

1. Zhenlong Zheng et al., Zhongguo Zhengquan Fazhan Jianshi [The History of China’s Securities Development] (Beijing, Economic Science Press, 2000), p. 114. 2. Shanghai Archives (ed), Jiuzhongguo de Gufengzhi [The Shareholding System of the Old China (1868–1949)] (1996), p. 247. 3. Zheng et al., above note 1, 126. 4. Shanghai Banking Association (ed), Minguo Jingji Shi [The Economic History of the Republic of China] (1948), pp. 145–153.

8

Chapter 2

famous Shanghai Chinese-founded Stock Exchange (Shanghai Huashang Zhenquan Jiaoyisuo) came into being in 1921, and later became the biggest stock exchange in the Far East in 1934.4 After the Second World War, another stock exchange was established in Tianjin in 1948. At the beginning of the establishment of the PRC in 1949, the Beijing Stock Exchange and the Tianjin Stock Exchange were allowed to continue operating, in order to stabilize the newly founded PRC’s economy and facilitate the social transition. This situation did not last long, however. The two stock exchanges ceased to operate in 1952 as China had began moving to a socialist economy. Under the highly planned economy and the public ownership system, joint stock companies and stock markets were regarded politically undesirable. Consequently, there had been no securities, let alone securities trading, for a period of nearly thirty years, until the introduction of the reform policy by the Third Plenary Session of the 11th National People’s Congress in 1978 with a view to addressing the bitterly ailing economy. After 1978, China’s economic system started transforming from a centrallyplanned economy to a socialist market economy. It was against this background that the shareholding system reappeared in China and thus China’s modern financial markets developed. Economic reform gave rise to the reallocation of productive resources and provided a fertile ground for the financial market to grow upon. Ironically, the market economy firstly burgeoned in the rural sector rather than the urban sector. This was largely due to the political reason that China began its economic reform trial in the rural sector. Before 1978, all the residents within one village were organized as one single team known as the ‘team of production’ (Shenchandui) which was the basic unit of productive forces in the rural sector. All of the members within one team worked collectively and products were being distributed equally. As a result of economic reform, this form of productive organization was gradually abandoned. Instead, individual villagers could separately conduct the task of production and take the responsibility for their own profits and losses. This privatization-like reform provided enormous incentives for farmers to work hard, resulting in the production efficiency in the rural sector increasing dramatically. This in turn created a considerable surplus of rural labor which started establishing all sorts of rural enterprises. Rural enterprises flourished in the 1980’s and have made a great contribution to national economic development. However, it was very difficult for the rural enterprises to get much needed funding from banks because banks were owned by the state and supposed to only fund state-owned enterprises at that time. Consequently, rural enterprises had to fund themselves through the pro-rata contributions from participating members and this was regarded as the incipience of China’s modern joint stock companies.5 It should be noted that the bond market developed before the stock market because the former was ideologically more easily accepted by the Communist Party at the outset of economic reform. In 1981, a bond market was established, 5. Zheng et al., above note 1, 172.

Inside Trading in China

9

signifying the birth of the present-day securities market. However, the bond market only met the liquidity needs of the government, leaving unaddressed the urgent capital needs of enterprises, especially private enterprises.6 Recognizing the financial difficulty private enterprises and state-owned enterprises were faced with, the government responded with the development of the stock market. Meanwhile, the successful trial of economic reform in the rural sector encouraged the government to extend the reform to the urban sector. In the urban sector, state-owned enterprises were generally of poor performance and the government felt too heavy a burden to finance them.7 In October 1984, the Communist Party issued the Decision of the Central Committee of the Chinese Communist Party on Several Issues Concerning the Reform of Economic System, and officially started economic reform amongst selected large and medium-sized state-owned enterprises.8 One major step of economic reform in the urban sector was to transform state-owned enterprises into joint stock companies. Beijing Tianqiao Department Store Company, registered in 1984, was the first joint stock company after the establishment of the PRC. However, this company was not a joint stock company in the strict sense because its issued shares could be redeemed three years later. In the same year, Shanghai Feile Acoustics Joint Stock Company, a real joint stock company, was formed in Shanghai. Thereafter, joint stock companies mushroomed nationwide and there were over 8,000 joint stock companies in China by the end of 1998.9 The issuance of shares created the need for share trading and thus a stock market. At the beginning, there was no highly organized stock exchange and all stocks traded in the over-the-counter (OTC) market. In September 1986, the Jingan Branch of Shanghai Trust Investment Company, the first OTC dealer, was established with governmental approval in Shanghai, and then the number of OTC dealers increased rapidly to nine in Shanghai alone within one year.10 However, there had been many problems with the OTC trading and more importantly, the OTC market could not meet the demand of rapidly growing trading volume. In response, two nationwide stock exchanges were established in Shanghai in December 1990 and in Shenzhen in July 1991 respectively.11 The establishment of

6. Wei 1Zhang & Chu Li, Zhongguo Zhaiwu Wenti Yanjiu [Research on the Questions of China’s Debts] (Beijing, China Finance Press, 1995), p. 42. 7. See e.g., D Jin, Dangdai Zhongguo Zhengquan Shichang [Contemporary Securities Market of China] (Beijing, Economic Science Press, 1999), pp. 21–23. 8. Zhonggong Zhongyang Guanyu Jingji Tizhi Gaige De Jueding [The Decision of the Central Committee of the Chinese Communist Party on Several Issues Concerning the Reform of Economic System], Renmin Chubanshe [People’s Publishing House] (1984). 9. Chengguang Ma, ‘Securities Law to Regulate Booming Sector’, Zhongguo Ribao [China Daily] 23 October 1998. 10. Shuguang Zhang (ed), Zhongguo Zhidu Bianqian de Anli Yanjiu [Research on the Cases in relation to China’s System Change] vol. I, (Shanghai, Shanghai People’s Press, 1996), p. 34. 11. Hong Wu et al., Zhongguo Zhengquan Shichang Fazhan de Falu Tiaokong [Legal Adjustment of the Development of China’s Securities Market] (Beijing, Law Press, 2001), p. 8; see also I. A. Tokley & Tina Ravn, Company and Securities Law in China (Thomson Professional Pub Cn, 1998), p. 63.

Chapter 2

10

these two stock exchanges marked the modern stage of the development of China’s securities market. Even though both of them are nominally non-profit, self-disciplined membership institutions, they in fact have made good profits and greatly stimulated local economic development. Having seen this, other provinces started to set up their own regional stock exchange centers and by the end of 1997 there were twenty-seven such centers. In 1998, the central government decided to clean up the securities market because there had been many serious problems with the regional stock exchange centers, such as lack of regulation and rampant misconduct.12 After this reform, all the regional stock exchange centers closed down, leaving the two stock exchanges in Shanghai and Shenzhen operating as the only legal places for securities trading.13 Today, the two stock exchanges have jointly set up an integrated stock market with nationwide coverage and made a substantial contribution to China’s economic development. To summarize, compared to its western counterparts, China’s modern stock market is very young, born in the 1980’s under the ‘reform and opening up’ (gaige kaifang) policy of the Communist Party to meet the needs of the rapidly growing economy. Although China’s stock market has a quite short history, it has made remarkable progress so far and played an increasingly important role in China’s economic development. There has been a rapid growth of the stock market since 1990. By the end of June 2004, the two stock exchanges in Shanghai and Shenzhen were handling an aggregate of 1,346 listed companies with a market capitalization of CNY 4.04 trillion (roughly USD 502 billion or AUD 788 billion).14 Thus, in terms of market capitalization, China’s stock market is now comparable to its Australian counterpart whose total market capitalization was AUD 838 billion at the end of June 2004.15 B.

FEATURES OF THE STOCK MARKET: TYPES OF SHARES

There are a number of distinctive features in the Chinese stock market, as a result of China’s economic transformation from a centrally planned economy to a market 12. Guowuyuan Bangongting Zhuanfa Zhenquan Jiaoyi Zhongxin Fangan De Tongzhi [Notice of the State Council on the Reorganization of the Regional Stock Exchange Centres] (Guobanfa [1998] No.135, promulgated by the State Council); Guanyu Yinfa Zhouzhengqin Chenyaoxian Tongzhi Zhai Qingli Zhengdun Zhenquan Jiaoyi Zhongxin Gongzuo Huiyi Shang Jianghua De Tongzhi [Notice Concerning the Circulation of the Speeches of Zhou Zhengqin and Chen Yaoxian in the Meetings on the Reorganization of the Regional Stock Exchange Centres] (Zhenjian [1998] No.53, promulgated by the China Securities Regulatory Commission, the watchdog of the securities industry in China). 13. Zheng et al., above note 1, 221–222. 14. See the official website of the China Securities Regulatory Commission: http://www.csrc. gov.cn/en/statinfo/index1_en.jsp?path=ROOT>EN>Statistical%20Information>Issuing (Summary of Raising Capital for Securities Market) (visited on 7 January 2005). 15. See the website of the Australian Stock Exchange: http://www.asx.com.au/statistics/l3/ HistoricalEquityData_MS3.shtm#End_of_month_values (visited on 7 January 2005).

Inside Trading in China

11

economy. It is expected that these features, embedded in the broader social and political infrastructure, would persist in the foreseeable future, even though they are weakening somewhat as reform proceeds. Thus, when discussing relevant legal issues in China, no sensible conclusion can be reached without taking these features into account. As a description of all the features is neither possible nor necessary for the present purpose, I will explore here some features of particular significance. It is important to note that the equity structure of the Chinese stock market differs greatly from those of western nations. There are, depending on the criteria used, several different types of shares in China. Apart from the dichotomy of common and preferred shares, which looks familiar to westerners, there are other special classifications and these seem to be peculiar to China. 1.

A-shares and B-shares

Depending on the eligible buyers and the currencies in which the shares are denominated, Chinese securities are traditionally divided into two classes of shares, namely A-shares, or A gu, and B-shares, or B gu.16 A-shares are basically limited to domestic investors, including individuals, legal persons and the state, with both the principal and dividends denominated in the local currency, namely the Chinese Yuan (CNY), also known as Renminbi (RMB). In contrast, B-shares are foreign-invested shares. Foreign investors, including investors from Taiwan, Hong Kong and Macao, can primarily invest in China’s stock market by purchasing B-shares. While B-shares carry a face value denominated in CNY, they are subscribed and traded in foreign currencies such as the US dollar on the basis of exchange rates at the time of transactions. For this reason, B-shares are also called Renminbi Special Shares (Renminbi Tezhong Gupiao). In addition, B-shares are issued in the form of registered shares, and no company can issue B-shares unless they meet certain requirements prescribed by the government.17 On balance, A-shares are the main body of shares, whereas B-shares account for only about 0.4% of all of the shares on China’s stock market in terms of market capitalization.18 Accordingly, B-shares have a very limited impact on the Chinese stock market. However, although the B-shares market is currently of a limited scale, it has played an important role in stimulating the development of China’s stock market because it provides a valuable channel for foreign capital to enter

16. Qulin Fu & Tingjie Shao, Zhongguo Zhengquan Jiaoyi Falu Zhidu Yanjiu [Study on the Legal Regime of Securities Exchange in China] (Beijing, Law Press, 2000), p. 8. 17. In this respect, the State Council promulgated Guowuyuan Guanyu Gufeng Youxian Gongsi Jingnei Shangshi Waizigu De Guiding [Regulation by the State Council on the Issues of B-shares] in December 1995 and subsequently, the China Securities Regulatory Commission promulgated detailed rules for the implementation of the regulation above. There are also other governmental rules concerning B-shares. 18. See the official website of the China Securities Regulatory Commission, http://www.csrc. gov.cn/en/statinfo/index1_en.jsp?path=ROOT>EN>Statistical%20Information>Issuing (Major Index) (visited on June 19 2004).

12

Chapter 2

China’s stock market. The development of the B-shares market is actually noticeable. The B-shares Market came into existence in 1991 when Shanghai Vacuum Electronic Appliance Joint Stock Company became the first company to issue B-shares, and by the end of 2002, there had been 110 companies which have issued B-shares.19 An important point to note is that the prices of A-shares and B-shares for the same listed company are always different, sometimes by a significant degree. The price of A-shares is traditionally much higher than, sometimes up to ten times, that of B-shares of the same company.20 At first glance, this is odd because A-shares and B-shares have many commonalities. For example, they are both issued domestically by Chinese companies and are listed and traded in stock exchanges within China. More zimportantly, B-shares carry the same voting and other relevant rights as A-shares. However, one should not be surprised by the big price difference because there is artificial market segmentation between the A-shares market and the B-shares market. Indeed, the A-shares market and the B-shares market are traditionally mutually independent: domestic investors cannot trade B-shares while foreign investors have no access to A-shares. The B-shares market is much less active than the A-share market because foreign investors are less confident in China’s stock market on the grounds that corporate governance of China’s listed companies is generally problematic and the market is ill regulated. As a distinctive Chinese characteristic, this severance of the A and B share markets is largely due to the incomplete convertibility of CNY and the so-called restricted foreign currency policy. For example, precluding domestic investors from B-shares is regarded as a measure to preserve the nation’s foreign currency reserve. Once the CNY becomes fully convertible, the separation between A-shares and B-shares might disappear. In fact, increasing economic globalization, coupled with China’s accession into the WTO, has recently resulted in the gradual mitigation of this problem. On the one hand, in February of 2001, B-shares became available to domestic individual investors.21 On the other hand, certain qualified foreign institutional investors (QFII) have been permitted to access A-shares in November of 2002.22 However, the market segmentation of A-shares and B-shares is not totally eliminated with the above measures for the following reasons. Firstly, there are at present a very 19. China Securities Regulatory Commission, Zhongguo Zhengquan Qihuo Tongji Nianjian [China Securities and Futures Statistical Yearbook] (Beijing, Baijia Publishing House, 2003), pp. 28–29. 20. Fu & Shao, above note 16, 106. 21. Guanyu Jingnei Jumin Geren Touzi Jingnei Shangshi Waizigu Ruogan Wenti de Tongzhi [Notice on Permitting Domestic Investors to Invest in B Shares] (promulgated by the CSRC on 21 February 2001). 22. Hege Jingwai Jigou Touzizhe Jingnei Zhengquan Touzi Guanli Zanxing Banfa [Provisional Measures on Investing in Tradable Shares on China’s stock market by Qualified Foreign Institutional Investors] (promulgated by the CSRC on 5 November 2002); see also e.g., Min Sun, ‘Domestic Stocks Open to Foreigners’ Zhongguo Ribao [China Daily] 5 November 2002 (reporting that foreign investors can enter China’s A share market under the QFII regime).

Inside Trading in China

13

limited number of QFII and only the upper echelon of international institutional investors are likely to receive such a privilege.23 Secondly, domestic institutional investors are still prevented from investing in B-shares. The feature of market segmentation, therefore, is still strong and might remain so in the foreseeable future. For example, according to a recent empirical study, even though the price gaps between A-shares and B-shares have decreased after February 2001, it has far from disappeared and continues to be statistically significant in that the price of B-shares generally equals to 60% of the price of A-shares in the same listed company.24 2.

Tradable Shares and Non-tradable Shares

More importantly, A-shares have been further sub-classified into three sub-sets in light of the strictly defined groups of shareholders in China, which are state shares (guojia gu), legal person shares (faren gu) and public individual shares (shehui geren gu).25 Only the public individual shares are freely tradable on the stock market while a large number of other sub-sets of shares cannot be freely traded on the stock exchange. Those non-tradable shares account for a majority of the shares in most listed companies, and can only be transferred by a private takeover agreement rather than by public offer.26 In 1998, non-tradable shares accounted for 66.32% of the total shares in the market. Empirical research has revealed that, in 1996, 74.52% of all the listed companies have a majority shareholder who holds more than thirty percent of the company’s outstanding stock.27 As of the end of May 2004, the tradable shares in the Shanghai Stock Exchange amounted to only 28.30% of all the shares, in terms of volume;28 while during that same time the amount of tradable shares in the Shenzhen Stock Exchange amounted to 39.41%, in terms of volume.29 23. Zhaohui Yuan & Juan Ju, ‘The Problems of the One-Year-Old QFII System’ Zhengquan Shichang Zhoukan [Securities Market Weekly] July 17, 2004, at 12. 24. Wenfeng Wu et al., ‘The Impact of the Permission for Domestic Individual Investors to Access B-shares on the Market Segmentation of A-shares and B-shares’ (2002) 12 Jingji Yanjiu [Economic Research Journal] 33, 35. 25. Baoshu Wang and Qinzhi Cui, Zhongguo Gongsifa Yuanli [The Principles of Chinese Corporate Law] (Beijing, Social Sciences Academic Press, 1998), p. 171. 26. Originally, state shares could be transferred to foreigners via private agreement, yet this has been prohibited since September 1995. In November 2002, this practice was jointly revived by the China Securities Regulation Commission, the Ministry of Finance, and the China Economic and Trade Commission. See Guangyu Xiang Waishang Zhuanrang Shangshi Gongsi Guoyougu he Farengu Youguan Wenti de Tongzhi [Notice on Relevant Issues about Transferring State Shares and Legal Person Shares of Listed Companies to Foreigners] (Promulgated in November 2002). 27. See Ling He, ‘An Empirical Analysis of the Corporate Governance in Chinese Listed Companies’ (1998) 5 Jingji Yanjiu [Economic Research Journal] 45. 28. See the official website of the Shanghai Stock Exchange, http://www.sse.com.cn/sseportal/ webapp/datapresent/MarketViewAct?reportName=NumberOfListing (Market Overview) (visited on 18 June 2004). 29. See the official website of the Shenzhen Stock Exchange, http://www.szse.cn/UpFiles/Attach/ 1468/2004/06/03/1526155937.html (Market Overview) (visited on 18 June 2004).

14

Chapter 2

The reason behind this unique feature of the Chinese stock market is both political and economic. The political reason is to prevent state assets from falling into the hands of individuals, while the economic reason is to protect state assets from depreciation and misappropriation (in a widely used Chinese term, Fanzhi Guoyou Zichan Liushi).30 At the beginning of the establishment of the Chinese stock market, the political reason seemed more important. Most of the listed companies in China are previously large state-owned and managed enterprises, which are seen as the basis and symbol of a socialist economy. When these enterprises initially went public, their original state assets translated into state shares of the listed companies.31 Thus, those state shares are labeled as state assets, which, in turn, represent the state’s ownership. State ownership is traditionally considered the highest form of ownership and the goal of socialism. After the 1999 amendment, the Chinese Constitution still provides that: in the primary stage of socialism, [China] shall uphold the basic economic system in which public ownership is dominant and diverse forms of ownership develop side by side. It shall also uphold the distribution system with distribution according to work remaining dominant and with a variety of models of distribution coexisting.32 Individual ownership is still seen as inferior to public ownership and as such is treated differently. The 1999 amendment of Article 11 of the Chinese Constitution reads as follows: the non-public sector, including self-employed and private businesses, within the domain stipulated by law, is an important component of [China’s] socialist market economy. The state shall protect the legitimate rights and interests of the self-employed and private enterprises, and China should also exercise guidance, supervision and management over them according to the law.33 Prior to this amendment, private businesses enjoyed an even lower status and were considered just a complement to the socialist public sector economy. Under this social and political framework, state shares, as the embodying form of state ownership, have been strictly protected from the threat of private ownership. It was feared that if state shares were permitted to be transferred to private owners, then the socialist economy would be baseless. Therefore, the prohibition of the free transfer of state shares serves to preserve the socialist nature of the Chinese economy and thus China as a whole. The economic reason for restricting the transfer of state shares is the fear that, if transferred, state shares could be mishandled or at the least lose value. In a socialist

30.

Hehong Chen et al., Guoyou Guquan Yanjiu [Study on State-owned Shares] (Beijing, China University of Political Science and Law Press, 2000), p. 324. 31. Ibid 81–83. 32. Zhonghua Renmin Gongheguo Xianfa [the Constitution of the People’s Republic of China] (enacted in 1982, emended in 1988, 1993, 1999) (hereinafter China’s Constitution), Art. 6 (emphasis added). 33. China’s Constitution, Art. 11 (emphasis added).

Inside Trading in China

15

state like China, public properties are said to be inviolable,34 but ironically they are most vulnerable to misappropriation and damage in reality. National properties are nominally owned by all Chinese people as a whole, but practically are not owned by any particular person. Thus, no people have incentives and responsibilities to protect public properties. In relation to state shares as a form of public properties, this phenomenon is vividly called ‘absence of functional owners of the state-owned shares’(Guoyougu Suoyouzhe Quewei).35 The lack of identifiable, responsible owners of state shares has caused serious problems. Under this situation, there is a real possibility that, if permitted to be transferred, state shares could be misappropriated or embezzled by people such as corrupted officials. In fact, this problem is common to those states in transition from a centrally-planed economy to a market economy, and has been well shown by the Russian privatization process.36 It is important to note that the Chinese stock market was deemed as just an experiment of economic reform at the outset. In early spring of 1992, China’s leader, Deng Xiaoping, made a very important speech during the inspection of South China that was intended to liberate minds and encourage further reform. With respect of the stock market, he pointed out, Are securities and the stock good or bad? Do they entail any dangers? Are they peculiar to capitalism? Can socialism make use of them? We allow people to reserve their judgment, but we must try these things out. If, . . . they prove sensible, we can expand them. Otherwise, we can put a stop to them.37 For this reason, the government was understandably reluctant to risk state shares in this experiment. And, the original purpose of the establishment of the stock market, and perhaps even now to a large degree, was to raise funds for state-owned enterprises and to help those enterprises get out of financial distress (Wei Guoyou Qiye Jiekun).38 Other than that purpose, the Chinese government has little interest in seeing its shares transferred. 34. China’s Constitution, Art. 12. 35. In response to this issue, the central government established a specific administrative body known as the State-owned Asset Supervision and Administration Commission of the State Council (SASAC), and placed the SASAC in charge of state-owned assets in 2003. Whether this new body will satisfactorily fulfill its important role is uncertain at the moment. See e.g., Jiahang Wang, ‘How to Establish an Effective SASAC’ Jingji Shibao [Economy News] 19 February 2003, at 4. 36. Anna Tarassova, Bernard S. Black and Reinier Kraakman, ‘Russian Privatization and Corporate Governance: What Went Wrong?’ (2000) 52 Stanford Law Review 1731. 37. Deng Xiaoping, Excerpts from Talks Given in Wuchang, Shenzen, Zhuhai and Shanghai (Jan. 18–Feb. 21, 1992), in 3 DENG XIAOPING, SELECTED WORKS OF DENG XIAOPING 361 (The Bureau for Compilation and Translation of works of Marx, Engels, Lenin and Stalin under the Central Committee of the Communist Party of China trans., Foreign Languages Press, 1994). 38. See, e.g., Guogang Wang, ‘Reform the Planned Economy System and Protect Investor Interests’ Jingji Cankao Bao [Economy Guidance News] January 29, 2004 (contending that the market’s purpose of raising funds for state-owned enterprises should be changed). See also Xiaonian Xu, ‘China’s Securities Market is now Experiencing Structural Change’ Zhongguo Zhengquan Bao [China Securities News] November 29, 2000 (arguing that China’s securities market should no longer primarily serve as a tool for state-owned enterprises to raise funds).

Chapter 2

16

As the economic and political reforms in China proceed, the concern over the transfer of state shares decreases. Over time, the original experimental color of the stock market has faded, and the market seems to function healthily and play an increasingly important role in the Chinese economy. Thus, the government currently feels that it might be safe to let state shares into the market.39 At present, there is perhaps a more important reason for permitting the transfer of state shares. Indeed, the majority of the shares on the market are non-tradable and currently present a serious impediment to the further development of the market.40 In particular, in the face of such a high percentage of non-tradable state shares in listed companies, takeover attempts by tender offer are practically impossible.41 Furthermore, the government is starting to recognize that state shares could maintain their value, and perhaps even appreciate, by transfer on an open market. Hence, the government has decided to sell most of the state shares under the program of Guoyougu Jianchi (reducing state shares),42 but this has been temporarily locked up due to a disagreement on the selling price of state shares since 24 June 2002.43 The deadlock is largely based on the fact that the price of tradable shares is usually higher, sometime significantly, than the price of non-tradable shares in the same company.44 Another reason is that the tradable shares have always been much more expensive than state shares when the companies initially went public. Thus, the tradable-share holders are strongly opposed to the government’s plan to sell state shares at market price.45 However, it appears that the trading restrictions on state shares will be lifted eventually and thus the distinction between tradable and non-tradable shares will become a history. 3.

Other Types of Shares

In addition to the A-share and B-share distinction as well as the tradable and nontradable distinction, there are distinctions based on the location of where certain 39. China Securities Regulatory Commission, above note 19, 6–7. 40. Ibid 7. 41. Hui Huang, ‘China’s Takeover Law: A Comparative Analysis and Proposals for Reform’ (2005) 30 Delaware Journal of Corporate Law 145, 159 (stating that ‘takeover by tender offer is not popular or feasible in China. To date, a very limited number of takeover cases by tender offer in China have occurred . . .’). 42. Jianchi Guoyougu Chouji Shehui Baozhang Jijin Guanli Zanxin Banfa [Provisional Measures on Selling State Shares to Raise Social Security Fund] (promulgated by the State Council on 12 June 2001). 43. Jian Lin, ‘The State Council has Decided to Stop Selling State Shares’ Shanghai Zhengquan Bao [Shanghai Securities News] 24 June 2002, at 1. 44. Chen et al., above note 30, 168. 45. See e.g., Zhiguo Han, ‘Eight Errors of the Plan to Sell State Shares’ Shanghai Zhengquan Bao [Shanghai Securities News] 5 November 2001, at 3. Further discussion of the problems arising from the sale of state shares goes well beyond the scope of this book. On 29 April 2005, the CSRC promulgated a regulation to launch a new effort to make those untradable shares tradable. It remains to be seen whether this reform will be successful. See Guanyu Shangshi Gongsi Guquan Fenzhi Gaige Shidian Youguan Wenti de Tongzhi [Notice on Relevant Issues about the Reform of the Ownership Structure of Listed Company] (promulgated on 29 April 2005 by CSRC).

Inside Trading in China

17

stocks are listed, such as H-shares and N-shares.46 H-shares and N-shares, for example, took their names from the location where the shares are listed. Respectively, H-shares are stocks of Chinese companies listed on the Hong Kong Stock Exchange, while N-shares are those listed on the New York Stock Exchange. The trading of these shares is mainly subject to the laws of listing locations rather than Chinese laws. Thus, these types of shares seem more akin to the shares on foreign stock market in terms of law application. Moreover, it is worth noting that the market capitalization overseas of such shares is rather small, only 2.3% of the domestic market capitalization of A-shares and B-shares.47 Therefore, these shares have very little impact on the Chinese stock market. However, notwithstanding the small amount of funds they have raised, these shares provide a very important way of utilizing foreign capital and enhancing the international image of the Chinese companies. C.

THE REGULATORY FRAMEWORK OF THE MARKET

In accordance with the step-by-step development of the underlying stock market, China’s regulatory regime has evolved over time, from a number of dispersed regional regulators to a highly centralized national regulator. The whole development can be loosely divided into three phases as follows. 1.

Before 1992: Dispersed Regulatory Regime

Before October 1992, the regulatory regime was highly dispersed and rather chaotic. This first phase can be therefore called ‘dispersed regulatory regime’. The regulatory regime was made up of a group of provincial regulatory bodies which operated relatively independently of each other under the direction of respective local governments. Originally, in response to the problems appearing in the newly established securities market, provincial governments set up their own regional regulatory bodies. These regulatory bodies operated independently of each other, being responsible primarily to their respective local governments. Thereafter, some national bodies, such as the People’s Bank of China and the National Economic System Reform Commission, intervened in the regulation. As a consequence, the regulatory regime was a combination of central governmental regulation and regional governmental regulation. This period of time witnessed a lot of regulatory

46. Baoshu Wang and Qinzhi Cui, Zhongguo Gongsifa Yuanli [The Principles of Chinese Corporate Law] (Beijing, Social Sciences Academic Press, 1998), p. 178. Notwithstanding their diminished relevance to the discussion in this book, they are noted for the sake of completing the picture of China’s stock market. 47. See the official website of the China Securities Regulatory Commission, http://www.csrc.gov. cn/cn/statinfo/index1.jsp?path=ROOT%3ECN% (Summary of Raising Capital) (visited on 19 June 2004).

Chapter 2

18

power struggles amongst those bodies and this non-centralized regulatory regime was thought to be responsible for regulatory inefficiency at that time.48 2.

1992–1997: Transitional Phase

From 1992 to 1997, the regulatory regime was in its second phase, namely the transitional phase. With the development of the stock market, there was a pressing need to enhance regulatory efficacy by streamlining the regulatory regime. In October 1992, the central government established the State Council Securities Commission (SCSC) and the China Securities Regulatory Commission (CSRC), marking the beginning of the uniformity of the national securities regulatory system. Under this scheme, the SCSC was the national authority responsible for the regulation of the securities market, and the CSRC was the SCSC’s executive branch which was charged with supervisory responsibility over the securities market nationwide in accordance with law. It should be noted that the existing local regulatory bodies were preserved in this reform and were authorized to continue their regulatory function.49 Further, many other state organs also had their roles to play in the regulation of the stock market. For example, the People’s Bank of China was empowered to approve the establishment of securities companies; The State Development Planning Commission was in control of the overall quantity of new securities issuance; The State Economic System Reform Commission had the power to choose which state-owned enterprises were to be transformed into joint stock companies and listed in the stock exchanges; The Ministry of Finance was charged with the task of supervising accounting professionals in the market. In addition, the stock exchanges in Shanghai and Shenzhen were supervised by both local governments and central government represented by the SCSC.50 In this second phase, the regulatory regime became basically national and centralized with the SCSC and the CSRC sitting at the core. Consequently, the national regulatory power was strengthened and regulatory efficiency improved. However, the regulatory regime was not yet totally centralized and uniform, because the reform was compromised by interest group politics between the central government and provincial governments and amongst different organs within the governments. As a result, the regional securities regulatory bodies which were not subordinate to the CSRC but actually controlled by local governments, survived this reform, and too many national organs shared regulatory powers. Therefore, the frictions and confusions with respect to regulatory powers between different regulatory bodies continued to remain and called for further reform.

48.

See e.g. Jinxuan Bao, ‘Improve the Securities Regulatory and Self-regulatory Regime in China’, (1999) 3 Fashang Yanju [Study on Law and Commerce] 66. 49. Guanyu Shouquan Difang Zhenquan Qihuo Jianguan Bumeng Xingshi Bufen Jianguan Zhize De Jueding [Decision on the Authorization of Regional Securities and Futures Regulatory Bodies to Perform Part of Regulatory Functions] (promulgated by the SCSC in March 1996). 50. Zhenquan Jiaoyisuo Guanli Zanxing Banfa [Provisional Measures for the Management of Stock Exchanges] (promulgated by the SCSC in July 1993).

Inside Trading in China 3.

19

After 1997: Centralized Regulatory Regime

Since 1997, the regulatory regime has gradually become highly centralized. In response to a flood of securities fraud scandals on the market in 1997, the central government felt the regulatory inefficacy and decided to further reform the regulatory regime. In August 1997, the State Council put the two stock exchanges in Shanghai and Shenzhen under the exclusive supervision of the CSRC. Soon after, the existing regional securities regulatory bodies became subject to the direct supervision of the CSRC in November 1997. Finally, in April 1998, due to the growing influence of the CSRC in the securities regulation, the State Council merged the SCSC (the former boss of the CSRC) into the CSRC in resolution of the conflicts of power between them. Consequently, the CSRC was upgraded as a ministry rank unit directly under the leadership of the central government and as a result, both the powers and functions of the CSRC were further strengthened. Meanwhile, other state organs handed over to the CSRC their powers in relation to securities regulation. For example, the CSRC took over the power to administer the securities companies which was previously held by the People’s Bank of China. After this overhaul of the regulatory regime, a centralized regulatory regime was finalized and the CSRC has been exclusively responsible for securities regulation in China.51 §2.II.

THE REGULATION OF INSIDER TRADING

A.

THE HISTORY OF INSIDER TRADING REGIME

1.

Before 1999: Governmental Regulations

The history of the regulation of insider trading in China can be traced back as early as 1990 when the stock market was at its very early stage. The term ‘insider trading’ (Neimu Jiaoyi) was first seen in the Provisional Measures for Regulating Securities Companies (1990), promulgated by the then stock market regulator, the People’s Bank of China.52 Article 17 of this regulation provided that ‘securities companies are prohibited from engaging in market manipulation, insider trading, and other types of misconduct which yield profits by unlawfully affecting the market’.53 However, since this regulation did not contain functional provisions concerning insider trading, it was largely of symbolic value and more like a political announcement than a real law. 51.

See the official website of the CSRC: http://www.csrc.gov.cn/csrcsite/eng/eabout/eintr.htm (visited on 16 June 2004); also Wu et al., above note 11, 9–10. 52. Zhenquan Gongsi Guanli Zanxing Banfa [Provisional Measures for Regulating Securities Companies] (Promulgated in October 1990) (PRC). 53. Zhenquan Gongsi Guanli Zanxing Banfa [Provisional Measures for Regulating Securities Companies] (Promulgated in October 1990) (PRC) Art. 17.

20

Chapter 2

As discussed earlier, in 1990 and 1991, two stock exchanges in Shanghai and Shenzhen came into being in succession, and about two years later, in October 1992, two national regulatory bodies, the SCSC and the CSRC, were established to perform regulatory functions. During the period after the formation of the two stock exchanges but before the establishment of the SCSC and the CSRC, the local governments of Shanghai and Shenzhen were authorized to administer the stock exchanges respectively.54 Both of the two local governments promulgated a series of regulations regulating the stock market. In relation to insider trading were Articles 39, 39, 40 of the Measures for Regulating Securities Trading in Shanghai (1990)55 and Article 43 of the Provisional Measures for Regulating Securities Issuance and Trading in Shenzhen (1991)56. In addition, insider trading provisions can also be found in Articles 93, 103 of the Provisional Measures for Regulating Listed Companies in Shenzhen (1992).57 In terms of legislative maturity, this cluster of local regulations made some progress vis-à-vis the regulation promulgated by the People’s Bank of China in that they provided likely insiders and relevant administrative liabilities. However, these local regulations were ineffective. The key issue of insider trading, namely inside information, was simply left unaddressed. Furthermore, some provisions seemed to be unreasonable and draconian. For instance, all government officials and military service persons were strictly prohibited from share trading under those regulations. Indeed, these regulations appeared inefficient in the face of widespread fraudulent misconduct on the 1993 bull market.58 In response, a string of important regulations regarding the stock market were promulgated in quick succession in 1993.59 On 22 April 1993, the State Council released the very powerful Provisional Regulations on the Administration of Stock Issuance and Trading (‘Provisional Regulations’)60. Introduced by the central government, this regulation was applicable nationwide and has made an important contribution to the regulation of the stock market. This regulation contained a number of important provisions regarding insider trading. Article 38 outlawed the practice of so-called ‘short swing’ transactions.61 More detailed administrative liabilities were set forth in Article 72. 54. Wu et al, above note 11, 9. 55. Shanghaishi Zhenquan Jiaoyi Guanli Banfa [Measures for Regulating Securities Trading in Shanghai] (27 November 1990) (PRC). 56. Shenzhenshi Gupiao Faxing yu Guanli Zanxing Banfa [Provisional Measures for Regulating Securities Issuance and Trading in Shenzhen] (15 June 1991) (PRC). 57. Shenzhenshi Shangshi Gongsi Jianguan Zanxing Banfa [Provisional Measures for Regulating Listed Companies in Shenzhen] (April 1992) (PRC). 58. See Hong Wu et al., Zhongguo Zhengquan Shichang Fazhan de Falu Tiaokong [Legal Adjustment of the Development of China’s Securities Market] (Beijing, Law Press, 2001), p. 11. 59. In 1993, China enacted one important law, namely Zhonghua Renming Gongheguo Gongsifa [Company Law of the People’s Republic of China] (promulgated on 29 December 1993 and effective from 1 July 1994, amended in 1999, 2004 and 2005) (PRC) (hereinafter Company Law). 60. Gupiao Faxing yu Jiaoyi Guanli Zanxing Tiaoli [Provisional Regulations on the Administration of Stock Issuance and Trading] (22 April 1993) (PRC) (hereinafter Provisional Regulations). 61. This article gives an issuer of securities the right to seek recovery of any profits made by any corporate directors, executive officers or substantial shareholders (that is, persons who are

Inside Trading in China

21

It is also worth noting that, under Articles 77 and 78, civil liability and criminal liability were made available for the first time, though merely in principle and thus largely non-operative. In addition, this regulation still had no detailed provisions in respect to the definitions of insider and inside information. Shortly afterwards, in September 1993, the CSRC promulgated the Provisional Measures for the Prohibition of Securities Fraud (‘Provisional Measures’).62 This regulation was specifically designed to address various types of fraudulent misconduct in the stock market, including insider trading. Efforts were made to substantially fill many gaps with respect to insider trading left by the existing regulations in China. A set of very clear, detailed provisions were devoted to insider trading. For example, Article 4 provided the forms of insider trading activities;63 Article 5 defined inside information as ‘information which is not publicly known but, if publicly disclosed, might have a material effect on the market price of securities on the market’ and specifically enumerates twenty-six types of inside information with a view to facilitating the application;64 Six types of likely insiders covered by this regulation were listed in Article 6, including corporate officials, governmental officials and other people who may have access to inside information;65 and, Articles 13, 14 set out administrative liabilities for violations of insider trading provisions, which were almost identical to Article 72 of the Provisional Regulations.66 However, civil liability and criminal liability were still left unaddressed. As discussed above, all the regulations were silent on the issue of criminal liability for insider trading. This is because criminal liability can only be provided by the paramount legislature in China, namely the National People’s Congress (‘NPC’). In October 1997, the NPC revised the Criminal Law of the People’s Republic of China (‘Criminal Law’)67 to include insider trading. Since then, insider trading has been able to attract potential criminal liability in China. Under Article 180 of the Criminal Law, insider trading perpetrators would be subject to a fine of up to five times the illegal proceeds or imprisonment for up to ten years or both, depending on the severity of cases.68 It should be noted that the Criminal Law does not define insider trading, but instead makes reference to other laws and regulations with respect to insider trading. Article 180(3), (4) expressly

62. 63. 64. 65. 66. 67. 68.

beneficial owners of more than 10% of any class of equity securities) of that issuer from any purchase and sale (or sale and purchase) of the issuer’s equity securities in any six month period. The Provisional Regulations, Art. 38. The profits are called ‘short swing profits’. This article was faithfully patterned on the US experience, namely Section 16(b) of the Securities Exchange Act 1934. Jinzhi Zhengquan Qizha Xingwei Zanxing Banfa [Provisional Measures for the Prohibition of Securities Fraud] (2 September 1993) (PRC) (hereinafter Provisional Measures). Ibid Art. 4. Ibid Art. 5. Ibid Art. 6. Ibid Arts. 13, 14. Zhonghua Renming Gongheguo Xingfa [Criminal Law of the People’s Republic of China] (October 1997) (PRC) (hereinafter Criminal Law). Ibid Art. 180.

Chapter 2

22

states that the scope of insiders and inside information should be determined by relevant laws and regulations for the purposes of the Article.69 2.

After 1999: Congressional Legislation

It was not until 1999 that China had national legislation specifically governing the stock market. Before 1999, China regulated the stock market solely with governmental regulations. However, these regulations proved inefficient due to their low level of legal effect in the legislative system. The period between 1996 and 1998 witnessed a considerable amount of fraudulent misconduct in the stock market, including misrepresentation, market manipulation, insider trading, and misappropriation by securities companies of clients’ funds.70 The perception that the existing governmental regulations were failing to meet regulatory needs led to the establishment of a national securities law. The well-known 1997 Asian financial crisis was also regarded as influencing this lawmaking process.71 In July 1999, the long-awaited Securities Law of the People’s Republic of China (‘Securities Law’) came into effect,72 aiming to ‘standardize the issuing and trading of securities, protect the lawful rights and interests of investors, safeguard the economic order and public interests of society and promote the development of the socialist market economy’.73 This law was a major milestone for securities regulation in China. For the first time, China’s stock market had its own national law which was enacted by the NPC. As a consequence, this law enjoys higher legal effects than the regulations promulgated by the government. It effectively ended the conflicts between those governmental regulations, providing greater regulatory uniformity to the rapidly growing Chinese securities market. The Securities Law paid a fair amount of attention to insider trading, devoting as many as five Articles to it. Simply put, Article 47 prohibits short-swing trading;74 Article 73 is the general provision outlawing insider trading;75 Article 74 details the

69. Ibid Arts. 180(3), 180(4). 70. Hong Wu et al., Zhongguo Zhengquan Shichang Fazhan de Falu Tiaokong [Legal Adjustment of the Development of China’s Securities Market] (Beijing, Law Press, 2001), p. 12. As will shortly be shown, there had been eleven insider trading cases in China by the end of June 2004, six of which took place during the period between 1996 and 1998. See below §2.III.A. 71. Roman Tomasic & Jian Fu, ‘The Securities Law of the People’s Republic of China: An Overview’ (1999) 10 Australian Journal of Corporate Law 268, 269. However, some commentators thought that the outbreak of the 1997 Asian financial crisis frightened the Chinese government which became more cautious about the stock market and thus retarded the lawmaking process. See e.g., Wu Hong et al., Zhongguo Zhengquan Shichang Fazhan de Falu Tiaokong [Legal Control on the Development of China’s Securities Market] (2000) 18. 72. Zhonghua Renming Gongheguo Zhengquanfa [Securities Law of the People’s Republic of China] (promulgated on 29 December 1998 and effective from 1 July 1999, amended in 2004 and 2005) (PRC) (hereinafter Securities Law). 73. Securities Law, Art. 1. 74. Ibid Art. 47. 75. Ibid Art. 73.

Inside Trading in China

23

scope of insiders by enumerating seven types of likely insiders;76 the definition and enumeration of inside information are found in Article 75;77 Article 76 prohibits tipping activities.78 These provisions will be critically examined in full detail in the following chapters. Further, Article 202 imposes administrative liabilities for insider trading, providing that [an insider] shall be ordered to dispose of the illegally obtained securities according to law, his illegal gains shall be confiscated and in addition, he shall be imposed a fine of not less than the amount of but not more than five times the illegal gains, or a fine of not more than the value of the securities illegally purchased or sold. 79 The Securities Law has greatly strengthened the regulation of insider trading in China. While this insider trading regime is not without problems, it paves the way for the regulation of insider trading in a rule-of-law based manner in China. It is worth noting that the main insider trading provisions laid down in the Securities Law are largely a faithful copy of the relevant provisions in the Provisional Measure with some minor variations. Furthermore, as discussed above, Article 180 of the Criminal Law and Article 183 of the Securities Law provide criminal liability and administrative liability for insider trading respectively, but the Securities Law does not contain functional provisions with regard to civil liability for insider trading. The absence of civil liability for insider trading is thought to be one of the biggest shortcomings in the insider trading regime.80 B.

FEATURES OF CHINA’S INSIDER TRADING LAW

As discussed above, China has been working hard to establish an effective insider trading regulatory regime, with the purpose of enhancing integrity and fairness of the securities market by forcefully cracking down on insider trading. Although China’s securities legislative history is quite short, China has made a noticeable achievement in setting up its insider trading regime. It is worth noting some important features in China’s insider trading law. 1.

The Willingness to Regulate Insider Trading

The first distinctive feature of China’s insider trading law is that the government has shown a great willingness to regulate insider trading. The regulation of insider trading in China was born at the very early stage of the stock market with little opposition to the idea that insider trading should be prohibited. In this respect, 76. 77. 78. 79. 80.

Ibid Art. 74. Ibid Art. 75. Ibid Art. 76. Ibid Art. 202. The issue of civil liability for insider trading is discussed in greater detail in Chapter 7.

24

Chapter 2

China contrasts sharply with other jurisdictions where the question of whether to outlaw insider trading has been greatly debated. For instance, Japan had no insider trading provisions until 1988 when it amended its securities exchange law.81 In the UK, it was not until 1980 that insider trading was criminalized, despite the UK stock exchange being in existence since the last quarter of the seventeenth century.82 Several reasons could be offered to account for this. Firstly, China might have prohibited insider trading simply because other advanced economies, notably the US, have done so.83 In other words, with overseas experience, China did not hesitate to prohibit insider trading. Secondly and more importantly, as will be discussed in Chapter 4, insider trading is widely regarded as harmful in China.84 Because China had been under a centrally planned economy for many years, people are generally concerned about misuses of position and speculative market activities. With the development of the securities market, more Chinese citizens are holding securities and thus financial stakes in the efficient and fair operation of the market, and more enterprises are becoming dependant on the influx of capital through the stock exchanges.85 Thus, there exists society-wide consensus on the impropriety of insider trading; there exist enough people with a stake in prohibiting insider trading. In such a situation, it is logical and comprehensible for the Chinese government to move quickly to combat insider trading within the resources available.86 The willingness to regulate insider trading is also reflected by the increase of legal liabilities of insider trading. One the one hand, the early governmental regulations provided only administrative liabilities, and then criminal liabilities were introduced to add more deterrence by the Criminal Law in 1997. And now China is working to introduce civil liability for insider trading. On the other hand, administrative liabilities have increased over time. For example, the amount of fine in the 1993 Provisional Measures ranged from CNY 50,000 to

81.

82. 83.

84. 85. 86.

See e.g., Tomoko Akashi, Note, ‘Regulation of Insider Trading in Japan’, (1989) 89 Colum. L. Rev. 1296, 98–99 (stating that the Japanese authorities lacked enthusiasm to regulate insider trading); Franklin A. Gevurtz, ‘The Globalization of Insider trading Prohibitions’ (2002) 15 Transnational Lawyer 63, 85 (maintaining that the Japanese government ‘was not sure how much it really wanted to enact an insider trading prohibition’). Gil Brazier, Insider Dealing: Law and Regulation (Cavendish Publishing Limited, 1996), pp. 90–95. Franklin A. Gevurtz, ‘The Globalization of Insider trading Prohibitions’ (2002) 15 Transnational Lawyer 63, 67 (arguing that one force leading to the explosive growth in insider trading prohibitions worldwide during the late 1980s and 1990s ‘may be simply instinctive imitation spawned by the growing cultural and economic dominance of the United States’). See below §4.III. The number of Chinese investors in the stock market soared from 7.8 million in 1993 to 68.8 million in 2002, and many more people are considering entering the market. China Securities Regulatory Commission, above note 19, 286. One US commentator has theorized this as stakeholder influence. See Brian Daly, ‘Of Shares, Securities, and Stakes: The Chinese Insider Trading Law and the Stakeholder Theory of Legal Analysis’ (1996) 11 American University Journal of International Law and Policy 971, 973 (stating that the development of the Chinese insider trading law demonstrates the importance of ‘stakeholders’ in the legal system).

Inside Trading in China

25

500,000 in any case. This amount range proved too rigid to suit a variety of cases because the sum of illegal profits therein differs greatly. Undoubtedly, a fine of CNY 500,000 can provide little deterrent for an insider who has made a huge profit. The 1999 Securities Law has dealt with this problem by borrowing relevant experience from the US, and now the fine is more reasonably computed by reference to the sum of illegal profits gained in insider trading.87 Furthermore, the level of legislative responses escalates, reflecting the increasing attention given by the government to securities regulation. As discussed above, the insider trading provisions were first introduced by the regional Shanghai and Shenzhen governments. These regulations had only local application effect because they were promulgated under delegated legislative authorities of local governments. In 1993, the State Council promulgated the Provisional Regulations which was applicable nationwide. However, because the Provisional Regulations was promulgated by the central government rather than the body responsible for exercising national law-making authority, namely the NPC, the Provisional Regulations was of administrative regulation nature and thus of limited legal effect. For example, it could stipulate only administrative penalties and thus provided insufficient deterrent. Finally, the NPC joined the cause to combat insider trading and exercised its paramount legislative power. It added criminal liabilities for insider trading in the Criminal Law and more significantly, enacted the Securities Law which is the first comprehensive and national law governing the securities market. Legislations enacted by the NPC in China have the greatest effect and thus, are the most powerful weapons in China’s legislative hierarchy.88 2.

Importation of Overseas Experience

The other feature of China’s insider trading law is its use of overseas experience. China’s insider trading law has benefited greatly from valuable overseas experience, particularly from the US. Indeed, the drafting of the Securities Law received direct assistance from the US.89 The advanced overseas experience provided China with a good starting point to enact its securities regulations. Learning from foreign experience has enabled China to significantly reduce legislative costs and thus facilitates the enactment of insider trading law. This may explain why China has established its 87. Article 202 of the Securities Law (providing ‘. . . a fine of not less than the amount of but not more than five times the illegal gains, or a fine of not more than the value of the securities illegally purchased or sold’). In the US, Section 21A (a)(2) of the Securities Exchange Act of 1934 provides that a civil penalty is up to three times the profit gained or loss avoided. See H.R. Rep. No. 100–910 to accompany H.R. 5133, 100th Cong., 2d Sess. at 20 n. 16 (adding a new Section 21A to the Exchange Act). 88. For a detailed discussion of the sources and hierarchy of law in China, see e.g., Jianfu Chen, Chinese Law: Towards an Understanding of Chinese Law, its Nature and Development (The Hague, Kluwer Law International, 1999), Chapter 4: ‘Sources of Law and Law-Making’. 89. See Mingkang Gu & Robert C. Art, ‘Securitization of State Ownership: Chinese Securities Law’, 18 Mich. J. Int’l L. 115, 117 (1996).

Chapter 2

26

insider trading regime in such a short period of time. With the benefits of overseas experience, China’s insider trading regime has become increasingly concrete and workable since insider trading was initially prohibited in 1990. In the US, the regulation of insider trading is largely judicially developed on the basis of the famous Rule 10b-5.90 The Congress of the US has twice rejected the suggestion of defining insider trading when it adopted the Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988.91 The US insider trading regulation has developed basically by way of case law, providing maximum flexibility for judges to deal with a complex issue like insider trading. However, this case law approach is unsuitable for China. In the first place, the Chinese legal system is basically a civil law system. In China, judicial cases carry no legally binding effect and cannot be directly invoked in judgments. More importantly, this approach entails a team of high quality judges which China lacks for the time being. Chinese judges are barely able to shoulder the burden of developing insider trading law by a case law approach, and China has had to enact statutes for the courts to apply. Thus, China has to introduce foreign experience in such a way that fits into its overall legal framework. Furthermore, in order to provide maximum clarification and facilitate the understanding of what constitutes insider trading, China has to describe the elements of insider trading in greater detail. For example, as to the issues such as the notions of insiders and inside information, the Provision Measures and the Securities Law took great pain to enumerate the possible items.92 Those detailed provisions greatly help people grasp the notion of insider trading. However, one problem may arise in this detailed enumeration legislative technique. The enumerated items can never be exhaustive and thus leave gaping holes, especially in a complicated and unsettled area like insider trading. To tackle this problem, delegation clauses and catch-all provisions have been added to cover all other items which are not expressly listed but are likely to emerge in the future.93 This provides necessary flexibility to suit the need of regulating insider trading. C.

PROBLEMS WITH CHINA’S INSIDER TRADING LAW

Despite the remarkable progress that China has made in setting up its insider trading regime, there are many problems with the insider trading law. Generally speaking, it 90.

See generally, Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991), vol. VII, pp. 3485–3490. The development of the US insider trading law is discussed in more detail in Chapter 5. 91. Ibid 3762–70. 92. Article 5 of the Provisional Measures lists twenty-six types of inside information and Article 6 of the Provisional Measures lists five types of likely insiders. Likewise, in the Securities Law, Article 74 enumerates seven types of likely insiders and Article 75 lists eight types of inside information. 93. See e.g., Securities Law, Art. 74(7) (‘other persons specified by the securities regulatory authority under the State Council’); Art. 75(8) (‘other important information determined by the securities regulatory authority under the State Council to have a marked effect on the trading prices of securities).

Inside Trading in China

27

appears that China has been too ready to import foreign experience and a variety of foreign experience has been simply stacked together without systematical digestion of them. This practice of borrowing from overseas experience with little criticism has led to a number of problems. Indeed, the Chinese government has come to believe that any successful development of China’s securities market would only be possible if China was equipped with laws and regulations comparable to those in place in developed countries, most notably the US. This has adversely affected the legislative process so as to preclude a sufficiently careful reflection on the necessity, coverage, and implications of the legislation in the local conditions.94 For this reason, in practice, China’s insider trading regime is far from effective.95 As will be discussed, thus far, there have been a very small number of reported insider trading cases in China.96 The following is a brief description on this aspect, and more detailed discussions will be carried out in following chapters. Firstly, the insider trading regime is still incomplete and has many serious loopholes. The issues concerning the basic elements of insider trading such as the scope of insiders, the notion of inside information and the state of mind of insiders, are unsettled and some of them are even left totally unaddressed. And the Securities Law is silent on private civil liability for insider trading. This significantly decreases the efficacy of the insider trading regime which in turn certainly needs to be refined and amended. These issues would be examined in greater detail in relevant chapters. Moreover, the totality of all the relevant regulations is quite chaotic, mutually overlapping and even conflicting. There are two major reasons behind this. The first reason lies in China’s uncritical implantation of foreign experience. The other reason is that most of the regulations have been hasty responses of the government to practical problems in the stock market. Indeed, the process of establishing the regulatory framework of the securities market in China was carried out in a hurried and somewhat disorderly manner, often with legislative draftsmen having no precise long-term project in mind. This practice of law-making can be compared to that of constructing a building. Architects do not know in advance exactly what functions the building is intended 94. Hui Huang, ‘The Regulation of Insider Trading in China: A Critical Review and Proposals for Reform’ (2005) 17(3) Australian Journal of Corporate Law 281, 297. 95. See e.g., Chunfeng Wang et al., ‘Insider Trading and the Regulation on China’s Stock Market: International Experience and China’s Response’ (2003) 3 Guoji Jingrong Yanjiu [International Finance Research] 57, 63 (stating that China’s insider trading regulation needs to be improved); Donghui Shi & Hao Fu, ‘The Regulation of Insider Trading in China: A Legal and Economic Study’ (paper presented at the Symposium on ‘Behavioral Finance and Capital Market’, Nanjing, China, 29–30 November 2003) 36 (positing that ‘China’s insider trading regulation is not effective’). 96. See below §2.III.A. Of course, a lot of factors may contribute to this situation, but the insider trading provisions, served as the legal basis for regulating insider trading, have an undeniable responsibility to take. Indeed, the inefficacy of the insider trading regime can be attributed to a plurality of factors, such as the inherent difficulty of regulating insider trading, the under-resourced agencies and the lack of other supporting institutions. See Bernard S. Black, ‘The Legal and Institutional Preconditions for Strong Securities Markets’ (2001) 48 UCLA Law Review 781. For a detailed discussion of the reasons for insider trading in China, See below Chapter 3.

Chapter 2

28

to serve, such as the capacity of the building, and thus have to design the building to temporarily suit the needs at the time. Then, the building is always in a process of continuous amendment according to the changing demands for accommodation. Therefore, the added structures may not harmonize with each other, which renders the whole building unduly complicated and causes many problems. It seems that the Chinese government promulgates insider trading regulations in much the same way. §2.III.

INCIDENCE OF INSIDER TRADING

A.

INSIDER TRADING CASES

By the end of June 2004, there were eleven insider trading cases reported in China. Under Article 179, the CSRC is authorized, among other things, to investigate and deal with violations of laws and administrative regulations concerning the regulation of the securities market.97 In practice, the CSRC plays a central role in regulating insider trading. As discussed below, nine out of the total eleven cases were dealt with by the CSRC through its administrative power and involved only administrative liabilities. And until March 2003, China did not have any criminal insider trading cases. 1.

Cases Handled by the CSRC

According to Article 184 of the Securities Law, ‘all the decisions reached by the securities regulatory authority under the State Council [the CSRC], on the basis of the results of its investigations, to impose penalties on illegal acts in relation to securities, shall be made public’.98 The CSRC publicizes all of the cases it handled in the China Securities Regulatory Commission Official Bulletin (Zhongguo Zhengquan Jiandu Weiyuanhui Gonggao), which is issued on a monthly basis and accessible by hard copy or via internet.99 By June 2004, the CSRC had publicized a total of nine insider trading cases. The following will discuss them in order of time. 1.

Xiangfan Shangzhen Case100

This case is the first insider trading case in China. In 1993, the CSRC undertook an inquiry into the share transaction by the Shanghai branch of the Xiangfanshi Trust Investment Co Ltd of the Agricultural Bank of China (‘Xiangfan Shangzhen’). The inquiry discovered that, on the evening of 16 September 1993, employees 97. Securities Law, Art. 179(7). 98. Ibid Art. 184. 99. See the official website of the CSRC: http://www.csrc.gov.cn/cn/homepage/index.jsp (last visited on 18 April 2005). 100. Decision of the China Securities Regulatory Commission on the punishment of the Shanghai branch of the Xiangfan Investment Company of Chinese Agricultural Bank for breaching the securities regulations (28 January 1994) (1994) 1 China Securities Regulatory Commission Official Bulletin.

Inside Trading in China

29

of Xiangfan Shangzhen held a business meeting with employees of another company – Shenzhen Huayang Health Care Production Co Ltd, and became aware that the latter company was about to purchase a large number of shares in Shanghai Yanzhong Joint Stock Company (‘Shanghai Yanzhong’). As a result, Xiangfan Shangzhen thrice purchased Shanghai Yanzhong shares between 17 September and 27 September, and the aggregate number was 627,300. All these purchased shares were sold on 7 October 1993 at a profit of more than CNY 16 million. The CSRC found on the grounds of the relevant articles in the Provisional Measures that Xiangfan Shangzhen had committed insider trading, and imposed administrative penalties, including confiscation of the illegal profit, fine and suspension of the business of Xiangfan Shangzhen for two months. 2.

Baoan Shanghai, Baoan Huayang and Shenzhen Ronggang Case101

This case has been the only short swing case reported in China to date. Once again, the shares traded in this case belonged to the Shanghai Yanzhong Joint Stock Company (‘Shanghai Yanzhong’). This case involved three defendants, namely the Shanghai Subsidiary Company of Shenzhen Baoan Group Co Ltd (‘Baoan Shanghai’), the Shenzhen Baoan Huayang Health Care Production Co Ltd (‘Baoan Huayang’), and the Shenzhen Ronggang Baoling Electrical Lighting Co Ltd (‘Shenzhen Ronggang’). All of the three defendants were related companies. On 29 September 1993, Baoan Shanghai held 4.56% of Shanghai Yanzhong shares, Baoan Huayang 4.52%, and Shenzhen Ronggang 1.57%. Thus, the aggregate Shanghai Yanzhong shares held by the three related defendants already reached 10.65% of all the outstanding Shanghai Yanzhong shares, which had trigged the block shareholding reporting duty under the existing law. However, the next day, namely on 30 September 1993, without fulfilling that reporting duty, Baoan Shanghai made a further purchase of Shanghai Yanzhong shares and as a result the total shareholdings of the three defendants became 17.07%. In the course of this transaction, Baoan Huayang and Shenzhen Ronggang sold 1,147,700 Shanghai Yanzhong shares they held to Baoan Shanghai on the Shanghai stock market and sold the remaining 246,000 Shanghai Yanzhong shares to the general public. After investigation, the CSRC reached the conclusion that the three defendants traded in Shanghai Yanzhong shares in violation of securities regulations. The conclusion was based on Article 38 of the Provisional Regulations which prohibits short swing transaction. Under this article, if directors, supervisors, senior management persons, or entity shareholders who hold not less than five percent of the shares of one joint stock limited company, sells, within six months of purchase, the shares he 101. Decision of the China Securities Regulatory Commission on the punishment of the Shanghai Subsidiary Company of Shenzhen Baoan Group Company, the Baoan Huayang Health Care Production Company, and the Shenzhen Ronggang Baoling Electrical Lighting Company for breaching the securities regulations (25 October 1993) (1993) 4 China Securities Regulatory Commission Official Bulletin.

Chapter 2

30

holds of the company to which they are affiliated, or repurchase the shares within six months after selling the same, the earnings so obtained would belong to the company. Thus, the CSRC ruled that the transactions of Baoan Huayang and Shenzhen Ronggang constituted short swing transaction and as such the profits realized should be returned to Shanghai Yanzhong. 3.

Zhangjiajie Tourism Development Co Ltd Case102

In 1997, an allegation of insider trading was laid by the CSRC against the Zhangjiajie Tourism Development Co Ltd (‘Zhangjiajie Tourism’). During the period from 2 September 1996 to 18 November 1996, Zhangjiajie Tourism purchased a total number of 2,128,883 of its own shares, through 15 accounts opened by its subsidiaries. Before its board of directors publicly announced one resolution which would drive down the market price on 22 November 1996, the defendant sold 1,432,000 of the said shares on 18, 20, and 21 November respectively at a profit of CNY 11,805,000. The CSRC held that, amongst other things such as unlawful buyback of own shares, the transactions of Zhangjiajie Tourism constituted insider trading on the grounds of Article 3 of the Provisional Measures which prohibits any entities or natural persons from using inside information to issue or trade shares for the purpose of gaining profits or avoiding losses. 4.

Nanfang Securities Co Ltd and Beida Chehang Joint Stock Company Case103

In October 1996, the vice president of Nanfan Securities Co Ltd (‘Nanfang Securities’) visited Beida Chehang Joint Stock Company (‘Beida Chehang’). In the course of the visit, Beida Chehang tipped the vice president of Nanfang Securities some inside information, including earnings forecasts, new investment programs and new share issue plans and so on. It was also found that Beida Chenhang and Nanfang Securities reached an agreement to cooperate to commit insider trading and market manipulation on the basis of the inside information. During the period between October 1996 and April 1997, Nanfang Securities purchased a huge number of Beida Chehang shares. This purchase drove up the market price of Beida Chehang shares by almost 100%. Finally, Nanfang Securities sold all the acquired shares at a net profit of CNY 77,418,900, of which 850,000 went to Beida Chehang. 102. Decision of the China Securities Regulatory Commission on the punishment of Zhangjiajie Tourism Development Company, Hunan Stock Exchange Center for breaching the securities regulations, (1997) 3 China Securities Regulatory Commission Official Bulletin. 103. Decision of the China Securities Regulatory Commission on the punishment of Nanfang Securities Limited Company, Beida Chehang Joint Stock Limited Company and other entities and individuals for breaching the securities regulations, (1999) 10 China Securities Regulatory Commission Official Bulletin.

Inside Trading in China

31

The CSRC held that Nanfang Securities committed insider trading in breach of Articles 3, 4(1), 4(3) of the Provisional Measures, while Beida Chehang was in breach of Articles 3, 4(2) of the Provisional Measures. 5.

China Qingqi Group Co Ltd Case104

This case concerned the defendant China Qingqi Group Co Ltd (‘Qingqi Group’), which was found liable on several counts including insider trading. The employees of the securities business division of Qinqi Group, were held to have access to inside information by virtue of the nature of their work and their positions. During the period between November 1996 and January 1997, the division continued to take up shares in Jinan Qingqi Motorcycle Joint Stock Company (‘Jinan Qinqi’) which was a subsidiary of Qingqi Group, and the shareholdings reached as many as more than 5,800,000 in the end. In February 1997, Jinan Qinqi announced its annual report in which the good news about its earnings and profits were present. The market price of its shares went up as a result and thus the securities business division of Qingqi Group sold its shareholdings altogether, making a profit of CNY 25,420,000. In August 1997, Qingqi Group decided to take over Qionghaiyao Joint Stock Company (‘Qionghaiyao’), another listed company in the stock market. The securities business division came into possession of this material information and subsequently purchased a large number of Qionghaiyao shares. After the takeover was finalized and the price of Qionghaiyao shares rose sharply, the division reaped a profit of CNY 2,630,000 by selling the shares. The penalties imposed by the CSRC included, among other things, confiscating the illegal profit, fining and disqualifying relevant persons responsible for the misconduct from securities business. 6.

Dai Lihui Case105

An allegation of insider trading was made by the CSRC against Dai Lihui who was then the legal representative of Sichuan Tuopu Computer Equipment Factory and the CEO of Sichuan Tuopu Technology Co Ltd (‘Sichuan Tuopu’). During the period of his employment, Dai Lihui got access to inside information that Sichuan Tuopu was going to carry out a capital reconstruction program with Sichuan Changzhen Machine Tool Joint Stock Company (‘Sichuan Changzhen’) and the primary business of Sichuan Changzhen would change significantly as a consequence. Based on

104. Decision of the China Securities Regulatory Commission on the punishment of China Qingqi Group Co Ltd, other entities and relevant individuals for breaching the securities regulations, (1999) 9 China Securities Regulatory Commission Official Bulletin. 105. Decision of the China Securities Regulatory Commission on the punishment of Da lihui for breaching the securities regulations, (1999) 6 China Securities Regulatory Commission Official Bulletin.

Chapter 2

32

this information, Dai Lihui purchased a total of 572,600 Sichuan Changzhen shares between 27 November 1997 and 29 November 1997, and resold all the shares after the share price surged as a result of the reconstruction program, at a profit of CNY 675,700. Under Article 72 of the Provisional Regulations and Articles 3, 13 of the Provisional Measures, the illegal profit of Dai Lihui was confiscated and, in addition, a fine of CNY 150,000 was imposed. 7.

Wang Chuan Case106

The next insider trading case involved Wang Chuan, who was then the vice-president of Beijing Beida Fangzheng Group Co Ltd (‘Beida Fangzheng’) and concurrently the manager-general (legal representative) of Beijing Beida Technology Development Co Ltd (‘Beida Keji’). In February 1998, Beida Fangzheng failed to get exemption from the CSRC on its planned takeover by agreement of tradable shares of Shanghai Yanzhong Joint Stock Company (‘Shanghai Yanzhong’). As a consequence of the failure of takeover by private agreement, in March 1998, the Office of the Universityowned Enterprise of Beijing University (‘Beijing University Office’) decided to take over Shanghai Yanzhong by tender offer and ordered four companies it owned to purchase Shanghai Yanzhong shares on the secondary market. By 11 May 1998, the four companies jointly held a total of 5.077% of Shanghai Yanzhong shares, 3.2964% of which was held by Beida Keji. Because Wang Chuan was the vice-president of Beida Fangzheng and the manager-general of Beida Keji, he became aware of the inside information relating to the takeover plan. On the basis of this information, Wang Chuan purchased 68,000 Shanghai Yanzhong shares on 10 February 1998, and garnered a profit of CNY 610,000 after reselling all the shares on 15 April 1998. On the grounds of Article 72 of the Provisional Regulations and Article 3 of the Provisional Measures, the CSRC confiscated the illegal profit and imposed an additional fine of CNY 100,000. 8.

Yu Mengwen Case107

In 1999, a charge of insider trading was brought by the CSRC against Yu Mengwen who was then the associate chief of the Technology Management Section of Panzhihua Iron Co Ltd. During the period between March 1998 and April 1998, on the basis of inside information concerning the capital reconstruction of Panzhihua Plate Joint Stock Company (‘Panzhihua Plate’) which was 106. Decision of the China Securities Regulatory Commission on the punishment of Wang Chuan for breaching the securities regulations, (1998) 10 China Securities Regulatory Commission Official Bulletin. 107. Decision of the China Securities Regulatory Commission on the punishment of Yu Mengwen for breaching the securities regulations, (1999) 6 China Securities Regulatory Commission Official Bulletin.

Inside Trading in China

33

a subsidiary of Panzihua Iron Co Ltd,Yu Mengwen purchased a total of 30,000 shares in Panzhihua Plate, and resold all the shares in May 1998 at a profit of CNY 80,000. According to Articles 3, 13 of the Provisional Measures, the illegal profit was confiscated and in addition a fine of CNY 50,000 was imposed. 9.

Gao Fashan Case108

This case involved Gao Fashan who was then the director of Tianjin Lida Group Co Ltd. On 20 June 1999, Gao Fashan attended a board meeting in which a resolution was reached about the equity transfer of Tianjin International Shopping Center Joint Stock Limited Company (‘Tianjin Guoshang’) to implement a takeover program. Subsequently, he purchased 2,000 Tianjin Guoshang shares on 22 June 1999. On 17 February 2000, the CSRC held that the transaction constituted insider trading in violation of Article 72 of the Provisional Regulations, and ordered Gao Fashan to sell all the illegally obtained securities with all proceeds going to the Treasury. 2.

Criminal Insider Trading Cases

In 1997, the Criminal Law was amended to expressly outlaw insider trading and set out its criminal liabilities as follows: [insider traders] shall be sentenced to not more than five years in prison or criminal detention, provided the circumstances are serious. They shall be fined, additionally or exclusively, a sum not less than 100 percent and not more than 500 percent as high as their illegal proceeds. If the circumstances are especially serious, they shall be sentenced to not less than five years and not more than 10 years in prison. In addition, they shall be fined a sum not less than 100 percent and not more than 500 percent as high as their illegal proceeds.109 However, criminal liabilities have been scarcely imposed in practice. As shown below, the first criminal insider trading case occurred in March 2003, almost seven years after the amendment of the Criminal Law. And there were only two criminal insider trading cases by the end of June 2004. Two main reasons account for this. Firstly, Chinese courts have not yet been well-prepared to hear complicated insider trading cases. Secondly and more importantly, there had been no guidelines on what is the proper judicial standard for dealing with economic crimes until 18 April 2001 when the Supreme People’s Procuratorate and the Ministry of Public Security jointly promulgated the Rules on 108. Decision of the China Securities Regulatory Commission on the punishment of Gao Fashan for breaching the securities regulations, (2000) 2 China Securities Regulatory Commission Official Bulletin. 109. Criminal Law, Art. 180.

Chapter 2

34

the Standard of Prosecuting Economic Criminal Cases.110 According to this regulation, an insider trader should be prosecuted only if (1) the profit involved is more than CNY 200,000; or (2) he or she has committed insider trading many times; or (3) the trading has caused abnormal fluctuation of share prices or trading volumes; or (4) the trading has had a severe social impact.111 1.

Shenshen Fang Case112

This case is the first criminal insider trading case in China. This case involved Ye Huanbao who was then the chairman of the board of Shenshen Fang Joint Stock Company (‘Shenshen Fang’), and Gu Jian who was then the director of Saige Shuma Guangchang Co Ltd (‘Saige Shuma’). In May 2000, Gu Jian borrowed CNY 10 million from Ye Huanbao and bought Shenshen Fang shares between 15 May and 19 May 2000. Two months later, in July when Shenshen Fang publicly disclosed the completion of its major investment in Saige Shuma, Gu Jian sold all of the shares at a profit of more than CNY 780,000 (roughly USD 95,122). In November 2002, Ye Huanbao and Gu Jian were charged with insider trading before the Luo Hu District People’s Court in the city of Shenzhen. The prosecutor set out two arguments to support the charge. Firstly, Gu Jian bought the shares before the information disclosure of Shenshen Fang and sold them thereafter. The information at issue was material information, and Ye Huanbao, as an insider of Shenshen Fang, knew the inside information. Secondly, Ye Huanbao helped Gu Jian open securities trading accounts and even personally lent CNY one million to Gu Jian for trading shares. In the view of the prosecutor, this fact was indicative of an unusual relationship between Ye Huanbao and Gu Jian and thus it was inferred that Ye Huanbao had tipped the inside information to Gu Jian. Ye Huanbao’s lawyer argued that Ye Huanbao did assist Gu Jian in opening securities accounts and providing some money, but did not tip any inside information to Gu Jian. The argument of Gu Jian’s lawyer was that the information concerning the investment was already public because the timetable of the investment had already been publicly disclosed on 3 April and no substantial new information was disclosed on 19 June 2000. On 10 March 2003, the court found Ye Huanbao and Gu Jian guilty of insider trading. The court simply rejected the arguments of the defense lawyers without offering any explanation. In the end, Gu Jian was sentenced to jail for two years

110. Guanyu Jijing Fanzui Anjian Zuisu Biaozhun De Guiding [Rules on the Standard of Prosecuting Economic Criminal Cases] (promulgated on 18 April 2001 by the Supreme People’s Procuratorate and the Ministry of Public Security of China). 111. Ibid Art. 29. 112. Yuan Gu, ‘The Former Chair of Shenshen Fang was Convicted of Insider Trading’, Zhengquan Ribao [Securities Daily] 30 June 2003, at 2; Ying Yu, ‘Insider Trading by the Chair of One Listed Company’ Zhengquan Shichang Zhoukan [Securities Market Weekly] 2 June 2003 at 6.

Inside Trading in China

35

and was fined CNY 800,000, while Ye Huanbao was sentenced to three years imprisonment and a fine of CNY 800,000 for insider trading.113 2.

Changjiang Konggu Case114

The next criminal case concerned Liu Bangcheng who was then the legal representative of several listed companies. In May 2000, Liu Bangcheng was invited to restructure loss-making Sichuan Changjiang Baozhuang Konggu Joint Stock Company (‘Changjiang Konggu’). In order to do this, Liu Bangcheng established several new companies and wildly overvalued them. In November 2000, Liu Bangcheng exchanged shares of the new companies for shares of Changjiang Konggu, and thus controlled Changjiang Konggu. With the fraudulent restructuring of Changjiang Konggu, Liu Bangcheng transformed Changjiang Konggu into a seemingly profit-making company on the face of the accounting book. On the basis of this false ‘good’ news, Liu Bangcheng bought a large number of Changjiang Konggu shares before disclosure of the information and then sold them thereafter at a profit of CNY 9.6 million (roughly USD 1.17 million). On 24 October 2003, the Intermediate People’s Court of Chengdu City in Sichuan Province sentenced Liu Bangcheng to three years imprisonment for insider trading. And, on 26 November 2003, the High Court of Sichuan Province affirmed the judgment. 3.

Guan Weiguo Case115

In this case, insider trading was clearly involved but not dealt with by the court, and the defendant was prosecuted on other counts. Even though the defendant was not charged with insider trading, some commentators nevertheless have regarded this case as insider trading.116 This case is not counted as an insider trading case in this book, but it is nevertheless discussed here because it can provide some useful insights into the incidence of insider trading in China.

113. Because Ye Huanbao was also found guilty on other counts, the final term of imprisonment was nine years. 114. Lu Wang, ‘The Restructuring Part of Changkong Company was Convicted of Crime of Swindling’, Shanghai Zhengquan Bao [Shanghai Securities News] 28 October 2003, at 5; Wenjian Xiang, ‘Taiguang Company is a Big Cheat and Who will Save Changkong Company’ 21 Shiji Jingji Baodao [21 Century Economic Reports] 1 December 2003 at 3. 115. The Research Office of the Central Disciplinary and Supervisory Commission of the Communist Party of China, Information Database of the Party’s Anti-Corruption Work and Disciplinary Cases (Beijing, China Procuratorial Press, 1996), p. 1389. See also Han Hu, ‘The Drowned are Always Those Able to Swim’ Meiri Caijing [Daily Business] 29 August 2003 at 2. 116. See e.g., Xie Fei, ‘Discussion on Some Issues about Insider Trading Legislations in China’, available at http://www.chinalawedu.com/news/2003_12%5C3121915365576.htm (last visited on 28 June 2004).

Chapter 2

36

This case concerned Guan Weiguo who was then the first vice director of the Shenyang System Reform Committee, the vice director of the Shenyang Securities Commission and the director of the Shenyang Securities Regulatory Commission.117 During the period between February 1993 and August 1993, Guan Weiguo took bribes from several joint stock companies in forms of cash and shares. Moreover, Guan Weiguo was engaged in share trading in the name of his family members so as to circumvent the regulation prohibiting staff members of the securities regulatory authority from trading shares.118 It was also alleged that, in 1993, Guan Weiguo attended an meeting in Beijing in which he became aware of material information about the planned listing of one company, and then purchased shares of the said company and resold them after the price rose, reaping a profit of CNY 770,000 (roughly USD 94,756). On 21 September 1994, the Intermediate Peoples’ Court of Shenyang City found Guan Weiguo guilty of bribery and handed down a sentence of six years imprisonment in addition to confiscation of the illegal profits. However, the misuse of the material information was not dealt with by the court, simply because there was no criminal liability for insider trading in the Criminal Law at that time.119 3.

Summary

As discussed above, a total of eleven insider trading cases have been reported in China to date. Compared to some Western countries, especially the US,120 China has certainly a small number of insider trading cases. However, given the short history of the insider trading regulation in China, eleven cases are actually a remarkable achievement. For example, the first insider trading case appeared in China as early as 1994, only one year after the Provisional Regulations was promulgated. This situation has even led the normally staid Economist to state that: One successful insider trading case puts China streets ahead of some far more developed markets. Switzerland and Italy have yet to bring a successful prosecution under their insider trading laws. Japan has nabbed just one culprit since it banned the practice back in 1989.121

117. The Shenyang Securities Commission and the Shenyang Securities Regulatory Commission were the regional branches of the SCRC and the CSRC respectively in the city of Shenyang at that time. 118. Securities Law, Art. 43. 119. Article 180 providing criminal liability for insider trading was added to the Criminal Law in 1997. See above §2.II.A.1. 120. See e.g., J Naylor, ‘The Use of Criminal Sanctions by UK and US Authorities for Insider trading’ (1990) 11 The Company Lawyer 53 (showing that in the period between 1994 and 1997 alone, 77 convictions were brought by the US Department of Justice and 189 civil cases were brought by the SEC). 121. ‘Turfing Insider-traders out’, Economist 16 July 1994, at 67; Brian Daly, ‘Of Shares, Securities, and Stakes: The Chinese Insider Trading Law and the Stakeholder Theory of Legal Analysis’ (1996) 11 Amercian University Journal of International Law and Policy 971, 1026 (concluding that ‘Chinese securities law has made a quantum leap in the area of insider trading).

Inside Trading in China

37

Indeed, most of the countries with insider trading prohibition except the US and the UK have a poor record of insider trading cases. For example, Australia had only three convictions before 1999, while its insider trading prohibition was introduced as early as 1970.122 Although the paucity of reported insider trading cases has made it virtually impossible to provide a comprehensive picture of the prosecution process in China, those cases are nonetheless valuable and useful for us to gain some understanding of insider trading incidence in China. They reflect, to a significant extent, the incidence of insider trading and the distinctive features of insider trading activities in China, such as who are likely insiders, what types of insider trading frequently take place, under what circumstances insider trading is likely to occur and so on.123 For the sake of analytical convenience, key elements of these cases are displayed in a tabular form (See Appendix 2: The Summary of Reported Insider Trading Cases in China). B.

THE EXTENT OF INSIDER TRADING

The above-mentioned cases serve as valuable direct evidence of the existence of insider trading in China and provide us with a good platform to analyze the incidence of insider trading. However, it is unclear how those cases reflect the true scope of insider trading. There can be no doubt that the actual insider trading incidence in China is in no way limited to the reported cases. But one cannot go any further and perfunctorily draw any sensible conclusion in this respect solely on the basis of this information. Clearly, more work needs to be done to answer the question of how widely insider trading is happening in China. 1.

Empirical Findings of Qualitative Research

There are few specific studies on the extent of insider trading in China. There are two main reasons for this. Firstly, it has been taken for granted by many people in China that insider trading has existed as a serious problem on the stock market and the important question is only how to deal with it.124 Secondly, even if one believes that there is a need to inquire into the extent of insider trading in China, they will be prevented from carrying it out due to methodological problems. Indeed, it is very difficult, if not impossible, to use traditional statistical methods to study insider trading which is a hidden form of misconduct. Even though qualitative

122. Lori Semaan and Mark A Freeman and Michael A Adams, ‘Is Insider Trading a Necessary Evil for Efficient Markets?: An International Comparative Analysis’ (1999) 17 Company and Securities Law Journal 220, 243. 123. For detailed discussion of these issues, See below §2.III.C. 124. See e.g., Xia Jun, ‘Information Asymmetry: Optimal Enforcement of Stock Market Insider Trading Regulation’ (2001) 9 Zhongguo Guanli Kexue [Chinese Journal of Management Science] 16 (stating that the prevalence of insider trading in China is an indisputable fact).

38

Chapter 2

research methodology such as interviews might offer an effective alternative, it has significant costs in terms of both time and money which would present a frustrating block to Chinese scholars. In fact, the issue of the incidence of insider trading is important for any debate on relevant topics. It is not as clear as many might think, and thus deserves more study. In this section, the question will be investigated thoroughly by interviews. While the empirical findings of interviews might be subject to the criticism that they are anecdotal evidence and merely perceptions of people rather than concrete economic data, their importance should never be underestimated, especially because insider trading, as a form of secret misconduct in nature, makes economic data virtually unavailable.125 The interviews took place in three major cities in China and covered a wide variety of occupational groups.126 All interviewees were asked specifically the question of the extent about insider trading in China. All of the regulatory officials consulted for this book responded that insider trading was ‘widespread’ and ‘perhaps it happens every day’. One official said that ‘insider trading is not only extensive, but also ingrained’. The point that ‘huge profits associated with insider trading are irresistible to everybody’ was the reason offered by another official to explain why insider trading is so widespread. This official reflected a common view that ‘insider trading is deeply entrenched and thus hard to eradicate’. However, one experienced investigator admitted that he had little direct evidence about the incidence of insider trading, stating that ‘insider trading is extremely difficult to detect and prosecute. So I can assure you that insider trading is quite widespread even though a small number of relevant cases have been reported’. In the meantime, one pointed out that ‘insider trading is not the most extensive misconduct and perhaps market manipulation or misrepresentation is’. But he thought that it was almost impossible to ascertain the precise extent of insider trading. Most of the securities practitioners said that ‘insider trading is pretty rife indeed,’ and that ‘it has been already an open secret’. One responded strongly by asking ‘wouldn’t you conduct insider trading if you had inside information? It is the reality of human nature. If you refuse, you will be sidelined and eliminated by the fierce competition simply because other people will take the chance when they have it’. Another echoed this view and said that ‘insider trading is not a taboo subject. It is very hard to outperform the market and survive if you do not engage in something illegal such as insider trading. Many people do not trade shares unless they have inside information. We simply have no choice in such an environment’. According to another broker, ‘insider trading is actually the main way to make profits for some companies. You need some skills to commit insider trading without being caught’. However, having admitted the possibility of insider trading occurring, 125. Such a methodology has been successfully used to investigate insider trading in Australia. See Roman Tomasic, Casino Capitalism? Insider Trading in Australia (National Gallery of Australia, 1991). 126. For more information on the interview methodology, See Appendix 1: Methodology.

Inside Trading in China

39

some did not agree nevertheless that insider trading is widespread because ‘there is no convincing evidence to support that view’ and ‘insider trading is not as serious as other abuses, such as market manipulation and misrepresentation’. The fact that securities practitioners are under enormous pressure to survive the fierce competition clearly has impact on the incidence of insider trading. Is this a safe and effective way to survive? The view on the risk of insider trading was expressed by a broker who said ‘the likelihood of getting caught is very low, almost negligible’. According to another broker, ‘even if you are unlucky enough to get caught, the punishment is not a big deal in comparison with the profits of insider trading. Indeed, insider trading can make a huge profit, but it is subject to relatively light punishment’. Ethical concern has also been absent here. As one fund manager pointed out that ‘almost everyone would commit insider trading if they had the chance, and nobody would feel ashamed of it if unfortunately being pinned down’. None of the officials from the Shanghai Stock Exchange denied the occurrence of insider trading but there was some disparity in their assessment of its extent. One responded that ‘insider trading does exist, but it is wrong to say that it is widespread. This is, in my view, due to the exaggerated media reports’. Another official said that ‘our surveillance system is highly computerized and newly updated. This will greatly deter the insiders because the computer program can detect any abnormal transactions. In most cases, price fluctuations have nothing to do with the occurrence of insider trading’. However, this optimistic view was opposed by a fellow member who made the point that ‘insider trading is quite widespread because insider trading is highly profitable and there was no effective way to stop it. Even if there is suspicion of occurrence of insider trading, it is very difficult to substantiate it’. He went on to say that ‘we probably can detect big insider trading cases with our computerized real-time surveillance system. However, it is very difficult to spot small insider trading cases. In practice, the majority of insider trading cases are in small volumes’. The common response of the ordinary investors is that ‘insider trading is very widespread’. One investor in Shanghai said that ‘I will be very surprised if someone thinks insider trading is not widespread’, and politely kidded that ‘frankly, I do not think you need to ask this question’. Another investor from Beijing backed his opinion with examples of insider trading he had personally seen or heard of and said that ‘it is so self-evident to us but we have no choice. After all, there is only one stock market in China and we have to play there even though we know we might be exploited’. In Guangzhou, one investor made his point that ‘widespread insider trading is totally understandable. We have got used to it to some degree. Quite frankly, I will make money through insider trading if I had inside information’. A well-known journalist aptly described this state of mind amongst many ordinary investors as ‘desperate, helpless and cynical’, and went on to say that ‘insider trading seems very extensive. Whenever some important information is disclosed, in retrospect, you can always find abnormal trading situations one day or two before that disclosure. It is quite possible those are caused by insider trading’. He also remarked that ‘many people, including my friends, often ask me whether I have inside information during my reporting work. Insider trading is illegal, but ironi-

Chapter 2

40

cally, many people want to do it and people with access to inside information are really popular. Insider trading is not a matter of shame, but instead, if you can commit insider trading, you can be proud of it’. Similarly, academics generally felt that insider trading was quite widespread and should be seriously dealt with. The strongest view from this group was expressed by a professor who said that ‘insider trading is so widespread as to severely endanger the stock market. Almost all the abnormal transactions prior to major information disclosure, especially in the context of takeover, have something to do with insider trading’. The phenomenon of this pre-disclosure trading abnormality was summed up by another professor who made the point that ‘it is often an omen of upcoming major disclosure. Chinese investors have been so familiar with this rule’. Another professor echoed this view by likening insider trading to ‘the biggest malign tumor in the body of our stock market’. However, in the words of a professor at a prestigious university, ‘insider trading does exist, and probably more than just a little, but I am not quite sure about the precise extent. Scientifically speaking, there is no sound evidence available to suggest that insider trading is widespread. Insider trading is probably the most serious problem in character, but perhaps not the most extensive misconduct on the market. Misrepresentation actually ranks first in terms of the number of reported cases’. This view was supported by another professor who said that ‘insider trading always happens in connection with market manipulation, and market manipulation is probably the most serious misconduct because insider trading is carried out in secret whilst many manipulators now dare to openly manipulate share prices’. In the judges’ view, ‘insider trading is out there and perhaps quite a lot’. One judge said that ‘it is very hard to assess accurately the extent of insider trading in reality. At present, we accept and hear civil securities cases in relation to misrepresentation, but not insider trading. Insider trading is hard to detect and prove’. Another judge remarked that ‘insider trading is a serious problem in need of solution in the market. But it does not appear to be the biggest problem in terms of the number of reported cases. Misrepresentation or market manipulation probably is’. The common view expressed by lawyers was that ‘a large percentage of securities trading on our market may be insider trading but it is hard to know the exact number’. A lawyer also offered examples to support this view. Another lawyer thought that ‘insider trading exists, but there is little evidence to support that it is widespread. In my experience, misrepresentation seems more serious. Insider trading often happens in relation to entrepreneurial stock’. 2.

Analysis of the Empirical Findings

a.

Insider Trading is Widespread

As the interviews have shown, a vast majority of interviewees commonly felt that insider trading is widespread in China. Ordinary investors thought that they were the direct victims of insider trading and held the strongest view about the prevalence of insider trading. Their disappointment and anger could be strongly sensed

Inside Trading in China

41

during the interviews. Governmental regulators were also prone to say that insider trading was serious. Predictably, the officials from the stock exchange generally appeared to be very cautious and stated that one should avoid overstating the incidence of insider trading. Other groups, including academics, judges and lawyers, were also in favour of the view that insider trading was widespread. It should be noted that the attitude of securities practitioners towards insider trading was fairly surprising. At the beginning of this project, it was expected that securities practitioners, often considered as the most likely insider trading perpetrators, would be evasive or at least very conservative to talk about insider trading. However, most, if not all, the securities practitioners, including brokers, investment bankers and fund managers, appeared very straightforward and frank. A majority of securities practitioners made the point clearly that insider trading was widespread. It was also suggested that insider trading has been widely and even openly resorted to in the industry. As one broker said, ‘the circle of securities industry is like a big dye vat, and you cannot possibly keep yourself clean. Otherwise, you will be certainly forced out of the market sooner or latter’. Therefore, even if one is suspected of insider trading, there will be a minimum of professional opprobrium. In fact, securities practitioners themselves are not satisfied with such situations and want to have a well-regulated and clean market because they are tired of this kind of vicious competition. This finding has been backed by other empirical works which indirectly indicate the incidence of insider trading in China. As early as in 1994, field work was carried out within Sichuan Province by researchers in the Legal Institute of the Sichuan Province Academy of Social Science, and found that insider trading had been widely committed, particularly by securities practitioners.127 Some researchers, notably economic scholars, have conducted empirical studies on the basis of the changes in some representative variables, such as stock price changes before and after material information disclosure. A recent comprehensive study selected a sample of all the listed companies on the Shanghai Stock Exchange between 2000 and 2001, and investigated the effects of the disclosure of four kinds of material information, namely substantial investment projects, rights issuance, corporate control transfer, and the substantial increase in earnings in the annual report.128 The study showed that the figures of the Cumulative Abnormal Return (CAR) increased remarkably in the period of 20 days before information disclosure and decreased sharply thereafter. In regards to the rate of changeover of shares, similar situations appeared; the rate was 1.125% before disclosure and 0.334% after. Another indicator, the figure of market volatility, also experienced the same change. It was concluded that the information at issue might

127.

Yousu Zhou et al., ‘The Situation of the Breach of Securities Regulations in Sichuan Province’ (1995) 2 Xiandai Faxue [Modern Legal Science] 81, 84. 128. Chunfeng Wang et al., ‘Insider Trading and the Regulation on China’s Stock Market: International Experience and China’s Response’ (2003) 3 Guoji Jingrong Yanjiu [International Finance Research] 57.

42

Chapter 2

have leaked out before its public disclosure and massive insider trading might have occurred to create the abnormal changes in those financial variables.129 The same conclusion was reached by other empirical studies which each focus on one single type of material information. In 1996, some commentators randomly sampled 100 listed companies on the Shanghai Stock Exchange and investigated their price changes from 1990 to 1995 around the time of information disclosure on the distribution of dividends.130 They found that stock prices hiked preceding information disclosure and then fell sharply following the disclosure; two other variables, namely the volatility figure and the CAR, showed similar changes. Based on this, they believed that the anomalies might have been due to the occurrence of insider trading.131 More researchers focused on the information about corporate control transfer and traced the changes in stock prices and trading volumes around information disclosure. A study selected a sample of all the reported cases of corporate control transfers of listed companies between January 1990 when the two stock exchanges were established and June 2002 when the program was undertaken.132 Its conclusion was that insider trading might have taken place in the case of takeovers, and that the anomalies emanated from insider trading since insiders purchased shares prior to information disclosure and sold them thereafter at huge profits.133 Another study selected a much smaller sample of 53 takeover cases in 1998, and concluded that there might have been existence of insider trading because stock prices changed violently before information disclosure.134 A later study which sampled 103 listed companies whose control were transferred in 1999 and 2000, also found that insider trading might have occurred in the event of takeovers, even one and half months before public announcement.135 Hence, those empirical studies have clearly shown that the incidence of insider trading is particularly high in the cases of takeovers and insider trading is 129. Ibid 61. 130. Chaojun Yang & Jin Xin, ‘An Empirical Study of Stock Price Movements on Shanghai Stock Exchange’ (1997) in Shanghai Stock Exchange (ed), Zhongguo Zhengquan Shichang Wenti de Shizheng Fenxi [Empirical Analysis of the Issues of China’s Securities Market] (Shanghai, Xuelin Press, 1997), p. 74. 131. Ibid 76. 132. Xiuchi Li, ‘Research on the Incidence of Insider Trading and Market Manipulation in the Case of Takeover on China’s Stock Market’ (2003) (unpublished working paper of China Securities Research Co Ltd, on file with the author). 133. Ibid. 134. Yilin Sun & Xuejie He, Shangshi Gongsi Jianbing Shougou Xiaoguo de Fenxi [Analysis on the Result of the Merger and Acquisition of Listed Companies] (2001) 68–72. For example, forty-two of the sampled fifty-three companies have seen their stock prices skyrocket 84% before information disclosure. 135. Donghui Shi & Hao Fu, ‘The Regulation of Insider Trading in China: A Legal and Economic Study’ (paper presented at the Symposium on ‘Behavioral Finance and Capital Market’, Nanjing, China, 29–30 November 2003). However, the researcher posited that the trading anomalies were not solely generated by insider trading, but instead the combination of insider trading and market manipulation, and insiders always begin selling the purchased shares before the disclosure rather than after. Ibid 28–29.

Inside Trading in China

43

rampant in China. There have been many similar empirical studies overseas which also found a noticeable relation between insider trading and takeover.136 However, the abnormal pre-announcement share price run-up in the US is later than in China where share prices usually change at least twenty days preceding announcement. For example, one American empirical study indicated that stock prices in the New York Stock Exchange fluctuated only one week before information disclosure, and most of the CAR took place on the announcement day.137 And in one case, the abnormal price change during the week prior to the public announcement of one acquisition had reportedly prompted the SEC to launch investigation.138 This suggests that insider trading may be more serious in China than in developed countries. In conclusion, the above studies strongly suggest that insider trading is widespread in China, but is nevertheless impossible to precisely describe the extent of insider trading. One Chinese commentator has stated that, On the [Chinese] stock market, about 80% of all securities cases are connected with insider trading, about 80% of the amount of money in all securities cases are connected with inside trading.139 However, the reliability of these numbers should be cautiously treated because the commentator said nothing on where the numbers came from and how he drew the conclusion. Although the numbers are open to question, they might reflect the scholar’s opinion that insider trading is very extensive in China. Thus, it can be safe to qualitatively rather than quantitatively argue that insider trading is widespread in China. Understandably, one might be wondering why large numbers of Chinese still invest in stock despite the widespread insider trading in China. We can find several possible explanations for this from the above empirical findings. Firstly, the return 136.

See e.g., Keown and Pinkerton, ‘Merger Announcements and Insider Trading Activity: An Empirical Investigation’ (1981) 36 J. Fin. 855 (empirical research showing above-normal gains in stock prices of takeover targets prior to the first public announcement of takeover plans); William G. Schwert, ‘Markup Pricing in Mergers and Acquisitions’ (1996) 41 Journal of Financial Economics 153 (arguing that insider trading posts an extra cost to the bidder); The Epidemic of Insider Trading, Bus. Wk., April 29, 1985, at 79–80 (a two-year analysis of stock price movements in advance of takeovers, mergers, and leveraged buy-outs indicated presence of insider trading); Use of Inside Data in the Takeover Game Is Pervasive and Can Lead to Huge Profit, Wall St. J., March 2, 1984, at 8, col.1 (‘[T]he takeover game as it exists today depends on . . . systematic use of inside information. . . ’.); Holland & Hodgkinson, ‘The Pre-Announcement Share Price Behaviour of UK Takeover Targets’ (1994) 21 Journal of Business Finance and Accounting; Calvet & Lefoll, ‘Information Asymmetry and Wealth Effects of Canadian Corporate Acquisitions’ (1987) 22 The Financial Review. Further, the volatile mix of takeovers and insider trading is entertainingly depicted in a famous US movie Wall Street (1987). 137. Robert Jennings, ‘Intraday Changes in Target Firm’s Share Price and Bid-Ask Quotes around Takeover Annoucements’ (1994) 17 The Journal of Financial Research 255. 138. The Epidemic of Insider Trading, Bus. Wk., April 29, 1985, at 79. 139. See preface by Professor Zhipan Wu in Shunyan Zhen, Zhengquan Shichang Budang Xingwei de Falu Shizheng [A Legal Analysis of Misconduct on the Securities Market] (Beijing, China University of Political Science and Law Press, 2000).

Chapter 2

44

from investing in stock, even when facing the risk of occasionally being on the wrong side of insider trading, might still be superior to the return on other available investments. As will be discussed in Chapter 3, most Chinese investors are speculative and prepared to live with speculative activities such as insider trading in the market. Secondly, one way to reduce the risk of being harmed by insider trading is simply to become an insider. It is thus very common in China that people openly talk about insider trading and actively seek inside information. Like gambling, this provides opportunity and hope to achieve above-market profits, which attracts people to enter the market. Of course, this is in turn leading to the widespread insider trading. Thirdly, there is only one market in China, and investors have no choice but to play there. According to one ordinary investor consulted for this study, he would invest more money if the market gets cleaner. Indeed, it is an oversimplification to suggest that people remain in the market because they do not really care about others committing insider trading. Rather, the fear of insider trading has greatly affected the behavior of investors in terms of the extent to which they are willing to invest, even though they have not yet been discouraged to such a degree that they totally refrain from investing in the market. In this sense, investors would choose to invest in a cleaner market, if they are provided with such a choice. b.

Insider Trading vs. Other Types of Misconduct

Even though insider trading was thought to be widespread, some interviewees pointed out that market manipulation and misrepresentation may be more serious. This is largely due to the comparison of the quantities of reported cases of them. In practice, market manipulation and misrepresentation account for a larger percentage of detected and reported securities cases. According to one empirical study, there were 60 cases publicized by the CSRC between 1993 and 1999, 30% of which were market manipulation cases and less than 10% of which fell into insider trading.140 This statistical result was echoed by a later empirical research in which all the cases handled by the CSRC before December 2001 were examined and insider trading cases were found to account for only 2.6% of total cases.141 Because more reported cases are related to market manipulation or misrepresentation, it is natural for people to get an impression that those types of misconduct are more serious. However, the statistical studies on the number of reported cases should be looked at with due caution for two reasons. Firstly, reported cases may not have fully reflected what actually happened. Compared to insider trading, market manipulation or misrepresentation is much easier to detect because their impacts on the market are more visible than those of insider trading. The evidence of market manipulation and misrepresentation is also more easily to collect: there are trading records in the cases of market manipulation and false statements are 140. Jianjun Bai, ‘An Empirical Study on the CSRC’s Sixty Punitive Decisions’ (1999) 11 Fa Xue [Legal Science] 55, 62. 141. Sibing You and Shentao Wu, ‘An Empirical Study of Illegal Securities Cases in China’ (2001) 6 Zhengquan Shichang Daobao [Securities Market Guiding News] 16, 23.

Inside Trading in China

45

readily available to prove misrepresentation. Thus, one above-mentioned study has rightfully pointed out that the small number of reported insider trading cases did not necessarily suggest that there is a low rate of occurrence of insider trading in reality, considering the difficulties in detecting insider trading.142 Secondly, the reliance on the classification of reported cases may be problematic. Securities cases are often very complicated, and some types of misconduct, especially insider trading and market manipulation, are frequently intertwined in one case for the purposes of enhancing the profitability of the overall misconduct.143 This makes it very hard to correctly characterize the involved misconduct. In some instances the CSRC might have unwittingly made mistakes in this characterization work, classifying insider trading cases as market manipulation. Additionally, out of the considerations of regulatory tactics, the CSRC might have intentionally chosen the count of market manipulation to deal with cases where insider trading and market manipulation were actually both present, because market manipulation or other charges can be more easily proved than insider trading. It is therefore dangerous to say that insider trading should be assigned a low priority on the agenda of the CSRC, even if it is not the most serious problem on the market. On the contrary, as discussed above, insider trading may exist extensively but in a hidden and perhaps more dangerous form. Furthermore, as one official from the Shanghai Stock Exchange pointed out, there are two levels of insider trading in terms of the sums involved. At the lower level, insider trading is conducted by individuals, especially low level staff and small investors. This category of insider trading is countless and even much harder to detect. Although each case may involve a small sum, the aggregate will be huge. More disturbing is the higher level where large players, notably brokers and other institutional investors, conduct insider trading. The sums involved in this category of cases are always considerably large. Some reported cases have shown us how much money insider trading can generate and why the temptation of insider trading is irresistible.144 During the course of the interviews, it was revealed that the average profit of insider trading committed by entities is about CNY one million, and in some big cases, the profit could be more than CNY 100 million. In light of the much smaller size and less liquidity of China’s stock market, the impacts of such cases on China’s market perhaps would be considerably bigger than those of the big US cases of ‘Boskey’ scale where more than USD 100 million was involved on the US market.145 Therefore, it would be dangerous to fail to realize that insider trading has been a real problem for the Chinese securities market. With respect to the extent of insider trading, it is relevant to note the strong feeling originating from the interviews, that is, the concept of insider trading is far 142. Bai, above note 140. 143. For a more detailed discussion of this issue, See below §2.III.C.5. 144. As discussed earlier, two publicized insider trading cases were committed by securities companies, namely the Xiangfan Shangzhen case and the China Qingqi Group Co Ltd case, each of which involved a profit of more than CNY 10 million. See above §2.III.A.1. 145. See 18 Sec. Reg. & L. Rep. (BNA) 1669 (S.D.N.Y., 14 November 1986).

Chapter 2

46

from clear to many people. During the course of interviews, it was not uncommon that many people, even some officials from the CSRC, have a wrong notion of inside information. Under Article 75 of the Securities Law,146 rumors, gossip, guesses and alike are clearly excluded from the definition of inside information. However, many interviewees actually treated rumors as inside information. Further, the phenomena that insider trading in China is always intertwined with some other types of misconduct, particularly market manipulation, deepens the confusion of many people about what is really insider trading. This factor may have some influence on interviewees’ impression about the incidence of insider trading in China. At the same time, this indicates the low level of general legal literacy as to the securities market in China, suggesting that more efforts are needed to improve awareness about securities laws and insider trading regulation in particular. C.

FEATURES OF INSIDER TRADING ACTIVITIES IN CHINA

Although those reported insider trading cases might not have painted a complete picture of the incidence of insider trading in China, they can, coupled with other materials, serve as a good starting point to analyze the features of insider trading activities in China. As will be demonstrated below, insider trading in China exhibits distinctive features which are of great significance for the purpose of seeking to effectively regulate insider trading in the context of China. 1.

Likely Insiders

As those reported cases shows, insiders can be both entities and natural persons. The prominent feature here is that entity insiders seem to contribute considerably to the incidence of insider trading in China. Of all the eleven reported cases, five involve entity insiders, including the Xiangfan Shangzhen case, the Baoan Shanghai, Baoan Huayang and Shenzhen Ronggang case, the Zhangjiajie Tourism Development Co Ltd case, the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case, and the China Qingqi Group Co Ltd case. Another feature common to those entity insiders is that all of them are state-owned corporations. This contrasts strikingly with insider trading in Western countries where insiders are usually natural persons. The fact that entities commit insider trading suggests that insider trading smacks of organized group crimes in China and not limited to individual crimes. This in turn reflects that insider trading is very serious in China and the corresponding regulation is very weak. As to natural person insiders, most of them are directors, senior management officers of state-owned corporations, such as Dai Lihui who was then the legal representative of Sichuan Tuopu Computer Equipment Factory and the CEO of Sichuan Tuopu Technology Co Ltd; Wang Chuan who was then the vicepresident of Beijing Beida Fangzheng Group Co Ltd and concurrently the general 146. Securties Law, Art. 75.

Inside Trading in China

47

manager (legal representative) of Beijing Beida Technology Development Co Ltd; Yu Mengwen who was then the associate chief of the Technology Management Section of Panzhihua Iron Co Ltd; Gao Fashan who was then the director of Tianjin Lida Group Co Ltd. Apart from business persons, there are also government officials and staff members of securities regulatory authorities found in reported cases, such as Guan Weiguo, who was then the first vice director of the Shenyang System Reform Committee, the vice director of the Shenyang Securities Commission and the director of the Shenyang Securities Regulatory Commission. This case suggests that there is a high chance of insider trading committed by government officials. This is not surprising to the extent that governmental officials frequently have privileged access to price sensitive information by virtue of their positions. Finally, there is a clear trend that more and more insider trading cases involve individual insiders. It is relatively easier to detect insider trading committed by entities than natural persons because more people are involved in the former situation. This trend suggests that insider trading become increasingly concealed and thus makes it more difficult to detect. 2.

Types of Insider Trading

In most of the reported cases committed by natural persons, insider trading was carried out by traditional insiders in a traditional way, namely, trading on inside information accessed by virtue of their positions. This is illustrated by the Wang Chuan case, the Dai Lihui case, the Yu Mengwen case, the Gao Fashan case and the Changjiang Konggu case. However, other types of insider trading also occurred on China’s stock market. There have been short swing cases, such as the Baoan Shanghai, Baoan Huayang and Shenzhen Ronggang case. In addition, there is no shortage of cases where constructive insiders are involved. For instance, in the Xiangfan Shangzhen case, one financial intermediary got inside information from a business meeting with its client. Further, tipping cases are also available such as the Shenshen Fang case. In general, the number of tipping cases is relatively small because of the increased difficulties in detecting or proving the communication of information. This suggests that more work needs to be done to handle more sophisticated forms of insider trading. Another interesting feature of those reported cases is that all of the used inside information was positive information or good news. As the cases showed, all of the perpetrators committed insider trading by purchasing shares on the information and reselling them after information disclosure. However, this by no means suggests that insider trading only takes place on the basis of good news in China. Two possible reasons may explain this feature. Firstly, it might be easier to detect insider trading on good news than that on bad news. Insider trading on good news needs two transactions, namely purchase and subsequent sale, while trading on bad news can consummate merely by sale before information disclosure. Secondly, the levels of the evidential difficulties

Chapter 2

48

involved in the two kinds of insider trading are different. It is always easier to find a readily available reason to justify a sale than a purchase before information disclosure. For example, insider trading suspects can readily argue that they sold the shares for urgent money to pay mortgage, their children’s tuition or something else, and it would be very hard to rebut such ostensibly plausible arguments.147 As far as the forms of conducting insider trading are concerned, all the reported cases appear to be so blatant that the CSRC has hardly experienced any major legal difficulties in handling those cases. Indeed, all of the defendants did not seriously defend themselves. This is not surprising because it is actually useless or difficult to present any meaningful defense in the face of egregious cases like those. In other words, all these cases were carried out in a traditional and primitive way, and there was little doubt about the culpabilities in those cases as a matter of law. As a result, the CSRC did not encounter any big problems with respect to the elements of insider trading, such as whether the information at issue is non-public and material, whether the perpetrator falls within the concept of insider, and whether the perpetrator meets the subjective elements of insider trading. In short, the reported cases did not raise any interesting legal problems, and this may disappoint those who expect to study China’s insider trading law on the basis of the reported cases. It is also important to note that in response to the increasingly effective regulation of insider trading, the ways of committing insider trading are becoming more and more sophisticated. Firstly, the types of insiders are changing from entities to individuals. Secondly, where entities commit insider trading, they began using investments in the names of other people rather than themselves, thereby minimizing the risk of being caught. For example, in the earliest cases, both Xiangfan Shangzhen Co Ltd and Baoan Co Ltd traded on their own accounts to carry out insider trading. Thereafter, Zhangjiajie Tourism Development Co Ltd and China Qingqi Group had evolved to employ the accounts of other entities and individuals as opposed to their own accounts. This change in the ways of carrying out insider trading presents a new challenge to the regulation of insider trading which in turn needs to improve accordingly. 3.

Serious Offences but Light Punishment

The reported cases have shown the seriousness of insider trading in China. In terms of profits realized in those cases, some cases could have been treated as big fishes even had they taken place in developed countries including the US.148 For example, the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case involved a total of up to CNY 77,419,000 (roughly USD 9.7 million); Xiangfan Shangzhen reaped CNY 16,700,000 (roughly USD 2 million) in a short period of 147. For more discussion of this issue, See below §6.V. 148. The Ivan F. Boesky case was famous in the US, involving profits of around USD 100 million from insider trading activities. See generally Robert D. Rosenbaum and Stephen M. Bainbridge, ‘The Corporate Takeover Game and Recent Legislative Attempts to Define Insider Trading’, (1988) 26 Am. Crim. L. Rev. 229; Donald C. Langevoort, Insider Trading: Regulation, Enforcement, and Prevention (West Group) (looseleaf) §1.01, p. 3.

Inside Trading in China

49

one month; the direct profits involved in the Zhangjiajie Tourism Development Co Ltd case also reached as high as CNY 11,800,000 (roughly USD 1.4 million); more notably, Qingqi Group made a profit of CNY 25,420,000 (roughly USD 3 million) by insider trading within four months, which in fact amounted to the annual net profit of Jinan Qingqi which was the main subsidiary of Qingqi Group and whose shares were traded in this case. As to individual insiders, Dai Lihui made a profit of CNY 670,570 (roughly USD 81,776); Wang Chuan CNY 610,000 (roughly USD 74,390); Guan Weiguo CNY 770,000 (roughly USD 93,902); Yu Mengwen CNY 80,000 (roughly USD 9,756). However, all these cases involve only administrative penalties, such as confiscation of illegal profits, small fine and business suspension for a short term. These penalties are far too lenient, compared to those imposed in overseas insider trading cases. R v. Rivkin,149 a recently reported Australian insider trading case, offers a good comparison. In April 2003, Rene Rivkin, a famous Australian stockbroker, was found guilty of insider trading in the New South Wales Supreme Court. It was alleged that he used inside information regarding a proposed takeover to buy 50,000 Qantas shares on 24 April 2001, and sold them a week later on the morning of 1 May 2001. The profit realized in the week-long trade was only AUD 2600 (roughly USD 1950).150 Despite this small amount of money involved, Rivkin was sentenced to nine months periodic detention and a fine of AUD 30,000 on 29 May 2003.151 It was held by the court that the sentence would act as a deterrent both to Rivkin and to other people in the industry. Although he recognized that ‘the present insider trading case is by no means the most serious or even a very bad case of insider trading’, Justice Whealy emphatically stated that ‘the community generally would be rightly outraged if a sentence other than imprisonment was imposed’.152 The Australian Securities and Investments Commission (‘ASIC’), the watchdog of the Australian securities market, echoed this view, stating that Rivkin deserved the sentence and accused Rivkin of trivializing his insider trading case.153 Assuming that the sentence of imprisonment is appropriate for Rivkin, it is safe to say that more severe penalties should have been imposed on those insiders in China who committed far more serious offenses than Rivkin in terms of profits realized, had those cases occurred in Australia. 149. 150. 151. 152. 153.

Regina v. Rivkin, 45 ACSR 366 (2003). Anne Lampe, ‘Rivkin Guilty but Vows Fightback’ Sydney Morning Herald 1 May 2003. ‘Rivkin Fined, Gets Periodic Detention’ Australian Financial Review 29 May 2003. Kate Askew, ‘Cell, Cell, Cell: Rivkin Goes Inside’ Sydney Morning Herald 30 May 2003. ‘Rivkin Deserves Jail: ASIC’ Illawarra Mercury 2 June 2003. However, this sentence did not come without scepticism. Some believed that such a sentence was reached partly because Rivkin was flamboyant, too rich and exhibited ‘contemptuous arrogance’ as the judge described his behaviour at trial, which rendered him an ideal example for the ASIC and the court to set. This cynicism is not wholly baseless, and even David Knott, the chief of the ASIC, admitted that ‘I am unable to determine whether Rene Rivkin is the victim of a witch-hunt or the recipient of some long overdue justice’. See ‘Rivkin: Witch-hunt or Justice Overdue’ Australian Financial Review 11 June 2003. However, there is little doubt that the penalties imposed by the CSRC on the insiders are far too light, even though it could be argued that Rivkin received a somewhat draconian punishment.

Chapter 2

50

Fortunately, it appears that China has recently realized the inadequate deterrent of administrative penalties for insider trading and has begun to impose criminal penalties. As discussed earlier, in 2003, the Shenshen Fang case became the first criminal insider trading case in China, and in the words of one commentator, ‘will have profound impact on the insider trading regulation in China’.154 Indeed, this case marks a new era of the regulation of insider trading in China because since insider trading was criminalized in 1997 by the Criminal Law, China had not employed this powerful weapon until this case. The first prosecution under a law, however perfunctory it might be, is an event of paramount importance, signaling that the probability of future prosecutions has become real. The Shenshen Fang case therefore would help increase the deterrent effect of China’s insider trading law and decrease the cost of capital in China.155 In addition, China may continue to strengthen its regulation of insider trading by introducing civil liabilities for insider trading. Although the Securities Law has in principle provided for civil liabilities for insider trading,156 the courts have so far refused to hear civil insider trading cases due to the lack of detailed provisions. But now China is considering a variety of proposals to introduce civil liabilities for insider trading.157 4.

Likely Situations where Insider Trading Occurs

On the basis of the reported cases, it appears that situational market factors play an important role in the incidence of insider trading. Indeed, market situations heavily affect opportunities for insider trading. More specifically, insider trading is more likely to occur during periods of heightened market activities, such as a bull market and takeover situations. This is hardly surprising because the level of market volatility is an important factor for carrying out insider trading. Firstly, insider trading is highly likely to happen when the market is very active in a bull market. Out of the eleven reported cases, eight took place in the bull markets of 1993, 1996, 1999 and 2000, and plus the Guan Weiguo case, the number reaches nine.158 The year of 1993 witnessed a speedy development of the stock market under favorable government policies.159 The first two cases, namely the Xiangfan Shangzhen case and the Baoan Shanghai, Baoan Huayang 154. Ying Yu, ‘Insider Trading by the Chair of One Listed Company’ Zhengquan Shichang Zhoukan [Securities Market Weekly] 2 June 2003 at 6. 155. Utpal Bhattacharya & Hazem Daouk, ‘The World Price of Insider Trading’, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=200914, at 4 (last visited on February 8, 2005) (concluding that the cost of capital in a country does not change after the introduction of insider trading laws, but decreases significantly after the first prosecution). 156. Securities Law, Art. 232. 157. Interview with a Judge in the Supreme Court of the People’s Republic of China (11 September 2003, Beijing). For a more detailed discussion of private civil liability for insider trading, See below Chapter 7. 158. See Appendix 2: The Summary of Reported Insider Trading Cases in China. 159. Xu Chen & Yong Liu, ‘Policy Suggestions and Empirical Analysis on the Efficacy of the Stock Market’ (1999) 3 Touzi Yanjiu [Investment Research] 34.

Inside Trading in China

51

and Shenzhen Ronggang case, happened at this very year. The Guan Weiguo case also took place in 1993. Then, in 1996, the market was again bullish and was so overheated that the government had to cool it down at the end of 1996.160 It was in 1996 that three serious cases emerged, including the Zhangjiajie Tourism Development Co Ltd case, the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case, and the China Qingqi Group Co Ltd case. Finally, after 19 May 1999, China entered another bull market. The Gao Fashan case, the Shenshen Fang case and the Changjiang Konggu case occurred during this period. Two factors may be responsible for this. On the one hand, a bull market provides more opportunities for insider trading. In a bull market, share prices are highly volatile and there are a lot of investment activities. The volatility of the market offers more chances for profitable speculations such as insider trading. On the other hand, a bull market may make it safer to commit insider trading because the chance of detection becomes lower. Thus, the volatility in share prices encourages insider trading to a significant degree. Secondly, the reported cases reveal a distinct relationship between takeover activity and the incidence of insider trading. Eight of the eleven reported cases, including the Xiangfan Shangzhen case, the Baoan Shanghai, Baoan Huayang and Shenzhen Ronggang case, the China Qingqi Group Co Ltd case, the Wang Chuan case, the Dai Lihui case, the Yu Mengwen case and the Gao Fashan case, took place in the context of takeovers and reconstructions. This can be explained by two reasons. The first is that takeovers always result in major price movements and thus create a favorable environment for insider trading. In the context of takeovers, insider trading is typically committed through buying shares ahead of information disclosure on takeovers and thereafter selling them at a profit. Secondly, the fact that many people are involved in preparing takeovers and thus the relevant information may be easily leaked out increases the chance of insider trading. As discussed earlier, this feature has been supported by other empirical studies.161 China’s unique takeover situations provide an even more fertile breeding ground for insider trading. According to Article 85 of the Securities Law, There are currently two main types of takeover in China: one is takeover by tender offer; the other is takeover by private agreement.162 As discussed earlier, shares on China’s stock market are generally classified into two groups: tradable shares and non-tradable shares.163 Tradable shares, mainly public individual shares, can be purchased by tender offer, whereas non-tradable shares, consisting of state shares and legal person shares, can only be transferred by private agreement.

160. Editorial, ‘Properly Viewing the Current Stock Market’ Renmin Ribao [People’s Daily] 15 December 1996, at 1. 161. See above §2.III.B.2. 162. Securities Law, Art. 85. Takeover by tender offer in China is similar to that defined through an eight-factor test in the US. See e.g., Wellman v. Dickinson, 475 F. Supp. 783 (S.D.N.Y. 1979). For a detailed discussion of China’s takeover law, See Hui Huang, ‘China’s Takeover Law: A Compara. tive Analysis and Proposals for Reform’ (2005) 30 Delaware Journal of Corporate Law 145. 163. See above §2.I.B.

52

Chapter 2

Because, as stated before, China’s listed companies commonly have a highly concentrated ownership structure with the state as the controlling shareholder, the majority of shares, mainly state shares, are non-tradable. In order to successfully acquire the control of a listed company, one has to obtain its non-tradable shares by private agreement. For this reason, takeover by private agreement has long been the main type of takeover used by listed companies in China, while the number of cases of takeover by tender offer is very limited.164 The predominance of takeover by private agreement is favorable for insider trading because the regulation over it is much looser than that over takeover by tender offer. In the case of takeover by tender offer, there are relatively comprehensive and stringent rules applied to govern the way of conducting the takeover, particularly those requiring adequate information disclosure, with a view to ensuring equality and fairness.165 By contrast, takeover by private agreement is much more secretive in that it is generally carried out by private negotiation.166 The regulation over takeover by private agreement is clearly lax. A comparison of the numbers of relevant articles in the Securities Law governing the two types of takeover may be illustrative of the favorable environment for insider trading in the instance of takeover by private agreement. Only three articles are related to takeover by private agreement whereas a total of six articles are devoted to takeover by tender offer.167 In addition, the CSRC has promulgated a series of regulations to further clarify the rules governing takeover by tender offer.168 The favorable environment for insider trading under takeovers by private agreement is multifold. In the first place, when a listed company is to be acquired by private agreement, the acquirer has no disclosure obligations until the private negotiation is finalized. Furthermore, apart from businesspersons, other people also have a role to play in takeovers by private agreement. In other words, more

164. China did not have any cases of takeover by tender offer in a strict sense until 2003. See e.g., Junfeng Huang, ‘The First Case of Takeover by Tender Offer in China’s Stock Market’ Zhongguo Zhengquan Bao [China Securities News] 9 April 2003. 165. For example, in China, the Securities Law provides for broad disclosure with respect to substantial shareholders. When an investor comes to hold five percent of the shares issued by a listed company, the investor must disclose his or her position. See Securities Law, Art. 86(1). There are also strict information disclosure rules in place with respect of tender offer in other jurisdictions. In the US, the Williams Act was designed to protect investors by requiring sufficient information to be disclosed with respect to a tender offer. See S. Rep. No. 550, 90th Cong., 1st Sess. 2 (1967); Australia has similar rules to require adequate information disclosure so that shareholders can make informed decisions on a tender offer. See e.g., Corporations Act 2001 (Australia), s 671B. 166. Securities Law, Art. 94. 167. In Chapter 4 of the Securities Law which is devoted to takeovers, Arts. 94, 95 and 96 are specifically governing takeover by agreement, while Arts. 88 to 93 for takeover by tender offer. 168. Recent important regulations include: Shangshi Gongsi Shougou Guanli Banfa [Measures for Regulating Takeovers of Listed Companies] (Promulgated on 28 September 2002 and effective from 1 December 2002); Shangshi Gongsi Gudong Chigu Biandong Xinxi Pilu Guanli Banfa [Measures for Regulating Information Disclosure of the Changes in Shareholdings of Listed Companies] (Promulgated on 28 September 2002 and effective from 1 December 2002).

Inside Trading in China

53

people are likely to be involved in takeover by private agreement than takeover by tender offer. Under Article 101 of the Securities Law, when the takeover of a listed company involves shares held by an investment organization authorized by the State, namely state-owned shares, the matter shall be subject to approval by relevant department in charge, in accordance with the regulations of the State Council.169 Not surprisingly, the more people are involved in a takeover, the more likely insider trading can occur. 5.

Insider Trading Connected with Other Types of Market Misconduct

A closer examination of the incidence of insider trading in China reveals that insider trading is often connected with other types of market misconduct. The temptation of making money through insider trading may embolden people to violate not only insider trading provisions, but also other relevant provisions. Coupled with other types of misconduct, insider trading has proven to have a more damaging effect on China’s stock market. Firstly, in the case of insider trading committed by securities companies, a huge block of funding is needed and securities companies always choose to misappropriate their clients’ transaction clearing funding, which is expressly prohibited under Article 139 of the Securities Law.170 This is well illustrated in the Xiangfan Shangzhen case in which the majority of the funding employed by Xiangfan Shangzhen was misappropriated clients’ transaction clearing funding.171 This is a very dangerous activity because it could seriously damage the interest of many ordinary investors and thus the stability of the market. Secondly, as shown in the Zhangjiajie Tourism Development Company case, listed companies always trade their own shares to commit insider trading. In fact, a company’s repurchase of its own issued shares has been strictly prohibited under Article 143 of the Company Law, save in very exceptional circumstances.172 It is interesting to note that, in order to avoid the breach of this provision, companies often form an alliance with another company, most commonly, securities companies, and let their allies trade on inside information. The Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case offers a good example. In this case, Beida Chehang provided Nanfang Securities with inside information, and then Nanfang Securities carried out transactions, in agreement that they shared the profits of insider trading.

169. Securities Law, Art. 101. 170. Ibid Art. 139. 171. Apart from insider trading, Xiangfan Shangzhen was also charged with misappropriation of its clients’ transaction clearing funds. See Decision of the China Securities Regulatory Commission on the punishment of the Shanghai branch of the Xiangfan Investment Company of Chinese Agricultural Bank for breaching the securities regulations, above note 100. 172. Company Law, Art. 143.

54

Chapter 2

Thirdly, insider trading appears to be closely connected with market manipulation.173 The combination of market manipulation and insider trading enhances the chance of succeeding in making money and as such, damages the market in a more subversive way. Moreover, the mixture of insider trading and market manipulation makes relevant regulations more confusing and difficult to apply. In face of a case involving both insider trading and market manipulation, one has to understand the respective natures of the two types of misconduct and their relationship. In practice, the CSRC’s knowledge and attitude in this respect have evolved over the years. In China, one stated form of market manipulation is carrying out combined or successive purchases or sales, alone or with others, by building up an advantage in terms of funding or shareholding or using one’s advantage in terms of information, thereby manipulating the trading prices of securities to an artificial level.174 This sort of manipulative practice is generally referred to as a ‘pool’ in Western countries.175 The so called ‘one’s advantage in terms of information’ is always inside information. As discussed earlier, market manipulation is thought to be more serious than insider trading in China. The seriousness of market manipulation should not be surprising, if we consider the particular situations of China’s stock market. It has been argued that an attempt to manipulate a highly liquid market is likely to be either self-defeating or so costly that the attempt is not worthwhile.176 Indeed, although sales of securities can generally be expected to exert a downward pressure on the price of those securities, and purchase an upward pressure, studies of trading on the New York Stock Exchange suggest that the price at which securities trade in a liquid market is unlikely to be affected by individual sales or purchases, unless the trades are in very large volumes.177 However, by way of comparison, the market for shares on the Shanghai Stock Exchange and Shenzhen Stock Exchange is much less liquid either generally or in particular stocks. Thus, the Chinese stock market may be more susceptible to manipulation, as a result of lower liquidity and trading volumes. When market manipulators plan to rig the market, they prefer to have an information advantage, aside from funding or shareholding advantages. Firstly, in so doing, they can certainly profit from the price movement caused by material

173. This feature is also present in the securities markets of Western countries. See e.g., Barry A. K. Rider, Insider Trading (Jordan & Sons Ltd, 1983), p. 53. 174. Securities Law, Art. 77(1). 175. In Australia, for example, the term ‘pool’ has long been used. See Senate Select Committee on Securities and Exchange, ‘Australian Securities Market and their Regulation’, 1974, paras. 8.1–8.2; See also Ashley Black, ‘Regulating Market Manipulation: Sections 997–999 of the Corporations Law’ (1996) 70 The Australian Law Journal 987, 994; Meyer, ‘Fraud and Manipulation in Securities Markets: A Critical Analysis of Section 123 to 127 of the Securities Industry Code’ (1986) 4 C&SLJ 92, 95. After 2001, this so-called pool activity is prohibited in Section 1041B(1) of the Corporations Act 2001 (Australia). In the US, the corresponding provision is Section 9(a)(1) of the Securities Exchange Act 1934. 176. Daniel R. Fischel and David J. Ross, ‘Should the Law Prohibit manipulation in Financial Markets’ (1991) 105 Harvard Law Review 503, 509. 177. Kraus and Sholl, ‘Price Impacts of Block Trading on New York Stock Exchange’ (1972) 27 J. Fin. 569; Kahan, ‘Securities Laws and the Costs of “Inaccurate” Stock Prices’ (1992) 41 Duke L. J. 986.

Inside Trading in China

55

information disclosure, even if other manipulative activities fail to move the price to an expected artificial level. Inside information is therefore acting as a security for profit-making in this scenario. Secondly, in the cases that other manipulative activities have already successfully moved share prices well enough to make profits, manipulators can reap even more if they use inside information to change the prices further. Thus, inside information can be employed as an additional tool to increase the profitability of market manipulation. This phenomenon has been well exemplified by the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case. In this case, apart from the charge of insider trading, Nanfang Securities was also found liable for market manipulation. After Nanfang Securities got inside information from its client, Beida Chehang, it acquired a large number of Beida Chehang shares in a succession of trades. These transactions, coupled with the disclosure of inside information, drove the share price up by almost 100%. Then, Nanfang Securities sold all the shares at a huge profit. Finally, Nanfang Securities was found to have committed, among other things, both insider trading and market manipulation.178 However, in an earlier case which was remarkably similar to the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case in terms of the combination of insider trading and market manipulation, only market manipulation was found by the CSRC. In 1998, an allegation of market manipulation was made by the CSRC in the Qiong Mingyuan case.179 Mingyuan Hainan Co Ltd and Shenzhen Non-ferrous Metal Financial Co Ltd (‘Shenzhen Non-ferrous Metal’) are both large shareholders of Hainan Mingyuan Modern Agricultural Development Joint Stock Limited (‘Qiong Mingyuan’). The legal representative of Mingyuan Hainan Co Ltd, Ma Yuhe, was concurrently the chairman of the board, and the general manager of Qiong Mingyuan. As a result, he had access to inside information of Qiong Mingyuan, including half yearly reports, annual reports, dividend distribution plans and so on. Prior to disclosure of 1996 half-year report in which material positive information was contained, Mingyuan Hainan Co Ltd and Shenzhen Non-ferrous Metal jointly purchased a substantial block of Qiong Mingyuan shares, which accounted for 10.51% of all outstanding shares of Qiong Mingyuan as of August 1996. This resulted in a sharp rise in Qing Mingyuan share prices. In March 1997, part of the acquired shares was sold at a profit of CNY 66,510,000.

178. Nanfang Securities was also found to have breached other provisions, including failure to report and announce its shareholdings, and opening investment accounts in the names of individuals. See, Decision of the China Securities Regulatory Commission on the punishment of Nanfang Securities Limited Company, Beida Chehang Joint Stock Limited Company and other entities and individuals for breaching the securities regulations, above note 103. 179. Decision of the China Securities Regulatory Commission on the punishment of Mingyuan Hainan Company for breaching the securities regulations, (1998) 5 China Securities Regulatory Commission Official Bulletin.

56

Chapter 2

In this case, the CSRC only charged Mingyuan Hainan Co Ltd and Shenzhen Non-ferrous Metal with market manipulation, stating nothing about insider trading. This judgment therefore presents a striking contrast with that of the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case. This reflects the difficulty with which to understand cases where insider trading and market manipulation are mixed. Since the Qing Minghuan case was handled earlier, it appears that the judgment of the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case might well represent the CSRC’s current policy.

Chapter 3

Why Insider Trading is Widespread: A Cost-benefit Analysis

§3.I.

INTRODUCTION

As discussed in the previous chapter, insider trading is a serious issue that is widespread in China. This chapter then focuses on the issue of why insider trading is widespread in China, and by doing so, sheds light on how to effectively regulate insider trading. Plainly, the incidence of insider trading can be attributed to many situational factors including cultural, economic, political and legal factors. This chapter will therefore take a holistic and contextual approach to explaining the high incidence of insider trading in China. To this end, a cost-benefit analysis will be conducted, taking into account all relevant situational factors. Indeed, a reasonable person would compare the costs and benefits of its acts before carrying them out. Insider trading is no exception. To justify the decision to commit insider trading, one test must be satisfied: there must be a net benefit to do so. In other words, only when the benefits which one may obtain from insider trading outweigh the accompanying costs, will a person feel it desirable to pursue insider trading. As the subjective term ‘feel’ implies, investors may also react to some extent on the basis of moral or other non-pecuniary judgments, because one does not behave solely on the basis of pure economic rationalization. Therefore, by benefits this chapter means not only sheer monetary profits, but also values of other aspects. A similar way of thinking applies to the scope of

Chapter 3

58

costs. Simply stated, the broad meaning of benefits and costs takes account of various contributing factors, such as cultural, economic, political and legal factors, in an organic and logical way. This chapter will discuss the benefits as well as costs of insider trading in the context of China. Part II explores the benefits of insider trading while Part III looks at the costs of insider trading. This inquiry will suggest that the benefits of insider trading greatly outweigh the costs, explaining why insider trading is being widely committed in China. This in principle charts a direction for enhancing the regulation of insider trading: trying to increase the costs of insider trading on the one hand and decrease the benefits on the other. §3.II.

BENEFITS

A.

DIRECT MONETARY PROFITS

The benefits of insider trading include direct monetary profits and other nonmonetary benefits. Clearly, monetary profits are the most direct incentive for people to commit insider trading. In the securities market, prospective profits are always the driving force for investments, but nevertheless, investment returns are in general accompanied by corresponding risks. Thus, investors will do their best to obtain the highest possible rate of return at the same time as minimizing the risks. Insider trading offers an attractive way to achieve this goal. As a matter of fact, information plays a critical role in the securities market to the extent that share prices are essentially determined by the totality of relevant information publicly available.1 Hence, once in possession of non-public material information, as is typically the case in practice, investors could securely reap huge profits with ease that is otherwise impossible. This safe and quick way of making money understandably presents an irresistible temptation to investors. The role of financial benefits has been well illustrated in a number of reported insider trading cases. As discussed in Chapter 2, the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case involved a total of up to CNY 77,419,000 (roughly USD 9.7 million); In the Xiangfan Shangzhen case, a huge profit of CNY 16,700,000 (roughly USD 2.1 million) was involved in a short period of one month; Within one month, Qingqi Group made a profit of CNY 25,420,000 (roughly USD 3.2 million) which was in fact equal to the annual net profit of Jinan Qinqi, the main subsidiary of Qingqi Group. As to individual insiders, Dai Lihui made a profit of CNY 670,570 (roughly USD 81,776); Wang Chuan CNY 610,000 (roughly USD 74,390); Guan Weiguo CNY 770,000 (roughly USD 93,902); Yu Mengwen CNY 80,000 (roughly USD 9,756). Therefore, making money through insider trading is a strong incentive for people to commit insider trading. This incentive is even stronger in China due to the particular conditions of China’s stock market, which will be discussed below. 1.

See e.g., Ronald J. Gilson and Reinier Kraakman, ‘The Mechanisms of Market Efficiency’ (1984) 70 Va. L. Rev. 549.

Why Insider Trading is Widespread 1.

59

The Heavy Speculative Tint of the Market

At this early stage of the development of the Chinese securities market, an atmosphere of speculation prevails. One empirical study on the market concludes that: The market is much more volatile than mature stock markets, notably the US market . . . . It suggests that China’s market has not yet been able to evaluate listed companies by stock trading, and is instead rather speculative. Further, there are few blue chip companies on the market.2 As it is not viable for investors to make profitable long-term investments in the market, investors have little choice but to speculate. Such a market provides a fertile breeding ground for insider trading in that insider trading is by nature a speculative economic activity and thus meets the needs of investors. The following discussion reveals how speculative the Chinese securities market is. Compared to its more mature overseas counterparts, China’s securities market has a much higher ratio of share price to earnings (‘P/E’).3 The P/E figure in most developed stock markets is around 15–20 whereas in China it is usually about 45–55.4 Such a high P/E means that share prices are generally far too high, departing considerably from the fundamentals of listed companies. Put differently, the intrinsic values of shares and share market prices have been disconnected and the pricing function of the market is ineffective. This is reflected by the fact that the share prices of many loss-making companies do not decrease as they should, but instead increase.5 Apparently, this severely damages the resource allocation efficiency of the market. It has been argued that as the high P/E figure

2. Hongmin Song & Jie Jiang, ‘An Empirical Study of the Volatility of China’s Stock Market’ (2003) 4 Jingrong Yanjiu [Journal of Financial Research] 13, 21. 3. The P/E is the ratio of share market price to after-tax earnings per share, and is the most commonly used financial figure to judge the profitability of a relevant listed company and whether a particular share has investment value. A high P/E figure means that the share price is too high or the investment earning is too low and thus renders the investment less profitable. 4. Lin Jin, ‘The Figures of P/E and P/S are Getting Better’ Zhongguo Zhengquan Bao [China Securities News] 24 December 2003, at 5. In 2000 and 2001, the figures were 58 and more than 60 respectively, which has concerned many economists. See e.g., Wei Zhang, ‘It is a Fact that the Figure of P/E is too High’ Zhongguo Jingji Shibao [China Economic Times] 13 February 2001, at 4; Xiaolei Ji, ‘Wu Jinglian, a Famous Chinese Economist, Thinks that the P/E Figure is Currently too High’ Renmin Ribao Haiwaiban [Peoples’ Daily Overseas Edition] 13 January 2001, at 5. However, some commentators have argued that the figure of P/E is not comparable between China and overseas due to a number of reasons, namely the difference of sampling for calculation and the high proportion of non-tradable shares on China’s market. See Hui Xu, ‘China’s Comparable P/E Figure of A-hares may be under 13’ Nanfang Ribao [Southern China Daily] 2 December 2002; Zuoji Xiao, ‘The Figures of P/E Vary Depending on the Markets’ Shanghai Zhengquan Bao [Shanghai Securities News] 5 March 2003 at 3. 5. See e.g., ‘The Share Prices of the Loss-making Companies did not Decline; Those of the Profitable Companies Increased’ Zhengquan Shibao [Securities Times] 15 August 2002, at 2 (reporting that the share prices of the loss-making companies surprisingly increased rather than decreased).

60

Chapter 3

suggests, the market becomes flooded with speculative activities which need to be expelled.6 The chilling effect of the high P/E figure on long-term investments is exacerbated by the fact that most listed companies in China do not distribute cash dividends or if they do, they distribute them in a very low proportion to their already poor profits. Indeed, at present, most Chinese listed companies choose to give bonus shares (Songgu) instead of cash dividends to their shareholders. Thus, it is hard for investors to receive a return on their investments in the form of dividends, which leads them to trade shares in order to realize their gains. According to an empirical study, the percentage of listed companies without a distribution of cash dividends rose from 9.28% in 1994 to 50.13% in 1998.7 For those companies distributing cash dividends, the pre-tax ratio of cash dividends to corresponding share prices was as low as 1.87%, less than the bank’s three month term deposit interest rate of 2.88% at that time.8 Amongst those companies who did not distribute cash dividends, there were many companies that actually made enough profits, but who offered no reason for why they refused to distribute cash dividends except simply stating that ‘it is in the long-term best interests of the company and shareholders not to distribute dividends’.9 A recent study has shown that this situation remains largely unchanged today, and has even worsened to some degree.10 One major reason for this is that China’s securities market is highly speculative and listed companies just want to exploit investors by locking in their money. This has led two commentators to say that, ‘because listed companies do not reasonably distribute cash dividends, investors have to make profits by frequently trading shares on the market’.11 In addition, the Chinese securities market, as an emerging market in a transitional economy, has one distinctive feature: the government often directly intervenes in the market with administrative measures and policies. This role played by the government makes the market vulnerable to policies, which has led to the market being called a policy market (Zhengce Shi).12 Indeed, market

6. Xiaonian Xu, ‘The Bubble of the Market must be Squeezed Out’ Beijing Qingnian Bao [Beijing Youth Daily] 14 February 2001 at 3. Jinglian Wu, ‘Slowly and Carefully Squeezing out the Bubbles in the Market’, available at http://news1.jrj.com.cn/news/2002-0114/000000304190. html (last visited on 5 January 2005). 7. Gang Wei, ‘An Empirical Study of Cash Dividend Distribution of the Listed Companies in China’ (1998) 6 Jingji Yanjiu [Economic Research Journal] 30, 30. 8. Ibid 31. 9. Ibid 32. 10. Shulian Liu & Yanhong Hu, ‘An Empirical Analysis of the Cash Dividend Distribution of Listed Companies’ (2003) 4 Kuaiji Yanjiu [Accounting Research Journal] 29, 29 (finding that the percentage of the listed companies without the distribution of cash dividend was 62% in 1999, 53% in 2000). 11. Cunsheng Zhou & Yunhong Yang, ‘The Rational Bubbles of China’s Securities Market’ (2002) 7 Jingji Yanjiu [Economic Research Journal] 33, 40. 12. See e.g., Weixing Zhang, Zhongguo Gupiao Shichang de Weilai Chulu [The Road before China’s Stock Market] (Beijing, China Finance Press, 2002), p. 268.

Why Insider Trading is Widespread

61

fluctuations in China are mostly caused by government policies. It is not uncommon that share prices have nothing to do with relevant corporate performance, but are fairly sensitive to government policies.13 One study examining the major ‘ups’ and ‘downs’ of the market between 1991 and 1997, found that these movements were not due to economic factors, but material government policies.14 The B-share market is a good example of this type of activity. In June 2001, B-share prices skyrocketed after the CSRC decided to open the B-share market to domestic investors: the Shanghai B-share Index surged from 83.20 on 19 February 2001 when the decision was announced, to 231.89 on 1 June 2001. There was a 178% increase in the Shanghai B-share Index within 4 months while the Shanghai A-share Index only increased by 10.9% during the same period.15 There is an interesting and peculiar way the government controls the development of the market in China. In the official Government newspaper, the People’s Daily (Renmin Ribao), the government often uses its editorials to exert an influence on the stock market. For instance, in response to the overheated market in 1996, the People’s Daily published an editorial which bitterly criticized the mania of trading shares and pointed out that the market was full of irregularities and was too speculative.16 As a result, the stock market slumped dramatically on three consecutive days. Likewise, after two years of bear market, the People’s Daily published another editorial to stimulate the market in 1999.17 Not surprisingly, compared to the rule of law, government policies change more frequently and are much less predictable. In order to meet the need of the rapidly growing market, the government has to change its policies correspondingly. One commentator has found that there have been at least thirteen noticeable cases of the government directly interfering with the market before 2000, seven of which rescued and stimulated the market and the rest of which chilled and slowed the market.18 After the new millennium, this situation remains. It follows that investors lose their confidence in long-term investments in the face of ever-changing and unpredictable policies, and choose to speculate in a short term mode. This has led one commentator to observe that ‘the securities market in China

13. Guangdi Liu et al., ‘Two Kinds of Relationships need to be Handled Properly to Ensure the Healthy Growth of the Stock Market’ in Task Force of the Association of Shanghai Securities News, Xunqiu Zhengquan Shichang Dazhihui [Seeking for the Truth of the Stock Market] (Beijing, Xuelin Press, 1997), p. 65. 14. Liang Yang, Neimu Jiaoyi Lun [Insider Trading] (Beijing, Beijing University Press, 2001), p. 71. 15. Wenfeng Wu et al., ‘The Impact of the Permission for Domestic Individual Investors to Access B Shares on the Market Segmentation of A Shares and B Shares’ (2002) 12 Jingji Yanjiu [Economic Research Journal] 33, 35, note 2. 16. Editorial, ‘Properly Viewing the Current Stock Market’ Renmin Ribao [People’s Daily] 15 December 1996, at 1. 17. Editorial, ‘Improving Confidence and Quickening Development’ Renmin Ribao [People’s Daily] 15 June 1999, at 1. 18. Zhiling Li, Jiedu Zhongguo Gushi [Understand China’s Stock Market] (Shanghai, Three United Bookshop, 2002), p. 3.

Chapter 3

62

is no different from a casino, because whoever knows government policies in advance can easily make money through speculative activities such as insider trading’.19 As a consequence, the rate of share hand-changing on the Chinese stock market is unusually high. The following table provides a comparison of share hand-changing rates between the Shanghai Stock Exchange and some other major stock exchanges across the world during the period from 1993 to 1998 (the figures therein are percentages of quoted shares changing hand each year).20 Table 1: The Rates of Share Hand-Changing (unit %) Year

Shanghai

New York

Tokyo

Hong Kong

London

1993 1994 1995 1996 1997 1998

341 787 519 760 535 355

53 53 59 52 66 70

26 25 27 27 33 34

61 40 37 44 91 62

81 77 78 58 44 47

The high rate of share hand-changing persists after 1998. In 1999 and 2000, the rates of share hand-changing were 499% and 504% respectively, indicating that the average time of holding shares was about two months.21 Such high rates of share hand-changing reflect the fact that Chinese investors prefer short-term investments and that the market is highly speculative. During the course of interviews conducted for this book, one interviewee explained this situation, stating that ‘there are few listed companies worthy of long-term investments on the market, so investors enter into the market in a speculative mood and trade shares with a high frequency’.22 Empirical studies have lent support to the argument that the Chinese stock market is highly speculative. According to one study, investors’ trading behavior in China is very unsteady, and investors are acutely sensitive to government policies.23 Another empirical study has shown that the majority of investors prefer

19.

20. 21. 22. 23.

Dong Yuan, Zhongguo Zhengquan Shichang Lun [China’s Securities Market] (Beijing, Oriental Press, 1997), p. 105; see also Tai Feng, ‘It is not Harsh to Describe the Market as a Casino’ Zhongguo Jingji Shibao [China Economic Times] 15 February 2001 at 3. In 2001, Wu Jinglian, one prominent economist, also likened the market to a casino and thus triggered a hot debate. See Jianjin Zhang, ‘A Meaningful Debate on the Stock Market’ Jianghuai Chenbao [Jianghuai Morning] 18 February 2001 at 3. Shunyan Zhen, Zhengquan Neimu Jiaoyi Guizhi de Bentuhua Yanjiu [Localized Research on Securities Insider Trading Regulation] (Beijing, Beijing University Press, 2002), p. 97. Rong Zhang & Xuejun Jin, ‘An Analysis of Short-term Behaviours of Investors on China’s Stock Market’ (2003) 1 Shuliang Jingji Jishu Jingji Yanjiu [Quantitative Economic and Technological Economic Research] 68, 70. Interview with an official from the CSRC (Beijing, 3rd September 2003). Xindan Li et al., ‘Empirical Studies on the Trading Behaviors of Individual Investors on China’s Stock Market’ (2002) 11 Jingji Yanjiu [Economic Research Journal] 54.

Why Insider Trading is Widespread

63

to trade shares with prices that are very volatile and thus provide speculative opportunities.24 It has also been found that China’s stock market abounds in short-term behavior, and investors are over-confident in their abilities to make fortune through speculation.25 Furthermore, one empirical study has suggested that apart form investors’ short-term behavior, listed companies also pursue short-term behavior and try to enhance their performance in many ways, no matter whether it is legal or illegal.26 As discussed in Chapter 2, insider trading in China has an interesting feature that entities like listed companies account for a significant percentage of insider trading cases.27 This feature is consistent with this empirical finding. In summary, for the above mentioned reasons, including high P/E figures, low cash dividends and unpredictable government policies, it is inevitable that investors find it unsuitable to make long-term investments and thus choose to speculate instead. To the extent that speculation is embedded in the social and market environments investors will remain highly speculative in the foreseeable future. Undoubtedly, in the face of such speculation, investors are more prone to speculative activities such as insider trading. 2.

Empirical Findings: the Importance of Insider Trading for Success in the Market

To better understand the incentives behind why people choose to commit insider trading, this chapter will look at how important insider trading is for success on China’s stock market. Most of the securities practitioners interviewed for this book felt that it was very difficult, if not impossible, to succeed on the competitive market without committing misconduct such as insider trading and market manipulation. The strongest response was from a Shanghai broker who said that ‘you cannot survive the fierce competition without breaching the law, such as committing insider trading’. This view was supported by another broker’s remark that ‘misconduct is commonplace on the market, and you have to follow the stream, otherwise, you will certainly get eliminated’. A thoughtful statement from a fund manager was that ‘the market is full of speculation. Share prices always have nothing to do with fundamentals. In other words, market analyses are often useless’. One broker in Beijing also said that ‘our market is far from mature, and it is hard to rely on fundamentals to make profitable investments. If you want to be a winner, you have to speculate and risk committing misconduct’. A similar view was that ‘it is not sensible to make long-term investments on the market and for short-term investments, insider trading is almost 24. Quan Jia & Zhangwu Chen, ‘An Empirical Study of the Efficiency of China’s Stock Market’ (2003) 7 Jingrong Yanjiu [Journal of Financial Research] 86, 91. 25. Zhang & Jin, above note 21. 26. Ibid 71. 27. See above §2.III.C.1.

64

Chapter 3

necessary’. Only one broker did not consider insider trading as very important for success, but nevertheless held that insider trading would greatly enhance the chance of success. The officials from the CSRC were understandably cautious in the face of this question. They generally stated that one could succeed without committing insider trading, but conceded that insider trading was important for making short-term profits. One official from the CSRC said that ‘success is of course possible without the help of insider trading. For long term investments, fundamentals are essential’. A similar view was that ‘good market research and astuteness are pivotal to success on the market’. However, another official felt that ‘frankly, insider trading and market manipulation are important to some degree for survival at the moment. It is a fact that everyone wants to beat the market through misconduct, and there is remarkable tolerance of market misconduct’. The views from the officials of the stock exchange were also mixed. One official thought that ‘you can succeed with doing that. Insider trading is an easy way to make money, but you cannot entirely rely on it’. Another official repeated the point that ‘insider trading is tempting and can help you outperform the market, but it does not mean that you can never succeed without it’. But a different view was that ‘our market is too speculative and bubbly, and those committing insider trading, if not caught, get huge profits and win the competition. Sadly, this is the reality’. The overwhelming view of the ordinary investors was that long-term investments were fruitless and insider trading was necessary to make money on the market. One Guangzhou investor considered misconduct, such as insider trading, market manipulation, as ‘necessary to win on the market. The market is even worse than a casino in that you cannot cheat in a casino but you can cheat here’. This view was shared by another investor who said ‘it is hopeless to make long-term investments on the market. Everyone is speculative and you have to rely on misconduct to outplay others’. Even though the interviewees were not asked to do so, they gave some examples where they suspected that there had been insider trading and the traders greatly benefited from that. The financial journalists also thought that insider trading was very important for success. As one journalist in Shanghai said, ‘in fact, many investors, especially those large investors, always rely on insider trading and market manipulation to outperform their competitors’. The academics generally thought that insider trading, though illegal, played an important role for investors to win on the market. One professor said that ‘fundamentals are important for long-term investments, but our market is arguably more suitable for short-term investments or even speculation. Most investors are speculative and sometimes insider trading is necessary for them to win’. This view was backed by another professor who pointed out that ‘in a mature market, as long as the market analysis of fundamentals is correct, you will be able to succeed. But this is not true of our market. Sometimes, nobody can predict and understand the movement of the market’. Another professor said that ‘undoubtedly, resort to inside information is superior to reliance upon fundamentals. But on balance, inside information is just a help, not vital’.

Why Insider Trading is Widespread

65

The attitude of lawyers to this question was that insider trading was a very important tool for investors to succeed. One lawyer said that ‘it is essential to make quick profits to survive in the market. For quick profits, it appears necessary to possess inside information’. An even more emphatic response was that ‘it is almost impossible for investors, especially large investors, to survive without doing misconduct. You can find that almost all of the top institutional investors have some records of being caught for misconduct like insider trading’. In conclusion, insider trading was widely regarded by interviewees as necessary or at least very important for success on China’s stock market. This implies that insider trading in China is committed not only out of greed, but also because of the pressure to survive on the market. This may partly explain the fact that more than half of securities companies, including all of the leading ones, have a history of being punished by the CSRC for various types of misconduct such as insider trading.28 Two securities practitioners explained in detail how insider trading is conducted in practice. The following statement offered by a securities practitioner in Beijing provides a vivid description of the way that entities commit insider trading. It is securities companies who often take the initiative to make a plan to conduct insider trading. In China, many securities companies are among top ten large shareholders in listed companies whose securities were underwritten by them. With initial public offerings, subsequent share placement and rights issues, securities companies might hold 30 percent or more of shares in one listed company, and they are often forced to hold such a large number of shares for reasons such as a sluggish market. In order to sell shares at a favourable price, securities companies will contact the relevant listed company to find out whether it has any inside information, and whether it wants to cooperate to commit insider trading. In practice, the listed company will always say yes and even lend money to the securities company to conduct insider trading. Then the securities company will carry out insider trading. Listed companies usually share the profits of insider trading. However, sometimes, listed companies do not directly share the profits, but get some other desirable benefit. The main benefits involve a boosted share price which is the result of pre-disclosure purchases. The boosted price in turn will protect the company from hostile takeovers, decrease its capital costs, make the company look financially better and enhance the chance of senior management getting promoted. 29 Another Shanghai securities practitioner also provided his insights into the importance of insider trading and how it takes place. In China, the government controls the quota of listed companies and thus the qualification of enlisting is a precious resource in China. Many listed companies 28. Zhen, above 20, 131. 29. Interview with a securities practitioner (Beijing 29 August 2003).

Chapter 3

66

are very keen to make the most of the status of listing to raise funds by any means available. They always invent seemingly lucrative projects for this purpose, regardless of whether the fundraising is truly necessary. But often, after having raised a considerable amount of money, listed companies will find that there are actually no good investment opportunities. Obviously, it is not financially desirable to deposit the money into a bank. In this situation, listed companies will choose to invest the money in the stock market. In some cases, the true purpose of many listed companies to raise funds is just to use them to trade shares, because share-trading is highly profitable through insider trading or market manipulation. Even though listed companies have both inside information and money, they do not commit insider trading themselves. Firstly, it is prohibited by the Company Law to buy-back shares save in limited circumstances. Secondly, listed companies are generally not expert at securities trading. Thus, listed companies will seek the cooperation of securities companies which are their long-time business partners. The securities companies are always very happy to cooperate. Listed companies will entrust money to the securities companies who then carry out insider trading. The profits of insider trading are normally shared by the listed companies and the securities companies.30 Although the above two stories are not identical, they both suggest that listed companies and securities companies often cooperate to conduct insider trading for huge profits. In the first story, it is securities companies who have proposed to commit insider trading while listed companies have done so in the second story. However, a common point of the two stories is that the driving force is the pressure of business rather than simple greed. 3.

Insufficient Compensation for Corporate Insiders

Also of significant relevance to the incidence of insider trading is the fact that management officers have been generally underpaid in China. Traditionally, the main form of compensation in China has been salary. According to one empirical study which sampled 45 listed companies who disclosed the salaries of their directors and senior executives in the annual reports of 1998, 47% of the directors and senior executives received less than CNY 30,000 (roughly USD 3,500) per year; 29% received annual compensation ranging from CNY 30,000 (roughly USD 3,500) to CNY 50,000 (roughly USD 6,000); 13% earned between CNY 50,000 (roughly USD 6,000) and CNY 100,000 (roughly USD 12,000); and 11% received more than CNY 100,000 (roughly USD 12,000) in annual compensation.31

30. Interview with a securities practitioner (Shanghai 20 September 2003). 31. Hanmin Zhou, ‘Consciousness is not the most Reliable Thing: Perspective on the Values of the Managers of State-owned Companies’ 1 Nanfeng Chuang [Window of South Wind] (1999) 6.

Why Insider Trading is Widespread

67

Such low salaries clearly do not match the actual work done by corporate directors and senior executives. For example, the chairman of the board of directors of China Light Motor Group Co Ltd earned CNY 40,000 (roughly USD 4,500) as annual compensation in 1998, while his corporation sold 1.5 million motorcycles that year; Similarly, the chairman of another corporation, Houjian, received only CNY 39,000 (roughly USD 4,400) in 1998, while his corporation sold CNY 8.2 billion (roughly USD 1 billion) worth of products that year.32 In addition, even though some new types of executive compensation have been introduced in recent years, they have not made much of an impact on the under-compensation situation. Stock options are a good example. Stock options have long been used to compensate managers in the US, accounting for a large percentage of the total compensation paid to US managers.33 Contrastingly, stock options were not used in China until 1999, and up to now have only been employed by a handful of Chinese companies. As of April 2003, compared to over 50% of American companies with stock option program in place, less than 100 out of a total of more than 1200 Chinese listed companies had used stock options.34 There are several important reasons why stock options have not been widely adopted in China. Firstly, before the 2005 revision, the feasibility of stock options had been severely undermined by many problems with the Company Law, such as the prohibition of an authorized capital system;35 the prohibition of companies being able to buy back their own shares except in very limited circumstances;36 and the prohibition that the shares held by corporate directors and managers cannot be transferred during their term of office.37 Secondly, China presently lacks appropriate executive performance assessment systems to properly determine the amount of rewards and prevent the abuse of stock option programs as demonstrated by the recent Enron case in the US.38 Thus, compensation schemes in China are unable to effectively compensate directors and senior executives. Hence they fail to provide adequate incentives for corporate managers to work properly. According to a survey conducted by 32. Ibid. 33. David Yermack, ‘Do Corporations Award CEO Stock Options Effectively’? 39 J. Fin. Econ. 237, 238 (1995). 34. Xudong You, ‘The Dream of Stock Options’ Guoji Jinrongbao [International Finance Times] 28 April 2003, at 4. 35. Company Law, Art. 73 (before the 2005 revision). This prohibition remains after the revision. See Company Law, Art. 77. 36. Company Law, Art. 149 (before the 2005 revision). The problem has been largely solved after the revision by expressly listing the grant of shares as one of the exceptional circumstances under which the company can buy back its own shares. See Company Law, Art. 143(1). 37. Company Law, Art. 147 (before the 2005 revision). The restriction is relaxed but not completely removed after the revision. See Company Law, Art. 142. 38. There are serious concerns about the side-effects of stock option programs in China. See Jianbo Zhou & Jusheng Sun, ‘Research on the Effects of Stock Options on Corporate Executives’ (2003) 5 Jingji Yanjiu [Economic Research Journal] 74, 82 (arguing that if a stock option program is not designed properly, it will harm the interests of shareholders).

Chapter 3

68

the China Confederation of Enterprises in 1999, 77% of respondent managers complained about their poor salaries and 83% said that the lack of an effective incentive and disciplinary mechanism was the biggest obstacle to the growth of competent directors and executives in China.39 Since corporate directors and senior executives are generally underpaid, they can be more easily tempted to seek illegal gains by exploiting their managerial powers and privileged access to inside information. As previously shown, all the perpetrators in the reported insider trading cases committed by individuals were either directors or senior executives. For instance, in the Dai Lihui case, Da Lihui was the CEO of Sichuan Tuopu; in the Wang Chuan case, Wang Chuan was the vice president of Beida Fangzheng; in the Yu Mengwen case, Yu Mengwen was the senior manager of Panzhihua Iron Co Ltd; in the Gao Fashan case, Gao Fashan was the director of Tianjin Lida Group. The huge profits of insider trading might have presented as an enormous incentive to them, particularly if they felt under-compensated. B.

OTHER BENEFITS

Apart from direct economic benefits, there are a number of other reasons (or benefits) why people commit insider trading. This category of benefits is closely connected with Chinese culture and society. 1.

Indirect Personal Benefits in cases where Entities Commit Insider Trading

In those cases where entities have committed insider trading, it is the individuals directly in charge, mostly senior management, who appear to have done it for the benefit of the entity rather than for their own personal benefit. This has led some commentators to say that this kind of insider trading is morally justifiable to some degree.40 This view is questionable. Despite the fact that entities benefit directly from insider trading, individuals may also indirectly benefit. Indeed, managers not only receive economic benefits but they may also improve their reputations if they enhance corporate performance by making money through insider trading. This provides a strong incentive for senior management to carry out insider trading on behalf of their entities. This may partly account for why as discussed before, a considerable percentage of insider trading cases are committed by entities in China. In the first place, senior managers are assured of receiving a certain amount of ‘bounty money’ or an increase in their salaries for enhanced corporate 39. China Confederation of Enterprise, ‘The Comments and Proposals from the Corporate Managers’ Zhongguo Jingji Shibao [China Economic Times] 2 September 1999, at 5. 40. Zhen, above note 20, 99–101; Yang, above note 14, 53–54.

Why Insider Trading is Widespread

69

performance. However, as discussed above, this kind of monetary benefit is generally limited, and is not a sufficient enough incentive to risk committing insider trading. Indeed, directors or seniors executives could make much more money by personally committing insider trading themselves. More importantly, managers could enhance their reputations and thus have a better chance of getting promoted, or at least retaining their existing positions. They would become more competitive in the labor market and have a greater chance of a successful career. Thus, it is in their self-interest to maintain the success of their companies. There is another powerful incentive for managers to enhance corporate performance through insider trading in China. Most of China’s listed companies are formerly state-owned enterprises, and many of the features of being stateowned enterprises remain. In practice, corporate offices, especially directors and managers, have a dual role: on the one hand, they are business persons in the sense that they work in companies; and on the other hand, they are government staff in the sense that they still have relevant administrative ranks and are subject to the administrative system. For many corporate officers, administrative promotions are very important, and perhaps provide the greatest incentive of all. According to one empirical study, managers view an administrative promotion as their first priority.41 Few managers want to work as businesspeople for the rest of their lives, and many managers just use corporate posts as a springboard for better government positions.42 Thus, in order to get promoted, there are strong incentives for managers to improve corporate performance even by illegal means such as insider trading. 2.

Maintaining Good Inter-personal Relationships

The benefits of maintaining good inter-personal relationships arise mostly from insider tipping. Inter-personal relationships (Renji Guanxi) are very highly valued in China, perhaps more so than in the West.43 As one commentator states: Chinese personhood and personal identity are not given in the abstract as something intrinsic to and fixed in human nature, but are constantly being created, altered, and dismantled in particular social relationships. Furthermore,

41. Qun Wang, ‘Incentives and Behavior: A New Explanation of Why Compensation is Insufficient for the Managers of State-Owned Enterprises’ (2001) 8 Jingji Yanjiu [Economic Research Journal] 71, 75. 42. Ibid 74. 43. Qizhai Zhang, Xin Jingji Shehui Xue [New Economic Sociology] (Beijing, China Social Science Press, 2001), p. 220; see also Carol A.G. Jones, ‘Capitalism, Globalization and Rule of law: an Alternative Trajectory of Legal Change in China’ (1994) 3 Social & Legal Studies 195 (stating that business practices in China rely heavily on guanxi, and China’s society depends on ‘the Rule of Relationships (guanxi)’ rather than the Rule of Law).

70

Chapter 3 the boundaries of personhood are permeable and can easily be enlarged to encompass a scope beyond that of the biological individual. As a result, Chinese culture presents a frequent lack of clear-cut boundaries between self and other. 44

The importance of inter-personal relationships is deeply embedded in China’s unique culture. The emphasis on inter-personal relationships results in the moral duty stipulating that people share their resources with each other. In China, there is a household proverb, Yi Ren De Dao Ji Quan Shen Tian, which literally means that if one reaches immortality, their chickens and dogs can expect to benefit from that and become immortal as well. This mirrors the Chinese cultural notion that people can reasonably expect to share the benefits which their family members or friends have attained. Thus, in China, the tipping of material nonpublic information may be perceived as a moral duty owed to relatives and friends. Therefore, if a person occupies a privileged position in life, then they are under a moral duty of sorts to share the benefits arising from their position in life with family members or friends. Otherwise, they will be socially rejected because of their failure to discharge their moral duty, even though they may have a legal duty not to do so. For example, there are many cases where officials or judges who fairly and impartially exercise their powers, showing no favor towards their relatives or friends, end up losing their families and friendships. Moreover, this moral duty is mutual and reciprocal. If one refuses to share their resources with other people, they cannot expect that other people will share their resources with them in the future. Thus, people always try their best to maintain good inter-personal relationships because it is necessary to do so to survive in China. This uniquely Chinese culture is to some degree responsible for much corrupt behavior and abuse of power in China. It is also responsible for insider trading which is even more serious because the tipping of information is generally hard to detect and profits are irresistibly huge. As discussed before, because investors are speculative and very keen to seek inside information to make money, they will be more inclined to solicit people who have access to inside information and who they have good relations with. In one interview, a securities practitioner complained that many friends constantly asked him for tips and he had difficulties in properly handling this.45 Hence, the fact that inter-personal boundaries are blurred in China facilitates the tipping of inside information and makes it more difficult to prove tipping cases. It is therefore much easier to collude with family members or friends to conduct insider trading in China.

44. Janet E Ainsworth, ‘Categories and Culture: On the “Rectification of Names” in Compara. tive Law’, (1996) 82 Cornell Law Review 19. 45. Interview with one securities practitioner (Beijing, 6 September 2003).

Why Insider Trading is Widespread §3.III.

71

COSTS

The costs of insider trading basically include operational costs and law-breaking costs. Law-breaking costs are determined by the risk of apprehension and the amount of penalties incurred. These three issues are discussed below in turn. A.

LOW OPERATIONAL COSTS

Operational costs include costs incurred carrying out insider trading, excluding the costs of being caught and punished. In other words, they are the costs which affect the likelihood that insider trading would occur in the absence of a prohibition. Operational costs mainly include the costs of getting inside information and the costs relating to a possible failure of making money through insider trading. 1.

The Cost of Information

Inside information is the key element of insider trading. In China, it appears to be much easier to get access to inside information and as a result, operational costs of insider trading decrease accordingly. a.

The Inefficacy of Information Disclosure

Effective information disclosure can deter insider trading because the resulting price adjustment eliminates an insider’s opportunity to make money. Indeed, one of the stated objectives of the UK information disclosure system is to prevent insider trading.46 An effective information disclosure regime has several elements, including the timeliness of disclosure and equal access to information which are of particular relevance to insider trading. The incidence of insider trading may decrease if corporations make timely public disclosure of material non-public information. The major reason is that ‘more timely disclosure of price sensitive information would reduce the premium value of that information and would reduce both the opportunity for and the scope of insider trading’.47 Thus, timely disclosure can effectively deter insider trading by diminishing insiders’ opportunity to gain access to privileged material information. In China, the Securities Law requires companies to immediately submit an ad hoc report on the details of nonpublic material information to the CSRC and the 46. The Financial Services Authority (UK), Updated Industry Regulator Guidelines: Guidelines for the Control and Releases of Price Sensitive Information by Industry Regulators 1, available at the official website of the FSA: http://www.fsa.gov.uk 47. Roman Tomasic, Casino Capitalism? Insider Trading in Australia (National Gallery of Australia, 1991), p. 8.

72

Chapter 3

stock exchange.48 However, it is not yet clear how ‘immediately’ this disclosure must be and in practice this vagueness, coupled with the inherent difficulty of the materiality standard, has resulted in problematic continuous information disclosure.49 According to an empirical study, interim reports have been regarded as not important because they have failed to effectively disclose information in a timely way and the disclosed information therein is not new.50 Thus, in circumstances where the timeliness requirement of information disclosure is not met, insiders can easily trade on material information by deliberately delaying information disclosure. Furthermore, the opportunities for insider trading arise from the fact that companies often selectively divulge material information which ordinary investors have no equal access to.51 The interviews conducted for this book found that the practice of selective disclosure is widely considered to be quite serious. Indeed, in the name of market research, listed companies often selectively provide price sensitive information to favored securities analysts. In China, market research is done largely in the hope that it picks up inside information. During the course of the interviews conducted for this study, a securities advisor stated that: Our discussion with listed companies is directed at getting sensitive information. Even though some big companies may refuse to cooperate, many companies are willing to give out some inside information, of course sometimes puffery, because they try to get their share prices up. In the sense that inside information is given out to analysts for the purposes of bolstering share prices, analysts act as accomplices of listed companies whose shares they are supporting. In turn, analysts benefit from inside information. Thus, in most cases, selective disclosure is in the common interest of both companies and analysts. If listed companies and securities companies collude to commit insider trading, the possibility of selective disclosure becomes even more real. This scenario has been illustrated in the Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case where Beida Chehang, a listed company, selectively disclosed inside information to Nanfang Securities for the purpose of insider trading.52 48. Securities Law, Art. 67. 49. See e.g., Jian Fu, ‘Information Disclosure and Corporate Governance in Listed Companies in China: from Yinguangxia to Enron’ (2004) 17(1) Australian Journal of Corporate Law 48. 50. Qinye Zhou et al., ‘A Survey of the Costs and Benefits of Information Disclosure’ (2003) 5 Kuaiji Yanjiu [Accounting Research Journal] 3. 51. The Regulation FD of the US was introduced to prohibit selective disclosure which was thought to bear a ‘close resemblance’ to fraudulent tipping and insider trading. See Selective Disclosure and Insider Trading, Exchange Act Release No.43154, [2000 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶86,319, at 83,677 (Aug. 15, 2000); T. Andrew Eckstein, ‘The SEC’s New Regulation FD: A Return to the Parity Theory?’ (2001) 69 University of Cincinnati Law Review 1289. For a more detailed discussion of Regulation FD, see below §5.III.C.2. 52. Decision of the China Securities Regulatory Commission on the punishment of Nanfang Securities Limited Company, Beida Chehang Joint Stock Limited Company and other entities and individuals for breaching securities regulations, (1999) 10 China Securities Regulatory Commission Official Bulletin.

Why Insider Trading is Widespread b.

73

Problematic Corporate Governance

There are many problems with the corporate governance of most listed companies in China at the present time with the lack of supervision of management generally thought to be the main issue.53 Without checks and balances, corporate management is more able to commit misconduct such as insider trading in order to make money for companies or for themselves, particularly when inside information is so readily available to them. There are in theory several ways of monitoring management in China, but they are far from effective in practice. First, according to the Company law, shareholders have the power to monitor managers.54 However, as discussed in Chapter 2, in China, state-owned shares account for the majority of shares on the market; hence the state is the largest shareholder in most listed companies.55 One empirical study has shown that the state has control of 84% listed companies.56 Due to problems resulting from agency costs and an omnipresent bureaucracy, the state, as the majority shareholder, carries out little monitoring of management.57 Furthermore, private minority shareholders are unable to place effective checks and balances on corporate management. It is important to note that China has yet to establish a derivative suit system, which is widely believed to be an effective managementmonitoring device.58 Second, the two-tier corporate governance system in China has resulted in a specifically designed supervisory board to monitor directors and corporate officials.59 Unfortunately in practice, the supervisory board has proved to be ineffective in serving its purported function.60 In many companies, important posts are not effectively separated, which has resulted in an excessive concentration of power and inefficient supervision. It is not uncommon that one person simultaneously occupies several leadership positions in a company, such as chair of the board, CEO, secretary of the Communist Party Committee of the company, and

53. 54. 55. 56. 57. 58.

59. 60.

See, e.g., ‘Prospect for China’s Corporate Law Reform after the Entry into WTO’ in Baoshu Wang, et al. (eds), Quanqiu Jingzheng Tizhi xia de Gongsifa Gaige [Corporation Law Reform for a Global Competitive Economy] (Beijing, Social Sciences Academic Press, 2003), p. 270. Company Law, Art. 100 (listing the powers of the shareholders’ general meeting). See above §2.I.B.2. Shaojia Liu et al., ‘Ultimate Ownership, Shareholding Structure and Corporate Performance’ (2003) 4 Jingji Yanjiu [Economic Research Journal] 51. Hehong Chen et al., Guoyou Guquan Yanjiu [Study on State-owned Shares] (Beijing, China University of Political Science and Law Press, 2000), pp. 247–248. Ian M. Ramsay, ‘Corporate Governance, Shareholder Litigation and the Prospects for a Statutory Derivative Action’ (1992) 15 The University of New South Wales Law Journal 149; Hui Huang, ‘Research on the Shareholder Derivative Suit System’ 7 Shangshifa Lunji [Commercial Law Review] 332 (2002). Company Law, Art. 119. Shenshi Mei, ‘The Roles of Supervisors and Supervisory Board in Modern Corporate Governance’ 1 Shangshifa Lunji [Commercial Law Review] 161, 195 (1995); Fengting Yin, ‘The Function of Supervisory Boards in listed Companies is in Urgent Need of Improvement’ Shanghai Zhengquan Bao [Shanghai Securities News] 4 December 2003, at 12.

Chapter 3

74

even chief of relevant government agencies.61 Thus, many Chairs and CEOs hold supreme powers that cannot be checked by other people.62 More recently, China has tried to introduce the system of independent directors, but the result is far from satisfactory. This system of independent directors is primarily modeled on its US equivalent with a focus on remedying deficiencies in management monitoring.63 However, to date, there are many problems with this practice and as a result, problems to do with management monitoring have not been solved as they were expected to be.64 c.

The Porous ‘Chinese Wall’ Procedure

In China, there are a number of procedural arrangements such as the ‘Chinese Wall’ in place within multi-service securities companies to protect price sensitive information. In practice however, these appear to be quite ineffective. Chinese Walls have been defined by one international legal authority as follows: The term ‘Chinese Wall’ is a metaphor to describe a set of internal rules and procedures (sometimes including procedures to monitor these rules and procedures) established by a firm for the purpose of preventing certain types of information in the possession of one party of the firm (or of an affiliated group of firms) from being communicated to other parts of the same firm or group.65 Chinese Walls have received official sanction in relation to securities industry conduct in many Western countries including the US, the UK and Australia.66 In the

61. Pinyu Ding, ‘How to Make Supervision Effective in State-owned Companies’ Renmin Ribao [People’s Daily] 9 June 1998, at 11. 62. Ibid. 63. Guanyu zai Shangshi Gongsi Jianli Duli Dongshi Zhidu de Zhidao Yijian [Guiding Opinion on Establishing Independent Directors System in Listed Companies] (promulgated by CSRC in Aug. 16, 2001); Cindy A. Schipani & Junhai Liu, ‘Corporate Governance in China: Then and Now’ 2002 Colum. Bus. L. Rev. 1, 46. 64. Many Chinese commentators have satirized independent directors as having no more function than a decorative vase. See, e.g., Jianxiong Wu et al., ‘What is Wrong with Independent Directors: An Empirical Study on the Current Situation of Independent Directors in China’ Zhengquan Shibao [Securities Times] 10 January 2002, at 9. 65. Norman S. Poser, International Securities Regulation (Boston, Little, Brown and Company, 1991), p. 189. One commentator has suggested that the use of the term Chinese Walls can be traced back to a phrase uttered by the US President Franklin Roosevelt to describe a particular Chinese wall of silence; see further Anthony Hilton, City Without a State: A Portrait of Britain’s Financial World (London, I.B.Tauris & Co. Ltd., 1987), p. 81. 66. See e.g., Norman S. Poser, ‘Chinese Wall or Emperor’s New Clothes? Regulating Conflicts of Interest of Securities Firms in the US and the UK’ (1988) 9 Mich. Y.B Int’l Legal Stud. 91; Roman Tomasic, ‘Chinese Walls, Legal Principle and Commercial Reality in Multiseverce Professional Firms’ (1991) 14(1) UNSW Law Journal 46; Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991), vol. VIII, pp. 3618–3630; William K.S. Wang & Marc I. Steinberg, Insider Trading (Aspen Publishers, 1996) §13.5.

Why Insider Trading is Widespread

75

US, for example, the 1984 Insider Trading Sanctions Act (ITSA) impliedly gave legislative support to the use of Chinese Walls, and then the 1988 Insider Trading and Securities Fraud Enforcement Act (ITSFEA) introduced procedures such as Chinese Walls as part of an anti-insider trading strategy.67 The ITSFEA expressly requires broker-dealers and investment advisors to establish, maintain, and enforce written policies and procedures reasonably designed to prevent insider trading abuses by their associated persons and employees.68 China has also endorsed the use of Chinese Walls in multi-service securities companies that have several divisions such as underwriting and trading divisions. Article 139 of the Securities Law provides that: Comprehensive securities companies shall conduct their brokerage business separately from business operated on their own account. The business persons and financial accounts for one type of business shall be kept separate from those for the other type. The same business persons may not operate both types of business and the same accountants may not keep the financial accounts for both types of business.69 Further, the CSRC has exercised its rulemaking power by requiring securities companies to use Chinese Walls to strengthen internal control and prevent certain violations of the securities law.70 In practice, multi-service securities companies have physically segregated their underwriting departments from other departments so as to control the flow of material non-public information which is likely obtained during the course of underwriting business. As discussed in Chapter 2, the problem of insider trading is an institutional one in China, and securities companies are quite often found to be associated with insider trading cases.71 Hence, Chinese Wall procedures in theory could play a very important role in preventing insider trading. However, there have long been serious doubts that the Chinese Wall system is reliable and effective in practice.72 There is little evidence that Chinese Walls are as effective in quarantining material information as their widespread use might suggest.73 Indeed, a number of US cases have illustrated the weakness of Chinese Walls.74 As one critic has stated:

67. 68. 69. 70. 71. 72. 73. 74.

See Poser, above note 65, 209–216. Securities and Exchange Act (US) §15(f), 15 U.S.C. §78o(f). Securities Law, Art. 139. Guanyu Jiaqiang Zhengquan Gongsi Yingyibu Neibu Kongzhi Ruogan Cuoshi de Yijian [Opinions on some Measures to Strengthen Internal Control of Securities Companies Business] (promulgated on 15 December 2003 by the CSRC). See above §2.III. See e.g., Poser, above note 66, 91; Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991), vol. VIII, pp. 3623–3631. Poser, above note 65, 227 (‘it seems surprising how little evidence there is that Chinese Walles are effective’). See e.g., Slade v. Shearson, Hammill & Co., 517 F.2d 398 (2d Cir. 1974); Securities Exchange Commission v. The First Boston Corp., Fed. Sec. L. Rep. (CCH) para. 92,712 at 93,465 (SDNY 1986).

Chapter 3

76

The existing evidence suggests that the Chinese Wall, despite its solid-sounding name, is not particularly difficult to penetrate . . . Doubts about the effectiveness of Chinese Walls are supported by common sense and knowledge of human nature. Because the Chinese Wall is essentially an exercise in self-discipline, its success ultimately must depend on the ethical values of the particular persons involved. Where the financial stakes are high and the temptations great (for example, where a principal or employee of a securities firm is in possession of confidential information concerning a pending takeover), the pressures on the ethical values of some persons are likely to be irresistible. 75 Unfortunately, this observation is particularly true of the Chinese Wall system in China. Indeed, compared to its Western counterparts, the Chinese Wall system in China is even more ineffective due to local conditions in China. The effectiveness of the Chinese Wall procedure depends, ultimately, on the people who erected them. In China where the level of ethics and professionalism in the securities industry is presently quite low, it is unrealistic to expect Chinese Walls to be effective. The intense pressure to make money and compete in the market can easily break down Chinese Walls. Further, as discussed above, there are problems with corporate governance within Chinese companies and thus corporate insiders can always get easy access to material, nonpublic information within a company. This situation is compounded by the problem that the requirements of the Chinese Wall system as set out by the CSRC are not sufficiently clear. Lastly, Chinese Walls do not change the reality that employees in the same firm meet frequently, nor do they eliminate the problem of informal contacts. Thus, if people are determined to commit insider trading, the Chinese Wall system can be easily crossed. This belief is confirmed by the empirical findings in this book. Interviews conducted for this book uncovered the unanimous view that the Chinese Wall system is superficial and ineffective. One securities practitioner said that ‘it is very easy to erect a Chinese Wall to satisfy the requirement of the CSRC, but it is totally cosmetic’.76 An investor stated that ‘the Chinese Wall system is just a joke, a self-deceiving idea’.77 One official from the CSRC conceded that ‘Chinese Walls may not be as effective as expected, but it is better than nothing. Nothing is perfect’.78 Another official from the CSRC stated that ‘it is true that the Chinese Wall is unsatisfactory at the moment. We are working to improve it by promulgating more detailed and stringent rules’.79

75. 76. 77. 78. 79.

Poser, above note 65, 227–228. Interview with one securities practitioner (Beijing 29 August 2003). Interview with one investor (Shanghai 10 October 2003). Interview with one official from the CSRC (Beijing 6 September 2003). Interview with one official from the CSRC (Beijing 9 September 2003).

Why Insider Trading is Widespread d.

77

Capricious Government Policies

As discussed before, the Chinese securities market is widely regarded as a policy market because government policies play an important role in regulating the market. Indeed, government policies affect share prices so significantly that investors have become acutely sensitive to them. In practice, government policies have been a rich source of inside information in China. These government policies are potentially exploited by corrupted officials and people who have good relationships with those officials. In practice, government policies are often leaked out prior to public disclosure. For example, on the evening of 19 February 2001, the CSRC revealed material information about opening the B-share market to domestic investors. However, trading records showed that there were already remarkable trading anomalies in the market from that morning. Even the CSRC itself suspected that the information had been leaked out before its announcement and thus suspended trading on that afternoon.80 This suggests that government policies may provide a large number of opportunities to commit insider trading. Government intervention in the market has long been common place in China. During the era of the planned economy, the government directly controlled and managed the national economy. This practice remained to a large degree even after China began transforming to a market economy. As discussed in Chapter 2, the stock market was established by the government under its economic reform policy with the primary function of raising funds for financially distressed state-owned enterprises.81 Ever since then, the government has painstakingly looked after the market in a paternalistic fashion. In essence, the Chinese stock market is the direct result of government policies, rather than a natural product of economic development as is the case in Western countries. Although moderate government intervention is desirable during the early stages of market development, the current level of government intervention in the market is clearly beyond what is necessary. This has harmed the healthy development of the market and impeded the growth of investors. Indeed, in the mind of many investors, the government takes full responsibility for market development. Investors always ignore the market risks and speculate heavily, assuming that the government will do something to help them out if they get in trouble. Thus, sometimes the government is forced to intervene to rescue the market. The following case well illustrates this point.82 In this case, Qiong Minyuan Joint Stock Company (‘Qiong Minyuan’), once considered as the biggest black horse in 1996 on the market, saw its share price

80. Shengyang Mei, ‘Who Leaked Information on the Opening of B-share Market’ Zhongguo Qingnianbao [China Youth Times] 21 February 2001, at 4. 81. See above §2.I.A. 82. Jiang Wen & Sheng Hai, ‘Shocking News about the Restructuring of Qiong Minyuan’ (2002) 8 Guoji Rongzi [International Finance] 34.

Chapter 3

78

skyrocket from CNY 2.00 in April 1996 to 26.18 in January 1997. In April 1998, the CSRC found that the chair and the CEO of Qiong Minyuan had committed misrepresentation and market manipulation.83 The company was suspended as a result of the investigation. Up to 100,000 investors were involved in this case, and trapped as a result of the suspension. These investors, regarded as innocent victims of the misrepresentation, exerted enormous pressure on the government to do something. In order to maintain social stability, the government eventually intervened to launch a restructuring program of Qiong Minyuan, whereby the aggrieved shareholders of Qiong Minyuan were relieved.84 Although the government’s intention to protect investors was worthy, the manner in which it set out to achieve this was very inappropriate. This case contrasted sharply with the Enron case where the US government just let the company go bankrupt and let shareholders bear the loss. As a general rule, investors should bear their own risks and be responsible for their own investment decisions. In China, the government’s paternalistic attitude to the market seriously hinders the maturity of its investors. Because of this, Chinese investors rely so heavily upon the government that they will never learn to make responsible investment decisions. Therefore, even though there is a need for government intervention, the level of government intervention is currently too high and needs to be changed. e.

Interpersonal Relationships

As discussed earlier, inter-personal relationships are particularly important in China. It is commonplace in China that people benefit from inter-personal relationships. Thus, it is relatively easy to get inside information from relatives and friends who have access to inside information by virtue of privileged positions in companies or in government agencies. This effectively reduces the operational costs of insider trading. 2.

High Success Rate

It seems that in the absence of prohibitions, insider trading is more profitable than other types of market misconduct, such as market manipulation and misrepresentation. Put differently, from an operational perspective, the market risk of insider trading is lower, so that it is easier and safer to make money through insider trading. For misrepresentation such as keeping false records of earnings, investors may question the statement, because it may look suspicious. As for market manipulation, some commentators have contended that market manipulation is self-deterring because the probability of successful manipulation is very low:

83. Ibid 34. 84. Ibid 35.

Why Insider Trading is Widespread

79

Profitable (successful) manipulations require two conditions: first, trading must cause the price of the relevant security to rise; and second, the manipulator must be able to sell at a price higher than the price at which the manipulator purchased (plus transactions costs incurred). . . .It is extremely difficult to satisfy both conditions simultaneously. In most cases, anonymous trades will have no effect on security prices, a violation of the first condition. To satisfy this condition, the manipulator will have to convince other traders that he has information about the value of the security they do not have, or he will have to expend huge amounts of capital. The consequence of this strategy, however, is that the price of the relevant security is likely to rise simultaneously with the trades but not to rise thereafter, a violation of the second condition.85 In contrast, insider trading can be more successfully carried out by simply trading before and after information disclosure. Take positive inside information as an example. Prior to public disclosure, insiders can purchase a quantity of shares, and then sell them at an increased price after information disclosure. Because the inside information, by definition, has a material effect on share prices, the increase in prices will be much greater than the transaction costs incurred, such as the capital outlay and commissions. In short, from a purely commercial point of view, insider trading has a higher chance of success and thus the costs of failure are lower. B.

LOW RISKS OF APPREHENSION

Of all the types of market misconduct, insider trading is the hardest to detect and prosecute. It has been argued that insider trading offences are crimes of opportunity and that breaches of such offences are very difficult to detect let alone to prove.86 Indeed, insider traders can often successfully get away with being caught because of the secret nature of insider trading and the attendant evidential difficulties. In contrast, exposure happens sooner or latter for misrepresentation; Once detected, it is easier to prosecute the suspect as the evidence of the previously disseminated misrepresentation is always readily available. As discussed previously, insider trading is considered to be very widespread in China but the number of detected insider trading cases has to date

85.

Daniel R. Fischel & David J. Ross, ‘Should the Law Prohibit “Manipulation” in Financial Market?’ (1991) 105 Harvard Law Review 503, 512–13; but see Steve Thel, ‘$850,000 in Six Minutes – The Mechanics of Securities Manipulation’ (1994) 79 Cornell Law Review 219 (specifically refuting the argument advanced by Professors Fischel and Ross by arguing that ‘manipulators can sometimes control prices with trades, and by doing so they can reap profits’). 86. Roman Tomasic and Brendan Pentony, ‘Crime and Opportunity in the Securities Markets: The Case of Insider Trading in Australia’ (1989) 7 Company and Securities Law Journal 186.

Chapter 3

80

been very small.87 The paucity of reported cases suggests that even though insider trading is not risk free, the risk of being caught is so low as to be worth taking. As one interviewee consulted for this study stated: the risks of detection and prosecution are actually few. As long as you exercise a little caution to cover your tracks, you will be quite safe. If there are no records or witnesses, then the chance of being caught is very low. Frankly, in the current situation, you do not need to seriously worry about the risk of apprehension.88 In practice, the low risk of detection and prosecution is mostly due to evidentiary problems. The costs and difficulties of proof have severely thwarted the efficacy of insider trading regulation. 1.

False Trading Names

Electronic surveillance systems over the market are the primary method used to detect insider trading. The stock exchanges have already put in place advanced surveillance systems over securities transactions. The CSRC also has its own market surveillance system. According to one official from the Shanghai Stock Exchange (SSE), in order to strengthen its front-line monitoring functions, the SSE has installed an automatic real-time computerized market trading monitoring system which is based on world-class modern technology; this surveillance system appears to have been effective in detecting technically abnormal trades.89 Further, traditional corporate insiders, such as directors, managers, supervisors and other senior officers are required to report any changes in the shareholdings of their own companies. Data is held on file with the Department of Listed Companies of Shanghai Stock Exchange which is specifically in charge of monitoring trading.90 However, the efficacy of the surveillance system has been severely undermined by trading tricks. After detecting abnormal trades, the SSE and the CSRC still face the difficult task of identifying real traders behind the trades. Those who are determined to commit insider trading often go to great lengths to avoid being caught by trading in other people’s names or even false names. This trading trick has long been widely used in China where investors can open securities accounts by using other people’s identification cards. For example, a story provided anecdotally says that an instance of market manipulation was found to be connected with a deceased peasant in a remote rural region whose ID card was previously lent to someone in exchange for money. The use of this trading trick also occurred

87. See above §2.III. 88. Interview with a securities practitioner (Guangzhou 20 October 2003). 89. Interview with an official of the Shanghai Stock Exchange (Shanghai 27 September 2003). 90. The Listing Rules of the Shanghai Stock Exchange, section 3.5.1.

Why Insider Trading is Widespread

81

in the publicized insider trading cases, such as the Zhangjiajie Tourism Development Co Ltd case and the China Qingqi Group Co Ltd case.91 By using multiple accounts to trade, insiders can trade a small number of shares in each account with the aggregate being large enough to make substantial profits. This effectively reduces the impact of an insider’s trade on the market and avoids triggering the alarm of surveillance systems. Moreover, even if the alarm is triggered, it is hard for regulators to identify those traders who are really responsible. Because regulators may only know the accounts used to commit insider trading and have no idea who actually used the accounts, the risk of apprehension decreases to a significant degree. 2.

Lack of Informers

Another important weapon in fighting insider trading is reliable informers. As discussed above, the effectiveness of the surveillance system has been reduced, and more importantly, surveillance is a very costly business. Indeed, detecting insider trading through surveillance is somewhat like trying to find a needle in a haystack. Even if the surveillance system does detect some suspicious trades, the CSRC still needs to devote a lot of resources to further corroborate these findings and might end up finding that none of the trades were insider trades. According to one official from the CSRC, the SSE refers 30 to 50 suspected insider trading cases to the CSRC for further investigation every year and based on this, the CSRC launches about 15 formal investigations; the percentage of substantiated insider trading cases is very low and most investigative efforts are in vain.92 Over time, this could waste a lot of already limited resources. However, if someone comes forward with first-hand information about insider trading, then the CSRC can act on this straight away and put together resources to investigate it. In this case, the CSRC would be more likely to achieve a result with certain resources because the said information is always more specific and targeted than abnormal price movements. Thus, with help from informers, regulators can more effectively detect insider trading, increasing insider traders’ risk of apprehension. Yet, in practice, this weapon has not been efficiently used by the CSRC to detect insider trading. In the course of the interviews conducted for this book, one CRSC official remarked that the vast majority of clues to insider trading cases come from surveillance, and a very small number of informers have come forward to date.93 This situation could be due to the following reasons.

91. For a more detailed description of these two cases, see above §2.III.A.1. 92. Interview with one official of the CSRC (Beijing, 6 September 2003). In the period of four years from 2000 to 2004, the CSRC did not find a single insider trading case. See above §2.III (suggesting that the last reported insider trading case dealt with by the CSRC was in 1999). 93. Interview with one official of the CSRC (Beijing, 3 September 2003).

82

Chapter 3

Firstly, as discussed in Chapter 2, there is a high degree of social tolerance for insider trading in China. If one possesses price-sensitive information, they will quite likely trade on it rather than disclose the person who gave them the information. In addition, brokers who are aware of the incidence of insider trading are always reluctant to be informers or witnesses for fear of losing clients. Secondly, investors have difficulty knowing whether they are harmed by insider trading and thus will not come forward to complain about it. This is largely due to the absence of private civil liability for insider trading in China. As will be discussed, the Securities Law has failed to set out functional provisions in regard to private civil liability for insider trading, resulting in civil remedies for insider trading being unavailable in practice.94 This creates a disincentive for people to come forward with clues to insider trading cases. Moreover, it has been argued that nobody is harmed by insider trading.95 Thus, people are not sure whether they are victims of insider trading, and have little incentives, both financially and morally, to serve the function of providing private enforcement against insider trading. Finally and perhaps most importantly, the incentive for people to inform is weak. In the US, informers are rewarded if their information leads to the detection of insider trading cases.96 In China, although the Provisional Measures for the Prohibition of Securities Fraud provides for the awarding of bounties to informants,97 there are few cases where informers have received bounties. On the contrary, the CSRC has sometimes failed to obey the basic principles of privacy and confidentiality in protecting informers. The case of Lukang Yiyao is an example of this. This case involved two corporate insiders who were suspected of informing the CSRC of their own corporation’s misconduct. On 12 December 2002, these two insiders, Mr. Wu and Mr. Ai, went personally to the CSRC to reveal that their company, Lukang Yiyao Co Ltd, had presented false accounting materials to justify issuing new shares. These two informers brought a lot of evidence, including up to 200 pages of detailed authentic accounting data, to prove the misrepresentation of their company. Further, in order to show their great resolution and good faith in their behavior, they even left their identification cards and passports with the CSRC and signed their names to guarantee the truth of their allegation. In response, the CSRC suspended the issuance of new shares of Lukang Yiyao Co Ltd and began investigating the issue. However, not long after this event, on 15 January 2003, Mr. Wu was interrogated by the procuratorate of the local region where he and his company were located, and later confined by the disciplinary committee of the company to a hotel. Finally, he was put in the custody of the procuratorate, charged with corruption and embezzlement and later

94. See below §7.II. 95. For a detailed discussion of this argument, see below §7.IV.B. 96. Securities Exchange Act of 1934 (US), s 21A(e). 97. Provisional Measures, Art. 27.

Why Insider Trading is Widespread

83

bailed out by his wife. However, the case against Mr. Wu has been suspended due to lack of evidence. The other informer, Mr. Ai, has also received many anonymous threatening calls, warning him not to do stupid things. As a result, he has had to change residence frequently for fear of being assaulted.98 It is widely suspected that Mr. Wu was framed because the chair of the company knew that he was the informer from information about the informers’ identities being leaked out from the CSRC.99 Mr. Ai reportedly wanted to sue the CSRC for leaking this information, but no lawyers have dared to represent him.100 This case has been widely thought of as a great embarrassment to the CSRC.101 Many interviewees consulted for this study, including one CSRC official, stated that the CSRC performed notoriously in this case and that people would be reluctant to come forward to be informers in the future as a result of this case. 3.

Evidentiary Obstacles

Even if regulators detect clues, such as abnormal price movements or information provided by informants, they still face formidable difficulties in further investigating and substantiating these clues. Regulators need to link suspicious market movements with insider trading. Establishing this link is extremely time-consuming and difficult due to evidentiary problems. In order to establish the existence of insider trading, regulators must prove many tricky points, such as, whether the information was in fact price sensitive, whether the insiders knew the nature of the information and actually used the information to trade.102 Insider trading is inherently a secret form of abuse of information where only circumstantial evidence is normally available.103 It is very easy for people to find plausible excuses to rationalize their trade and deny that they were motivated to trade as a result of having price-sensitive information. Moreover, this problem is exacerbated by the reluctance of people, especially securities professionals, to lend support in substantiation or to act as witnesses. One official from the CSRC reported that ‘it is often very difficult to find witnesses when collecting evidence because business people won’t rat on each other’.104

98. Qihua Li, ‘Informers Went to the CSRC with Their Real Identities’ Caijing shibao [China Business Post] 15 February 2003, at 3. 99. Ibid. 100. Zhong Wei, ‘The Lukang Yiyao Case is not Over and Informers Want to Sue the CSRC’, Jingji Guancha Bao [Economy Watch News] 10 March 2003 at 2. 101. ‘Lukang Yiyao is Suspected of Falsifying Accounting Data, and One Informer is Sent to Jail’ Zhongguo Qingnian Bao [China Youth News] 21 February 2003 at 4. 102. For detailed analysis of these issues, see below §6.V. 103. See below §6.V.B.3. 104. Interview with one official from the CSRC (Beijing 3 September 2003).

Chapter 3

84

4.

The Ineffectiveness of the CSRC

In the face of widespread insider trading, the paucity of publicized cases and low rates of conviction for insider trading cases suggest that insider trading law has been inadequately enforced by the CSRC. In interviews conducted for this book, the CSRC has a reputation of not fulfilling its functions and more vigorous regulation was demanded. While many interviewees strongly criticized the ineffectiveness of the agency, it was generally agreed that the CSRC is hampered by a lack of resources, including funding, staffing and more importantly, regulatory power and independence. Indeed, a lack of resources is a major constraint on the CSRC. On the surface, compared to other government agencies of the same rank, the CSRC enjoys more resources in terms of funding and staffing. CSRC officials generally receive higher salaries than their counterparts in other departments. There is intense competition for positions in the CSRC, and the CSRC has many staff with higher degrees105 and even overseas educations and experience. For example, the former executive deputy chairman of the CSRC was a prominent professional who was educated in the US and had work experience on Wall Street; one of the former deputy chairmen of the CSRC previously served as a deputy chairman of the Securities and Futures Commission of Hong Kong (‘SFCHK’); the former chief advisor of the CSRC was the former chairman of the SFCHK. However, the CSRC still has real problems in the area of funding and staffing. Resource constraints are a universal problem faced by regulatory bodies worldwide, including the US’s Securities and Exchange Commission (‘SEC’)106 and the Australian Securities and Investments Commission (‘ASIC’). However, this problem is particularly severe for the CSRC. For example, in Australia where the total population is about 20 million, the ASIC received an appropriation of AUD 162.8 million in 2002–03 fiscal year and employed 1,396 full time equivalent staff during that period.107 In contrast, by the end of December 2002, there were about 68 million investors in China,108 while there were only about 1,465 CSRC staff.109

105. Up to 40% of the CSRC staff holds masters or PhDs. Email from Ruiming Guo, the Second Enforcement Bureau, China Securities Regulatory Commission, to this author, 17 May 2004. 106. Donald C. Langevoort, Insider Trading: Regulation, Enforcement, and Prevention (West Group) (looseleaf) §1.04, pp. 1–24. 107. See Australian Securities and Investments Commission, 2002/03 Annual Report, available at http://www.asic.gov.au/asic/asic.nsf/byheadline/Annual+reports?opendocument (visited on 20 June 2004). 108. China Securities Regulatory Commission, Zhongguo Zhengquan Qihuo Tongji Nianjian [China Securities and Futures Statistical Yearbook] (Beijing, Baijia Publishing House, 2003), p. 286. 109. Email from Ruiming Guo, the Second Enforcement Bureau, China Securities Regulatory Commission, to this author, 17 May 2004.

Why Insider Trading is Widespread

85

The CSRC also has difficulties in retaining good staff. In practice, the CSRC seems to have served as a training ground for the private sector. According to one official from the CSRC, many people just want to gain work experience or establish good personal relationships within the agency to help their future careers in the private sector.110 Additionally, it has been pointed out that compared to Western countries China’s real-time monitoring technique is under-developed and ineffective.111 Furthermore, it seems that insider trading has been given a low priority on the agenda of the CSRC. The first reason for this is the pressure from other more urgent tasks. There are many kinds of misconduct occurring on the market, and some, such as market manipulation and misrepresentation, are thought to be more serious and harmful than insider trading.112 Secondly, insider trading regulation is highly resource-sensitive. There is a huge disincentive facing the CSRC in investigating insider trading because insider trading cases require a lot of work in detection and evidence-gathering, and the end results may be disappointing due to evidentiary problems. Thus, the CSRC understandably chooses to deploy its limited resources in areas where there are more tangible results, leaving the task of regulating insider trading even more under-resourced. The regulatory power of the CSRC is also said to be inadequate, particularly its power to investigate and collect evidence. Before the very recent amendment in 2005, Articles 167 and 168 of the Securities Law granted regulatory and investigatory powers to the CSRC for the enforcement of the law.113 However, the CSRC’s powers seemed to be quite limited in practice. This problem was expressed by the chief advisor of the CSRC who was the former president of the SFCHK: The investigatory power of the SFCHK is much bigger than that of the CSRC. For example, the SFCHK can apply to courts for search warrants with which the SFCHK is able to search suspects or check their bank accounts. In contrast, the CSRC has very limited power in this aspect, which has severely affected its regulatory efficiency.114 Although Article 168 of the old Securities Law also provided that the CSRC could apply to courts to examine and freeze the fund accounts and securities accounts of those suspects under investigation if necessary,115 this mechanism was proven far

110. Interview with one official of the CSRC (Beijing, 6 September 2003). 111. Jia He et al., ‘Disclosure of Material Information and Anomalous Price Change on China’s Stock Market’ Zhengquan Shibao [Securities Times] 27 May 2002. 112. See above §2.III.B.2. 113. Securities Law, Arts. 167, 168 (before the 2005 revision). 114. China Central Television, ‘The Bottom Line of the Securities Regulation’, Talk [Duihua], 17 February 2001 at 19 February 2001. 115. Securities Law, Art. 168(4) (before the 2005 revision). The 2005 revision has sought to address this problem by giving the CSRC more powers. Now, under Article 180, the successor to the old Article 168, the CSRC can itself decide to preserve or freeze properties, if it has evidence that the property is in jeopardy of dissipation, waste or improper removal. It remains to be seen how the CSRC will use this power.

86

Chapter 3

from effective in practice. Several officials from the CSRC consulted for this book pointed out this problem, stressing the need for more regulatory power. According to these interviewees, the courts always fail to efficiently respond to the application of the CSRC for freezing or seizing suspicious accounts, in which case it is very difficult to collect evidence if suspects refuse to cooperate. This is largely due to: (1) Localism – the courts at local levels are generally amenable to local governments who often protect their listed companies from the CSRC; (2) endemic judiciary corruption; and (3) red tape and bureaucracy. The most serious problem is perhaps that the CSRC lacks regulatory independence. As a subsidiary branch of the government, the CSRC is directly controlled by the government.116 In the Securities Law, the CSRC is referred to as ‘the securities regulatory authority under the State Council’.117 In contrast, its Western counterparts such as the SEC in the US, the FSA in the UK and the ASIC in Australia, are independent of their respective governments to ensure enforcement efficacy. It goes without saying in developed securities markets that a securities regulatory body should be structured independently to enable it to effectively carry out its regulatory role. Hence, the Chinese government has a dual role in the market. On the one hand, because state-owned shares make up about two thirds of all shares on the market, the government has enormous direct interests in listed companies where it is the largest shareholder. On the other hand, the government has the responsibility to regulate the market and protect investors. This is clearly a conflict-of-interest situation, just as one acts as both a player and the referee in a football game. Thus, it is very hard for the government to behave properly when, as is often the case in practice, there is a conflict of interest between the two roles. If listed companies behave unlawfully to make money and the government, as the largest shareholder, gains a benefit, the interested government agencies will seek to cover it up and exert enormous political pressure on the CSRC to withdraw from investigations. Likewise, because listed companies generate tax revenue and provide employment for local governments, local governments often harbor their culpable companies. In practice, in order to get more companies listed, local governments will even assist companies to falsify business records to meet listing requirements. For example, the Hainan Provincial Securities Office was found to have intentionally tampered with the accounting records of Luoniushan Co Ltd, a company based in Hainan, in order to get it listed.118 The lack of regulatory independence is also reflected in the inconsistency of the regulatory standard. It has been observed that the regulatory standard varies according to the current market situation. More specifically, when the market is bullish, the CSRC is inclined to tighten the regulation; when the market is bearish,

116.

For detailed discussion of the institutional structure of the CSRC, see above §2.I.C (stating that the CSRC is under the direct leadership of the government). 117. Securities Law, Art. 7. 118. 42 ZhengJian Cha Zi [CSRC Official Bulletin] (26 May 1998).

Why Insider Trading is Widespread

87

the CSRC is prepared to loosen the regulation. For example, in 1997, since the market was considered dangerously overheated, the CSRC strengthened its regulation, announcing 1997 as ‘a regulation year’, and produced a record number of securities cases; in 2002 when the market was sluggish, the CSRC relaxed its regulation, resulting in a smaller number of securities cases being reported that year. This regulatory pattern, sometimes called ‘a regulatory art’ (Jianguan Yishu), is intended to adjust the pace of market development, but nevertheless destroys the seriousness of securities laws and leads to an inequality in law enforcement.119 One major reason behind this is that the government has been focusing on the fundraising function of the market.120 The government plans the development of the market and uses it to accomplish its policy goals, notably relieving the financial distress of state-owned enterprises. Indeed, the government has tight control over how much money shall be raised and how many new companies shall be listed each year. In order to achieve this goal, the CSRC has to vary its levels of regulation to adjust the development of the market. Thus, the regulation of the second market is designed to meet the fundraising needs of the primary market rather than the need for shareholder protection. As a result, misconduct is not effectively dealt with in a consistent manner. C.

THE LOW COSTS OF PENALTIES

1.

Light Legal Liability

The ultimate cost of insider trading comes from the legal liability imposed on perpetrators once they are caught. In China, there are generally three types of legal liability, namely administrative liability, civil liability and criminal liability. As a practical matter, only administrative and criminal liabilities are available to deter insider trading at the moment. According to Article 202 of the Securities Law, in the case of insider trading, [insider trader] shall be ordered to dispose of the illegally obtained securities according to law, his illegal gains shall be confiscated and, in addition, he shall be imposed a fine of not less than the amount of but not more than five times the illegal gains, or a fine of not more than the value of the securities illegally purchased or sold . . .121

119. The chief adviser of the CSRC has expressed his concern about this problem. See China Central Television, ‘The Bottom Line of the Securities Regulation’, Talk[Duihua], 17 February 2001 at 19 February 2001. 120. For more analysis on the fundraising function of the Chinese securities market, see above §2.I.B. 121. Securities Law, Art. 202.

88

Chapter 3

Article 231 provides that if the contravention of the Securities Law is serious enough to constitute a crime, criminal liability shall be pursued.122 This, of course, applies to insider trading provisions. Criminal liability for insider trading is set out in detail in Article 180 of the Criminal Law which states: [insider traders] shall be sentenced to not more than five years in prison or criminal detention, provided the circumstances are serious. They shall be fined, additionally or exclusively, a sum not less than 100 percent and not more than 500 percent as high as their illegal proceeds. If the circumstances are especially serious, they shall be sentenced to not less than five years and not more than 10 years in prison. In addition, they shall be fined a sum not less than 100 percent and not more than 500 percent as high as their illegal proceeds. 123 Under the Securities Law, nothing has been said about private civil liability for insider trading except a simple provision which provides for private civil liability in very general terms. Article 76(3) of the Securities Law reads: Where insider trading activities cause losses to investors, the insider shall be subject to the liabilities of compensation in accordance with the law.124 However, the Securities Law does not devote any specific provisions to civil damages payable to the aggrieved party by a person who has engaged in insider trading. No provisions in the Securities Law expressly address the issues concerning civil remedies, such as the standing of the plaintiff and measurement of damages, rendering private civil liability virtually unavailable in practice and thus making Article 76(3) illusory. Indeed, a private right of action against insider trading could arise from contract or tort law. However, due to the impersonality and anonymity of exchange transactions, it is extremely difficult, if not impossible, in terms of causation and reliance, to assert insiders’ liability on those conventional grounds.125 In practice, legal liability for insider trading does not appear to act as effective deterrent because the costs it brings to insiders are far too low. The courts in China still refuse to hear any private civil insider trading cases, because there are no operative provisions on this issue. Even though criminal liability has been available to combat insider trading since 1997 when the Criminal Law was amended, they were not employed until 2003.126 Since the stigma of crime has very strong effect in Chinese society, the criminal law is normally invoked as a last resort. However, it seems that the criminal law is currently under utilized in China. Thus, in the arsenal of China’s securities law, administrative liabilities, including warnings, confiscation of illegal gains and fines, have been the main 122. 123. 124. 125. 126.

Ibid Art. 231. Criminal Law, Art. 180. Securities Law, Art. 76(3). For detailed discussion of private civil liability for insider trading, see below Chapter 7. The first criminal insider trading case was the Shenshen Fang case in March 2003. See above §2.III.A.2.

Why Insider Trading is Widespread

89

weapon used to combat insider trading. As discussed in Chapter 2, nine of the eleven reported insider trading cases applied administrative liabilities, while only two recent cases imposed criminal liabilities. The administrative liabilities imposed were thought to have been too light.127 Furthermore, in general, there is a judicial predisposition to lighter sentences for white-collar crimes such as securities violations. The prosecutor in a famous market manipulation case, the Qiong Minyuan case,128 said that this case was the biggest case she had ever handled in terms of the amount of money involved, yet only a very light punishment was imposed.129 This situation further reduces the deterrent effect of criminal liability which is considered to be a particularly powerful weapon to combat insider trading. Indeed, criminal liabilities to date have been rarely used or if they have, they have been used too leniently in China in the war against insider trading. One empirical study has shown in the case of one emerging market that the existence of insider trading laws without their enforcement – as proxied by prosecutions – does not deter insiders.130 Thus, the inadequacy of the imposition of criminal liability in practice seems to be an important contributing factor to the high incidence of insider trading in China. 2.

Low Levels of Damages to Reputation

In China, having a legal liability is generally viewed as a social disgrace. In a sense, the stigma and humiliation associated with legal liability have a greater deterrent effect than the liability itself. This is particularly so in China where reputation is very highly valued as part of the traditional system of Confucianism.131 For example, Confucius said that ‘Junzi Ji Moshi Er Min Bu Chen Yan (Noble people are and should be deeply concerned with their fames)’. However, less damage is done to the reputation of insider traders with legal liabilities and as a result they suffer less anguish for their misdeeds. A number of reasons can be offered to account for this. Firstly, insider trading is a type of white-collar crime which is viewed not as bad violent crimes such as murder and arson, and thus less repugnant to people. Violent crimes are usually simple and clear, and the harm can be easily understood and directly felt. In contrast, white-collar crime is often very complicated and 127. 128. 129. 130. 131.

See above §2.III.C.3 (observing that light punishment is a noticeable feature of insider trading cases in China). For a detailed account of this case, see above §2.III.C.5. See the website of the Second Branch of People’s Procuratorate of Beijing Municipality http://www.bjjc2.jcy.gov.cn/news/20030720/020220030720139.html (last visited 16 February 2004). Utpal Bhattacharya et al., ‘When an Event is not an Event: The Curious Case of an Emerging Market’ (2000) 55 Journal of Financial Economics 69. See section 15(20) of Lun Yu [The Saying of Confucius], at Yujin Xia et al (eds), Sishu Wu jing Zhujie Xiandaiban [Annotated Confucian Classics in Modern Chinese] (Beijing, Xinchao Press, 1998), p. 220; also available at http://www.cnd.org/Classics /Philosophers/Kong_Zi/ Kong_Zi-TOC.hz8.html (last visited on 16 February 2004).

90

Chapter 3

carried out by people with knowledge and high social status. Furthermore, the harm caused by white-collar crime is not as easily felt by the general public. As a result, violent crimes are more easily judged than white collar crime. This is especially so in the case of insider trading. Insider trading is by definition committed in secret and therefore much harder to detect. Further, the harm generated by insider trading is much less easily felt as it is normally carried out on an impersonal market making it harder to identify specific victims.132 Victims of insider trading are often unaware that they have been the victims of insider trading. This situation has been compounded by those arguments that inside trading is victimless, and that it even has beneficial effects.133 In short, because people do not feel the impact of insider trading, they are less repulsed by it. Secondly, insider trading is currently so widespread in China that it has been socially accepted to a certain degree. There are many people who are attracted to insider trading because they can make a lot of money from it and have no shame in asking others for inside information. Market professionals for example as a group are very accepting of insider trading. Indeed, people do not object morally to conduct which they themselves are also doing or want to do. Thus, even if somebody is caught committing insider trading, people do not despise them in the same way they despise violent criminals. They may even be sympathetic to their bad luck. In turn, a person convicted of insider trading will not experience the same level of disgrace and humiliation. Rather, they might even question why they were so unlucky. For example, in the Qiong Minyuan case, Ma Yuhe, the defendant, showed little remorse, stating that ‘everybody is doing what I did, why only catch me?’134 Moreover, because inside information is often accessible only to people who hold privileged positions in society, holding such positions and thus having access to inside information have become a token of a person’s capability and the embodiment of social status. As a matter of fact, in China, people feel proud of having privileged access to inside information and being able to take advantage of it. This phenomenon is deeply embedded in the Chinese social culture where abuses of power are widespread and accepted. Consequently, people have adapted to this type of behavior. Thirdly, because the act of insider trading does little damage to a person’s reputation, this is accentuated in cases where entities commit insider trading. In such situations, individuals may feel less guilty because the profits of insider trading appear to go to these entities rather than their own personal pockets. In the Qiong Minyuan case, the defendant argued that he committed misconduct for the benefits of the company he worked for, not for his own personal benefits. He stated that ‘what I did was in the interests of the shareholders . . . I am not guilty’.135 Indeed, the defendant was well respected by other company employees and praised as 132. For more discussion of this issue, see below §7.IV. 133. For a detailed analysis of these arguments, see below §4.I.A. 134. See the website of the Second Branch of the People’s Procuratorate of Beijing Municipality http://www.bjjc2.jcy.gov.cn/news/20030720/020220030720139.html (last visited 16 February 2004). 135. Ibid.

Why Insider Trading is Widespread

91

‘a hardworking, capable and responsible entrepreneur’, because the company’s performance was enhanced under his leadership.136 Thus, individuals who carry out insider trading in the name of their entities suffer far less moral condemnation from society, even though they may have personally benefited in some way. 3.

Low Risk of Career Damage

The risk of damaging one’s career is generally a very powerful disincentive to market professionals. Career damage involves either direct damage such as the temporary suspension and permanent revocation of licenses. Or it involves indirect damage such as the impact of legal sanctions on one’s career in the future. However, in China, both direct and indirect damages to career present a low risk or cost to insider traders. In Western countries, career-related sanctions such as license suspension and revocation are viewed as very severe and they are used only after criminal prosecution fails to secure compliance.137 However, in China, even though the CSRC has the power to impose license revocation or suspension,138 the direct deterrent effects of these sanctions have been very limited in practice to date for the reasons set out below. Firstly, these kinds of sanctions, particularly license revocation, are rarely used in China. Because the withdrawal or suspension of a license has severe consequences, it is viewed as being ‘politically impossible and morally unacceptable to use it with any but the most extraordinary offenses’.139 Even in the case that license suspension is imposed, the suspension term is often quite short and thus cannot effectively punish violators. For instance, none of the eleven reported insider trading cases in China to date have involved license revocation and only three have imposed license suspension.140 Even in the Zhangjiajie Tourism Development Co Ltd case where a large profit of USD 1.3 million was made, the term of license suspension was only one month. Secondly and more importantly, the consequences of license revocation or suspension are far less harsh in China than in Western countries, due to the weakness of the labor market. In China, people can manage to stay in the securities industry even without a license and thus are not very concerned about losing their licenses. As one interviewee said, Revoking or suspending licenses does not play much of a deterrence role because those who are punished may use other people’s names to continue 136. An Gang, ‘Report on the Trial of the Case of Qiong Minyuan’, Shenhuo Shibao [Life Times] 13 November 1998. 137. Ian Ayres & John Braithwaite, Responsive Regulation (New York, Oxford University Press, 1992), p.35. 138. The CSRC has the power to bar a person who has violated the securities laws from the securities industry. Zhengquan Shichang Jinru Zanxing Guiding [Provisional Rules on Barring Violators from the Securities Industry] (promulgated on 3 March 1997 by the CSRC). 139. Ayres & Braithwaite, above note 137, 35–36. 140. See above §2.III.A.

92

Chapter 3 their work during the period of punishment. Put differently, even if they are prohibited from openly working in the industry, they can secretly work. For example, they may work with another licensed practitioner who can publicly and lawfully sign relevant documents and share the profits. It is hard to detect and stop such strategies.141

Further, the indirect damage of legal sanctions to one’s future career is also very weak. When the suspension term is over, legal punishment has little impact on the future careers of those who are punished. In mature market economies, such as the US economy, professional norms are enforced by threats to the reputations of directors, not by the threat of legal liability.142 In a competitive labor market, professionals who are known to have engaged in dishonest conduct will not only lose their jobs, but also have difficulty competing for new jobs in the future.143 In contrast, in China, damage to professional reputations is generally small for the following reasons. Firstly, the manager market is far from competitive in China and the punishment imposed by the CSRC is not able to effectively affect the future careers of those managers who misbehave. In China, the most important quality for a manager is their ability to make money. Their past or criminal record is irrelevant. The following example, which is not unusual in China, illustrates the little impact legal punishment has on a person’s career.144 In June 2002, in order to rescue the financially troubled Nanfang Securities Co Ltd which was based in Shenzhen and controlled by the Shenzhen municipal government, the Shenzhen government appointed Kan Zhidong and He Yun to be the president and the chairman of the company respectively. A common feature of these two people was that they were both famous for their capability to make profits, and both infamous for having been punished by the CSRC for serious market misconduct. More specifically, Kan Zhidong, once the founder and president of another big securities company, was punished by the CSRC in 1997 for market manipulation. He Yun, once the president of a major bank, was excluded by the CSRC in 1997 from the securities industry for five years, due to his unlawful market activities. Their appointments were widely considered as good news for Nanfang Securities Co Ltd, and the two once disgraced men were warmly welcomed by the company.

141. Interview with one official of the CSRC (Beijing, 3 September 2003). 142. Michael Klausner, ‘The Limits of Corporate Law Reform’ (Paper presented at the 21st Century Commercial Law Forum: Corporate Law Reform for a Global Competitive Economy, Beijing, 14–15 September 2002). 143. In law and economics literature, the reputation is central to the market force mechanism, providing a key incentive for corporate directors to behave properly and responsibly. See generally, Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law (Cambridge, Harvard University Press, 1991). 144. ‘Kan Zhidong and He Yun Become the New Leaders of Nanfang Securities Company’ Beijing Chengbao [Beijing Morning], 27 June 2002, at 5; see also ‘Kan Zhidong Talk about Nanfang Securities Company’ Zhengquan Shichang Zhoukan [Securities Market Weekly] 15 December 2003, at 23.

Why Insider Trading is Widespread

93

The second reason is that the role the government plays in the market decreases the deterrence effect of damage to one’s career. In China, the careers of managers seem to depend more on their relationships with relevant government agencies than sheer corporate performance. In practice, it is not uncommon for managers who have mismanaged their companies to be reappointed by government agencies to serve in another enterprise.145 Sometimes, companies behave unlawfully even under the acquiescence of relevant local governments who have an interest in the misconduct. In practice, local governments are always prepared to protect their companies if they get caught. One interviewee for this book relayed the story of the president of one famous Shanghai-based securities company. This president was transferred to another government position after it was discovered that he had committed market misconduct in order to stimulate trading in the Shanghai Stock Exchange in accordance with the directive of the Shanghai government. Further, he did not receive any legal punishment.146 §3.IV.

CONCLUSION

This chapter looked at why insider trading is so widespread in China. A cost-benefit analysis was conducted to examine those incentives to commit insider trading. It has been shown that insider trading can bring enormous monetary and non-monetary benefits while the costs, including operational costs, risks of being caught and costs of punishment after being caught, are quite low. Although it is very hard to quantify the benefits and costs, it seems safe to say that the benefits of insider trading far exceed its costs.147 This may explain why insider trading is so widely committed in China. This finding has significant implications for the regulation of insider trading in China. It suggests that the most effective way of regulating insider trading is to increase the costs of insider trading and reduce its benefits. Indeed, if the costs of insider trading start to equal its benefits, the incentive to commit insider trading will be effectively removed. Under this premise, the following chapters will discuss in detail the issue of how to improve the efficacy of the insider trading regulation in China.148

145. Shixin Cui, ‘Do not Put the Fate of an Enterprise into One Person’s Hand’, Renmin Ribao [People’s Daily], April 21 1998, at 11. 146. Interview with one financial journalist (Shanghai 26 September 2003). 147. One Hong Kong commentator has said that the law-breaking cost of misconduct is far too low in China and this largely contributes to the high incidence of misconduct on the market. See Huang Na, ‘Lang Xianpin: costless misconduct means hopeless future’ available at http://news1.jrj.com.cn/news/2002-10-09/000000419248.html (last visited on 14 May 2004). 148. See below Chapters 5–8.

Chapter 4

Effects of Insider Trading: Harmful or Beneficial

§4.I.

INTRODUCTION

After discussing the high incidence of insider trading in China and the reasons behind it, this chapter will deal with the basic question of whether to forbid insider trading. This question is essentially based on the potential effects of insider trading. Since Professor Manne published his groundbreaking book in 1966,1 there has seen a longstanding policy debate on this issue and many distinguished scholars, mostly in the US, have taken part in this debate from such various standpoints as economics, morality and even feminism.2 Although this debate is mainly about the desirability of regulating insider trading, it is also of particular significance to 1. Henry G. Manne, Insider Trading and the Stock Market (New York, the Free Press, 1966). 2. The literature in this field is simply too voluminous to cite in its entirety. For works discussing insider trading from an economic perspective, see e.g., Frank H. Easterbrook, ‘Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information’ (1981) 1981 Sup. Ct. Rev. 309; Dennis W. Calton and Daniel R. Fischel, ‘The Regulation of Insider Trading’ (1983) 35 Stanford Law Review 857; Jonathan R. Macey, ‘Insider Trading: Economics, Politics, and Policy’ (The AEI Press, 1991); David D. Haddock and Jonathan R. Macey, ‘A Coasian Model of Insider Trading’ (1986) 80 Nw. U. L. Rev. 1449; Stephen Bainbridge, ‘The Insider Trading Prohibition: A Legal and Economic Enigma’ (1986) 38 U. Fla. L. Rev. 35; Morris Mendelson, ‘The Economics of Insider Trading Reconsidered’ (1969) 117 U. Pa. L. Rev. 470; Victor Brudney, ‘Insiders, Outsiders, and Informational Advantages Under the Federal Securities Law’ (1979) 93 Harv. L. Rev. 322; Robert J. Haft, ‘The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation’ (1982) 80 Mich. L. Rev. 1051; James D. Cox, ‘Insider Trading and Contracting: A critical Response to the “Chicago School’’ (1986) 1986 Duke L. J. 628; Richard J. Morgan, ‘Insider Trading and the Infringement of Property Rights’ (1987) 48 Ohio St. L.J. 79. For those emphasizing the ethical concerns of insider trading, see e.g., Harry

Chapter 4

96

the further question of how to regulate insider trading, because it would help to define the appropriate scope of a proscription on trading whilst in possession of material non-public information.3 This chapter is comprised of two parts. In the first part, the theoretical arguments on the effects of insider trading will be examined. More specifically, this part examines the alleged beneficial as well as detrimental effects of insider trading. This theoretical debate has not yet been conclusive with the contending arguments being described as speculative, which suggests that empirical work is needed for the debate. Indeed, when talking about the effects of insider trading and thus whether to prohibit it, one should consult those people who are closely connected with the market. After all, their views on the issue are decisive of how they make investment decisions and how the market should be. The second part therefore contains empirical findings on what the Chinese people think about insider trading, in order to assess the regulatory and social conditions under which China’s insider trading law is enacted and enforced. As discussed in the first part, while the theoretical debate on the effects of insider trading is far from settled, the general view is that the arguments on the harmful effects of insider trading carry more weight. The empirical findings demonstrate that this general view is widely shared by Chinese people, which may provide a supportive environment for prohibiting insider trading in China. §4.II.

ARGUMENTS AS TO THE EFFECTS OF INSIDER TRADING

A.

THE BENEFICIAL EFFECTS OF INSIDER TRADING

1.

Compensation to Corporate Executives

One of the most powerful arguments about the beneficial effects of insider trading is that profits from insider trading are appropriate compensation for corporate Heller, ‘Chiarella, SEC Rule 14e-3 and Dirks: “Fairness” Versus Economic Theory’ (1982) 37 Bus. Law. 517; Gary Lawson, ‘The Ethics of Insider Trading’ (1988) 11 Harv. J.L. & Pub. Pol’y 727; Steven R. Salbu, ‘The Misappropriation Theory of Insider Trading: A Legal, Economic, and Ethical Analysis’ (1992) 15 Harv. J.L. & Pub. Pol’y 223; Kim Lane Scheppele, “It’s Just Not Right”: The Ethics of Insider Trading’ (1993) 56 Law & Contemp. Probs. 123; Ian B. Lee, ‘Fairness and insider trading’ (2002) 2002 Columbia Business Law Review 119; Alan Strudler and Eric W. Orts, ‘Moral Principal in the Law of Insider Trading’ (1999) 78 Tex. L. Rev. 375. For those considering insider trading from a feminist viewpoint, see e.g., Judith G. Greenberg, ‘Insider Trading and Family Values’ (1998) 4 Wm & Mary J. Women & L. 303. For a summary of the debate, see Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991), vol. VII, pp. 3448–3466; Charles C. Cox and Kevin S. Fogarty, ‘Bases of Insider Trading Law’ (1988) 49 Ohio St. L. J. 353, 354–360; Dyer, ‘Economic Analysis, Insider Trading, and Game Markets’ (1992) 1992 Utah L. Rev. 1, 11–39; Moore, ‘What is Really Unethical About Insider Trading?’ (1990) 9 J. Bus. Ethics 171; William K.S. Wang & Marc I. Steinberg, Insider Trading (Aspen Publishers, 1996), pp. 13–39; Ian B. Lee, ‘Fairness and insider trading’ (2002) 2002 Columbia Business Law Review 119, 131–141. 3. Loss and Seligman, above note 2, 3451.

Effects of Insider Trading

97

insiders.4 Professor Manne stressed that insider trading profits should be limited to corporate entrepreneurs who perform innovating functions, as opposed to corporate managers or corporate capitalists.5 Because the value of innovations cannot be budgeted in advance, as the argument goes, the wage market can hardly provide adequate compensation to the innovative entrepreneur, and only insider trading ‘readily allows corporate entrepreneurs to market their innovations’.6 It was even claimed that the value of insider trading as a method of compensating entrepreneurs may be ‘fundamental to the survival of our corporate system’.7 Professors Carlton and Fischel have added to this by saying that insider trading has a ‘unique advantage’ over other forms of compensation in the face of the cost-of-renegotiation dilemma: managers can alter their level of insider trading unilaterally, thereby avoiding the costs of continual renegotiation about their compensation.8 Furthermore, insider trading encourages managers to produce quality information and pursue good investments if managers are rewarded upon success.9 These two commentators have also stated that insider trading, as a type of incentive compensation mechanism, can effectively overcome corporate executives’ tendency to be overly conservative and risk averse.10 This argument has been subject to criticism for the reasons set out below.11 Even those scholars who are otherwise sympathetic to Manne’s work have expressed doubts over this argument, recognizing that this argument ‘was a difficult argument to make in 1966 and has receded in its impact since then’.12 The US Supreme Court has made it clear that ‘[a] significant purpose of the Exchange Act was to eliminate the idea that use of inside information for personal advantages was a normal emolument of corporate office’.13 The first response is that insider trading may not be an efficient compensation device. In reality, managers’ investments, including human capital and much of financial capital, are committed to a single company and thus become firm-specific. As a result, managers are generally risk averse as to their compensation. For instance, they would prefer the certainty of one million dollar salary over a salary 4. Manne, above note 1, 132–141. 5. Ibid 111–121. However, Manne also stated that ‘directors, large shareholders, executives, lawyers, investment bankers, or many other individuals may, at one time or another perform an entrepreneurial function, and may have access to profits of insider trading’. Ibid 156–157. 6. Ibid 131–145. 7. Ibid 110. 8. Carlton and Fischel, above note 2, 870. 9. Ibid 871. 10. Ibid 871–872. 11. See, e.g., Loss and Seligman, above note 2, 3460–3462; Easterbrook, above note 2, 332; W. Painter, ‘The Federal Securities Code and Corporate Disclosure’ (1979 & Supp. 1982) 235–250; Barry A. K. Rider and Leigh Ffrench, The Regulation of Insider Trading (Oceana Publications, 1979), p. 5; Mendelson, above note 2, 486–490; Saul Levmore, ‘Securities and Secrets: Insider Trading and the Law of Contracts’ (1982) 68 Va. L. Rev. 117, 145 n. 75, 149–150. 12. See e.g., Robert B. Thompson, ‘Insider Trading, Investor Harm, and Executive Compensation’ (1999) 50 Case Western Reserve Law Review 291, 302–304. 13. Dirks v. SEC, 463 U.S. 646, 653 n. 10 (1983).

98

Chapter 4

of half a million dollar and a ten percent chance of a bonus of five million, even though the two have the same expected value. Insider trading as a fringe benefit is like a lottery ticket in the sense that the profit is uncertain. Thus, when paying managers by insider trading, the package costs the shareholders the actuarial value of the payoff, but risk averse managers value the ticket at less than that.14 In other words, the company has to give up more to compensate managers by insider trading than necessary under other compensation schemes with certainty. Secondly, although the value of an entrepreneur may be somewhat uncertain, it has been contended that several capable types of contingent remuneration have arisen out of modern business practice, such as stock options, ‘phantom’ stock or ‘stock appreciation’ rights, bonuses based on a percentage of the firm’s profits, and the opportunity to own all or a controlling percentage of the firm’s stock.15 These kinds of contingent remuneration have the same capacity to capture all or some portion of the appreciation in a firm’s profits or stock market price as insider trading profits, and in other aspects may be superior to insider trading. It is very difficult, if not impossible, to monitor and control the profits from insider trading, because insider trading is a ‘fringe benefit that is as untidy and senseless as an unlimited personal travel allowance’.16 And, entrepreneurs could give the tip to other people such as relatives or friends who may not make any contribution to the corporation and who will unjustly receive insider trading profits which in turn incur the costs burdened by investors.17 In contrast, the above-mentioned forms of contingent remuneration are more manageable and provide more certainty and fairness as they correlate with the contributions entrepreneurs make.18 With those forms of contingent remuneration, the wage market could aptly compensate the valuable contributions of entrepreneurs. If a corporation fails to reward the innovative work of an entrepreneur adequately, the entrepreneur can simply change to a competitive firm and receive greater compensation.19 14. Easterbrook, above note 2, 322; Haddock and Macey, above note 2, 1462. Professors Calton and Fischel defend against this argument by suggesting that ‘lottery tickets given every day are much more likely to be valued at their expected value than tickets given once a lifetime’. Carlton and Fischel, above note 2, 876. 15. Robert C. Clark, Corporate Law (Boston, Little, Brown and Company, 1986), pp. 277–278. In recent years, there have been many criticisms over overpayment to management in the US. See e.g., Lucian A. Bebchuk, ‘Managerial Power and Rent Extraction in the Design of Executive Compensation’ (2002) 69 U.Chi. L. Rev. 751 (advocating actions to bring down executive pay); Charles M. Elson, ‘Director Compensation and the Management-Captured Board-The History of a Symptom and a Cure’ (1996) 50 SMU Law Rev. 127 (arguing that directors overpay themselves exorbitantly); but see Randall S. Thomas, ‘Explaining the International CEO Pay Gap: Board Capture or Market Driven’ (Paper presented at the Corporate Governance Conference, Melbourne Australia, 13 February 2004) (discussing theories that support high executive pay in the US). 16. Ronald J. Gilson and Reinier Kraakman, ‘The Mechanisms of Market Efficiency’ (1984) 70 Va. L. Rev. 549, 632 n. 221; Levmore, above note 11, 145. 17. Wang & Steinberg, above note 2, 14–19. 18. Cox, above note 2, 649; Shen-Shin Lu, Insider Trading and the Twenty-Four Hour Securities Market (The Christopher Publishing House, 1994), pp. 11–12. 19. Mendelson, above note 2, 489.

Effects of Insider Trading

99

Thirdly, of greater concern is that insider trading profits may create a serious problem of moral hazard.20 Although insider trading may encourage managers not to be risk averse, it may cause managers to go to the opposite extreme and adopt overly risky projects that have an expected value less than that of more predictable ventures.21 Further, insider trading privilege may create incentives for insiders to radically diverge from the corporate interest, because for the purpose of insider trading, insiders may rationally choose to increase share price volatility rather than enhance firm value. Even worse, insiders may benefit from a failed project or a decline in the value of the firm by trading on negative information. This may encourage harmful acts or decrease the incentive to avoid such harms. Professors Carlton and Fischel have responded that the critics of insider trading have exaggerated the magnitude of perverse incentives.22 According to them, allowing managers to profit by a decrease in the value of the firm may not prompt managers to disregard the firm value, because insiders would more likely treasure the value of their human capital and professional reputation which would be undoubtedly damaged by a failure of investment.23 Moreover, the deliberate pursuit of a value-decreasing investment opportunity is unlikely because collusion of the team of managers would be required and the individual decision-maker would have an incentive to defect from any such strategy.24 However, this argument appears to be contrary to the fact that numerous successful conspiracies have happened and are happening in the real world. There has been an empirical study that the moral hazard problem is not a purely theoretical one, and insider trading on ‘bad news’ accounts for a considerable percentage.25 Finally, it is difficult to define ‘entrepreneurial’ efforts. The good output of entrepreneurs will typically depend on factors other than just their own performance, such as the efforts of other corporate officers or random events such as developments in the relevant industry or in the economy as a whole. It is certainly unfair to attribute all the achievements to the entrepreneur and only allow the entrepreneur to insider trade.26 Otherwise, corporate morale might suffer if other corporate

20. Easterbrook, above note 2, 309; Levmore, above note 11, 145; Cox, above note 2, 649–662. 21. Easterbrook, above note 2, 332. 22. Carlton and Fischel, above note 2, 875. Professor Manne argued that natural incentives would lead insiders to prefer creating good news over bad news. See Manne, above note 1, 155–156. 23. Carlton and Fischel, above note 2, 872. 24. Ibid 874. 25. Kenneth E. Scott, ‘Insider Trading: Rule 10b-5, Disclosure and Corporate Privacy’ (1980) 9 J. Legal Stud. 801, 815–16. Other scholars further pointed out that without Section 16(c) of the Securities Exchange Act of 1934, insider trading on ‘bad news’ would probably be an even more widespread event. Loss and Seligman, above note 2, vol. V, 2470–2474. 26. For a broader discussion of efficient mechanisms to determine executive pay, such as the idea of pay-for-performance, and the disparity of payments between CEOs and other employees, see Brian R. Cheffins and Randall S. Thomas, ‘The Globalization Trend for Executive Pay’ (Paper presented at the Corporate Governance Conference, Melbourne Australia, 13 February 2004); Harley E. Ryan and Roy A. Wiggins, ‘Differences in the Compensation Structures of the CEO and Other Managers’ (2000) 6 J. Bus. & Econ. Stud. 22.

100

Chapter 4

employees are precluded from the same privilege.27 Further, as far as those chosen entrepreneurial directors are concerned, competition amongst them for insider trading profits might result in distrust in the group and thus harm the quality of board decision-making.28 Additionally, even if the ‘entrepreneurial’ efforts have been reasonably attributed to some people, the corporation would have to take on substantial investigation and enforcement costs to prevent a large number of persons who do not perform an entrepreneurial function, such as messengers, secretaries, outsider directors, bookkeepers and executives not performing entrepreneurial functions, from capitalizing on inside information.29 This had led one commentator to say that ‘even assuming that insider trading has certain virtues as incentive compensation, its costs probably outweigh its benefits’.30 2.

Enhancing Market Efficiency and Smoothing Stock Price

It has been argued that market price actually departs from the true value before inside information is disseminated to the market, and that insider trading will move prices in the correct direction because the trading volume and price movement itself may send a message to outside investors that something is happening.31 Such a message would in turn induce more trades which move prices further to the right level, and thus enhance market efficiency.32 Moreover, communicating information through insider trading may have great value and advantages in certain circumstances, because sometimes the disclosure of information would not be credible, would compromise the firm’s competitive position, would be costineffective for analysts to process or would subject the firm to potential liability if the information turned out to be untrue.33 Thus, if the issuer has valid business reasons for delaying information disclosure, as the arguments goes, insider trading provides a useful conduit to disseminate information, and ensures that the market price reflects some of this information. Further, because insider trading acts as a price accelerator and helps bring the price of securities to their proper level more quickly than would otherwise be the case, insider trading has been thought to be able to smooth the price changes that occur after the non-public information is disclosed publicly. If insider trading is

27. Wang & Steinberg, above note 2, 18; Haft, above note 2, 1058; Roy A. Schotland, ‘Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market’ (1967) 53 Va. L. Rev. 1425, 1456–1457. 28. Haft, above note 2, 1060–1064. 29. Easterbrook, above note 2, 333–335. 30. Wang & Steinberg, above note 2, 18; Cox, above note 2, 653–655. 31. Manne, above note 1, 61–99; Carlton and Fischel, above note 2, 866–868; Lorie, ‘Insider Trading: Rule 10b-5, Disclosure, and Corporate Privacy: A Comment’ (1980) 9 J. Legal Stud. 819, 821. 32. Carlton and Fischel, above note 2, 868; Gilson and Kraakman, above note 16, 574–579. 33. Manne, above note 1, 572–575; Carlton and Fischel, above note 2, 868.

Effects of Insider Trading

101

strictly prohibited, the stock price will change abruptly after disclosure of material information. On the contrary, if insiders are permitted to trade in securities before the information is released to the public, insider trading will move the price more quickly to the efficient level. This led Professor Manne to even argue that insider trading would benefit outsider traders. For example, investors buying stocks from insiders will suffer a smaller loss under the drop in stock price as a result of the insiders’ sale than if they had purchased at the higher price that would have occurred if insider trading was strictly proscribed.34 This argument has been criticized on a number of grounds. Firstly, empirical evidence has indicated that the impact of insider trading on market prices is not as significant as Professor Manne argued.35 Although temporary disparities in supply and demand for a security may briefly affect its price, any price changes caused by insider trades are likely to be short-lived if they are not supported by more contemporary information concerning the value of the security thereafter. Thus, insider trading ‘functions slowly and sometimes only sporadically’ as a means of transmitting information to the market and therefore is unlikely to have much of an effect on securities price efficiency.36 The second counterargument is that insiders may have incentives to camouflage their trades and thus significantly hamper their contribution to price efficiency.37 Indeed, the information-conveying mechanism of insider trading entails the ability of market participants to identify insider trading.38 Simply stated, specialists and other market makers must be able to infer or decode the identity of insiders when they trade, otherwise the information implied by objective large transactions is not reliable to investors if they are not sure exactly who the traders are. However, it is in serious doubt whether the market can systematically decode the identity of insiders. In the US, for example, the market generally cannot learn the identity of insider traders until the SEC publishes insider trading reports under Section 16(a) of the Securities Exchange Act of 1934.39 To the extent that insiders can deliberately camouflage their trades by strategies such as trading over longer periods of time and using intermediaries, the trading impact on market prices will go unnoticed and it will become very difficult for the market to decode the identity of insiders, particularly when insiders secretly undertake trading in other people’s names. As such, price decoding will not be 34. 35. 36. 37. 38.

Manne, above note 1, 77–110. Schotland, above note 27, 1443–1446. Gilson and Kraakman, above note 16, 629–634. Carlton and Fischel, above note 2, 868. Ibid (stating that the amount of information conveyed by insider trading depends on the ability of market participants to identify insider trading). 39. Loss and Seligman, above note 2, 3463–3464. In order to facilitate price decoding, some scholars have proposed that insiders should be required to disclose their identities prior to trades. See e.g., Jesse M. Fried, ‘Reducing the Profitability of Corporate Insider Trading Through Pretrading Disclosure’ (1998) 71 S. Cal. L. Rev. 303, 313; Gilson and Kraakman, above note 16, 632. However, by doing this, it would be no different from that of full public disclosure, and as a result the stock price will change abruptly.

Chapter 4

102

sufficiently precise in assessing the significance of the undisclosed information.40 Even Professors Carlton and Fischel themselves conceded that insider trading would convey less information than full disclosure due to this reason.41 Hence, the signaling function of insider trading may not be cost-efficient, because the relevant analyzing costs will increase substantially as a result of the increased difficulty of price decoding. Even if sometimes the market eventually does succeed in decoding the identity of insiders, it will take such a long time that investors would be unavoidably deprived of valuable investment opportunities and the market’s allocative efficiency would decrease. Thirdly, the side-effects of the signaling function of insider trading may be very strong. It is quite possible that if the market is deceived by camouflaged trading, wrong conclusions would be reached and market efficiency impaired accordingly. Indeed, if insider trading was permitted, any stock price movement is likely to be regarded as a symbol of inside information, leading to a lot of false news and rumors prevailing on the market. Consequently, share prices would become intensely volatile and the market would incur substantial costs to analyze and distinguish all of the information. Moreover, once the signaling function of insider trading is widely recognized, it could create opportunities for exploitation. For instance, a corporate insider could buy company shares in anticipation that this would send false signals to the market that there is as yet unreleased positive price-sensitive information. The insider could subsequently resell the shares at a profit following a market reaction to that signal. This would therefore provide insiders with opportunities to manipulate the market and harm market efficiency. B.

THE HARMFUL EFFECTS OF INSIDER TRADING

The harmful effects of insider trading have several aspects. More specifically, the first aspect is harm to the market; the second is harm to corporations, including those particular corporations whose securities are traded and all corporations as a class in the market; the third is harm to investors, including those individual investors involved in specific insider trading cases and all investors as a group in the market. In addition, it has been argued that, in the instance that the employer of the insider trader is not the issuer of the securities traded, insider trading may harm the employer.42 For example, a financial newspaper will be harmed if its readers lose faith in its stories because its contributors may commit insider trading on the contents of forthcoming articles. However, this harm may be better attributed to the contributors’ breach of the relevant contract between them and their employer, and

40. Loss and Seligman, above note 2, vol. VII, 3464. 41. Carlton and Fischel, above note 2, 868. 42. Wang & Steinberg, above note 2, 38–39.

Effects of Insider Trading

103

can only justify the punishment imposed by the newspaper on the contributors, such as expulsion. The harmful effect of insider trading by the contributors here, as a form of securities fraud, is not on the newspaper which has nothing to do with the securities transaction, but instead on the market and the individual traders.43 In other words, even if insider trading was not illegal per se but the newspaper contracted to protect its stories from being abused, the pre-publication trading by the contributors would still harm the newspaper. 1.

Harm to the Market Generally

The market will shrink in volume if investors become reluctant to participate in the market as a result of the existence of insider trading. Insider trading has been widely perceived as unfair by investors. In the words of the House Committee on Energy and Commerce of the US before adopting the Insider Trading Sanctions Act of 1984: The abuse of informational advantages that other investors cannot hope to overcome through their own efforts is unfair and inconsistent with the investing public’s legitimate expectation of honest and fair securities markets where all participants play by the same rules.44 Not surprisingly, investors’ perception of unfairness of insider trading will result in the erosion of market confidence. On the assumption that investors prefer a ‘fair’ market, it is clear that investors would be deterred from entering the market in the presence of insider trading. The statement of the legislative report of the Insider Trading and Securities Fraud Enforcement 1988 Act by the House Committee on Energy and Commerce of the US has well illustrated this point: [T]he far greater number of commentators support efforts to curb insider trading, viewing such efforts as crucial to the capital formation process that depends on investor confidence in the fairness and integrity of our securities markets. Insider trading damages the legitimacy of the capital market and diminishes the public’s faith . . . [T]he small investors will be – and has been – reluctant to invest in the market if they feel it will be rigged against them.45 Thus, the loss of general investor confidence in the market will certainly decrease the volume and liquidity of the stock market. This has been supported by empirical studies which suggested that markets characterized by weak insider trading regimes are less liquid than markets where insider trading prohibitions are strictly enforced.46 An international study has found that the cost of equity in a country is

43. The fraud on the employer, the information’s source, is exactly the basis on which the misappropriation insider trading theory is established. However, this reasoning seems dubious and awkward. For a detailed analysis of this issue, see below §5.IV.A.2. 44. H.R. Rep. No. 98–335, 98th Cong., 1st Sess. 5 (1983). 45. H.R. Rep. No. 100–910, 100th Cong., 2nd Sess. 8 (1988).

104

Chapter 4

reduced by about five percent if insider trading laws are enforced.47 As suggested by the statements of the US Congress, this harm to the integrity of market appears to be the most feared harm of insider trading and the main policy reason for proscribing insider trading. In addition, insider trading impairs market efficiency because permitting insider trading might cause insiders to delay information disclosure for the purpose of exploiting insider trading opportunities.48 Clearly, insiders will have strong incentives to withhold nonpublic price-sensitive information, if they can profit from trading on the basis of the information. Moreover, managers will also choose to ‘bunch’ the disclosure of items of information that are not individually material, but may be in the aggregate.49 In order to reduce the risk that the market may not move as anticipated, the manager would reasonably withhold disclosure of multiple items of information and release this bunched information as a group. This practice would result in delaying disclosure of material information, which in turn would decrease market efficiency. This detrimental effect of delaying information disclosure has even been acknowledged by those scholars against the regulation of insider trading. Notably, Professor Manne himself stated that the propensity of insiders to delay publication could not be denied.50 Professors Carlton and Fischel have also conceded that this criticism is a logical possibility.51 Although one empirical study suggested that ‘insider trading had no effect on the timing of publication’,52 its reliability has been strongly questioned.53

46. Kimberly D. Krawiec, ‘Fairness, Efficiency, and Insider Trading: Deconstructing the Coin of the Realm in the Information Age’ (2001) 95 Northwestern University Law Review 443, 470. 47. Utpal Bhattacharya and Hazem Daouk, ‘The World Price of Insider Trading’ (2000) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=200914, at 10 (last visited on 8 February 2005). 48. Mendelson, above note 2, 489; Schotland, above note 27, 1448–49; Joel Seligman, ‘The Reformulation of Federal Securities Law Concerning Nonpublic Information’ (1985) 73 Geo. L. J. 1083, 1095; Fried, above note 39, 315. In fact, one of the purposes of insider trading regulation is said to be inducing rapid disclosure of material information. See e.g., Dennis S. Karjala, ‘Statutory Regulation of Insider Trading in Impersonal Markets’ (1982) 1982 Duke L. J. 627, 630. 49. J. Choper, J. Coffee and C. Morris, Cases and Materials on Corporations (Aspen Publishers, 6th ed., 2004), p. 463. This point has been well illustrated by the problems of earnings management. See e.g., Ron Kasznik, ‘On the Association Between Voluntary Disclosure and Earnings Management’ (suggesting that earnings management affects corporate disclosure policies) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=15062; Gerald J. Lobo and Jian Zhou, ‘Disclosure Quality and Earnings Management’ (indicating that there is a statistically significant negative relationship between corporate disclosure and earnings management) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=265550. 50. Henry G. Manne, ‘Insider Trading and the Law Professors’ (1970) 23 Vand. L. Rev. 547, 553. 51. Carlton and Fischel, above note 2, 879. However, they argued that it might be beneficial to delay disclosure of information in some situations. Ibid. 52. Michael P. Dooley, ‘Enforcement of Insider Trading Restrictions’ (1980) 66 Va. L. Rev. 1, 33–34. 53. Loss and Seligman, above note 2, vol. VII, 3455 (stating that the conclusion ‘does not focus on those who abstained from trading while in possession of material non-public information in

Effects of Insider Trading 2.

105

Harm to Listed Corporations

Insider trading harms not only the specific listed corporations whose securities are traded, but also all the listed corporations in the market as a whole. The harm to specific listed corporations can be broadly categorized into two types, depending on whether insider trading is permitted by the corporations. In cases that insider trading is permitted by individual corporations, the harm is largely the reverse side of the alleged benefit of insider trading as an incentive compensation mechanism. Firstly, insider trading may result in a moral hazard. Indeed, if corporate insiders were able to profit from material information, whether positive or negative, they might choose riskier projects than they otherwise would have gone into, on the theory that they can trade on the news of the project, regardless of whether the project succeeds or fails. 54 Secondly, since the privilege of insider trading is restricted to a fraction of corporate managers, namely ‘entrepreneurs’, corporate morale may suffer or even distrust amongst corporate managers may arise due to the competition for trading profits.55 Finally, insider trading may impair internal corporate decision making at all hierarchical levels and thus reduce the overall decision making efficiency of the corporation.56 Plainly, all subordinates would likely stall the upward flow of information to maximize their opportunities for insider trading. It follows that, since there are many hierarchical levels in large corporations, even if the delay at each hierarchical level was slight, the aggregate delay in upward transmission to the top decision-making level could be substantial. On the other hand, in cases that insider trading is not permitted by corporations, it may harm the corporations on a ‘property rights’ theory under which inside information, such as information about a new corporate product or a takeover project, is viewed as corporate business property.57 If the inside information is misused or misappropriated, it can be argued that the corporation has been harmed because the trader illegally took corporate property. It has also been held that trading by corporate insiders harms the reputation of the corporation.58

54. 55. 56.

57. 58.

order to avoid violating the law’ and ‘does not recognize the likelihood that many of these persons would have delayed disclosure but for the deterrent of laws against insider trading’); Cox, above note 2, 644 (‘[T]he topic of abusive insider trading practices does not lend itself to reliable empirical inquiry’.). See above note 23 and accompanying text. See above notes 29–31 and accompanying text. Haft, above note 2, 1053–55. From the perspective of self-regulation, some commentators have also suggested that relevant law compliance can facilitate corporate internal information flow, and thus in the interest of corporations. See Christine Parker, The Open Corporation: Effective Self-Regulation and Democracy (Cambridge University Press, 2002), pp. 63–66. Loss and Seligman, above note 2, vol. VII, 3458–3460. Diamond v. Oreamuno, 24 N.Y.2d 494, 499, 248 N.E.2d 910, 912, 301 N.Y.S.2d 78, 81 (1969). But see, Rider and Ffrench, above note 11, 4–5 (stating that harm to corporation is highly speculative); Schein v. Chasen, 313 So.2d 739 (Fla., 1975) (rejecting Diamond).

Chapter 4

106

Furthermore, the harm of insider trading is not limited to the specific corporation that is the subject of the information. Rather, insider trading may harm all corporations generally in the market. Because as discussed earlier, the depth and liquidity of the market will decrease due to insider trading, this will harm all corporations in the form of increased cost of capital. One commentator has provided a good observation on this issue of ‘loss of liquidity externalities’: If any one firm allowed insider trading by its employees, the policy might affect the liquidity not only of its own stock but of other stocks because investors shunned stocks generally.59 Indeed, because investors cannot easily distinguish shares in companies that present the risk of insider trading from those that do not, they will discount all of their investments to reflect the potential costs of insider trading, and at the extreme, some of them will refrain from investing altogether.60 Thus, all corporations would suffer in the sense that it may be harder for them to raise capital in the market. 3.

Harm to Investors

The harm to investors is the most fundamental harm arising from insider trading. The above harmful effects to the market and to corporations are in fact largely based on the notion of harm to investors which gives rise to the erosion of market confidence and investors’ reluctance to enter the market. Put differently, if investors were not harmed by insider trading, then the notion of unfairness associated with insider trading would be a misperception and investors would have no reason to lose their confidence in the market. Hence, the issue of harm to investors is crucial and decisive of whether to prohibit insider trading.61 The harm to investors resulting from insider trading can be understood in two ways. One way is to look at the harm to individual investors in specific insider trading cases from a micro perspective. Because this question is fairly complicated and closely connected with the issue of private civil liability for insider trading, it will be left to be discussed in another chapter.62 The other way is to look at the harm to investors in general from a macro perspective. Of course, these two levels of harm are inherently interrelated, and they provide different lenses for us to 59. Mark Klock, ‘Mainstream Economics and the Case for Prohibiting Insider Trading’ (1994) 10 Ga. St. U. L. Rev. 297, 330–331. 60. Brudney, above note 2, 355–56; Dooley, above note 52, 48; Mark Klock, ‘Mainstream Economics and the Case for Prohibiting Insider Trading’ (1994) 10 Ga. St. U. L. Rev. 297, 330, 335. However, one empirical study has suggested that investors do not systematically discount the shares of firms traded more actively by insiders. See Moran, ‘Insider Trading in the Stock Market: An Empirical Test of the Damages to outsiders’ (Center for the Study of American Business, Washington Univ., St. Louis, Working Paper No. 89, July 1984). 61. Wang & Steinberg, above note 2, 39 (stating that ‘if each stock market insider trade does harm individual investors, that may be sufficient reason for prohibiting such trading, so that the debate over the effect on the issuer and society becomes less important’). 62. See below §7.IV.B.

Effects of Insider Trading

107

understand the harm of insider trading. The following will look at the overall impact of insider trading on investors in the second way. In the context of the New York Stock Exchange, Professors Haddock and Macey have pointed out that insider trading represents a cost borne in the first instance by market makers and passed along to other outsiders in the form of widened bid-ask spreads.63 The gains of market makers in their transactions systematically come from the bid-ask spreads, since the price at which market makers offer to buy securities from other market participants (bid price) is lower than the price at which they offer to sell (ask price). These gains are appropriate compensation to market makers for the risks and costs associated with their role in maintaining a two-sided market for securities. However, in transactions with insiders, market markers will systematically lose, because insiders will never buy unless the market price is too low and they will never sell unless the market price is too high. Market makers will treat these potential losses to insiders as an additional cost of maintaining a market in the particular security and will tend to recover this cost from market participants through widened bid-ask spreads. Thus, all market participants except insiders actually bear the cost and as such, are the victims of insider trading. The above reasoning can be more pertinently applied to outsider investors than market makers, because market makers are not the ultimate traders but the intermediaries. This is particularly so in other markets, such as China’s securities market, where there are no market markers. Because insiders will only buy undervalued stock and sell overvalued stock, outsider investors who trade simultaneously with and in the opposite direction from insiders will always buy when the price is too high or sell when the price is too low. Hence, it can be argued that uninformed outsiders systematically lose in their trades with insiders. One commentator further pointed out the mathematical relationship between an insider trader’s gain and the loss of all other investors.64 According to the socalled ‘Law of Conservation of Securities’, if an insider purchases/sells shares, all other investors on the market as a whole, must have less/more shares and get worse off. Thus, when someone trades on inside information, the group of all other investors suffers a net loss, which is equivalent to the insider trader’s gain.65 C.

SUMMARY

On the whole, the theoretical debate on the effects of insider trading appears far from conclusive even more than thirty years after its beginning.66 It has also been 63. Haddock and Macey, above note 2, 1457; Jonathan R. Macey, ‘Securities Trading: A Contractual Perspective’ (1999) 50 Case Western Reserve Law Review 269, 278–279. 64. William K.S. Wang, ‘Trading on Material Nonpublic Information on Impersonal Stock Markets: Who is Harmed, and Who can Sue Whom Under SEC Rule 10b-5?’ (1981) 54 Southern California Law Review 1217, 1234–1235. 65. Ibid. See also Wang and Steinberg, above note 2, §3.3.5; Mendelson, above note 2, 484–486 (suggesting that outside investors may suffer a net loss as a result of an insider trade). 66. Strudler and Orts, above note 2, 382 (describing the debate as ‘notoriously inconclusive’); Easterbrook, above note 2, 338 (arguing that the arguments are ‘closely balanced’); Haft, above

108

Chapter 4

said that the supposed benefits and harms are ‘quite speculative’.67 The current standoff of the debate will probably persist in the foreseeable future. However, mainstream opinion today tends to claim that the net effect of insider trading has been largely detrimental. As summarized by the Australian Parliamentary Explanatory Memorandum to the 1991 amendments: The effects of insider trading on investor confidence are regarded as outweighing any efficiencies arising from the faster dissemination of information which some commentators allege would accrue if insider trading were decriminalized.68 American courts also held that ‘even when confronted with the possibility of a trade-off between fairness and economic efficiency . . . find that the balance tips in favour of discouraging insider trading’.69 Many commentators shared this view.70 In sum, while it is very hard, if not impossible, to quantitatively compare the beneficial and detrimental effects of insider trading, the debate tips in favour of the arguments on the detrimental effects of insider trading. It should be noted that in this debate, there is a so-called ‘private ordering’ theory. This theory is based on the conceptualization of inside information as the subject of property rights,71 contending that like any other corporate property, inside information should be employed and allocated at the discretion of the corporation rather than the government. According to this theory, insider trading will sometimes be beneficial and sometimes detrimental, and in the situation that insider trading is thought to bring harms to a corporation and its shareholders, they can negotiate a contract prohibiting it.72 Thus, it is a question of costs and benefits for the individual corporations to decide whether insider trading should be permitted or prohibited. This theory seems appealing at first glance, especially when it is hard to prove that insider trading is solely harmful or solely beneficial. Those in favour of insider trading regulation also recognize the ‘useful heuristic value’ of the theory.73 However, upon closer examination, this argument is problematic.

67. 68. 69. 70. 71. 72. 73.

note 2, 1053 (concluding that neither side of the debate has ‘achieved universal acclaim’); Lee, above note 2, 131(stating that the debate ‘remains inconclusive’). Wang & Steinberg, above note 2, 39. Explanatory Memorandum accompanying the Corporations Amendment Bill 1991 (Australia) para. 307. Freeman v. Decio, 584 F.2d 186, 190 (7th Cir. 1978). Wang & Steinberg, above note 2, 39 (holding that ‘the case for detrimental effects is stronger’); Lee, above note 2, 140 (arguing that ‘the proponents of the ban on insider trading have the better part of the economic debate’). Manne, above note 1, 47–57. Carlton and Fischel, above note 2, 866; Haddock and Macey, above note 2, 1449; Jonathon R. Macey, ‘From Fairness to Contract: The New Direction of the Rules Against Insider Trading’ (1984) 13 Hofstra L. Rev. 9, 58–63. Robert C. Clark, Corporate Law (Boston, Little, Brown and Company, 1986), p. 275.

Effects of Insider Trading

109

Firstly, the relevant costs of prohibiting insider trading by contract are far too high and it is highly likely that the contract could not be successfully negotiated and enforced. The costs here include the contract-negotiating costs and the contract-enforcing costs. Unlike the economist’s theoretical world, in the real world, there are substantial transaction costs for each corporation in negotiating a proscription of insider trading, due to collective action problems.74 And, because each corporation has to incur the costs to make a new contract each time the need for it arises, ‘private ordering’ would be less cost-efficient than a mandatory regulation. Apart from the high contract-negotiating costs, private ordering also incurs prohibitive contract-enforcing costs. Specifically, private enforcement of contractual prohibition against insider trading involves diseconomies of small scale.75 Every individual corporation would have to bear the considerable costs of detecting and punishing violations of contractual prohibitions against insider trading. Indeed, effective monitoring of insider trading may require a costly computerized surveillance system over the entire trading market, so that corporations may defer to governmental monitoring and enforcement. Furthermore, to the extent that private companies cannot impose criminal penalties which are necessary to deter insider trading as the possibility of detecting insider trading is so low, private enforcement is not effective.76 In contrast, a national regulatory agency would be more efficient by virtue of its expertise, investigative authority and market-wide impact. The enforcement cost is indeed a very important factor in the task of combating insider trading. There has been an argument against regulation of insider trading on the grounds that insider trading regulation is very costly and has not fully deterred all insider trading.77 This argument, of course, has its weaknesses. As Professors Loss and Seligman pointed out, this point hardly rebuts the theoretical case for a proscription on trading while in possession of material nonpublic information. Society would still adopt laws prohibiting murder if the incarceration rate were low.78 Moreover, even if as is the case in China, insider trading remains prevalent after enactment of a prohibition, this does not mean that the practice would not be even more prevalent without enactment of the prohibition. Thus, the right response to the enforcement problem is not to abolish the insider trading prohibition, but instead to reinforce it. The point here is that if even a national regulatory regime 74. Loss and Seligman, above note 2, vol. VII, 3465. 75. Easterbrook, above note 2, 334–335; Gilson and Kraakman, above note 16, 634 n. 224. However, according to some commentators who advocate corporation self-regulation, nowadays many corporations have already established self-regulation systems to internally detect potential violations. See e.g., Parker, above note 56, 115–119. Thus, as internal self-regulation systems have been already in place, corporations might not incur substantial new costs to detect violations of insider trading contracts. 76. Richard A. Posner, Economic Analysis of Law (Aspen Publishers, 4th ed., 1992), pp. 417–418. 77. See e.g., Dooley, above note 52, 1. 78. Loss and Seligman, above note 2, vol. VII, 3466 n. 38.

110

Chapter 4

is challenged by the above argument, private ordering which incurs a much higher cost of enforcement would be a lot more susceptible to such a serious challenge. Secondly, leaving the decision whether to prohibit insider trading to individual corporations could empower corporate insiders to exploit shareholders, because corporate insiders can manipulate decision-making and contracts to their advantage. Due to many factors, such as information asymmetry and expertise, insiders enjoy a natural bargaining advantage over outsider shareholders. Thus, insiders may manipulate the costs and benefits analysis of insider trading, convincing shareholders to allow insider trading which is actually not in the best interests of the corporation. Moreover, even if a decision is reached to prohibit insider trading, insiders may draft the contract in their favor. These possibilities become even more real for the following reasons. In the first place, the capital market and the market for managerial labor are not strong enough to provide effective constraints on managers. According to some commentators, it is almost unlikely that market forces would act to constrain the decision to opt out of insider trading laws.79 The other reason is the free rider problem which would render shareholders having little incentive in any event to come to the negotiation table and thus shareholders’ interests would be left unattended. This problem has been well captured by one commentator who observed that: Each stockholder receives only a proportionate share of the expected benefits. Both the presence of high costs and shared benefits discourage stockholders from privately contracting with their managers. Stockholders will not expend their own resources to constrain managerial misbehavior because the passive stockholders will still receive a proportionate share of the resulting benefits; this free rider problem discourages any stockholder from taking action.80 Finally and most importantly, even putting aside the problems of internal contracting within corporations, insider trading still has an important ‘externality’ problem. An externality is a social cost not borne (absent a legal rule) by the person whose conduct gives rise to that cost.81 By virtue of externalities, shareholders of particular corporations can maximize their wealth by taking actions whose benefits they reap but whose costs are borne by society at large. Thus, the interests of shareholders of particular corporations may substantially diverge from the public interest on those actions involving externalities, in which case it is inappropriate to subject the actions to private ordering. As one commentator stated,

79. Krawiec, above note 46, 497; Fried, above note 39, 315; Gilson and Kraakman, above note 16, 632 n. 221. 80. Cox, above note 2, 656; see also Loss and Seligman, above note 2, vol. VII, 3466 (adding that this problem is even worse when shareholders choose to hold securities in a portfolio to diversify away firm-specific risks). 81. Posner, above note 76, 51–52. The pollution problem is an example of divergence of economic interests between shareholders and the public, in which the costs of increased pollution such as a worse living environment are borne by society as a whole.

Effects of Insider Trading

111

Whether the divergence of interest threatens to impose a social or an economic cost on the public, once the decision is made that such a cost is unacceptable, it is obvious that the legal rule or regulation cannot be suppletory. Otherwise, all firms would seek to evade the rule in order to serve their own interest that, by definition, is contrary to the public’s.82 Insider trading can be seen as an externality problem in a number of ways. As noted before, insider trading reduces public confidence in capital markets, thereby reducing the amount of capital available for investment and harming the overall economy. Indeed, all the companies on the market will suffer from increased costs of capital if investors discount indiscriminately all the shares in the market because they cannot easily distinguish the corporations which choose to prohibit insider trading from those which do not. And for those choosing to prohibit insider trading, it is hard for investors to differentiate between those that expend few resources on enforcement and those that expend more resources. Moreover, shareholders who choose to prohibit insider trading might not be immune from insider trading committed by shareholders in other corporations who permit insider trading. To understand this point, suppose that corporation A prohibits insider trading and corporation B permits insider trading, and that corporation B intends to acquire corporation A. If the managers of corporation B are permitted to buy corporation A’s stock on the inside information concerning takeover, the shareholders of corporation A who sold their shares would suffer from the insider trading activity permitted by corporation B. Thus, corporation A’s contract to prohibit insider trading becomes useless and its shareholders cannot be protected from insider trading. Thus, the harmful effects of insider trading are not only on the owner of the information, but also on other companies and society at large. The externality problem, along with high contracting costs, makes it inappropriate to deal with insider trading by private ordering. An Australian survey has found that over 80 percent of respondents disagreed with the proposition that insider trading should be decriminalized or left to the discretion of individual companies to control.83 §4.III.

EMPIRICAL FINDINGS ON THE EFFECTS OF INSIDER TRADING

The following are the empirical findings on the effects of insider trading obtained by interviews conducted in China.84 This empirical work is very important for reasons set out below. Firstly, as discussed above, the theoretical arguments on the effects of

82. Todd A. Bauman, ‘Insider Trading at Common Law’ (1984) 51 The University of Chicago Law Review 838, 845 (emphasis original). 83. Mark A. Freeman and Michael A. Adams, ‘Australian Insiders’ Views on Insider Trading’ (1999) 10 Australian Journal of Corporate Law 148, 156. 84. For more information on the empirical work, see Appendix 1: Methodology.

112

Chapter 4

insider trading have been described as ‘quite speculative’, and the debate remains inconclusive.85 This suggests that the academic debate needs input from empirical work, especially the opinions from people who are more closely connected with the market. Their views on insider trading may be less sophisticated than those of scholars, but may be more relevant for the law-making purpose because they are real market participants whose behaviors directly affect the market. Secondly, this book is primarily concerned with regulating insider trading in China, so that it is unwise to whole-implant the US debate as the sole basis for relevant law-making in China without consulting the views of Chinese people. As will be shown, most Chinese people consulted for this study, including some legal scholars, did not know of the ongoing debate in the US, much less examine carefully the arguments in the debate. In other words, they are largely unaffected by the debate and have formed their own views on insider trading. Their voices deserve serious attention because the local situation in China is crucial for the functioning of any regulatory regime there. Having said the importance of the empirical findings, it should be noted that they have their limitations in the sense that they are peoples’ perceptions, rather than concrete economic data. However, the key question here is perhaps less whether insider trading is actually harmful than whether people think that it is, because ‘if people get the impression that they’re playing against a marked deck, they’re simply not going to be willing to invest’.86 Indeed, from the perspective of law enforcement, the public’s moral concerns over misconduct and their perception of the law’s ‘legitimacy’ are important to gaining voluntary compliance. As one social scientist has pointed out, The way people behave is primarily a reflection of their views about: (1) what is right and wrong and (2) their obligations to the law and to legal authorities.87 It would seem to follow that, if people perceive insider trading as harmful and thus lose their confidence when the market is fraught with insider trading, then insider trading should be prohibited and people would recognize the legitimacy of the prohibition.88 Nevertheless, due to its limitations, the following empirical finding is not intended to, nor is able to replace the theoretical arguments to act as the sole basis for determining the effects of insider trading. Rather, they are considered in 85. See above §4.II.C. 86. Paul Blustein, ‘Widening Scandal on Wall Street: Disputes Arise over Value of Laws on Insider Trading’ Wall St. J., 17 November 1986, at 28 (quoting former SEC Chairman John Shad) (emphasis added). 87. Tom R. Tyler, ‘Compliance With Intellectual Property Laws: A Psychological Perspective’ (1996–1997) 29 N. Y. U. J. Int’l L. & Pol. 219, 225. 88. The concern over the public’s perception of the securities market is probably the chief motivation of the US Congress when it enacted Section 10(b) of the Securities Exchange Act of 1934. See Juliet P. Kostritsky, Comment, ‘Rationalizing Liability and Nondisclosure Under 10b-5: Equal Access to Information and United States v. Chiarella’, 1980 Wis. L. Rev. 162, 182, n. 88 (‘If investor confidence is to come back to the benefit of the exchanges and corporations alike, the law must advance’) (quoting H.R. Rep. No. 1383, 73d Con., 2d Sess. 5 (1934)). The report

Effects of Insider Trading

113

tandem with those theoretical arguments in answering whether insider trading should be prohibited in China. The foregoing part has suggested that the general academic view has come to argue in favor of the arguments on the harmful effects of insider trading. The empirical finding below will show whether this academic inclination is shared by the Chinese public and to what degree. A.

THE BENEFICIAL EFFECTS OF INSIDER TRADING

Interviewees were asked to talk about their opinions on what benefits, if any, insider trading has, and on the arguments of Professor Manne about the beneficial effects of insider trading as discussed earlier. There was very little support for Manne’s arguments from the regulatory officials in the CSRC. One official said that ‘those points are specious, and the person [Professor Manne] is a sophist. For example, the executive compensation argument is highly questionable as there are many other better ways to compensate executives. And, more importantly, I think insider trading is not ethical. I am sure that if insider trading is legalized in China, it will be a total disaster’. This perspective was shared by another official who stated that ‘it is very hard for me to accept those arguments. Law is essentially about fairness not about efficiency. It seems to me that the harm of insider trading far outweighs the benefit. If insider trading is permitted, many people will stay away from the market. So, where can the efficiency come from? In this sense, fairness and efficiency are closely interrelated’. The strongest rejection to the arguments came from an official who said that ‘honestly, it is the first time I heard these arguments. They sound ridiculous and baseless. Permitting directors to conduct insider trading amounts to giving them a blank cheque, because it is hard to control how the directors trade. Those arguments justify evils and are very dangerous’. Some did point out benefits of insider trading. According to one official, ‘insider trading is sometimes good for the market by increasing the trading volume and turnover’. He went on to say that ‘this benefit is undesirable though in my view simply because the boosted turnover is only a superficial prosperity and unsustainable, unhealthy. We should view the problem in the long run’. Another official echoed this view, stating said that ‘admittedly, higher trading volume will bring more transaction fees to the stock exchange and the government will benefit from additional stamp duty revenue. But this benefit cannot last long and cannot justify insider trading anyway, because it is at the expense of ordinary investors’. The responses of the securities practitioners to the arguments were also overwhelmingly negative. One broker said that ‘they are all nonsense. Permitting insider trading to serve as a compensation mechanism is equivalent to permitting people to steal, to rob. This should never occur. There are many other good ways

stresses the need to control unfair practices and to restore investor confidence after the stock market crash of 1929. Ibid.

114

Chapter 4

of providing incentives to executives’. This sentiment was shared by another broker who said that ‘it is so funny to hear such naïve arguments. It is completely the fantasy of ivory-towered scholars. Those arguments are rubbish indeed. The only benefit of insider trading is the self-interest of insiders’. Acknowledging that those arguments make some sense, another broker said that ‘insider trading may have some benefits. However, the benefits are too little and the accompanying harms are huge. Insider trading offends against the basic principles of ethics and the custom of business’. As to the information communication argument, one fund manager responded that ‘the argument will justify a black market. Information disclosure undoubtedly needs improvement but this should not be done through insider trading. It is better to require the company to publicly announce the information. Insider trading may send an unclear or even wrong message to the market’. Benefits were also seen by one broker who said that ‘in some sense, the government benefits from insider trading in the form of increased stamp duties. That is why sometimes, the government turns a blind eye to it, as long as insider trading is not too serious and beyond control’. The officials from the stock exchange generally opposed those arguments. One official argued that ‘the executive compensation argument is simply unacceptable. It is in no way desirable to reward executives in such an unfair way. Further, how can we ensure that inside information is only used by executives? How can we discern illegal insider trading from legal insider trading? This will make it even harder to detect insider trading. Admittedly, insider trading may sometimes stimulate the market and increase trading volume. However, such benefits are neither sustainable nor desirable because they come by harmful means’. Another official said that ‘insider trading has no benefits at all and should never be permitted. The incentive to executives should be provided in other forms. Likewise, if we need to improve information efficiency, inside information should be announced by the company itself or sent to us to publicize it’. This view was backed by another official who remarked that ‘it is a sad case if we need to resort to insider trading to enhance information dissemination. In my view, there are many other better ways of disseminating information. We already have regular reporting and continuous disclosure regime in place, and now what we should do is to get these systems to work well. The only benefit of insider trading is for insiders to make profit, and if insider trading is committed by a listed company, the local government of the place where the listed company is located will also benefit from increased tax and local employment. However, those are at the expense of the whole market’. The strongest objections to those arguments were expressed by ordinary investors. One investor in Guangzhou said that ‘they are simply rubbish and outrageous. It is trying to defend evils’. Another investor from Beijing felt that ‘it is obviously crap and the logic of robbers. Academics are always isolated from reality. I think that executives already get well paid and are wealthy, why do we need such a dirty way to compensate them’. This strong aversion to those arguments was shared by another investor who said that ‘insider trading is obviously unfair and harmful. How can he [Professor Manne] think of such silly

Effects of Insider Trading

115

ideals? He is clearly out of touch with the market and makes those arguments for self-amusement’. The responses from financial journalists were also condemnatory. One journalist pointed out that ‘the arguments are questionable. Insider trading is harmful and should be prohibited’. Another journalist said that ‘insider trading has no benefits to investors as a whole. Of course, insiders benefit from that. Perhaps, the stock exchange and the government also benefit in the form of increased transaction fees and stamp duties’. The academics’ views on the arguments were largely unfavorable too. One professor remarked that ‘the arguments are largely groundless, especially the management compensation one. It is a bit like rewarding somebody by permitting them to steal. There are so many other better ways to sufficiently compensate executives’. A similar view was that ‘the executive compensation argument is highly questionable. Humans are greedy in nature. Permitting insider trading would worsen this situation and executives may get over-compensated because in theory they can reap as many profits by insider trading as they want’. Another professor thought that there was some appeal in the arguments, stating that ‘those arguments are interesting and have changed the way we look at insider trading. I appreciate the wisdom and innovative spirit of Professor Manne. However, those arguments are not without problems and thus I cannot accept them’. A more informative view was that ‘there has long been a debate on this issue in the US, and many insights have already been provided to counter those arguments. However, the debate is yet to be settled. As for me, I disagree with him [Professor Manne], but it is very hard to fully refute those arguments before telling data are available’. A serious and insightful comment made by a professor who pointed out that ‘those arguments may be of some merit in America, but they are inappropriate in China. Insider trading there is different from insider trading here. For example, the most serious form of insider trading in China is committed by entities such as securities companies and listed companies. The executive compensation argument is therefore not applicable in China. Likewise, as to the price accelerator argument, the problem is how to determine the proper price level. In China, the pricing mechanism of the market is far from efficient. It is better to make public information disclosure than disseminate information through insider trading. We should be very careful in accepting foreign theories’. The lawyers consulted for this study also commonly rejected the arguments. One lawyer said that ‘it is chop logic indeed. I can see no benefits of insider trading, apart from the obvious benefits to insiders’. Another lawyer responded that ‘it is trying to legitimatize something that is wrong. There is genuine need for better information disclosure, but this should not be achieved through insider trading. In fact, insider trading will delay the announcement of information because the insiders want to make use of it’. The reaction to the executive compensation argument was much stronger. One lawyer described the argument as ‘baseless and ridiculous’. Another lawyer asked that ‘how has the argument survived for such a long time? It is obviously wrong’. Similarly, the view amongst judges was that there

Chapter 4

116

were no benefits. One judge made his point clear that ‘I have no doubt that insider trading has no benefits. The real question is how to regulate it’. B.

THE HARMFUL EFFECTS OF INSIDER TRADING

The officials from the CSRC uniformly held that insider trading was harmful and unfairness seemed to be the main reason for the perceived harm caused by insider trading. One official said that ‘small investors are unfairly disadvantaged by insider trading. They are always the trading counterparts of insiders. The top priority of our work is to protect small investors’. The importance of fairness was also stressed by another official who said that ‘insider trading is unfair to the weaker group in the market, notably small investors. Confidence in the market will fall if fairness is damaged’. He went on to add that ‘if investors lose confidence in the market, the market has no choice but to close down’. Another official said that ‘small investors are vital to our market because at the moment, they account for a large percentage of all investors. They help the market operate by providing capital. But they are often victims of insider trading’. A similar view is that ‘a fairer market will attract more investors and more capital. Insider trading makes investors less willing to enter the market, leading to both market efficiency and liquidity decreasing. In this sense, the market is the ultimate victim’. From the global perspective, one official remarked that ‘insider trading is widely considered harmful and an increasing number of countries choose to prohibit it. If we fail to follow this trend, the reputation of our market will be damaged and international capital will be reluctant to invest here’. Securities practitioners unanimously held that insider trading was harmful, but they were deeply divided as to what the harmful effects were. One view was that ‘the trading counterparts of insiders are the unfortunate losers. It is unfair for insiders to benefit from inside information’. One broker said that ‘small investors are invariably disadvantaged and vulnerable to insider trading. Currently, they are the main players in China’s stock market and therefore important. They deserve a fair treatment’. This view was shared by one financial advisor who said that ‘if small investors choose to quit the market because of insider trading, the market will fall down. Then, it would be harder and more costly for companies to raise money in the market’. In contrast, other interviewees in this group expressed a different view that ‘there is actually no victim in specific transactions. Those who were on the other side of the transaction would have traded in any event. Their losses have nothing to do with insiders’ trading’. One fund manager remarked that ‘maybe at the macro level, insider trading is harmful to the market as a whole. But, in any specific transaction, there is no victim as the counterparts of insiders are not induced, let alone forced, by the insiders to trade’. This opinion was echoed by a broker who said that ‘every investor is rational and should be responsible for their own decision to trade. Obviously, investors will trade only if they think the price is attractive. Even if there is no insider trading, they will trade at the same price’.

Effects of Insider Trading

117

The officials from the stock exchange commonly thought that the market was the ultimate victim of insider trading. One official asked ‘who will play in an unfair game? Insider trading may erode market confidence and lead to disinvestment’. A more robust view was that ‘small investors are presently the majority in China’s stock market. They regard insider trading as unfair, and would lose confidence in the market if insider trading was not effectively regulated. If they opt out of the market, the market will suffer the decrease in both liquidity and efficiency’. Another official said that ‘insider trading will also harm the international image of our market. If the market fails, every investor and every listed company will suffer’. The financial journalists observed that insider trading was harmful and the words ‘unfair’, ‘immoral’ and ‘defraud’ were used in describing its effects. The representative view expressed by a journalist in Shanghai was that ‘insider trading is unfair, and it destroys both market confidence and efficiency’. A secretary of the board of directors of a big listed company responded that ‘if the market is sluggish, it will be more difficult for us to raise capital. And, if directors commit insider trading, the image of their companies will be damaged’. All the ordinary investors strongly believed that they were directly harmed by insider trading. One investor in Guangzhou stated that ‘we get harmed of course. Everyone can see this. They [insiders] have privileged access to information and can make easy money at the expense of us. It is simply unfair’. It was also said that ‘the chance to win is not equal for everyone. Insider trading is just like a rigged horserace. How can we win the game? The only hope is that one can luckily discern and follow the insiders’ move. It is difficult though’. Another investor in Beijing said that ‘we are the prey of insider traders, but we have no choice as there is only one market. However, I would invest more money if the market was cleaner’. Almost all academics agreed that there were harms caused by insider trading. The harms identified here were more comprehensive than those referred to by any other group, including the harm to the market, to the fundraising listed company, to the company that is the subject of the information, and to the trading counterparts of insiders. One Beijing professor said that ‘insider trading is fundamentally unfair. This unfairness in turn will damage market confidence. If people become reluctant to enter the market, market efficiency will fall and fundraising will be harder. Individuals also suffer from insider trading but maybe they do not know this because insider trading is secretly committed’. Another professor observed that ‘the market is surely the victim of insider trading. In addition, the company to whom the inside information belongs is also harmed by insider trading in the sense that the insider abused its property right in information. Further, small investors as a whole may suffer from insider trading in the long run, but it is less clear that there is a victim in any specific transaction, because the causal relationship between the loss of other investors and insiders’ trading is absent from a legal point of view’. Acknowledging that ‘under the traditional causality theory, it is a stretch to argue that any specific investors are harmed by insider trading’, another professor

Chapter 4

118

remarked that ‘small investors are the weak group and the victims of insider trading. They are essential to our market and deserve special protection. Perhaps the traditional legal theory is inapplicable here due to the special features of insider trading. We need a new version of causality theory in the context of insider trading’. In a similar vein, a Shanghai professor remarked that ‘securities law is a special law, and we need a new way of thinking to provide special protection for small investors’. A very pragmatic view was that ‘from a policy standpoint, civil liability is an important tool in protecting small investors and deterring insider trading. The real issue now is how to apply civil liability to insider trading, and we should not act like doctrinarians in dealing with the causation problem’. As for the lawyers consulted for this study, the general view was that insider trading had harmful effects. The victims referred to include the market, listed companies and more importantly, those who were on the other side of the transaction. The strongest view was taken by a Shanghai lawyer who said that ‘market confidence is harmed by insider trading. It is also obvious to me that ill-informed small investors are harmed by insider trading. It is simply unfair because they do not have the information which insiders hold. Insider trading is a form of fraud and insider traders should be sued to pay damages’. But this lawyer also admitted that there is a troubling causation problem with private civil suits. One lawyer in Beijing said that ‘some academics are legalistic and conservative. They do not know that small investors need special protection and the securities market is a special market. No small investors, no China’s stock market. The market will collapse if small investors opt out of the market’. An interesting response was that ‘small investors are already disadvantaged by more expensive brokerage fees than institutional investors. They are always ill-informed and misdirected. They need special protection and our law should grant them legal standing to sue for compensation in insider trading cases. We can help them bring suit’. This suggests that lawyers may play a useful role in curbing insider trading if civil liability is available. The judges also thought that insider trading was harmful. One judge said that ‘insider trading is unfair and unjust. The importance of fairness can never be exaggerated and can hardly be measured in money. We are fighting for justice, aren’t we? If investors cannot get justice and lose their confidence in the market, it is all over’. Another judge also responded that ‘insider trading harms the market and investors. It is simply unethical and harmful’. C.

ANALYSIS OF THE FINDINGS

1.

Beneficial Effects

In sum, the interviewees overwhelmingly objected to Professor Manne’s arguments. More specifically, interviewees reacted much more strongly to the executive compensation argument than other arguments on the benefits of insider trading. The executive compensation argument was almost completely dismissed. In contrast,

Effects of Insider Trading

119

some interviewees saw some appeal in the price accelerator or information disclosure argument, even though they eventually rejected it. The common response was that the alleged beneficial effects of insider trading are illusive, and even if they exist to some degree, those benefits are not desirable because the attendant harmful effects would far outweigh them. In the course of the interviews, some interviewees cynically pointed out the benefits of insider trading other than the benefits argued by Professor Manne. These benefits include the profit to insiders, the increased transaction fee to the stock exchange, the increased stamp duty to the central government, and the enhanced tax revenue and employment to the local government. To be sure, these benefits are concrete but nevertheless undesirable. As discussed in Chapter 3, the huge profits of insider trading provide strong incentives for people to commit insider trading and the relevant benefit to government are one of the important reasons why insider trading law has not been efficiently enforced.89 The impression from the interviews was that on the whole, the strength of the rejection was surprising. Even Professor Manne was described as ‘a pedantic man’, ‘a man without a common perception of morality’. The vehement response is partly because the majority of the interviewees, including some regulators, had never heard of such arguments before and thus overreacted upon first knowing about them. It seems that those answers were somewhat emotional reactions with little serious and sober consideration. It is very hard however to predict whether over time the merits of these arguments will, more or less, gradually be understood by the Chinese people and change their perception of insider trading. 2.

Detrimental Effects

In short, according to the interviews, insider trading has strong detrimental effects. Specifically, several types of victims of insider trading were commonly identified, including the market, listed companies that want to raise funds, companies whose confidential information is misused, and investors who trade on the other side of insiders. Based on the conception of fairness and market confidence, the market was universally thought to be harmed by insider trading. The theory is that if the market lacks fairness, market confidence will be eroded and investors will, if not completely refrain from, at least be more reluctant to enter the market. Consequently, the market will be less liquid and efficient, and as such it will cost more for companies to raise funds. It is noteworthy that there appears to be a certain degree of disagreement on whether the investors trading on the opposite side from insiders are harmed. This negative voice came mainly from the group of securities practitioners. In their opinion, the trading counterparts of insiders would have traded anyway, and they are not induced to trade by insiders. However, all other interviews generally held 89.

See above §3.II.

120

Chapter 4

a contrary view. Some of them, notably ordinary investors and regulators, strongly believed that those investors trading with insiders are harmed. However, those interviewees did not realize the causation problem. And others, notably academics and judges, recognizing the existence and the difficulty of the causation issue, offered various answers. Some of them said that they were not sure of the answer, while others remarked that securities cases are special cases, and thus a new theory is needed to solve the causation problem in order to protect small investors who are critical to China’s stock market. Interestingly, it was even said by one academic and one judge that causality is no longer a crucial theoretical issue in China, because small investors deserve special protection and special situation demands special treatment. The divergence in the responses to the question of who is specifically victimized by insider trading reflects the fact that civil liability for insider trading is currently absent in China. Although the Securities Law does in principle provide for civil liability in insider trading cases, there are no functional provisions on this issue, resulting in no private insider trading suits having been brought so far.90 As a result, people are not sure who the real victims of insider trading are and who have standing to sue for compensation. Clearly, there is a need to solve this problem. Indeed, Chinese scholars are now examining the relevant US statutory provision, namely Section 20A of the Securities Exchange Act of 1934, which creates an express private right of action for so-called ‘contemporaneous traders’.91 Although the statute does not precisely define ‘contemporaneous traders’, it is clear that contemporaneous traders include those trading on the other end of insider trading. Therefore, the interviewees might have identified ‘the trading counterparts of insiders’ as victims largely due to the influence of this US legislation. The issue of who are eligible claimants in private insider trading cases will be examined in greater detail in another chapter.92 An important point to note is that the conception of fairness plays a central role for the interviewees in arguing that insider trading is harmful. Whichever victim they identified, they always draw their conclusion from this basis. The first impression of insider trading to most interviewees was that it is inherently and even self-evidently unfair. The damage to fairness, as the story goes, would lead to the loss of market confidence and the fall in market efficiency. As a result, it would be more difficult for companies to raise funds in the market. For this reason, any efforts to defend insider trading, like those arguments for the benefits of insider trading, were strongly denounced and thought to be ‘dangerous’ by the interviewees. Although there are some legal technical problems with the identification of individual victims in specific transactions, the ingrained feeling of unfairness about insider trading appears to render them less important. 90. See above §3.III.C. 91. The Insider Trading and Securities Fraud Enforcement Act of 1988 added Section 20A to the Securities Exchange Act of 1934. Act of 19 November 1988, Pub. L. No. 100–74, §20A, 102 Stat. 4677, 4680–81 (1988) (codified at 15 U.S.C. §78t-1). 92. See below §7.IV.

Effects of Insider Trading

121

All in all, the fairness argument is the main source of the widely shared feeling that insider trading is ‘a malign tumor of the market’ and should be cut off. In other words, although the views on the precise victims of insider trading are varied, there is a strong and almost universal sentiment that insider trading should be prohibited due to its harmful effects. 3.

Summary

The above findings suggest that insider trading is generally considered harmful by the Chinese public, which makes a strong case for prohibiting insider trading in China. At first glance, however, the generally held view that insider trading is harmful seems to contradict the current prevalence of insider trading in China. As discussed in Chapter 2, insider trading is widespread in China. Presumably, people would not condemn things which they are actually doing. One might ask why people choose to commit insider trading, while holding that insider trading is harmful and immoral. In the US, for example, a plausible reason for the prevalence of insider trading is that people are tempted to consider insider trading moral.93 Indeed, some US public opinion surveys suggest that a significant portion of the public would engage in insider trading if given an opportunity.94 To answer this question, it is important to first differentiate the various interviewee groups. Some interviewees who thought insider trading is widespread might not have committed insider trading. This is likely to be the case for some interviewee groups, such as academics, judges, and regulators. It is hardly surprising that these types of interviewees may hold a strong view on the harmful effects of insider trading. Moreover, for those ordinary investor interviewees who might have suffered losses due to insider trading, they had every reason to hate insider trading. By contrast, as to other interviewees, notably securities practitioners, who might have committed insider trading, there are several possible reasons for their condemnation on insider trading. The first explanation is that they might have pretended to be opposed to insider trading. Since the general view in China is unfavorable towards insider trading, holding a contrary view may bring unnecessary trouble and even can be seen as an individual propensity for insider trading. Secondly, although they think that insider trading is harmful, the difficulty of identifying individual victims in specific transactions may reduce the feeling of immorality about insider trading. As the empirical finding has shown, there is considerable confusion around the issue of who are really harmed by insider trading. Since insider traders normally 93. Wang and Steinberg, above note 2, 108–109 (‘many Americans do not consider insider trading unethical’). 94. See e.g., Baumhaut, ‘How Ethical Are Businessman?’ 39 Harv. Bus. Rev. 6, 16 (July–Aug. 1961) (indicating that a large percentage of the surveyed corporate executives would insider trade if given material inside information); Business Week/Harris Poll: ‘Insider Trading Isn’t a Scandal’, Bus. Wk., 25 August 1986, at 74 (finding that a majority of the American adult respondents would buy stock on a tip).

Chapter 4

122

do not know their trading partners, they might not feel as unethical as they would if the transaction was conducted face-to-face. Thus, the difficulty of identifying the specific victims of insider trading might give insiders some comfort in committing insider trading.95 Finally and perhaps most importantly, they might have committed insider trading under the intense pressure of survival in the market, even though they recognize that insider trading has harmful effects. As discussed in Chapter 3, insider trading is widely regarded as very important for success in China’s stock market because if you keep yourself clean, you will get eliminated by fierce competition.96 In this sense, they are forced to commit insider trading to some degree. In fact, they are also victims of this situation to the extent that their competitors may unfairly win through insider trading. Such an unfair and vicious competition is certainly not in the best interests of professional practitioners. In the course of the interviews, some brokers sincerely expressed their wish that insider trading should be strictly prohibited, so they can have a fair and safe business environment. §4.IV.

CONCLUSION

Although the theoretical debate on the effects of insider trading has not yet been settled more than thirty years after it began, the case for its detrimental effects seems much stronger, especially on the basis of fairness and market confidence. Professor Langevoort believed that ‘the debate has largely passed by and it is now widely accepted that the net effect of insider trading is detrimental’.97 This view is backed by the fact that insider trading has been increasingly disfavored by legislators on the global level. The decade of the 1990s witnessed an explosion in the number of nations adopting laws prohibiting insider trading. Before 1990, just 34 countries had insider trading laws, but by 2000, this number surged to 87.98 Indeed, the world has evolved from a situation, at the start of the 1990’s, in which the majority of countries with stock market did not prohibit insider trading, to a situation where the overwhelming majority of countries with stock markets had adopted such a prohibition by the year 2000.99 This has led some commentators to say that: [t]hough the debate about the pros and cons of allowing insider trading in stock markets has been quite contentious in the law, economics, and finance literature, it seems that from the point of view of actual practice, the debate seems to have been settled.100

95. For discussion of specific individual investors harmed by insider trading, see below §7.IV.B. 96. See above §3.II.A.2. 97. Interview with Professor Donald C. Langevoort (19 July 2002, The University of Sydney, Sydney Australia). 98. Bhattacharya & Daouk, above note 47, 3. 99. Ibid 10. 100. Ibid 22.

Effects of Insider Trading

123

China is one of the countries prohibiting insider trading. The empirical findings about the views of the Chinese people on the effects of insider trading have clearly shown that insider trading is considered to have detrimental effects, especially the impairment on fairness and market confidence, and the arguments in favor of insider trading are strongly rejected in China. However, this by no means suggests that the American debate is conclusive in China. Indeed, such a debate is yet to be seriously examined by Chinese people.101 Thus, it is too early to say that the arguments on the benefits of insider trading have no merits at all to China or would not have any impact in the future. However, what is clear and important now is that the Chinese people have been consistently taking a hostile attitude toward insider trading and strongly opposing insider trading. The perceived harmful effects of insider trading appear to be even bigger in China and thus make a stronger case for proscribing insider trading. At least for the time being, this provides a favorable social environment for regulating insider trading in China. It also seems quite inconceivable that the Chinese people will significantly change their views on insider trading in the foreseeable future. The empirical findings may help to explain the fact that China has unhesitatingly introduced its insider trading regulation at the very early stage of its stock market without encountering any major theoretical obstacles in doing so. As discussed in previous chapters, China began prohibiting insider trading almost at the same time as the establishment of its modern stock market.102 This again suggests that the detrimental effects of insider trading and thus the prohibition of insider trading have been widely recognized by the Chinese people. In order to promote market fairness and efficiency, it is necessary to prohibit insider trading. Indeed, insider trading regulation is one of the core components of securities laws, playing an important role in protecting investor confidence in the integrity of the market. Market integrity would be eroded if insider trading was not regulated. In this sense, China’s insider trading regulation, as part of its securities legal regime, is not only important to domestic investors, but also important to foreign investors. With the opening up of China’s securities market, it is increasingly important to encourage foreign investors to participate by prohibiting insider trading. As noted above, there is a clear trend that more and more countries have chosen to prohibit insider trading, suggesting that people in those countries are averse to insider trading. It thus can be safely argued that these foreign investors would be discouraged from entering China’s market, if China was out of line with international standards and failed to provide a fair and safe investment environment.

101. Recently, there have been several doctoral theses in China which cover this issue. However, most of them are focused on describing the American debate with little critical analysis. See e.g., Liang Yang, Neimu Jiaoyi Lun [Insider Trading] (Beijing, Beijing University Press, 2001), pp. 16–32; Guangzhi Hu, Neimu Jiaoyi Jiqi Falu Kongzhi Yanjiu [Insider Trading and Its Legal Restraint] (Beijing, Law Press, 2002), pp. 111–145. 102. See above §2.II.

124

Chapter 4

After discussing the question of whether to prohibit insider trading, the following chapters will proceed to deal with the further question of how to effectively regulate insider trading in China. Of course, these two questions are closely interrelated, and the answer to the former question could help answer the latter one.

Chapter 5

Theories of Insider Trading Liability: A Comparative Analysis

§5.I.

INTRODUCTION

As showed in the preceding chapter, insider trading is widely regarded as harmful and should therefore be prohibited. Hence, the next question is how to effectively prohibit insider trading. Before we discuss the elements of insider trading regulation, it is crucial to first explore the underlying principles which in turn determine specific elements of the regulation. This chapter will therefore focus on theories for prohibiting insider trading and try to find a suitable one for China. This chapter is organized as follows. Part 2 will examine the theory underlying China’s insider trading regulation, and point out its problems. Part 3 will trace the historical development of insider trading regulation statute in the US, due to the US developing a comprehensive body of insider trading prohibition theories. This will provide the basis for subsequent discussion. Part 4 will critically compare and analyze varies types of theories for prohibiting insider trading, with a view to seeking an appropriate one to suit the particular needs of China. §5.II.

THE REGULATION OF INSIDER TRADING IN CHINA: THEORY AND PROBLEMS

Even though China’s securities law has a short history, China has already set up a relatively complete framework of insider trading laws. Nevertheless, China’s insider trading regime is not without flaws. As discussed in Chapter 2, China’s insider trading law has greatly benefited from the US experience. Unfortunately

126

Chapter 5

however, it appears that China has relied too heavily on the US experience and has uncritically, hastily implanted it without a proper assimilation in the light of local situations. As will be shown, over time, the US has developed several different and even conflicting theories for prohibiting insider trading. China appears to have simply taken all of them and put them together, having no regard to the potential conflicts between them. Due to the failure to clearly set out the theory underlying the law, China’s insider trading law appears self-contradicting and confusing, which has seriously affected the effectiveness of the law. In China, the Securities Law has devoted four articles to specifically address insider trading, namely, Articles 73, 74, 75, 76. Article 73 is a general provision concerning insider trading, providing that ‘persons with knowledge of inside information on securities trading or persons illegally obtaining inside information are prohibited to take advantage of such inside information to engage in securities trading’.1 A literal reading of this article may suggest that China adopts a parity of information theory to regulate insider trading.2 In order to avoid the potential over-breadth of Article 73, legislators enacted Article 75 which limits the scope of insider information, and thus renders Article 73 based on an equality of access theory.3 According to Article 75, ‘major events’ that a company is required by Article 67 to disclose to the regulatory authority under a continuous disclosure regime, as well as a range of other specific types of information are deemed ‘inside information’. Article 75 reads as follows: Inside information is information that is not made public because, in the course of securities trading, it concerns the company’s business or financial affairs or may have a major effect on the market price of the company’s securities. 1. The major events listed in the second paragraph of Article 67 of the Securities Law; 2. Company plans concerning distribution of dividends or increases of capital; 3. Major changes in the company’s equity structure; 4. Major changes in security for the company’s debts; 5. Any single mortgage, sale or write-off of a major asset used in the business of the company that exceeds 30 percent of the said asset; 6. Potential liability for major losses to be assumed in accordance with law as a result of an act committed by a company’s director(s), supervisor(s), manager(s), deputy manager(s) or other senior management person(s);

1. Zhonghua Renming Gongheguo Zhengquanfa [Securities Law of the People’s Republic of China] (promulgated on 29 December 1998 and effective from 1 July 1999, amended in 2004 and 2005) (hereinafter Securities Law), Art. 73. 2. For an analysis of the parity of information theory, See below §5.IV.B.1. 3. For an analysis of the equality of access theory, See below §5.III.B.

Theories of Insider Trading Liability

127

7. Plans concerning the takeover of listed companies; and 8. Other important information determined by the securities regulatory authority under the State Council to have a marked effect on the trading prices of securities.4 The following items are the ‘major events’ listed in Article 67: 1. A major change in the company’s business guidelines or scope of business; 2. A decision by the company concerning a major investment or major asset purchase; 3. Conclusion by the company of an important contract which may have an important effect on the company’s assets, liabilities, rights, interests or business results; 4. Incurrence by the company of a major debt or default on an overdue major debt; 5. Incurrence by the company of a major deficit, or incurrence of a major loss; 6. A major change in the external conditions of the company’s production or business; 7. A change in the chairman of the board of direction, not less than one-third of the directors or the manager of the company; 8. A considerable change in the holdings of shareholders who each hold not less than five percent of the company’s shares; 9. A decision made by the company to reduce its capital, to merge, to divide or dissolve, or to apply for bankruptcy; 10. Any major litigation involving the company, or where the resolution of the general meeting of shareholders or the board of directors have been cancelled or announced invalid; or 11. Where the company is involved in any crime, which has been filed as a case as well as investigated into by the judiciary organ, or where any director, supervisor or senior manager of the company is subject to compulsory measures as rendered by the judiciary organ; or 12. Other matters as specified by the securities regulatory authority under the State Council.5 As the quotations have showed, most of the enumerated types of inside information are factual information generated within companies, and those people with privileged access to the information would have an ‘unerodable’ information advantage. Clearly absent from the lists is material, nonpublic information which derives from insight, acumen and diligent research on generally known information. Thus, taking Articles 73 and 75 together, one may believe that China’s insider trading law is based on the equality of access theory.6 This implies that

4. Securities Law, Art. 75. 5. Ibid Art. 67. 6. Victor Brudney, ‘Insiders, Outsiders, and Informational Advantages Under the Federal Securities Law’ (1979) 93 Harv. L. Rev. 322, 354–55.

Chapter 5

128

anyone with unequal access to inside information would be generally subject to the prohibition. However, this belief is seriously challenged by Article 74 and Article 76. Article 74 curbs the broad nature of Article 73 by enumerating specific types of persons who are regarded as ‘persons with knowledge of insider information’ and thus subject to the insider trading prohibition. They include: 1. Directors, supervisors, and senior management persons of an issuer; 2. Shareholders who hold no less than 5 percent of the shares in a company as well as the directors, supervisors, and senior management persons thereof, or the actual controller of a company as well as the directors, supervisors, and senior managers thereof; 3. The holding company of an issuer as well as the directors, supervisors, and senior managers thereof; 4. Persons who are able to obtain material company information concerning the trading of its securities by virtue of the positions they hold in the company; 5. Staff members of the securities regulatory authority, and other persons who administer securities trading pursuant to their statutory duties; 6. The relevant staff members of public intermediary organizations, including sponsors, underwriters, stock exchanges, securities registration and clearing institutions and securities trading service organizations; and 7. Other persons specified by the securities regulatory authority under the State Council.7 The list seems to be faithfully modeled on the classical insider trading theory as established in Chiarella and Dirks.8 Firstly, it covers traditional insiders, such as directors, officers, and substantial shareholders. Secondly, constructive or temporary insiders – staff members of intermediaries including underwriters, accountants, consultants, lawyers – are also listed. Moreover, Article 76 casts a cloud over the belief that China’s insider trading regime is predicated on the equality of access theory. In pertinent part, Article 76 provides that: No person with knowledge of inside information on securities trading of a company or other person who has illegally obtained such inside information may purchase or sell the securities of the company, divulge such information or counsel another person to purchase or sell such securities.9 Pursuant to Article 76, there are two types of people who are exposed to insider trading liability. One type is ‘persons with knowledge of insider information’

7. Securities Law, Art. 74. 8. For discussion of the classical theory, See below §5.III.C. 9. Securities Law, Art. 76 (emphasis added).

Theories of Insider Trading Liability

129

as enumerated in Article 74; the other is ‘other persons who have illegally obtained such insider information’. It has been argued that the second type of person corresponds to the American-style ‘misappropriators’ under the misappropriation theory.10 Thus, there are serious doubts that China’s insider trading law follows the equality of access theory, because Article 76 seems to be intended to introduce a complementary misappropriation theory to extend insider trading liability. In other words, if Article 73 has established an insider trading regime based on the equality of access theory, there is no need to add the misappropriation theory which is a necessary complement to the classical theory. Instead, it appears that Articles 74 and 76 have jointly imported the current US insider trading law which is based on the combination of the classical theory and the misappropriation theory.11 It is thus not unfair to say that when enacting the Securities Law, China’s legislators appear to have failed to get a full and critical understanding of the US insider trading regime which the Securities Law mimics. Indeed, the history of the US insider trading regime is quite complicated: at the outset, the SEC and the Second Circuit advocated the equality of access theory in the 1960’s; then the Supreme Court replaced it with the classical theory in Chiarella, and finally accepted the ‘fraud on the source’ theory to complement the classical theory in O’Hagan.12 It seems that China’s legislators simply put all of them together, without understanding their mutual relationships and without paying adequate attention to the potential conflicts amongst them. More specifically, they first embraced the equality of access theory in Article 73, then the classical theory and the misappropriation theory by enacting Articles 74 and 76. To the extent that China merely seeks to attain the fruits of American development, without

10.

Many Chinese commentators hold that the phrase ‘persons with knowledge of insider information’ as used in Article 74 is independent of the phrase ‘other persons who have illegally obtained such insider information’ as used in Article 76, and that Article 76 is similar to the American approach to the scope of insiders. See e.g., Guo Feng, ‘Insider Trading and Private Remedy’ (2000) 2 Faxue Yanjiu [Legal Study] 91, 94; Liang Yang, Neimu Jiaoyi Lun [Insider Trading] (Beijing, Beijing University Press, 2001), pp. 210–211; Guangzhi Hu, Neimu Jiaoyi Jiqi Falu Kongzhi Yanjiu [Insider Trading and Its Legal Restraint] (Beijing, Law Press, 2002), p. 93. More accurately, it seems that Article 76 relates better to the ‘fraud on investors’ misappropriation theory than the ‘fraud on the source’ misappropriation theory which applies in the situation where a person misuses the information in breach of a duty of loyalty to the information’s source. This belief is reinforced by the legislative history of the Securities Law which was passed by the National People’s Congress in December 1998, but was drafted as early as in 1992. See e.g., Roman Tomasic and Jian Fu, ‘The Securities Law of the People’s Republic of China: An Overview’ (1999) 10 Australian Journal of Corporate Law 268, 269. Thus, it seems that the drafters might have more likely incorporated into Article 70 the ‘fraud on investors’ theory which emerged in the 1980 case Chiarella v. United States, than the ‘fraud on the source’ theory which was judicially endorsed in the US in the 1997 case United States v. O’Hagan. For a detailed discussion of the two misappropriation theories, See below §5.III.C.3. 11. For a detailed discussion of the current US insider trading law, See below §5.III.C. 12. See below §5.III.

130

Chapter 5

first examining the process from which those fruits were derived, China’s insider trading law is much less effective than expected. To summarize, China’s insider trading law does not have a clear and consistent theory of its own. This leads to a confusing interpretation of the insider trading provisions, which makes the regime largely ineffective. Thus, in this chapter, I will conduct an in-depth analysis of various insider trading theories from a comparative perspective, and seek the most appropriate one for China, taking into account China’s particular conditions. This provides a foundation for detailed discussion of specific elements of insider trading regulation, such as insiders, inside information and so on, which will be conducted in the following chapter.13 §5.III.

INSIDER TRADING REGULATION THEORIES: THE US EXPERIENCE

As a pioneer in the field of insider trading regulation,14 the US has developed several theories for regulating insider trading and other countries regulating insider trading pick one of them to establish their insider trading regimes. Because almost all the insider trading regulation theories applied worldwide can be found in the history of US insider trading regulation, this part will focus on US insider trading regulation to provide a platform for further analysis. It is important to note that by acknowledging the pioneering role of the US, it should not be inferred that the US current insider trading regime is the best one. Indeed, as will be discussed, the US insider trading regulation is far from ideal. Some theories which the US initially developed but subsequently abandoned now appear to be superior to the theories currently adopted by the US, and thus have been taken up by other nations. An exhaustive account of the historical development of the US insider trading regulation will not be given, because it has already been done extensively.15 However, the following summary may nonetheless assist in putting the subsequent discussion in context for readers, especially those less familiar with doctrinal details of the US law. In the US, the primary source of insider trading regulation is federal law.16 In response to the stock market crash of 1929 and the Great Depression that followed, 13. See below Chapter 6. 14. The US is said to be the first nation to regulate insider trading. See Franklin A. Gevurtz, ‘The Globalization of Insider trading Prohibitions’ (2002) 15 Transnational Lawyer 63, 65. 15. There is a vast amount of legal scholarship on the law of insider trading. For some excellent accounts on the development of insider trading regulation in the US, see, e.g., Donald C. Langevoort, Insider Trading: Regulation, Enforcement, and Prevention (West Group) (looseleaf); William K.S. Wang and Marc I. Steinberg, Insider Trading (Aspen Publishers, 1996); Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991) Ch. 9(B). 16. See generally Langevoort, above note 15, Ch. 2. Although some states, such as New York, allow derivative suits against insider traders based on unjust enrichment, and perceive injury to

Theories of Insider Trading Liability

131

the US Congress passed the Securities Exchange Act of 1934 (Exchange Act)17 with the broad goal of promoting fairness and integrity in the securities market.18 Congress enacted the Exchange Act with the intention that it would be flexible enough to apply in the variety of circumstances that would eventually surface in regulating the complex securities industry. Thus, flexibility was largely allowed to leave room for the future development of relevant theories and to avoid producing possible loopholes that are often inevitable under a rigid statutory scheme. Insider trading regulation is precisely a fruit of this strategy. For the most part, the federal insider trading regulation results from administrative and judicial interpretations of a broad anti-fraud rule, namely Rule 10b-5, adopted by the SEC pursuant to authority under Section 10(b), an even broader statutory provision. Over time, the courts in the US have developed several underlying theories of insider trading regulation. More specifically, the first theory appears to be the equal access theory which subsequently was replaced by the fiduciary-duty-based theories. The fiduciary-duty-based theories, including the classical theory and the misappropriation theory, currently underlie the US insider trading regulation.

A.

THE STATUTORY BASIS

The modern US federal insider trading regulation derives its statutory authority from Section 10(b)19 of the Exchange Act. The broad language of Section 10(b) is a good example of the flexibility of the Exchange Act. Indeed, as a catch-all provision,

the corporate enterprise, state law often is unavailable in this context, especially when transactions occur on impersonal securities markets. See, e.g., Diamond v. Oreamuno, 248 N.E. 2d 910, 912 (N.Y. 1969); Freeman v. Decio, 584 F.2d 186, 187–96 (7th Cir. 1978); Schein v. Chasen, 313 So.2d 739, 746 (Fla. 1975); Hotchkiss v. Fischer, 16 P.2d 531 (Kan. 1932); Bailey v. Vaughan, 359 N.E 2d 599 (W. Va. 1987); Thomas Lee Hazen, ‘Corporate Insider Trading: Reawakening the Common Law’ (1982) 39 Wash. & Lee L. Rev. 845, 856–57 (discussing the Florida Supreme Court’s rejection of a derivative suit due to the absence of any injury to the corporation). For a detailed discussion of the state law applicable to insider trading, see Wang and Steinberg, above note 15, Ch. 16. 17. 15 U.S.C §§78a-mm (2001). 18. 15 U.S.C §78b (2001) (explaining the necessity for regulation of securities transactions in the secondary market). 19. 15 U.S.C. §78j(b) (2001). In pertinent part, the text reads as follows: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

132

Chapter 5

Section 10(b) has allowed the SEC to prohibit ‘manipulative or deceptive’ conduct as it arose between the cracks in the statutory scheme.20 Insider trading clearly falls within the scope of ‘deceptive’ conduct which is not expressly covered by specific provisions of the Exchange Act, and is therefore left to Section 10(b). Consequently, it has been said that the US insider trading regulation dates back to the enactment of the Exchange Act in 1934.21 This is questionable, however. In fact, the text of Section 10(b) does not even mention insider trading, and the legislative history does not suggest that Congress intended Section 10(b) to create a sweeping prohibition of insider trading. It has been strongly argued that the prohibition against insider trading was not the original purpose of Section 10(b), despite the fact that Congress was concerned about insider trading at the time.22 Section 16 of the Exchange Act23 is more specifically aimed at addressing insider trading,24 or more accurately, ‘short swing’ transactions. It requires certain insiders, such as officers, directors and holders of more than ten percent of the stock of a reporting issuer under the Act, to report their trades in the issuer’s equity and to pay over to the issuer any profits realized on purchases and sales made within a period of six months (so-called short-swing transactions). To be true, Section 16 plays an important role in restricting the abilities of certain insiders to trade on insider information. However, the role of Section 16 in combating insider trading seems to be quite limited because it does not generally outlaw the use of inside information.25 20.

21. 22.

23. 24.

25.

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 203 (1976) (describing the flexible nature of Section 10(b) as a ‘catchall provision’); Thomas Gardiner Corcoran, Counsel to the Reconstruction Finance Corporation, stated that ‘[o]f course subsection [(b)] is a catch-all clause to prevent manipulative devices . . .’ Stock Exchange Regulation: Hearings on H.R. 7852 and H.R. 8720 Before the House Common Interstate and Foreign Commerce, 73d Cong. 115 (1934). See e.g., Utpal Bhattacharya & Hazem Daouk, ‘The World Price of Insider Trading’, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=200914, at 11 (last visited on 8 May 2005). Stephen M. Bainbridge, ‘Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition’ (1995) 52 Wash. & Lee L. Rev. 1189, 1228–1237; Michael P. Dooley, ‘Enforcement of Insider Trading Restrictions’ (1980) 66 Va. L. Rev. 1, 55–69; Frank. H. Easterbrook, ‘Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information’ (1981) 1981 Sup. Ct. Rev. 309, 317–20. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 202 (1976) (pointing out that ‘the intended scope of §10(b) . . . [is not] revealed explicitly in the legislative history of the 1934 Act, which deals primarily with other aspects of the legislation); See also Richard W. Painter et al., ‘Don’t Ask, Just Tell: Insider Trading After United States v. O’Hagan’, 84 VA. L. Rev. 153, 160 (1998) (opining that ‘it seems unlikely that [Congress] specifically envisioned insider trading as coming within the proscriptions of Section 10(b)’.). 15 U.S.C. §78p(b) (1994). Some commentators have even argued that the US Congress initially intended to regulate insider trading only by enacting Section 16. See Michael P. Dooley, ‘Enforcement of Insider Trading Restrictions’ (1980) 66 Va. L. Rev. 1, 56–57; Bainbridge, above note 22, 1229 (suggesting that Congress intended to address insider trading in Section 16(b), not in Section 10(b)). William H. Painter, ‘Insider Information: Growing Pains for the Development of Federal Corporation Law Under Rule 10b-5’ (1965) 65 Colum. L. Rev. 1361, 1375 (noting that ‘in

Theories of Insider Trading Liability

133

On the one hand, under Section 16, insiders can safely earn profits by trading on in-and-out transactions separated by more than six months. On the other hand, an insider is liable for any profits earned on transactions within any six-month period, regardless of whether they actually used insider information. A lot of debate has occurred around its validity and suitability, resulting in both sarcastic criticism and enthusiastic praise.26 Interpreted literally, Section 10(b) is not self-operative because there is a prerequisite that there be a ‘contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate’. Thus, unless the SEC exercises its rulemaking authority, Section 10(b) is unavailing. Moreover, as Section 16(b) offers no statutory basis for a sweeping prohibition on insider trading, the SEC eventually promulgated famous Rule 10b-5 under Section 10(b) in 1942.27 Rule 10b-5 is the direct foundation on which the US modern insider trading regulation rests. In full, the Rule provides: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.28 In contrast with Section 10(b), Rule 10b-5 reaches more deceptive practices to the extent that it covers actions such as untrue statements, omissions of material fact,

considering various proposals for Section 10(b), Congress rejected a suggestion that the use of inside information be made unlawful, in view of the problems of proof involved’.). Indeed, some have argued that Section 16(b) was not even intended to deal with insider trading, but rather with manipulation. See Dooley, above note 22, 56–58. 26. See e.g., Marleen O’Connor, ‘Toward a More Efficient Deterrence of Insider trading: The Repeal of Section 16(b)’, 58 Fordham L. Rev. 309, 313 (1989) (criticising it as an ‘archaic, blunt weapon’); Roberta S. Karmel, ‘Outsider Trading on Confidential Information – A Breach in Search of a Duty’, 20 Cardozo L. Rev. 83, 101 (1998) (praising it as a ‘remarkably effective prophylactic tool’ for preventing insider trading’). There has been in the US a longstanding debate whether Section 16(b) should be repealed, based on its alleged merits and demerits. See e.g., Loss and Seligman, above note 15, 2319–2324; Michael H. Dessent, ‘Weapons to Fight Insider Trading in the 21st Century: A Call For the Repeal of Section 16(b)’ (2000) 33 Akron Law Review 481. 27. Rule 10b-5 was created when the drafter put Section 10(b) and Section 17 together by chance. The language of Rule 10b-5 is largely borrowed from Section 17(a). For an account on the dramatic history of the birth of Rule 10b-5, see Loss and Seligman, above note 15, vol. VII, 3485–3489. 28. 17 C.F.R. §240.10b-5 (1998).

Chapter 5

134

and half truths, as well as the employment of manipulative or deceptive devices or contrivances which are already covered by Section 10(b). Thus, Rule 10b-5 embraces more types of market misconduct so as to facilitate its enforcement while its flexibility remains sufficient to apply to all possible circumstances. The rule has played a pivotal role in the US securities regulation and has been a wonder in the law field, because as Professors Loss and Seligman have stated, ‘the interaction of the legislative, administrative rulemaking, and judicial processes has produced so much from so little’.29 US Supreme Court Chief Justice William Rehnquist famously likened Rule 10b-5 to ‘a judicial oak which has grown from little more than a legislative acorn’.30 This is particularly true in the field of insider trading regulation where insider trading regulation is exclusively generated from a tiny and illusive legislative acorn. Indeed, Rule 10b-5 does not contain any specific language regulating insider trading. Moreover, Rule 10b-5 was initially used against insider trading in face-toface transactions, instead of transactions on public secondary trading markets.31 It was not until 1961that the SEC finally concluded that Rule 10b-5 could be applied to insider trading on an impersonal stock exchange.32 From then on, the US federal insider trading prohibition began taking shape, and courts have developed various theories for regulating insider trading. B.

THE EQUALITY OF ACCESS THEORY

For nearly two decades after its promulgation, Rule 10b-5 had not been used by the courts to address insider trading in open markets. During this period, insider trading on impersonal markets was primarily governed by Section 16(b).33 This situation was changed in 1961 by In re Cady, Roberts & Co.,34 the SEC’s landmark enforcement action, which marked the beginning of the US modern federal insider trading prohibition. 1.

In re Cady, Roberts & Co.

Cady, Roberts clearly involved trading on an impersonal stock exchange, as opposed to a face-to-face transaction. A broker in the Cady, Roberts brokerage firm received a tip from a corporate director – who was also a partner in Cady, Roberts–that the corporation had just decided to reduce its quarterly dividend.

29. Loss and Seligman, above note 15, 3485. 30. Blue Chip Stamp v. Manor Drug Store, 421 U.S. 723, 737 (1975). 31. See e.g., Speed v. Transamerica Corp. , 99 F. Supp. 808 (D. Del. 1951); Kardon v. National Gypsum Co., 73 F. Supp. 798 (E.D. Pa. 1947); In re Ward La France Truck Corp., 13 S.E.C. 373 (1943). 32. In re Cady, Roberts & Co., 40 S.E.C. 907 (1961). 33. Painter et al., above note 22, 162. 34. 40 S.E.C. 907 (1961).

Theories of Insider Trading Liability

135

The broker then sold a large number of shares of that corporation held in customer accounts before the corporation publicly announced the material information. For the first time, the SEC held that trading on open markets by corporate insiders in possession of material, non-public information is in violation of Rule 10b-5, and corporate insiders have a duty under Rule 10b-5 to refrain from trading as long as they were privy to material information that has not been disclosed. The SEC then articulated what became known as the ‘disclose or abstain’ rule: corporate insiders in possession of material information are required to either disclose that information or abstain from trading. To be true, as a practical matter, disclosure is rarely a feasible option because most inside information needs to be kept secret for legitimate corporate purposes. Hence, in most cases, the ‘disclose or abstain’ rule will simply reduce to a complete ‘abstain’ rule. The SEC offered its reasons for the ‘disclose or abstain’ rule: Analytically, the obligation [to disclose or abstain] rests on two principal elements; first, the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantages of such information knowing it is unavailable to those with whom he is dealing.35 2.

SEC v. Texas Gulf Sulphur Co.

The administrative ruling in Cady Roberts was affirmed by the Second Circuit in SEC v. Texas Gulf Sulphur Co. in 1968.36 In this case, Texas Gulf Sulphur Corporation had kept secret the information about a significant ore discovery in order to facilitate the acquisition of surrounding parcels of land. The defendants, all of whom were convicted, were employees of Texas Gulf Sulphur who made openmarket purchases or exercised stock options before the public disclosure of the information. The Second Circuit upheld the ‘disclose or abstain’ rule, stating that: [A]nyone in possession of material inside information must either disclose it to the investing public, or if he is disabled from disclosing it in order to protect a corporate confidence, or he choose not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.37 35. Ibid at 912 (emphasis added). It should be noted that the ‘relationship’ here is not the requisite fiduciary relationship under the classical theory in Chiarella. Justice Blackmun, in his dissenting opinion, stated: The Commission . . . regarded the insider ‘relationship’ primarily in terms of access to nonpublic to non-public information, and not merely in terms of the presence of a common-law fiduciary duty or the like. 36. 37.

Chiarella v. United States, 445 U.S. 222, 249 (1980) (Justice Blackmun, dissenting). 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968).

Chapter 5

136

The policy foundation on which the Second Circuit supported the disclose or abstain rule was the equality of access theory. According to the Second Circuit, there is a ‘justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information’.38 The Second Circuit held that because any persons with access to material, non-public information enjoy an advantage that hard work and discriminating research cannot overcome, the use of this advantage in securities transactions was not just ‘unfair’, but fraudulent as well.39 Thus was born what is known as the equality of access theory.40 Under this theory, anyone with unequal access to insider information, whether they are corporate insiders or outsiders, have a duty of disclosure before trading, and if they fail to disclose, they will breach the duty and thus Rule 10b-5. C.

FIDUCIARY-DUTY-BASED THEORIES: THE CLASSICAL THEORY AND THE MISAPPROPRIATION THEORY

The equality of access theory was squarely rejected by the US Supreme Court on the grounds that it departs from traditional common law principles and casts far too wide a net on insider trading. The Court then imported the common law notion of fiduciary duty into the federal securities law and, by doing so, completely changed the path on which the US insider trading regulation follows. 1.

Chiarella v. United States

In Chiarella v. United States,41 the US Supreme Court analysed insider trading liability under Section 10(b) and Rule 10b-5. Vincent Chiarella was an employee of a financial printer who, through his employment, handled documents containing five announcements of corporate takeover bids. Although the identities of the acquiring and target companies of the takeover were intentionally concealed for the purpose of confidentiality, Chiarella succeeded in decoding them. Without declaring his knowledge concerning the prospective takeover bids, Chiarella purchased target company stocks and then sold them for a profit

38. Ibid. 39. Ibid 848 n. 33. 40. See e.g., Painter et al., above note 22, 163 (stating that Texas Gulf Sulphur established the equality of access theory); Gevurtz, above note 14, 77 (contending that ‘the equal access rule’ was adopted by Cady, Roberts and Texas Gulf Sulphur); but see Marc I. Steinberg, ‘Insider Trading, Selective Disclosure, and Prompt Disclosure: A Comparative Analysis’ (2001) 22 University of Pennsylvania Journal of International Economic Law 635, 638 (maintaining that the Second Circuit adopted the parity of information approach in Texas Gulf Sulphur). For a comparison of the parity of information theory and the equality of access theory, See below §5.IV. 41. 445 U.S. 222 (1980).

Theories of Insider Trading Liability

137

immediately following the public announcement of the takeover.42 The key issue in this case was whether Chiarella had a duty to disclose the non-public information after obtaining it.43 The Second Circuit had upheld Chiarella’s conviction under the equality of access theory which imposed a general duty to disclose on anyone who has superior access to material, non-public information, no matter whether they are corporate insiders or not.44 The Supreme Court, in a six to three decision, reversed the conviction. To begin with, the Court held that ‘[w]hen an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak’.45 Then, as to when a duty to speak arises, it rejected the equality of access theory by ruling that the equal access theory supports too broad a duty to disclose and departs from the common law.46 In an effort to find when a duty to disclose does arise, the Court looked to the common law and held that ‘a duty to disclose arises when one party has information “that the other party is entitled to know because of a fiduciary or other similar relation of trust and confidence between them’’’.47 Because this theory is grounded on the classical common law fraud, this theory was called the ‘traditional’ or ‘classical’ theory of insider trading liability. Under this classical theory, the Court set Chiarella free on the grounds that [n]o duty could arise from petitioner’s relationship with the sellers of the target company’s securities, for petitioner had no prior dealings with them.

42. Chiarella v. United States, 445 U.S. 222, 224 (1980). 43. Ibid 226. 44. United States v. Chiarella, 588 F.2d 1358, 1365 (2d Cir. 1978), rev’d, 445 U.S. 222 (1980). The Supreme Court described the Second Circuit’s reasoning as follows: [The Second Circuit’s] decision thus rested solely upon its belief that the federal securities laws have ‘created a system providing equal access to information necessary for reasoned and intelligent investment decisions’. The use by anyone of material information not generally available is fraudulent, this theory suggests, because such information gives certain buyers or sellers an unfair advantage over less informed buyers and sellers. Chiarella, 445 U.S. at 232 (quoting Chiarella, 588 F.2d at 1362) (citations omitted). Chiarella, 445 U.S. 222, 235 (1980). Ibid 235. The Chiarella Court also acknowledged the lower courts specific contention that its ‘ “regular access to information” test would create a workable rule embracing “those who occupy . . . strategic places in the market mechanism”’. Chiarella, 445 U.S. at 231 n. 14 (quoting United States v. Chiarella, 588 F.2d 1358, 1365 (2d Cir. 1978)). However, the Court rejected this test, maintaining that ‘[t]hese considerations are insufficient to support a duty to disclose’ and that such ‘[a] duty arises from the relationship between parties and not merely from one’s ability to acquire information because of his position in the market’. Chiarella, 445 U.S. at 231 n. 14 (citations omitted). The Court seemed to have mistakenly confused the equality of access theory with the parity of access theory, and set out the defects of the parity of access theory to overrule the decision reached by the Second Circuit under the equality of access theory. See below §5.IV.B.1. 47. Chiarella, 445 U.S. 222, 235 (1980). 45. 46.

138

Chapter 5 He was not their agent, he was not a fiduciary, he was not a person in whom the sellers had placed their trust and confidence.48

Although Chiarella correctly holds that a duty to disclose is an essential element of fraud by nondisclosure under Section 10(b) and Rule 10b-5, it does not properly answer when a duty to disclose arises. Based on the common law notion of fiduciary duty, the classical theory seems far too narrow and has serious loopholes.49 For instance, individuals not in a fiduciary relationship with corporations, so called ‘outsiders’ like Chiarella, may safely exploit material, non-public information to trade. For this reason, five members of the Court, namely, the Chief Justice Burger and Justices Stevens, Brennan, Blackmun, and Marshall, expressed their concerns and gave several alternative theories imposing insider trading liability. In his dissenting opinion, Chief Justice Burger, questioned the very basis of the majority opinion, namely, the general common law rule that the parties to a transaction have no duty to disclose information except where there is some confidential or fiduciary relation between them.50 Burger argued that ‘this rule should give way when an informational advantage is obtained, not by superior experience, foresight, or industry, but by some unlawful means’,51 and that ‘any person who has misappropriated non-public information has an absolute duty to disclose that information or to refrain from trading.52 Thus, Burger’s theory clearly conflicts with the classical theory in the sense that any information obtained as the result of ‘unlawful means’, regardless of the presence of a fiduciary relationship, must be disclosed.53 The government also put forward an alternative theory, arguing that Chiarella owed a fiduciary duty to his employer’s customer, the acquiring corporation, and his misappropriation of confidential information from his employer therefore constituted a fraud against the acquiring corporation.54 The majority of the Court, however, refused to address this ‘fraud on the source’ argument because it had not been presented to the jury.55 While agreeing with the majority that the ‘fraud on the source’ argument could not be considered, Justice Stevens discussed it with some approval in his concurrence and emphasized that the Court specifically left the door open for the argument.56

48. 49. 50. 51. 52. 53.

Ibid 232. For detailed analysis of this, See below §5.IV.A. Chiarella, 445 U.S. 222, 240 (1980). Ibid. Ibid 240 (Burger, C.J., dissenting). Ibid 242. Burger went on to characterize Chiarella’s conduct as ‘working literally in the shadow of the warning signs in the printshop [and having] misappropriated – stole to put it bluntly – valuable non-public information entrusted to him in the utmost confidence’. Ibid 245. 54. 445 U.S. 222, 235–36 (1980). 55. Ibid 237 (1980). 56. Ibid 238 (Stevens, J., concurring) (‘[I]f we assume that petitioner breached a duty to the acquiring companies that had entrusted confidential information to his employers, a legitimate argument could be made that his actions constituted “a fraud or a deceit” upon those companies “in

Theories of Insider Trading Liability

139

Although both Justice Stevens and Chief Justice Burger based their reasoning on misappropriation of information from a third party rather than corporations whose securities are traded, their theories are essentially different. Burger’s theory, the ‘fraud on investors’ misappropriation theory, premises insider trading liability on a trader’s duty to disclose his misappropriated information to other market participants. In contrast, Stevens’s theory, the ‘fraud on the source’ misappropriation theory, based liability on a trader’s duty to disclose to the source of his misappropriated information. After Chiarella, the SEC and the Justice Department appeared to be more inclined to choose to litigate the ‘fraud on the source’ misappropriation theory rather than the ‘fraud on investors’ theory,57 and finally got the ‘fraud on the source’ theory endorsed by the Supreme Court in 1997.58 For the purpose of brevity and because the ‘fraud on the source’ theory has been officially adopted by the US, the phrase ‘misappropriation theory’ used in this chapter generally refers to the ‘fraud on the source’ misappropriation theory, unless otherwise indicated.

connection with the purchase or sale of any security” ’.). Stevens also found, however, that the acquiring companies, the owners of the confidential information which had been misappropriated by Chiarella, could not recover damages under Rule 10b-5 from the perpetrator because ‘they are neither purchasers nor sellers of target company securities’, and then ‘it could also be argued that no actionable violation of Rule 10b-5 had occurred’. Ibid at 238 (Stevens, J., concurring) (citing Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975)). 57. The US Government clearly favoured the ‘fraud on the source’ misappropriation theory. In United States v. Newman, 664 F.2d 12 (2d Cir. 1981), its first post-Chiarella opportunity to litigate a misappropriation theory, the Government intentionally chose the ‘fraud on the source’ theory. The reasons are perhaps that the Government might have feared that the ‘fraud on investors’ theory clearly conflicts with the classical theory and thus may stand a slim chance of success before the courts, or might have presumed that the ‘fraud on the source’ misappropriation theory, already supported by Justice Stevens, was easier for the juries to accept and apply. See Donald C. Langevoort, ‘Words from on High about Rule 10b-5: Chiarella’s History, Central Bank’s Future’ (1995) 20 Delaware Journal of Corporate Law 865, 883 (noting that Chief Justice Burger’s misappropriation theory ‘was deliberately not pursued’); Donna M. Nagy, ‘Reframing the Misappropriation Theory of Insider Trading Liability: A PostO’Hagan Suggestion’ (1998) 59 Ohio St. L.J. 1223, 1240 (stating that Chief Justice Burger’s theory ‘would confuse the jury and trigger an acquittal’). After Newman, almost all cases involving ‘outsiders’ trading on material, non-public information were litigated under the ‘fraud on the source’ theory. See e.g., SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991); Rothberg v. Rosenbloom, 771 F.2d 818 (3d Cir. 1985); SEC v. Clark, 915 F.2d 439 (9th Cir. 1990); Carpenter v. United States, 791 F.2d 1024 (2d Cir. 1986); United States v. O’Hagan, 92 F.3d 612, 622 (8th Cir. 1996). In Moss v. Morgan Stanley Inc., F.2d 5 (2d Cir. 1983), cert. denied, 465 U.S. 1025 (1984), the Government did try to use the ‘fraud on investors’ theory once, but failed. In this case, a private plaintiff instituted a cause of action under Section 10(b) and Rule 10b-5 against the investment banks’ employees and their tippees who had traded on confidential information concerning a tender offer. The SEC presented the ‘fraud on investors’ theory to support the plaintiff. However, the Second Circuit held that the defendants owed a duty to disclose to their investment bank employers as the ‘fraud on the source’ theory suggested, but ‘owed no duty of disclosure to the plaintiff’. Ibid 16. 58. United States v. O’Hagan, 521 U.S. 642 (1997).

140

Chapter 5

Justice William Brennan, concurring in the judgment, agreed with Burger, CJ., that ‘a person violates §10(b) whenever he improperly obtains or converts to his own benefit non-public information which he then uses in connection with the purchases or sale of securities,’ but concurred in the judgment because the issue had not been presented to the jury.59 Like Burger, Brennan did not demand the breach of any fiduciary relationship in the course of misappropriating information as the requisite requirement for the violation of Rule 10b-5. Instead, a duty to disclose would certainly arise insofar as information is obtained improperly. Justice Harry Blackmun, in a dissenting opinion joined by Justice Thurgood Marshall, argued in favour of the equality of access theory by stating that: persons having access to confidential material information that is not legally available to others generally are prohibited by Rule 10b-5 from engaging in schemes to exploit their structural informational advantage through trading in affected securities. 60 This equality-of-access based standard appears to be the broadest of the theories set forth in the separate Chiarella opinions. It prohibits any misuse of material, non-public information, regardless of whether the information is obtained unlawfully or not, as long as the information is legally unavailable to others.61 In conclusion, in order to limit the perceived broad scope of insider trading liability, the Court imported common law concepts of fraud and developed the fiduciary-duty-based classical theory. However, the classical theory turned out to be far too narrow. As will be shown, in order to expand insider trading liability within the framework of the fiduciary-duty based theory, the Supreme Court had to distort the notion of fiduciary duty and make a lot of rather strained reasoning.

59. Chiarella, 445 U.S. 222, 239 (Brennan, J., concurring). 60. Ibid 251 (Blackmun, J., concurring) (emphasis added). 61. As far as ‘outsider’ trading is concerned, the equality of access theory is broader than the ‘fraud on the source’ theory and the ‘fraud on investors’ misappropriation theory, because it does not require that the information is acquired unlawfully or used deceptively. For example, Justice Blackmun indicated that he would define the actions of Chierella as fraudulent even if he had ‘obtained the blessing’ of his employer before using the information. Chiarella, 445 U.S. 222, 246 (Blackmun, J., concurring). If Chiarella had told his employer about his trading plan, he would have not defrauded his employer under the ‘fraud on the source’ theory, and also arguably would have obtained the information not by unlawful means under the ‘fraud on investors’ theory. For a full analysis of the limits of the ‘fraud on the source’ theory, See below §5.IV.A.2. Moreover, the equality of access theory can also cover some types of ‘insider’ trading which the two misappropriation theories are unable to apply. For instance, the ‘fraud on investors’ theory may effectively impose on corporate outsiders insider trading liability, but may be hard to cover corporate insiders because corporate insiders always legally get inside information in their employment. The ‘fraud on the source’ theory, as the Supreme Court stated in O’Hagan, is only a complement to the classical theory in that it extends to outsiders insider trading liability. See below §5.III.C.3.

Theories of Insider Trading Liability a.

141

Rule 14e-3

The SEC was clearly unhappy with the classical theory and promulgated Rule 14e-362 under the rulemaking authority of Section 14(e)63 in September 1980 soon after Chiarella. Rule 14e-3 prohibits trading by any person in possession of material, non-public information relating to a tender offer when the person knows or has reason to know that the information is non-public and was received from the offeror, the target, or any person acting on behalf of either the offeror or the target. Under Rule 14e-3, a fiduciary relationship between traders as required by the classical theory is irrelevant for insider trading liability to attach. Thus, with Rule 14e-3, the SEC actually applies the equality of access theory in the tender offer setting where much if not most of insider trading is seen. However, due to the inconsistency between Rule 14e-3 and Chiarella, the question whether the SEC exceeded its rulemaking authority under Section 14(e) when it adopted Rule 14e-3 was not settled until 1997 when the Supreme Court finally declared Rule 14-3 valid in United States v. O’Hagan.64 2.

Dirks v. SEC

Three years after Chiarella, in Dirks v. SEC,65 a case involving trading by persons receiving information from a corporate insider’s tippee, the Supreme Court adhered to its fiduciary-duty-based theory and once again emphasized that insider trading liability under Rule 10b-5 occurs only when the defendant owes a fiduciary duty to shareholders with whom he is trading. However, the Court took great pains to find the requisite fiduciary duty. In this case, Raymond Dirks, an investment analyst, received a tip from Ronald Secrist, a former officer of Equity Funding, that the corporation’s assets were vastly overvalued as a result of fraudulent corporate practices.66 Secrist also

62. 17 C.F.R. §240.14e-3 (1997). 63. 15 U.S.C. 78n(e) (1994). Section 14(e) states in relevant part: ‘[t]he Commission shall, for the purposes of this subsection, by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative’. Ibid. The legislative history of Section 14(e) has indicated that, in contrast to Section 10(b) which is the dubious ancestor of insider trading regulation, Section 14(e) is clearly amended, amongst other things, to empower the SEC to promulgate rules to curb abuses associated with trading on the basis of material, non-public information in connection with tender offers. See Additional Consumer Protection in Corporate Takeovers and Increasing the Securities Act Exceptions for Small Businessmen: Hearings on S. 336 & S. 3431 Before the Subcomm. on Sec. of the Senate Common Banking and Currency, 91st Congress 10–12 (1970) (statement of Hamer H. Budge, Chairman, SEC). It is clear that the presence of a fiduciary relationship is not required by the US Congress for the purposes of Section 14(e). Ibid 12. 64. 521 U.S. 642 (1997). For the reasoning of the O’Hagan Court to validate Rule 14e-3, See below §5.III.C.3.b. 65. 463 U.S. 646 (1983). 66. Ibid 649.

142

Chapter 5

told Dirks that various regulatory agencies were not responding to similar charges coming from other company employees, and therefore encouraged Dirks to verify and expose the fraud.67 In the course of his investigation, Dirks did find the fraud, and then divulged the information to several of his clients who in turn sold their holdings as a result.68 The SEC conducted an administrative proceeding against Dirks, and arrived at the conclusion that Dirks had aided and abetted insider trading,69 but only censured him because of his positive contribution in uncovering the fraud.70 In reversing Dirk’s censure, the Supreme Court reaffirmed the requirement that a breach of fiduciary duty between the parties to a transaction must have occurred in order for liability to be imposed.71 Trying to meet this requirement, the SEC presented an artificially created fiduciary duty by holding that a tippee ‘inherits’ the tipper/insider’s fiduciary duty to disclose before trading when he knowingly receives material non-public information.72 The Court also recognized that it would be difficult to find a breach of fiduciary duty between tippees and their trading counterparts for the purposes of tipping liabilities,73 because ‘[un]like insiders who have independent fiduciary duties to both the corporation and its shareholders, the typical tippee has no such relationship’.74 The fiduciary-duty-based theory thus appears to be deeply troubled. In order to resolve this problem, the Court went out of its way to find a fiduciary duty to remedy the classical theory. Firstly, the Court technically treated intermediaries, including underwriters, accountants, lawyers, and consultants, as tippers rather than tippees, even though these intermediaries were actually tippees. This group of persons is referred to in their entirety as constructive or temporary insiders. According to the Court, where corporate information is revealed legitimately to intermediaries working for the

67. Ibid. 68. Ibid. 69. The SEC concluded that ‘[w]here ‘tippees’ – regardless of their motivation or occupation – come into possession of material ‘corporate information that they know is confidential and know or should know came from a corporate insider’, they must either publicly disclosure that information or refrain from trading’. In the Matter of Raymond L. Dirks, 21 SEC Docket 1401, 1407 (1981) (quoting Chiarella v. United States, 445 U.S. 222, 230 n. 12 (1980)). 70. Ibid 652. An important reason why the SEC only censured Dirks was that Dirks also reported to the SEC his findings with respect to the relevant frauds. Ibid 650 n. 3. 71. Dirks v. SEC, 463 U.S. 646, 654–655 (1983). It should be noted that the fiduciary duties focused on here by the Court are those that traders and their tippers own to the issuer and to other traders, not those to third parties that characterized Justice Stevens’s opinion in Chiarella. 72. Ibid 655–56 (‘Tippees such as Dirks who receive non-public, material information from insiders become “subject to the same duty as [the] insiders” ’.) (quoting Shapiro v. Merill Lynch, Pierce, Fenner & Smith, Inc., 495 F. 2d 228, 237 (CA2 1974)). Then, the SEC argued that Dirks breached his inherited fiduciary duty in transmitting the information to his clients. Ibid 656. 73. ‘This requirement of a specific relationship between the shareholders and the individual trading on inside information has created analytical difficulties for the SEC and courts in policing tippees who trade on inside information’. Dirks v. SEC, 463 U.S. 646, 655 (1983). 74. Dirks v. SEC, 463 U.S. 646, 655 (1983).

Theories of Insider Trading Liability

143

corporation, these outsiders may become fiduciaries of the shareholders, because ‘they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes’.75 In order for the fiduciary duty to occur, the Court held that: the corporation must expect the outsider to keep the disclosed non-public information confidential, and the relationship at least must imply such a duty.76 However, the types of intermediaries do not include analysts, even though analysts might also gain access to inside information for corporate purposes.77 Secondly, as to those outsiders who can be only treated as ‘tippees’, the Court basically accepted the SEC’s idea that fiduciary duty can be inherited,78 but disagreed on the issue of when a tippee inherits a fiduciary duty from an insider. The SEC argued that tippees assume an insider’s duty to the shareholders as long as they knowingly receive insider information. The Court contended that the SEC’s view was virtually the same as the view which had been rejected in Chiarella, and then offered its ‘derivative duty’ theory as follows: [A] tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material non-public information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there was been a breach.79 Thus, tippees can be held liable on the grounds that they violate their fiduciary duty inherited from tippers/insiders who breach their fiduciary duty to disclose

75. 76.

77. 78. 79.

Dirks v. SEC, 463 U.S. 646, 655 n. 14 (1983). From a practical viewpoint, this treatment greatly facilitates the allegation against intermediaries, despite its weak theoretical basis. Ibid. For more analysis of the requirement that apart from the issuer’s expectation of confidentiality, constructive insiders must have expressly or impliedly entered into a fiduciary relationship with the issuer, See Langevoort, above note 15, §3.02[3], 10–16; Stephen M. Bainbridge, ‘The Law and Economics of Insider Trading: A Comprehensive Primer’, 46–48, available at http://papers.ssrn.com/paper.taf?abstact_id=261277 (last visited on 8 May 2005). The Court was particularly concerned that imposing liability against analysts like Dirks would have a chilling effect, and thus discourage them from investing time and resources in ‘ferret[ting] out and analyz[ing] information’. Dirks v. SEC, 463 U.S. 646, 658 (1983). Ibid 659 (‘the tippee’s duty to disclose or abstain is derivative from that of the insider’s duty’). Ibid 660. The Court rejected the SEC’s argument, holding that the tippee would not inherit the fiduciary duty of the insider as a result of ‘the mere receipt of information from an insider’. Ibid 656 n. 15. In the Court’s opinion, the SEC’s theory of tippee liability is essentially premised on the idea which the Court had clearly rejected in Chiarella, that is, to require ‘equal information among all traders’. Ibid 646. The Court then reasoned that some tippees would assume an insider’s duty to the shareholders ‘not because they receive inside information, but rather because it has been made available to them improperly’. Ibid 660 (citing In re Investors Management Co., 44 S.E.C. 633, 641 (1971)) (emphasis in original). In the Rule 10b-5 cases, the Court explained that the insider’s disclosure is improperly only where it would violate his fiduciary duty to shareholders. Ibid 660.

Chapter 5

144

confidential information in the first place. Recognizing that not all disclosures of inside information are contrary to an insider’s fiduciary duty, the Court held that whether the disclosure of tippers is a breach of duty depends ‘in large part on the purpose of the disclose’.80 In order to judge whether an insider’s purpose is proper, the Court provided an objective criterion. This involved an inquiry into ‘whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings’.81 Therefore, unless tippers/insiders gain personally from their disclosure, they will not be found to have breached their fiduciary duty, and no derivative duty will be passed on to tippees. Applying the ‘personal benefit’ test to Secrist’s disclosure to Dirks, the Court concluded Dirks did not violate Section 10(b) and Rule 10b-5, holding that Secrist did not breach his fiduciary duty because he did not receive any direct or indirect personal benefit, and thus Dirks did not inherit a fiduciary duty from Secrist.82 However, as will be discussed, this ‘personal benefit’ criterion has been proven problematic.83 a.

Regulation FD

As discussed above, under the US insider trading regime, Section 10(b) is violated when an insider tips for personal benefit. However, it is always difficult to establish such personal benefit. This problem becomes more poignant as to the selective disclosure practice, the practice of companies selectively disclosing material, non-public information to financial analysts, institutional investors and other favoured market participants before making full disclosure of the same information to the general public. The SEC has long been concerned with the unfairness of this practice, stating that: We believe that the practice of selective disclosure leads to a loss of investor confidence in the integrity of our capital markets. Investors who see a security’s price change dramatically and only later are given access to the information responsible for that move rightly question whether they are on a level playing field with market insiders.84 Although the practice of selective disclosure closely resembles the tipping of inside information, the SEC is unable to effectively deal with it under insider trading regime. Indeed, because it is very difficult to prove that company selective disclosure is motivated by personal benefit, it is in effect out of the reach of

80. Ibid 662. 81. Ibid 663. 82. Ibid 666-7. 83. See below §5.IV.A.1.b. 84. See Selective Disclosure and Insider Trading, Exchange Act Release No. 43154, [2000 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶86,319, at 83,678 (Aug. 15, 2000) [hereinafter Selective Disclosure Release].

Theories of Insider Trading Liability

145

the tipping regime under Dirks.85 Faced with the inability of insider trading law to effectively address the selective disclosure practice, the SEC promulgated Regulation FD (Fair Disclosure)86 to create a non-insider trading based mechanism to address it. Regulation FD basically provides that ‘when an issuer, or person acting on its behalf, discloses material non-public information to [selective] persons . . . , it must make public disclosure of that information’.87 The timing of the required public disclosure depends on whether the selective disclosure is intentional or nonintentional. Where the selective disclosure is intentional, then the issuer must simultaneously disclose the information in a manner designed to convey it to the general public; Where the disclosure is unintentional, then the issuer must disclose the information to the public promptly, but in no event after the later of 24 hours or the opening of the next day’s trading on the New York Stock Exchange. It is worth noting that the underlying concerns of promulgating Regulation FD appear to be related to the equality of access theory. The SEC stated that selective disclosure closely resembles the tipping of insider information, because ‘in both cases, a privileged few gain an informational edge – and the ability to use that edge to profit–from their superior access to corporate insiders, rather than from their skill, acumen, or diligence’.88 Then, the SEC made it clear that ‘unerodable information advantages’ exploited by selected persons would result in investors losing confidence in the fairness of the market.89 This has led one commentator to say that: [b]ecause the underlying goal of Regulation FD is to provide equal access to information to all investors, the rule in effect resurrects the discarded ‘parity of information’ theory.90

85. Selective Disclosure Release, at 83, 677 n. 7 (‘in light of the ‘personal benefit’ test set forth in the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983), many have viewed issuer selective disclosures to analysts as protected from insider trading liability’.); Loss & Seligman, above note 15, vol. VIII, 3606–3607 (stating that ‘the analyst category is very likely the prime example of a tip that normally is not given for either friendship or personal gain’ (emphasis original)). 86. Selective Disclosure Release, at 83, 676. 87. Ibid. It is important to note that Regulation FD does not mandate that issuers publicly disclose all material development when they occur. Rather, it only requires that when an issuer chooses to disclose material, non-public information, it does so broadly to the general public. In contrast, the New York Stock Exchange and NASDAQ rules both require listed issuers to promptly make public disclosure of information regarding all material developments. See NYSE Listed Company Manual, para. 202.05 (Timely Disclosure of Material News Developments) and NASD Rules 4310(c)(16), 4320(e)(14), and IM-4210-1 (Disclosure of Material Information). However, in practice, these timely disclosure rules are rarely enforced against listed companies. 88. Selective Disclosure Release, at 83, 677. 89. Ibid at 83, 677–78. 90. T. Andrew Eckstein, ‘The SEC’s New Regulation FD: A Return to The Parity Theory?’ (2001) 69 University of Cincinnati Law Review 1289, 1313. Note, ‘parity of information’ theory referred to here is actually the equality of access theory. Ibid 1303 n. 96 (explaining that the phrase ‘parity of information’ actually refers to ‘parity of access to [material] information’).

Chapter 5

146

To the extent that the SEC seeks to regulate insider tipping in the selective disclosure setting by resorting to the disclosure regime imposed on companies,91 it is submitted that Regulation FD is merely a backhanded way to recapture as much as possible the ground it had lost in Dirks. 3.

United States v. O’Hagan

In 1997, over seventeen years after Justice Stevens expressed his approval of the ‘fraud on the source’ misappropriation theory in Chiarella, the Supreme Court finally endorsed this theory in United States v. O’Hagan.92 As elaborated below, the misappropriation theory had gone through a very hard path to obtain this judicial endorsement. a.

The Misappropriation Theory Prior to O’Hagan

In response to the setback it suffered in Chiarella, the SEC soon began to advocate the ‘fraud on the source’ misappropriation theory articulated by Justice Stevens to extend insider trading liability to ‘outsiders’, namely, those persons who trade on material, non-public information, but who do not owe a fiduciary duty to the shareholders of companies whose shares were traded. However, judicial responses to the theory were mixed. The Second Circuit firstly upheld the misappropriation theory. In United States v. Newman,93 employees of an investment bank misappropriated confidential information concerning proposed mergers involving clients of the firm. The court found that the defendants had defrauded the investment bank employer as well as their respective clients and this fraud sufficed to impose insider trading liability. 94 However, the validity of the theory was open to question, because the misappropriation theory focuses on a fraud on the information’s source, someone other than the shareholder with whom the misappropriator traded, someone who may even have nothing to do with securities transactions. In 1987, the misappropriation theory was presented to the Supreme Court in Carpenter v. United States.95 This case involved a Wall Street Journal reporter who had leaked material, nonpublic information about the content of his upcoming ‘Heard on the Street’ column to two stockbrokers who then purchased affected

91. In order to address the selective disclosure problem outside of the constraints of insider trading law, the SEC emphatically characterized Regulation FD as ‘a new issuer disclosure rule’ under its authority to mandate disclosure by public companies. Selective Disclosure Release, at 83, 676. 92. 521 U.S. 642 (1997). 93. 664 F.2d 12 (2d Cir. 1981). 94. Ibid 17–18. 95. 484 U.S. 19 (1987).

Theories of Insider Trading Liability

147

securities.96 The Court affirmed the convictions on the basis of mail and wire fraud, but split four to four on the issue of the validity of the misappropriation theory.97 The reason behind the evenly divided Court was that the seat vacated by the retired Justice Powell had not yet been filled by his successor at the time of the case. Had Justice Powell, an opponent of the misappropriation theory,98 joined the Carpenter Court, the theory would likely have been invalidated by a five to four vote, and the US insider trading regime might have developed in a manner that is very different from the present way. The failure of the Court to deliver a clear opinion about the validity of the misappropriation theory thus left the door open for lower courts to decide whether to accept the misappropriation theory or not. Like the Court, lower courts also split on the issue. While the Second,99 Seventh,100 Ninth,101 and arguably Third102 Circuits chose to accept the theory, the Fourth103 and Eight104 Circuits declined. 96.

97. 98.

99.

100. 101. 102.

103. 104.

Ibid 20–24. With respect to the issue of the validity of the ‘fraud on the source’ misappropriation theory, the Court offered but one sentence: ‘The Court is evenly divided with respect to the convictions under the securities laws and for that reason affirms the judgement below on those counts’. Ibid 24. Ibid 24 (‘The Court is evenly divided with respect to the convictions under the securities laws . . . ’). Justice Powell expressed his opposition to the misappropriation theory, holding that the theory was inconsistent with the classical theory because the relevant inquiry under Section 10(b) and Rule 10b-5 must focus on the relationship between market participants. Draft of Dissent from the Denial of Certiorari for Carpenter v. United States, Justice Powell (Dec. 10, 1986), reprinted in A.C. Pritchard, ‘United States v. O’Hagan: Agency Law & Justice Powell’s Legacy for the Law of Insider Trading’, 78 B. U. L. Rev. 13, 58 (1998). See, e.g., United States v. Newman, 664 F.2d 12 (2d Cir. 1981) (recognizing federal securities liability premised on two investment bank employees’ misappropriation of information entrusted to them by their employers); SEC v. Materia, 745 F.2d 197 (2d Cir. 1984) (applying the misappropriation theory in a case against a financial printer involving facts almost identical to those of Chiarella), cert. denied, 471 U.S. 1053 (1985); United States v. Reed, 601 F. Supp. 685 (S.D.N.Y.) (applying the misappropriation theory against son who allegedly traded on the basis of nonpublic information obtained from his father, a corporate director), rev’d on other grounds, 773 F.2d 477 (2d. Cir. 1985). See SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991) (applying the misappropriation theory in an action against an individual who stole information from his former employer and then traded on it); See SEC v. Clark, 915 F.2d 439 (9th Cir. 1990) (recognizing liability of one employee who misappropriated information concerning his employer’s tender offer plan); See Rothberg v. Rosenbloom, 771 F.2d 818 (3d Cir. 1985) (recognizing tippee’s Rule 10b-5 liability for trading on the basis of inside information obtained from corporate official), rev’d on other grounds after remand, 808 F.2d 252 (3d Cir. 1986). But See SEC v. Lenfest, 949 F. Supp. 341, 345 (E.D. Pa. 1996) (expressing uncertainty as whether the Third Circuit actually applied the misappropriation theory in Rothberg, but nevertheless recognizing the validity of that theory in denying defendant’s motion for summary judgment). See United States v. Bryan, 58 F.3d 933 (4th Cir. 1995) (rejecting the misappropriation theory and refusing to impose liability where lottery commissioner used information about a pending contract with the state lottery commission); See United States v. O’Hagan, 92 F.3d 612 (8th Cir. 1996) (rejecting the misappropriation theory).

Chapter 5

148

The main reason why the misappropriation theory was rejected is that it involves no deception upon market participants, but rather simply a breach of fiduciary duty to the source of information.105 The split of the circuits over the validity of the misappropriation theory prompted the Supreme Court to finally deal with the issue in O’Hagan. b.

Adoption of the Misappropriation Theory in O’Hagan

O’Hagan involved trading in the securities of a tender offer target company by an attorney whose law firm represented the prospective bidder. James Herman O’Hagan was a partner in the law firm of Dorsey & Whitney in Minneapolis, Minnesota. The law firm was retained in July of 1988 by Grand Met PLC (‘Grand Met’) for a planned tender offer for the stock of Minneapolis-based Pillsbury Company (‘Pillsbury’). Although O’Hagan did not personally represent Grand Met, he learned of the tender offer from one of his colleagues and began purchasing call options for Pillsbury stock as well as shares of common stock. After Grand Met announced its tender offer for Pillsbury in October 1988, O’Hagan sold his options and stock at a profit of over USD 4.3 million.106 He was charged, convicted, and sentenced to forty-one months of imprisonment on fifty-seven criminal counts, including securities fraud (in violation of Section 10(b) of the Exchange Act and Section 14(e), and Rules 10b-5 and 14e-3 promulgated thereunder) and federal mail fraud.107 The government employed the misappropriation theory, rather than the classical theory, to build its Section 10(b) and Rule 10b-5 case because neither O’Hagan nor his law firm had any fiduciary relationship with, or owed any fiduciary duty to, the shareholders of Pillsbury with whom O’Hagan traded.108 On appeal, the United States Court of Appeals for the Eighth Circuit reversed O’Hagan’s convictions for violating Section 10(b) and Rule 10b-5,109 holding that

105. 106. 107.

108.

109.

See e.g., United States v. Bryan, 58 F.3d 944 (4th Cir. 1995) (concluding that while Bryan violated a fiduciary duty owed to his employer, breach of that duty did not constitute deceptive conduct ‘in connection with the purchase or sale of [a] security’.). United States v. O’Hagan, 521 U.S. 642, 648 (1997). Ibid. O’Hagan was also disbarred and convicted on other counts in the state court. See O’Hagan, 117 S. Ct. at 2205 n. 2 and accompanying text (citing State v. O’Hagan, 474 N.W.2d 613 (Minn. Ct. App. 1991); In re O’Hagan, 450 N.W.2d 571 (Minn. 1990)). In a civil action, the SEC separa. tely sought and received disgorgement of profits and an injunction. See SEC v. O’Hagan, 901 F. Supp. 1461 (1995). United States v. O’Hagan, 521 U.S. 642, 648 (1997). O’Hagan was not a constructive insider of Pillsbury, but could be one of Grand Metropolitan. See Dirks v. SEC, 463 U.S. 646, 655 n. 14 (1983) (noting that outsider lawyers, accountants, consultants and others could be regarded as constructive insiders of the companies who retained them and gave them access to information for corporate purposes). Had O’Hagan traded the shares of Grand Metropolitan, as opposed to Pillsbury, he might have been caught under the established classical theory in Dirks, and the misappropriation theory might have lost its opportunity to be addressed in this case. United States v. O’Hagan, 92 F.3d 612, 622 (8th Cir. 1996). The Eight Circuit also reversed O’Hagan’s convictions under Section 14(e) and Rule 14e-3, holding that Rule 14e-3 exceeds

Theories of Insider Trading Liability

149

a conviction under Section 10(b) and Rule 10b-5 cannot be based on the misappropriation theory for two reasons:110 (1) contrary to Section 10(b)’s explicit requirement, the misappropriation theory does not require the element of ‘deception’; (2) the theory ‘render nugatory the requirement that the “deception” be “in connection with the purchase or sale of any security” ’. The Supreme Court reversed the Eighth Circuit judgement and adopted the misappropriation theory.111 Both of the Eighth Circuit’s holdings regarding the misappropriation theory, in the view of the Court, were in error. The Court first explained why the misappropriation theory encompasses the ‘deception’ element which is required under Section 10(b) and Rule 10b-5. In the Court’s view, Section 10(b), read literally, is not limited to deception of a purchaser or seller of securities, but rather covers any deceptive device used ‘in connection with the purchase or sale of any security’.112 Then, the Court held that ‘misappropriators, as the Government describes them, deal in deception’ because they pretend to be loyal to the principal while secretly converting the principal’s information for personal gain, and this conduct “dupes” or defrauds the principal’.113 Because the fraud under the misappropriation theory is on the source of information, the Court concluded that, a fiduciary can avoid liability only by disclosing his intent to trade to the principal in the fiduciary relationship, not to investors with whom he trades.114 Further, the Court elaborated on the other requirement of Section 10(b) that the misappropriator’s deceptive use of misappropriated information must be ‘in connection with the purchase or sale of [a] security,’ and concluded that this requirement was satisfied because the misappropriator’s undisclosed securities trade itself consummates the deception.115 In other words, insider trading liability under Section 10(b) is triggered because the deception and the securities transaction necessarily coincide. Thus, under the misappropriation theory, perpetrators do not deceive the shareholders of companies whose shares they trade, but those who entrusted them with confidential information. Despite the differences in identifying who is deceived, the classical theory and the misappropriation theory are both premised on the presence of a fiduciary duty. More specifically, a fiduciary duty creates a duty to disclose one’s trades to their trading counterparts under the classical

110. 111. 112. 113. 114. 115.

the SEC’s rulemaking powers, and convictions under the federal mail fraud statutes because they depended on the securities convictions. Ibid 627–28. United States v. O’Hagan, 92 F.3d 612, 617 (8th Cir. 1996). United States v. O’Hagan, 521 U.S. 642, 667 (1997). Ibid 651. Ibid 653–54. Ibid 655 (‘if the fiduciary discloses to the source that he plans to trade on the non-public information, there is no “deceptive device” and thus no. §10(b) violation’). Ibid 656 (‘the fiduciary’s fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities’.).

150

Chapter 5

theory while to the source of information under the misappropriation theory.116 For this reason, these two theories can be collectively labelled ‘fiduciary-duty-based’ theories. The Court also expressly validated Rule 14e-3, holding that the rule is within the SEC’s rulemaking authority under Section 14(e) because it is reasonably designed to prevent misappropriation of confidential information in the tender offer context and thus does not need the requisite breach of fiduciary duty which is necessary under Section 10(b).117 The endorsement of Rule 14e-3 marks the SEC’s victory in attempting to apply the equality of access theory to the misuse of material, non-public information concerning tender offers, even though the fiduciary-duty-based theories generally dominate outside the tender offer setting. It should be noted that the misappropriation theory advanced by the Government and then endorsed by the Court in this case is the ‘fraud on the source’ misappropriation theory, rather than the ‘fraud on investors’ misappropriation theory. As discussed previously, in his dissenting opinion in Chiarella, Chief Justice Burger articulated the ‘fraud on investors’ misappropriation theory which premised insider trading liability on a trader’s duty to disclose his misappropriated information by ‘unlawful means’ to those with whom he trades in the market.118 Because the Government did not advance this ‘fraud on investors’ misappropriation theory in O’Hagan, the Court simply felt no need to address the theory.119 Although the ‘fraud on investors’ misappropriation theory is not ruled out by the Court, it seems virtually inconceivable that the theory will be specifically addressed, let alone endorsed by the Court in the foreseeable future,120 simply because, as the Court stated, the ‘fraud on the source’ misappropriation theory already neatly

116.

117.

118. 119. 120.

Ibid 653 (‘[T]he misappropriation theory outlaws trading on the basis of non-public information by a corporate “outsider” in breach of a duty owed not to a trading party, but to the source of the information’.); Painter et al., above note 22, 175 (‘[f]iduciary duty lies at the core of liability under the misappropriation theory . . . whether a fiduciary duty relationship exists creating a duty to disclose to the principal the fiduciary’s use of information’.). United States v. O’Hagan, 521 U.S. 642, 666–75 (1997). The Court refused to specifically address whether the SEC’ power to define fraudulent acts under Section 14(e) is broader than its rulemaking power under Section 10(b), but nevertheless stated in a footnote that ‘[t]he Commission’s power under Section 10(b) is more limited’. Ibid 672–73 n. 18. Instead, the Court focused on the nature of Rule 14e-3 as a prophylactic measure to justify its validity, holding that ‘under Section 14(e), the Commission may prohibit acts not themselves fraudulent under the common law or Section 10(b), if the prohibition is “reasonably designed to prevent . . . acts and practices [that] are fraudulent” ’. Ibid 673. See above §5.III.C.1. United States v. O’Hagan, 521 U.S. 642, 655 n. 6 (1997) (noting that the government did ‘not propose that we adopt a misappropriation theory of that breath’). There have seen differing opinions amongst legal scholars as to the viability of this theory. See e.g., Brief of Amici Curiae North American Securities Administrators Association, Inc., and Law Professors in Support of Petitioner, United States v. O’Hagan, 117 S. Ct. 2199 (1997) (No. 96-842), available in 1997 WL 86236 (proposing the ‘fraud on the investors’ misappropriation theory to the O’Hagan Court); Langevoort, above note 57, 883–84 (advocating judicial recognition of the ‘fraud on the investors’ misappropriation theory); Nagy,

Theories of Insider Trading Liability

151

complements the classical theory,121 and thus there is no practical need for the government to risk testing the ‘fraud on investors’ theory before the Court. Indeed, after its victory in O’Hagan, the SEC has now an acceptable, though not perfect or even theoretically flawed as suggested in the following section, set of weapons to combat unfair use of material, non-public information in securities trades. §5.IV.

A PROPOSAL FOR CHINA: THE EQUALITY OF ACCESS THEORY VS. FIDUCIARY-DUTY-BASED THEORIES

This section undertakes an in-depth analysis of whether the equality of access theory or the fiduciary-duty based theory is suitable for China. As discussed above, the US firstly employed the equality of access theory, and then replaced it with the fiduciary-based theories, including the classical theory and the misappropriation theory. This by no way suggests, however, that the current US insider trading theories, namely the fiduciary-based theories, are necessarily superior to the equality of access theory. Rather, as discussed below, the fiduciary-duty-based theory suffers from serious problems and appears less effective to promote investor protection than the equality of access theory. This is particularly so when the unique circumstances in China are considered. A.

FIDUCIARY-DUTY-BASED THEORIES ARE UNSUITABLE

Current US insider trading theory, namely the fiduciary-duty based theory, has been riddled with problems. Initially, the US Supreme Court perhaps felt that the scope of insider trading regulation under the equality of access theory was too broad, and then tried to find a limiting principle. It did so by importing the common law concept of fiduciary duty into insider trading law and thus developing the classical theory in Chiarella. However, since this approach has turned out to be excessively narrow, the Court had to struggle to expand the breadth of insider trading regulation in Dirks and O’Hagan, albeit at the price of new layers of conceptual difficulty. Indeed, in order to fit the requirement of fiduciary rela-

abovenote 57, 1240 (arguing that the ‘fraud on the investors’ misappropriation theory is far superior to the ‘fraud on the source’ misappropriation theory); but See Barbara Bader Aldave, ‘Misappropriation: A General Theory of Liability for Trading on Nonpublic Information’ (1984) 13 Hofstra L. Rev. 101, 115–116 (contending that the legal basis for ‘fraud on investors’ misappropriation theory is not strong enough); Alan Strudler and Eric W. Orts, ‘Moral Principle in the Law of Insider Trading’ (1999) 78 Tex. L. Rev. 375, 398–419 (arguing that the ‘fraud on investors’ theory is incoherent because it relies on a pair of flawed and mutually inconsistent rationales). 121. United States v. O’Hagan, 521 U.S. 642, 651–52 (1997) (‘[t]he two theories are complementary, each addressing efforts to capitalize on non-public information through the purchase or sale of securities. The classical theory targets a corporate insider’s breach of duty to

Chapter 5

152

tionship previously established in Chiarella, the Court was compelled to apply strained reasoning in Dirks and O’Hagan where more perversions appeared. In short, it appears that the importation of the common law conception of fiduciary duty has set a wrong direction for the advancement of US insider trading law. As Professor Langevoort pointed out, current US insider trading law ‘seems vague and complicated, and probably too narrow’.122 Furthermore, the reliance on the notion of fiduciary duty is particularly unsuitable for China as it is traditionally undeveloped there. 1.

Problems with the Classical Theory

a.

Problems with the Fiduciary Duty Requirement

As discussed above, in order to identify a duty to disclose before trading, the classical theory borrows the fiduciary duty concept from common law. However, the fiduciary duty appears to be inadequate in serving as a basis for insider trading law. Traditionally under the common law, corporate insiders, such as directors and other senior officers, do not owe fiduciary duties to individual shareholders, but rather to the corporation as a legal entity. Thus, there would be no fiduciary duty on the part of corporate insiders in their private dealing with shareholders.123 Even if corporate insiders can be regarded as standing in a fiduciary duty relationship to shareholders when trading stock,124 the classical theory cannot account for all of the cases that modern insider trading law recognizes as insider trading. One huge category of insider trading cases, involving outsiders who owe no fiduciary duty to the shareholders with whom they trade (sometimes referred to as ‘outsider trading’), falls well outside of the classical theory parameters. Because of its fiduciary-duty requirement, the classical theory can only reach traditional insiders, such as corporate directors and officers. In order to extend to outsiders trading liability on material, non-public information, the US Supreme Court had

shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of non-public information by a corporate “outsider” in breach of a duty owed not to a trading party, but to the source of the information’.). As noted before, the SEC has been deliberately avoiding litigating the ‘fraud on investors’ misappropriation theory even prior to the O’Hagan, and thus its incentive to use the theory, if any, might have died out after the judicial recognition of the ‘fraud on the source’ theory. 122. Langevoort, above note 15, §13.03[1], 10. 123. see e.g., H. L. Wilgus, ‘Purchase of Shares of a Corporation by a Director from a Shareholder’, 8 (1910) Mich. L. Rev. 267, 267 (‘The doctrine that officers and directors [of corporations] are trustees of the stockholders . . . does not extend to their private dealings with stockholders or others, though in such dealings they take advantage of knowledge gained through their official position’.). This is the so called ‘majority rule’ or ‘no duty rule’. See e.g., Hooker v. Midland Steel Co., 74 N.E. 445 (Ill. 1905). 124. Overtime, the ‘majority rule’ has gradually given way to the so called ‘minority rule’ and the so called ‘special facts’ doctrine. Under the ‘minority rule’, directors have a modern fiduciary

Theories of Insider Trading Liability

153

to adopt the misappropriation theory, even though this theory has many serious problems.125 Apart from the abovementioned ‘outsider trading’, the classical theory also ironically fails to cover traditional insiders. This basically happens in two situations. Firstly, the fiduciary duty principle may not easily resolve insider trading involving sales of securities rather than purchases of securities. Under the classical theory, insiders may sell shares to prospective shareholders on the basis of material, non-public information with impunity.126 Because prospective shareholders are not yet shareholders, insiders would have no fiduciary relationship with them before trading.127 Absent a fiduciary duty, there is no insider trading liability under the classical theory. To the extent that insiders may unfairly benefit from inside information by selling shares to the same degree as by buying shares, this is a problem to do with the classical theory’s failure to cover insiders’ sales of shares. In Cady, Roberts,128 the SEC specifically addressed this issue, stating that: [t]here is no valid reason why persons who purchase stock from an officer, director or other person having the responsibilities of an ‘insider’ should not have the same protection afforded by disclosure of special information as persons who sell stock to them.129 Though this policy consideration is right, it is not consistent with the fiduciary duty principle. Thus, the SEC contended that ‘it is clearly not appropriate to introduce [the common law principle of fiduciary duty] into the broader anti-fraud concepts embodied in the securities acts’.130

125. 126. 127.

128. 129. 130.

duty to disclose material non-public information to shareholders before trading with them. See e.g., Oliver v. Oliver, 45 S.E. 232 (Ga. 1903). Under the ‘special facts’ doctrine, although directors generally owe no duty to disclose material facts when trading with shareholders, such a duty can arise in ‘special circumstances’ in which directors conceal their identities and fail to disclose price-sensitive facts. See e.g., Strong v. Repide, 213 U.S. 419 (1909). For commentary on the state common law of insider trading, See e.g., Wang & Steinberg, above note 15, 1107–1129 (Common Law Fraud/Breach of Fiduciary Duty); Bainbridge, above note 76, 4–6; Joel Seligman, ‘The Reformulation of Federal Securities Law Concerning Nonpublic Information’ (1985) 73 Geo. L. J. 1083, 1091. For analysis on problems with the misappropriation theory, See below §5.IV.A.2. See e.g., Alison Grey Anderson, ‘Fraud, Fiduciaries, and Insider Trading’ (1982) 10 Hofstra L. Rev. 341, 356; A. C. Pritchard, ‘United States v. O’Hagan: Agency Law and Justice Powell’s Legacy for the Law of Insider Trading’ (1998) 78 B.U. L. Rev. 13, 26. Marhart, Inc. v. Calmat Co., No. 11820, 1992 WL 212587, at *1 (Del. Ch. Aug. 19, 1992) (‘fiduciary duties run to stockholders, not prospective shareholders’); Strudler and Orts, above note 120, 392 (‘The prospective purchaser is a stranger to the company, and no fiduciary duties are owed to strangers’.). 40 S.E.C. 907 (1961). Ibid 914. Ibid.

154

Chapter 5

The Chiarella Court agreed to the extension of an insider’s responsibility to prospective shareholders, but unlike the SEC, it nevertheless fitted the effort into the classical theory by employing an ‘incipient shareholder’ rule to find the existence of fiduciary duty. In a footnote, the Court stated: [t]he director or officer assumed a fiduciary relation to the buyer by the very sale; for it would be a sorry distinction to allow him to use the advantage of his position to induce the buyer into the position of a beneficiary although he was forbidden to do so once the buyer had become one.131 According to this view, it is fair to extend the law of fiduciary obligation to prospective shareholders because they are incipient shareholders and will soon be real shareholders. This reasoning is rather strained, and in the words of one commentator, ‘this extension would be an evasion’.132 In fact, because of the perceived difficulty in overcoming this theoretical problem which posts a serious challenge to the classical theory, the Court technically downplayed the anomaly by dealing with it in a simple footnote. Hence, even though the US insider trading prohibition now indisputably applies to insiders who buy and sell, this result cannot be easily explained by the classical theory. Secondly, the classical theory may be squarely applied to insider trading in publicly traded equity securities, but it is a stretch to apply it to insider trading in other types of securities such as options and debt securities. That insiders can profit by trading in options on the basis of inside information should be readily apparent. For instance, an insider could purchase a large number of call options from one company after becoming aware of good news about the company, and then exercise his/her right to buy the shares after the information is disclosed and the share price goes up, in anticipation that he/she can reap a profit by reselling the shares at the boosted price. Conceptually, the classical theory has difficulty curbing this situation because the options seller is not necessarily a shareholder of the issuer of the underlying security, and therefore may not be owed any fiduciary duty by the insider. For this reason, a number of courts in the US refuse to impose insider trading liability in cases of options trading.133 This problem was addressed in 1984 by the Insider Trading Sanction Act which changed the existing law and expressly prohibited insider trading in options or other derivative instruments.134 However, as one commentator said, this legislative effort ‘creates a conceptual anomaly in the law’.135 131. 132. 133. 134. 135.

Chiarella v. United States, 445 U.S. 222, 227 n. 8 (1980) (quoting the SEC’s argument in Cady, Roberts, 40 S.E.C. 907, 913 n. 23 (1961), and Gratz v. Claughton, 187 F.2d 46, 49 (CA2), cert. denied, 341 U.S. 920 (1951)). Strudler and Orts, above note 120, 392 (arguing that ‘[u]ntil the sale of securities is completed, the company stands in no fiduciary relation to a prospective purchaser of stock who does not yet own stock’). See e.g., Laventhall v. General Dynamics Corp., 704 F.2d 407 (8th Cir.), cert. Denied, 464 U.S. 846 (1983); O’Connor & Assoc. v. Dean Witter Reynolds Inc., 529 F. Supp. 1179 (S.D.N.Y. 1981). See 130 Cong. Rec. S8913 (29 June 1984); 130 Cong. Rec. H7758 (25 July 1984). Langevoort, above note 15, §3.03[1], 20.

Theories of Insider Trading Liability

155

The same problem exists in cases of debt securities trading. Yet, the application of insider trading law to debt securities has received very little judicial attention in the US. Even though debt securities are less susceptible to price fluctuations because they are fixed obligations, many commentators have argued that there is no sound reason why insider trading law should distinguish between equity and debt securities, reasoning that: Because the roles of debt, equity, and hybrid debt-equity instruments in the capital structure of the firm are to a significant extent interchangeable, and because various kinds of debt qualify as ‘securities’ subject to [American] federal law, there seems to be no relevant difference between stock and public debt for the purposes of insider trading law. Because firms finance themselves through issuing public debt as well as equity, both of which are often traded in securities markets, a formal legal distinction between debt and equity in insider trading law does not make sense.136 If insider trading liability as applied to trading in publicly held stock is extended to publicly held debt under the same criteria, the classical theory may be problematic. The conceptual difficulty arising here is that neither the corporation nor its officers and directors ordinarily have fiduciary duties to debt-holders.137 Because the classical theory requires a breach of fiduciary duty, it is unable to impose liability on those who inside trade in debt securities. b.

Problems arising from the ‘Personal Benefit’ Test for Tipping Liability

In Dirks, the Supreme Court extended the classical theory to insider tipping liability, but nevertheless erected a barrier in the form of the ‘personal benefit’ test. Under this test, an insider would not breach his/her fiduciary duty in disclosing inside information, so that the tippee would not inherit, much less breach, a fiduciary duty as required by the classical theory, unless the insider personally benefited from the disclosure.138 This test is quite problematic for reasons given below.

136. Strudler and Orts, above note 76, 392–393; See also Note, ‘Insider Trading in Junk Bonds’, 105 Harv. L. Rev. 1720, 1738–39 (1992) (arguing on economic grounds that insider trading law should not distinguish between equity and public debt); Langevoort, above note 15, §3.03[2], 21 (stating that the potential for profit by insider trading in debt securities is present). 137. Debt-holders’ rights are normally limited to the express terms of the contract and an implied covenant of good faith. See e.g., Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989); Katz v. Oak Indus., 508 A.2d 873 (Del. Ch. 1986). See also Lawrence E. Mitchell, ‘The Fairness Rights of Corporate Bondholders’, (1990) 65 N.Y.U. L. Rev. 1165, 1175 (explaining that bondholders are limited to the contractual terms for their remedies); Eric W. Orts, ‘Shirking and Sharking: A Legal Theory of the Firm’ (1998) 16 Yale L. & Pol’y Rev. 265, 306–308, 323–35 (stating that creditors have no extra-contractual protection against a corporation). 138. See above §5.III.C.2.

156

Chapter 5

Firstly, the ‘personal benefit’ test may be too vague to use in practice. Under the test, a qualified personal benefit can be either direct or indirect, such as ‘a pecuniary gain or a reputational benefit that will translate into future earnings’.139 However, as the dissenting judge pointed out, ‘the distinction between pure altruism and self-interest has puzzled philosophers for centuries; there is no reason to believe that courts and administrative law judges will have an easier time with it’.140 This is particularly so when personal benefit is indirect and non-monetary. Thus, even the US Supreme Court itself admitted that it is difficult to determine whether an insider personally benefits from a particular disclosure or not.141 In SEC v. Stevens, the SEC did try to clarify what constitutes an ‘indirect benefit’.142 Stevens, the CEO of a company, allegedly disclosed negative nonpublic information to several securities analysts whose clients then dumped their shares on the basis of the information and avoided losses.143 The SEC carefully argued that in doing so Stevens was able to protect and enhance his reputation, in addition to the disclosure being regarded by him as having a direct, tangible benefit on his status as a corporate manager.144 Thus, the SEC contended that the disclosure satisfied the personal benefit test in the sense that Stevens maintained his professional reputation. However, this case was eventually settled and thus the SEC’s position remained untested in the court.145 Secondly and more importantly, it is unclear why a ‘personal benefit’ to an insider is relevant to wrongfulness of the tippee’s conduct. From the perspective of a third party in the market, the key point is whether someone traded on privileged information, and it is irrelevant to ask where they got the privileged information, let alone whether the tipper benefited from the tipping. As the dissenting judge pointed out, the shareholder’s injury was not eliminated by the fact that the insiders themselves did not gain personally from the breach.146 Indeed, the impact on investors would seem to be exactly the same regardless of whether or not the tipper/insider gained personally from the tipping. As a result, this test would create serious loopholes. Suppose that non-public information is communicated consistently with fiduciary duties, for example, to secure a corporate loan or business relationship. Given that the tipper may not be held liable for the communication of the information, are all tippees then consequently free to trade on that information?147 The Court had little choice but to 139. Dirks v. SEC, 463 U.S. 646, 663 (1983). 140. Ibid 676 n. 13 (Justice Blackmun, dissenting). 141. Ibid 664. 142. 48 SEC Docket 739 (1991). 143. Ibid 739. 144. Ibid. To further support its view, the SEC recalled a 1984 incident in which an analyst who was then covering Stevens’ company ceased his coverage and publicly challenged Stevens’ representation of the company’s financial disclosure. Ibid. 145. T. Andrew Eckstein, ‘The SEC’s New Regulation FD: A Return to the Parity Theory?’ (2001) 69 University of Cincinnati Law Review 1289, 1310. 146. Dirks v. SEC, 463 U.S. 646, 673 (1983) (Justice Blackmun, dissenting). 147. Loss and Seligman, above note 15, 3577.

Theories of Insider Trading Liability

157

remedy it, footnoting that if corporate information was communicated legitimately to outsiders, such as underwriters, accountants, lawyers, or corporate consultants, these outsiders would become fiduciaries of the shareholders and be treated as constructive insiders rather than tippees.148 This remedial measure essentially circumvents the ‘personal benefit’ test, suggesting the inadequacy of the test. Moreover, because analysts were not included in this footnote, the selective disclosure practice escaped the net of the Dirks tipping regime, leading to the SEC’s promulgation of Regulation FD.149 As discussed above, the underlying concerns of promulgating Regulation FD are related closely to the equality of access theory, and thus it has been said that Regulation FD in effect resurrects the discarded equality of access theory.150 This clearly exposes the weaknesses of the classical theory, whilst at the same time revealing the strengths of the equality of access theory. 2.

Problems with the Misappropriation Theory

The misappropriation theory has two serious problems. Firstly, it is supported by dubious legal reasoning. This in turn damages the authority of the theory itself and has provided insufficient protection to investors. Secondly, the misappropriation theory has huge loopholes and some securities transactions involving the use of material, nonpublic information would fall outsider the scope of Section 10(b) and Rule 10b-5. These problems profoundly reflect the inadequacy of importing the common law requirement of fiduciary duty into securities law. Based on the existence of a fiduciary duty between traders, the classical theory is incapable of reaching ‘outsiders’ like O’Hagan who owed no fiduciary duty to the investors of companies whose shares were traded. From a policy standpoint, the adoption of the misappropriation theory is therefore entirely sensible,151 because it complements the classical theory by extending liability to outsiders, thereby ‘protec[ting] the integrity of the securities market against abuses by “outsiders” . . .’.152 Put differently, the O’Hagan Court might have believed that as a policy matter, the traditional theory results in too narrow a prohibition. Hence, the Court had little choice but to adopt the misappropriation theory, even though it has serious problems as discussed below. 148. 463 U.S. 646, 655, n. 14 (1983). 149. See above §5.III.C.2.a. 150. See above §5.III.C.2.a. 151. Indeed, because the misappropriation theory serves the practical need to extend to outsiders for trading on the basis of material, nonpublic information, many commentators have given complimentary commentary on O’Hagan, even while acknowledging the problems with the Court’s reasoning. See e.g., Joel Seligman, ‘A Mature Synthesis: O’Hagan Resolves “Insider” Trading’s Most Vexing Problems’, 23 (1998) Del. J. Corp. L. 1; Elliott J. Weiss, ‘United States v. O’Hagan: Pragmatism Returns to the Law of Insider Trading’, 23 (1998) J. Corp. L. 395; Victor Brudney, ‘O’Hagan’s Problems’, Sup. Ct. Rev. 249 (1997); Pritchard, above note 126. 152. United States v. O’Hagan, 521 U.S. 642, 653 (1997).

Chapter 5

158

a.

Dubious Legal Reasoning

The legal reasoning of the misappropriation theory is dubious. The Court has struggled to expand the breadth of insider trading liability established by the classical theory, but at the same time, it has had to fit the Chiarella-Dirks requirement of a breach of fiduciary duty. Under the misappropriation theory, the fiduciary duty is owed to the source of information and thus is extrinsic to the securities transaction itself. The reasoning used by the Court to link this breach to a violation of Section 10(b) and Rule 10b-5 becomes more obscure. In the Court’s view, the fraud on the information’s source is in connection with the purchase or sale of a security within the meaning of Section 10(b) because the fraud occurs when the fiduciary buys or sells the securities, not when the confidential information is obtained; hence, ‘[t]he securities transaction and the breach of duty . . . coincide’.153 Such a view of the misappropriation theory uses legal gymnastics to reconcile the theory with the statutory language of Section 10(b). Indeed, the misappropriation theory can be criticized as ‘a theory in search of a rationalization’.154 Deception through nondisclosure is essential for insider trading liability to occur, because ‘§10(b) is not an all-purpose breach of fiduciary duty ban; rather it trains on conduct involving manipulation or deception’.155 However, the theory focuses on a fraud on the source of information, rather than market participants, who may have little or no relationship with securities transactions. For example, the misappropriation theory protects newspapers from their columnists,156 patients from their psychiatrists,157 spouses from each other,158 parents from 153. Ibid 656. 154. Harold S. Bloomemthal, Securities Law Handbook 1183 (1998). For more criticism on the dubious reasoning of the misappropriation theory, See e.g., Michael P. Kenny & Theresa D Thebaut, ‘Misguided Statutory Construction to Cover the Corporate Universe: The Misappropriation Theory of Section 10(b)’, 59 (1995) Alb. L. Rev. 139, 188 (arguing that ‘whatever irresistible force’ brings together a misappropriator’s so-called ‘fraud on the source’ and his securities transactions, it is ‘not the magnetic attraction of the statutory text’); John R. Beeson, ‘Rounding the Peg to Fit the Hole: A Proposed Regulatory Reform of the Misappropriation Theory’, 144 (1996) U. Pa. L. Rev. 1077, 1138 (stating that ‘it is only through considerable legal gymnastics that the misappropriation theory leaps from the requirement of finding a breach of a duty unrelated to the market, to a holding that causation of remote and indict harm to investors in the market is the basis for Rule 10b-5 liability’); Nagy, above note 57, 1276 (contending that the misappropriation theory ‘may be functioning largely as a pretext for enforcing the parity of information approach . . . ’). 155. United States v. O’Hagan, 521 U.S. 642, 655 (1997) (citing Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977)) (emphasis added). The languages of Section 10(b) and Rule 10b-5 clearly suggest that the statutes proscribe ‘deceptive device’, ‘fraud’ or ‘deceit’ used in connection with securities transactions. See 15 U.S.C. §78j(b) and 17 CFR §240.10b-5 (1996). 156. Carpenter v. United States, 484 U.S. 19 (1987). 157. United States v. Willis, 737 F. Supp. 269 (S.D.N.Y. 1990). 158. United States v. Chestman, 947 F. 2d 557 (2d Cir. 1991) (en banc), cert. denied, 503 U.S. 1004 (1992).

Theories of Insider Trading Liability

159

their children,159 state lotteries from their commissioners,160 passengers from their taxi and limousine drivers, people from their retained lawyers or accounts, and so on. All the above relationships are formed outside the securities market, but the misappropriation theory connects them with securities trading for the purpose of establishing acts of securities fraud which fall within the zone of securities laws.161 This search for the required fiduciary relationships which can give rise to liability appears to be a results-oriented approach. Due to its dubious reasoning, the legal authority of the theory would decrease. In this regard, social scientists have found that individuals tend to obey laws primarily out of a sense of obligation and respect for the rule of law, holding that ‘the effectiveness of both political and legal authorities is heavily dependant upon the willing, voluntary cooperation of citizens with laws and legal decisions’.162 If the legal decision in O’Hagan is perceived to be built on dubious reasoning and lacking ‘legitimacy’, then it would be very hard to gain sufficient compliance from the public, and even support from the courts.163 This has been well illustrated by the fact that the validity of the misappropriation theory had remained notoriously uncertain for a long time before O’Hagan.164 Further, the dubious reasoning of the misappropriation theory may have a negative impact on the investor protection goal which it purports to serve.165 The misappropriation theory does recognize that trading on misappropriated information ‘deceives the source of the information and simultaneously harms members of the investing public’.166 However, the only injury proximately caused by the deception of nondisclosure under the misappropriation theory is to the source of

159. 160. 161. 162.

163.

164. 165. 166.

United States v. Reed, 601 F. Supp. 685 (S.D.N.Y.), rev’d on other grounds, 773 F.2d 477 (2d Cir. 1985). United States v. Bryan, 58 F.3d 933 (4th Cir. 1995). For an in-depth analysis on the dubious reasoning used by the O’Hagan Court to explain how misappropriation is ‘in connection with’ the securities trading, See e.g., Painter et al., above note 22, 181–186. See e.g., Tom R. Tyler, ‘Public Mistrust of the Law: A Political Perspective’ (1998) 66 U. Cin. L. Rev. 847, 856; Harold G. Grasmick & Robert J. Bursik, Jr., ‘Conscience, Significant Others, and Rational Choice: Extending the Deterrence Model’, 24 Law & Soc’y Rev. 837–39 (1990) (discussing research suggesting that moral concerns may be more important than legal sanctions in explaining future intentions regarding crime). See Tyler, above note 162, 858–60 (discussing research revealing that the public’s perception of the law’s ‘legitimacy’ is important to gaining voluntary compliance); See also Tom R. Tyler, ‘Compliance With Intellectual Property Laws: A Psychological Perspective’, 29 (1996–1997) N. Y. U. J. Int’l. L.& Pol. 219, 225 (concluding that ‘the way people behave is primarily a reflection of their views about: (1) what is right and wrong and (2) their obligations to the law and to legal authorities’). For the pre-O’Hagan history of the misappropriation theory, See above §5.III.C.3.a. United States v. O’Hagan, 521 U.S. 642, 658 (1997) (‘the [misappropriation] theory is also well tuned to an animating purpose of the Exchange Act: to insure honest securities market and thereby promote investor confidence’.). Ibid 656.

160

Chapter 5

information; the harm to investors stems from the misappropriator’s trading, not the deception which creates liability under Section 10(b).167 In other words, the theory identifies the information’s source as the only defrauded victim, and investors are indirectly protected under the misappropriation theory. The indirect investor protection is far from ideal and presents an obstacle to private rights of action. If investors are not regarded as the defrauded victim under the misappropriation theory, then it is natural that investors would not expect to have standing to initiate private actions. This was exactly the essence of the court’s view in Moss v. Morgan Stanley Inc.168 There, a private plaintiff who unwittingly sold shares in a soon-to-be tender offer target brought a Rule 10b-5 suit against those who had purchased the target’s securities based on misappropriated information regarding the upcoming tender offer. The Second Circuit held that the plaintiff lacked a private right of action under Rule 10b-5 because the plaintiff had not been deceived by the defendants who did not owe the plaintiff any duty to disclose the information.169 Thus, under the misappropriation theory, investors would have no standing to bring private civil suits. This major loophole has been plugged by the US Congress who amended the Exchange Act to provide contemporaneous traders, such as Moss, with an express right of action under Section 20A,170 because the result of Moss was ‘inconsistent with the remedial purposes of the Exchange Act’.171 Even though desirable from a policy point of view, this legislative revision creates a conceptual anomaly in the law of insider trading. If, as the Court has concluded, investors are not owed a fiduciary duty by insider traders under the misappropriation theory, what the US Congress is saying is that insider trading liability attaches in some circumstances absent any fiduciary relationship. This is inconsistent with the traditional theory, reflecting that the reasoning of the misappropriation theory is dubious and problematic. 167. Nagy, above note 57, 1277 (‘individuals and the securities markets are harmed, not from the misappropriator’s deception of the source, but from the very fact that the misappropriator was using stolen information in his securities trading’.) (emphasis in original). 168. 719 F.2d 5 (2d Cir. 1983), cert. denied, 465 U.S. 1025 (1984). 169. Ibid at 16 (‘defendants owed no duty of disclosure to plaintiff Moss’). 170. 15 U.S.C. §78t-1(1994). Section 20A provides that: Any person who violates any provision of this chapter or the rules or regulations thereunder by purchasing or selling a security while in possession of material, non-public information shall be liable in an action in any court of competent jurisdiction to any person who, contemporaneously with the purchase or sale of securities that is the subject of such violation, has purchased (where such violation is based on a sale of securities) or sold (where such violation is based on a purchase of securities) securities of the same class. 171.

15 U.S.C. §78t-1(a) (1994). See ITSFEA House Report, H.R. Rep. No. 100–910, at 27 (1988), reprinted in 1988 U.S.C.C.A.N. 6043, 6063. The US Congress expressly pointed out that Section 20A is ‘specifically intended to overturn court cases [like Moss] which have precluded recovery for plaintiffs where the defendant’s violation is premised upon the misappropriation theory’). Ibid.

Theories of Insider Trading Liability b.

161

Liability Loopholes

The forgoing analysis has suggested that the misappropriation theory extends to outsiders trading liability under Section 10(b) and Rule 10b-5 from a problematic route. However, the problems of the theory are not limited to this. Even though the misappropriation theory can reach persons outside the range of the classical theory, it has loopholes from which they can escape liability. Under the misappropriation theory, the deception is the act of failing to inform the information’s source about the intent to use misappropriated information to trade securities, not the act of trading itself. The misappropriation theory focuses on a fiduciary duty to the source of information which gives rise to a duty to disclose, and, thus, absent disclosure, to deception.172 Thus, the requisite elements of the misappropriation theory include: (1) the existence of a prior fiduciary duty; and (2) a failure to disclose the intent of trading to the source of information. Serious liability loopholes arise from these requirements. Firstly, if the information had been misappropriated for securities trading by a person not standing in a fiduciary relationship with the source, there would have been no violation under the misappropriation theory. Thus, non-fiduciaries who wrongly obtain information, such as thieves,173 could slip through the insider trading law. Because non-fiduciaries owe no requisite fiduciary duty to the source, and would not have defrauded the source, no misappropriation theory liability would arise, even though they may be guilty of other offences, such as burglary and theft. Secondly, if a brazen misappropriator discloses his/her trading plans to the source, then the subsequent trade would not violate Rule 10b-5, even if the source of information did not give permission to trade and objected strenuously.174 The O’Hagan Court stated: [F]ull disclosure forecloses liability under the misappropriation theory: because the deception essential to the misappropriation theory involves feigning fidelity to the source of information, if the fiduciary discloses to the source that he plans to trade on the non-public information, there is no ‘deceptive device’ and thus no §10(b) violation – although the fiduciaryturned-trader may remain liable under state law for breach of a duty of loyalty.175 172. United States v. O’Hagan, 521 U.S. 642, 652 (1997). 173. United State Supreme Court Official Transcript, O’Hagan (No. 96–842), available in 1997 WL 182584 at *5 (‘QUESTION: Well, Mr. Dreeben, then if some stole the lawyer’s briefcase and discovered the information and traded on it, no violation? MR. DREEBEN: That’s correct, Justice O’Connor’.). 174. This kind of trading has also been referred to as ‘candid trading’. Saikrishna Prakash, ‘Our Dysfunctional Insider Trading Regime’ (1999) 99 Colum. L. Rev. 1491, 1506. 175. United States v. O’Hagan, 521 U.S. 642, 655 (1997). The government has already agreed to this point that misappropriation liability could be avoided by disclosure of an intent to trade: To satisfy the common law rule that a trustee may not use the property that [has] been entrusted [to]

162

Chapter 5

Undoubtedly, if after disclosure, the fiduciary can trade even without the permission of the source, then it would be safer to do so with the consent of the source. The US Supreme Court later underscored this point, observing that no misappropriation theory liability could result ‘when a person trading on the basis of non-public information has disclosed his trading plans to, or obtained authorization from, from the principal’.176 One might think that the problems of brazen fiduciaries and authorized trading are highly hypothetical and may rarely happen in real life. This is not true, however. Securities trading by brazen fiduciaries is likely to occur, especially when the requisite fiduciary relationship under the misappropriation theory is a familiar relationship. 177 As for authorized trading, the practice of warehousing takeover stocks and tipping acquisition plans to friendly parties is a good example. The practice of warehousing, which was once common and led to the promulgation of Rule 14e-3, may still occur. The above loopholes are troubling, because the impact on the market would seem to be precisely the same, regardless of whether the securities trading on misappropriated information is carried out by a deceitful fiduciary, by a non-fiduciary or by a brazen fiduciary. As Justice Thomas pointed out in his dissent in O’Hagan, ‘even if it is true that trading on nonpublic information hurts the public, it is true whether or not there is any deception of the source of the information’. 178 Thus, even the majority of the O’Hagan Court conceded that Section 10(b) is ‘only a partial antidote to the problems it was designed to alleviate’.179 To be sure, in the tender offer setting, those loopholes could be closed by Rule 14e-3. This Rule has no requirement that trading parties are subject to a duty of confidentiality, and instead focuses on the fraud done to market participants. Thus, even if the misappropriator is not a fiduciary to the source, or has not defrauded the source because he/she has disclosed his/her trading plans to the source, or has even got permission from the source, he/she would still be held liable. This is exemplified in United States v. Chestman.180 There, Chestman used information entrusted to him by his wife about a forthcoming tender offer involving her family’s company. The Second Circuit held that Chestman was not liable under Section 10(b) because the government failed to provide sufficient evidence of a fiduciary duty between Chestman and his wife.181 Nevertheless, Chestman

him, there would have to be consent. To satisfy the requirement of the Securities Act that there be no deception, there would only have to be disclosure. Ibid 654 (quoting government counsel at oral argument) (emphasis added). 176. United States v. O’Hagan, 521 U.S. 642, 659 n. 9 (1997). 177. Nagy, above note 57, 1257–58. 178. United States v. O’Hagan, 521 U.S. 642, 690 (1997) (Thomas, J., concurring in the judgment in part and dissenting in part). 179. Ibid 659 n. 9. 180. 947 F.2d 551 (2d Cir. 1991) (en banc), cert. denied, 503 U.S. 1004 (1992). 181. Ibid 570–71.

Theories of Insider Trading Liability

163

was convicted under Rule 14e-3 because he knowingly traded while in possession of material non-public information relating to a tender offer.182 As discussed before, Rule 14e-3 was the SEC’s immediate response to the classical theory, and is based on the equality of access related concerns. The role of the Rule as a loophole-filler suggests the superiority of the equal access theory over the fiduciary-duty based theory. However, Rule 14e-3 is limited to information relating to a tender offer, so that outside the tender offer context the above loopholes remain. For example, if the information used by Chestman had not been related to a tender offer, but to another feasible acquisition alternative, such as a merger or sale of assets, Chestman would have avoided the Rule 14e-3 liability.183 Such a scenario is to be found in SEC v. Switzer.184 This case involved the securities trading by Barry Switzer, a football coach, on the basis of nonpublic information concerning an upcoming merger transaction. Switzer overheard the information from a corporate executive when he rested in the stands at a track meet.185 Because the SEC was unable to prove that the executive had intentionally or recklessly tipped the coach, the court held there was no unlawful tipping.186 More importantly, the prosecutor did not charge Switzer with Rule 14e-3, because the information at issue was not relating to a tender offer. It thus seems that Chestman’s liability was totally dependant on how the affected transaction was structured. This is not a consistent treatment because, once again, the impact on the securities market would seem to be the same regardless of whether the transaction is carried out as a tender offer or a merger. Thus, in order to provide even treatment in similar situations, the equality of access theory should be applied more broadly, rather than restricted to the tender offer setting. 3.

The Local Situation of China

A sensible conclusion as to the feasibility of implantation of any foreign legal experiences won’t be reached without taking into account the local situation in China. Apart from the problems inherent with the fiduciary-duty-based theories, the particular conditions in China make these theories even more unsuitable for China. Of particular relevance are the notion of fiduciary duty and the inefficacy of law enforcement in China. a.

The Undeveloped Concept of Fiduciary Duty

The undeveloped and inadequate notion of fiduciary duty in China may pose a considerable obstacle to adopting the fiduciary-duty-based theories. As discussed 182. Ibid 556–64. 183. Steinberg, above note 40, 644–645. 184. 590 F. Supp. 756 (W.D. Okla. 1984). 185. Ibid 724. 186. Ibid 766.

164

Chapter 5

previously, the US Supreme Court used the common law concept of fiduciary duty to establish insider trading law. Indeed, the notion of fiduciary duty lies at the heart of insider trading liability under both the classical theory and the misappropriation theory. More specifically, the critical determination is whether a fiduciary relationship exists and creates a duty to disclose to the trading party in the classical theory case, and to the source of information in the misappropriation theory case. In the presence of a duty to disclose, nondisclosure may amount to fraud. However, in order to meet the requirement of a breach of fiduciary duty, the US courts have had to adjust the common law notion of fiduciary duty. As one court pointed out, ‘federal courts applying a ‘federal fiduciary principle’ under Rule 10b-5 could be expected to depart from state fiduciary duty standards at least to the extent necessary to ensure uniformity within the federal system’.187 Thus, in applying the classical theory and the misappropriation theory, the US courts will either have to inquire into state fiduciary law, or develop their own federal fiduciary law, to determine when a fiduciary relationship exists to generate a duty to disclose. It seems, however, that even the US Supreme Court was uncertain about, and had been struggling with the scope of fiduciary relationship under Rule 10b-5. This is evident by the choice of language the Court used: a more expansive ‘relationship of trust and confidence’ in some cases188 and a more restrictive ‘fiduciary relationship’ in others.189 The relationship between the two terms is far from clear. According to the Black’s Law Dictionary, a ‘confidential relation’ is equated with a ‘fiduciary relation’.190 Nevertheless, it appears that the two terms are different. One commentator has argued that ‘fiduciary’ relationships arise from a legal mandate attached to certain positions, while the latter arise from specific conduct and expectations between two parties.191 Indeed, neither the scope of fiduciary relationship nor that of confidential relationship is clear. In the US, relationships traditionally considered to be fiduciary include: attorney and client, executor and heir, guardian and ward, principal 187. Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 479 (1977) (footnote omitted). 188. See e.g., Chiarella v. United States, 445 U.S. 222, 228 (1980); United States v. Reed, 601 F. Supp. 685, 696 (S.D.N.Y.), reviewed on other grounds, 773 F.2d 477 (2d Cir. 1985); United States v. Willis, 737 F. Supp. 269, 274 (S.D.N.Y. 1990); United States v. Chestman, 947 F. 2d 557, 564 (2d Cir. 1991) (en banc), cert. denied, 503 U.S. 1004 (1992). 189. See e.g., United States v. O’Hagan, 521 U.S. 642, 652 (1997). In O’Hagan, the Court also used ‘a duty of loyalty and confidentiality’. Ibid. The concept of ‘relationship of trust and confidence’ seems to be broader than that of ‘fiduciary relationship’. See e.g., United States v. Reed, 601 F. Supp. 685, 704–05 (S.D.N.Y.) (holding that relationship between father and son is not inherently fiduciary, but was arguably confidential in that instance’.). 190. Bryan A. Garner (ed.), Black’s Law Dictionary (West Publishing Company, 8th ed., 2004), p. 298. 191. George G. Bogert, ‘Confidential Relations and Unenforceable Express Trusts’ (1928) 13 Connell L. Q. 237, 248. Under this approach, the relationship between corporate directors and their shareholders will automatically be a fiduciary one, while the relationship between a father and son may or may not be confidential, depending on the specific relationship and expectations between the two parties.

Theories of Insider Trading Liability

165

and agent, trustee and trust beneficiary, partner and partner, and corporate officer or director and shareholder.192 Apart from these traditional types, many other types of relationships can also be fiduciary in nature, and thus the notion of fiduciary is quite vague.193 This has led one commentator to say that, [b]eyond these two categories [of corporate officer to shareholder and attorney to client], we must make educated guesses. Until a majority of the [US] Supreme Court has held that a particular relationship is fiduciary in nature, however, we cannot know for sure.194 The phrase ‘confidential relationship’ is even more indeterminate, because it has no traditional common law concept. Especially unclear is whether certain nonbusiness relationships, including family and other personal relationships, can be considered as confidential relationships under the misappropriation theory. For example, in United States v. Reed,195 the father-son relationship was regarded as one of trust and confidence, while in United States v. Chestman,196 the husbandwife relationship was found not to be confidential per se. Thus, the indeterminacy of the fiduciary relationship makes it very hard to determine in advance exactly whether activity by a family member falls within reach of the misappropriation liability. To solve this problem, the SEC promulgated Rule 10b5-2 in 2000,197 setting forth a non-exclusive description of the circumstances in which a ‘duty of trust or confidence’ exists for the purposes of the misappropriation theory under Section 10(b) and Rule 10b-5.198 According to Rule 10b5-2, certain types of close family relationships – spouses, parents, children and siblings – are now presumed to be fiduciary in nature. However, other family relationships, such as cousins, grandparents, and friendships are not. And, the prosecutor still needs to prove, under the facts and circumstances, that an expectation of confidence existed between the traders and their source. Thus, although this Rule has provided some guidance on the status of family relationships, some uncertainty around the issue remains.

192. 193.

194. 195. 196. 197. 198.

See e.g., John C. Coffee, ‘From Tort to Crime: Some Reflections on the Criminalization of Fiduciary Breaches and the Problematic Line Between Law and Ethics’ (1981) 19 Am. Crim. L. Rev. 117, 150; Austin W. Scott, ‘The Fiduciary Principle’ (1949) 37 Cal. L. Rev. 539, 541. The scope of fiduciary duties is far from clear. See John C. Coffee, ‘From Tort to Crime: Some Reflections on the Criminalization of Fiduciary Breaches and the Problematic Line Between Law and Ethics’ (1981) 19 Am. Crim. L. Rev. 117, 150 (‘[T]he common law has in fact always defined the term [fiduciary] with deliberate imprecision . . . ’); United States v. Chestman, 947 F.2d 551, 567 (1991) (en banc) (‘[F]iduciary duties are circumscribed with some clarity in the context of shareholder relations but lack definition in other contexts’.), cert. denied, 503 U.S. 1004 (1992). Bainbridge, above note 76, 45. 601 F. Supp. 685 (S.D.N.Y.), rev’d on other grounds, 773 F.2d 477 (2d Cir. 1985). 947 F. 2d 557, 564 (2d Cir. 1991) (en banc), cert. denied, 503 U.S. 1004 (1992). 17 C.F.R. §240.10b5-2 (2001). 17 C.F.R. §240.10b5-2(b) (2001).

166

Chapter 5

Firstly, it has been argued that the validity of the Rule is in doubt because it contradicts with other court decisions.199 Secondly and more importantly, for those relationships which are not presumed to be fiduciary in nature under Rule 10b5-2, their status may vary depending on specific facts and circumstances. One still needs to apply a fact-specific analysis as to whether a particular relationship suffices to engender a duty of trust and confidence under the misappropriation theory. In practice, the answer to this issue depends very much on the discretion of a court. Indeed, this is a vexing problem, and even Americans have wrestled with it for centuries.200 It follows that if the US courts find it difficult to handle this task, the Chinese courts will find it even harder because there is no traditional concept of fiduciary duty in China. This renders the fiduciary-duty-based theories largely unworkable in China. The concept of fiduciary duty is traditionally undeveloped in China. As a civil law country, China did not even have the legal term ‘fiduciary duty’ (Xinyi Yiwu) until very recently. In 1993 when the Company Law of the People’s Republic of China (‘Company Law’) was enacted,201 legislators implanted some principles of fiduciary duty from overseas. At present, however, the notion of fiduciary duty is still at its earliest stage in China and far from developed. For instance, the duty of care has been largely absent in China’s Company Law, and the duty of loyalty far too simple and hard to apply in practice.202 Thus, fiduciary duties are not clear even in the context of shareholder relations, let alone in other contexts. Plainly, this problem will seriously undermine the workability of the fiduciary-duty-based theories in China. Further, it is doubtful that the Rule 10b5-2 approach will take root in China. Without the traditional notion of fiduciary duty, it will be very difficult for the Chinese to judge whether there is a fiduciary duty between, for instance, investment bankers and their clients; doctors and their patients;203 taxi drivers and their

199. Steinberg, above note 40, 646–47 (arguing that by Rule 10b5-1, the SEC in practical effect has ‘overturned’ the relevant decision in Chestman). 200. See e.g., Langevoort, above note 15, §3.02, 3 (stating that common-law courts have struggled for centuries in deciding the scope of fiduciary duty); Painter et al., above note 22, 190–191 (stating that the scope of fiduciary duties lacks clarity); Bainbridge, above note 76, 34 (pointing out that the question how to know whether a person is a fiduciary is frustratingly unanswered). The Second Circuit has also described the definition of confidential relations as ‘elastic’ and as such held it could not used in the criminal cases. See United States v. Chestman, 947 F. 2d 557, 570 (2d Cir. 1991). 201. Zhonghua Renming Gongheguo Gongsi Fa [Company Law of the People’s Republic of China] (promulgated on 29 December 1993 and effective as of 1 July 1994, amended in 1999, 2004 and 2005) [hereinafter Company Law]. 202. See e.g., Kaiping Zhang, Yingmei Gongsi Dongshi Falu Zhidu Yanjiu [Study on Director Duty at Common Law] (Beijing, Law Press, 1998), p. 313. In 2005, the Company Law added Article 148, which explicitly states that directors owe duties of loyalty and duties of care to their companies. However, the Company Law remains silent as to the standard of duty of care and what the duty of loylty means except specifically listing several instances of misconduct by directors. See Company Law, Arts. 148, 149. 203. United States v. Willis, 737 F. Supp. 269, 274 (S.D.N.Y. 1990). In this case, the court held a psychiatrist liable under the misappropriation theory for insider trading based on the breach of fiduciary duty owed by the psychiatrist to his patient.

Theories of Insider Trading Liability

167

passengers; newspaper columnists and their employers and their readers;204 sons and their fathers;205 husbands and their wives;206 and so on. In China, it is unclear whether these relationships meet the term ‘a history, pattern, or practice of sharing confidences’ in Rule 10b5-2(2). Thus, if fiduciary duty could be said to be an undeveloped term in the company context, then it is totally alien in these situations. b.

Ineffective Enforcement Framework

As discussed above, the current US insider trading regime, premised on the classical theory and the misappropriation theory, has serious shortcomings. However, it has been widely accepted that insider trading is relatively effectively regulated in the US, at least in terms of the number of reported insider trading cases.207 One major reason for this is that the US securities regime maintains an effective enforcement framework which is based on government as well as private action, and thus induces strong law compliance.208 Thus, even though the US insider trading law is far from good, effective enforcement elevates it to preeminence amongst securities markets around the world. However, since China lacks such an effective enforcement framework, it can hardly expect the same results that the US has achieved by simply transplanting US insider trading regulation.209 Firstly, with its capable personnel and plentiful resources, the SEC in the US plays a crucial role in fighting insider trading, and has been said to be ‘the most significant ingredient comprising effective enforcement of the US securities law’.210 In contrast, the CSRC, due to resource constraints, is far from effective in practice. As discussed in Chapter 3, the CSRC suffers from inadequate personnel

204. A famous example is Carpenter v. United States, 484 U.S. 19 (1987), in which the author of the ‘Heard on the Street’ column in the Wall Street Journal traded on information learned in connection with research conducted for the column, in violation of a policy of his employer prohibiting such trading. 205. For such an example, See United States v. Reed, 601 F. Supp. 685 (S.D.N.Y.), rev’d on other grounds, 773 F.2d 477 (2d Cir. (1985) (holding that the son breached a fiduciary duty to his father by trading on confidential information disclosed by his father). 206. An example is United States v. Chestman, 947 F. 2d 557, 564 (2d Cir. 1991) (en banc), cert. denied, 503 U.S. 1004 (1992) (holding that no fiduciary or similar relationship of trust and confidence existed between the husband and wife to satisfy the misappropriation theory). 207. A study has shown that in a period of three years alone, from 1994 to 1997, there were 77 convictions brought by the US Department of Justice and 189 civil cases brought by the SEC. This number is far more than that of any other country. For example, there were only 23 convictions in the UK for a period of 14 years, from 1980 to 1994. See Lori Semaan and Mark A Freeman and Michael A Adams, ‘Is Insider Trading a Necessary Evil for Efficient Markets?: An International Comparative Analysis’ (1999) 17 Company and Securities Law Journal 220, 244. 208. Steinberg, above note 40, 672. 209. Interview with Professor Donald C. Langevoort (19 July 2002, The University of Sydney, Sydney Australia) (stating that the US insider trading regulation may be only suitable for the US). 210. Steinberg, above note 40, 674.

168

Chapter 5

and resources; there are also some problems with the regulatory power and independence of the CSRC. These factors severely limit the regulatory efficacy of the agency and result in little deterrent to prospective violators. In addition, compared to foreign jurisdictions, China’s real-time monitoring technique is under-developed and ineffective.211 Secondly, US judges seem to be willing to and able to collaborate with the SEC to combat insider trading.212 For instance, they uphold insider trading convictions based on circumstantial evidence.213 In contrast, Chinese judges are much less capable and more reluctant than their American counterparts to join the war against insider trading. As mentioned in Chapter 2, in China, the first conviction for insider trading was not procured until 2003. An important reason behind this is that Chinese judges lack the necessary knowledge and experience to deal with securities cases, especially complicated insider trading cases.214 In China, judges are traditionally selected from non-legal careers, such as military and governmental officials, who have normally received little structured legal educations. For example, a 1997 survey has shown that out of 250,000 judicial officers in China’s court system, only 5.6% have bachelor degrees and out of 180,000 procuratorial officers in China’s procuratorate system, only 4% hold bachelor degrees.215 In recent years an increasing number of legal students and academics have joined the judiciary, yet little can be expected of them at the moment.216 Firstly, although better-equipped with legal theoretical knowledge, they have little practical experience. Secondly, because judicial salaries are quite low at the moment, after 211. He Jia et. al., ‘Disclosure of Material Information and Anomalous Price Change on China’s Stock Market’ Zhengquan Shibao [Securities Times] 27 May 2002. 212. Stephen M. Bainbridge, ‘Insider Trading Regulation: The Path Dependent Choice between Property Rights and Securities Fraud’ (1999) 52 SMU Law. Rev. 1589, 1635–1640 (explaining why judges are willing to aid and abet the SEC’s efforts to fight insider trading). 213. See e.g., SEC v. Sargent, 229 F.3d 68, 75 (1st Cir. 2000) (‘Circumstantial evidence, if it meets all the other criteria of admissibility, is just as appropriate as direct evidence . . . ’), quoting United States v. Gamache, 156 F.3d 1, 8 (1st Cir. 1998). Wang & Steinberg, above note 15, 185 (‘Scienter may be established by circumstantial evidence’). 214. See e.g., Liming Wang, ‘Perfection of Private Civil Liability Regime in China’s Securities Law’ (2001) 4 Faxue Yanjiu [Legal Study] 55, 69 (suggesting that the quality of Chinese judges should be improved so as to deal with emerging securities cases). 215. Weili Zhang, ‘China Needs More Excellent Judicial Talents’ Fazhi Ribao [Legal News Daily] 3 October 1997, 3. Further, it has been reported that in 1998, half of the newly appointed chief judges of the high courts of 16 provinces and autonomous regions were found to have never received any systematic legal education. See Min Cui, ‘Some Thoughts on the Judiciary Reform’ (1998) 2 Susongfa Luncong [Procedural Law Review] 47. Indeed, the judiciary in China is plagued with problems and subject to widespread dissatisfaction and complaints. See generally, Yuwen Li, ‘Court Reform in China: Problems, Progress and Prospects’ in Jianfu Chen, Yuwen Li & Jan Michiel Otto (eds), Implementation of Law in the People’s Republic of China (The Hague, Kluwer Law International, 2002), p. 55; Graig R. Avino, ‘China’s Judiciary: An Instrument of Democratic Change?’ (2003) 22 Penn State International Law Review 369. 216. See Shigui Tan (ed), Zhongguo Sifa Gaige Yanjiu [Study on Judicial Reform in China] (Beijing, Law Press, 2000), pp. 93–98.

Theories of Insider Trading Liability

169

gaining experience or establishing relationships within the judicial system, many of them, especially the young and talented, will transfer to private sectors such as law firms, leaving the incompetent and the corrupt to staff the judiciary.217 Indeed, the institutional ineffectiveness of the judiciary in China poses a big problem in adopting the US-model insider trading law, which based upon a very complicated notion of fiduciary duty, involves highly convoluted legal reasoning. In fact, even in the US, insider trading cases are amongst the most difficult cases. As discussed above, insider trading regulation is basically judicially developed in the US and is still unsettled. It would seem to follow that, if US judges who are usually chosen from among prominent practicing lawyers with strong legal educations, have enough difficulty hearing insider trading cases, Chinese judges will fare even worse. Thirdly, in China, the weakness of government enforcement is compounded by the lack of private enforcement because there is currently no insider trading civil liability in practice.218 In the US, private actions serve an important function to assist the SEC in detecting insider trading cases and providing an additional powerful deterrent to potential perpetrators.219 The SEC itself has argued that it does not have adequate resources to provide enforcement at levels sufficient to deter insider trading and as such private enforcement is a necessary complement.220 In sum, the participation of the aggrieved issuers and shareholders in the enforcement of insider trading regulation, to a considerable degree, compensates the inadequacy of government enforcement. B.

ADOPTION OF THE EQUALITY OF ACCESS THEORY

The foregoing critique of the classical theory and the misappropriation theory brings to light a number of fundamental problems which have resulted in ambiguity, complexity and sometimes inconsistent treatment of the US insider trading law. Due to these problems, it is submitted that the equality of access theory is a better choice. The equality of access theory is different from the fiduciary-duty-based theories in that a duty to disclose before trading arises from unequal access to information, rather than a fiduciary duty. The legal analysis of this theory seems to be more logical and more persuasive.

217. Interview with Guiping Chen (Beijing, 15 September 2003) (Mr Chen is a former judge in one intermediate court in Beijing, and is now working in the private sector). 218. For a more detailed discussion of this issue, See below §7.II. 219. In addition to its role in providing compensation to victims of insider trading, private action has an important role in deterring illegal conduct. See e.g., Donald C. Langevoort, ‘Capping Damages for Open-Market Securities Fraud’ (1996) 38 Arizona Law Review 639, 652 (assuming necessity of private action); Janet C. Alexander, ‘Rethinking Damages in Securities Class Actions’ (1996) 48 Stanford Law Review 1487, 1490 (recognizing ‘the need for a private litigation remedy as supplement to SEC enforcement). For more analysis of the issue of private action against insider trading, See Chapter 7. 220. See H. R. Rep. No. 100–910, at 14 (1988) (citing testimony at legislative hearing on Insider Trading and Securities Fraud Enforcement Act of 1988 of SEC Chairman David S. Ruder).

Chapter 5

170

This argument receives compelling support from several sources. First, the equality of access theory is not parity of information theory, and thus there is no risk that its application will discourage legitimate information gathering. Second, the theory is consistent with common law principles and the statuary language of Rule 10b-5. Third, almost all of the countries with insider trading prohibition, except the US, have soundly adopted the equality of access theory, and even in the US, the SEC has been trying hard to resurrect the theory. Finally, it is politically much easier to accept the equality of access theory in China. 1.

Parity of Information vs. Equality of Access

The equality of access theory has been all too often confused with the parity of information theory and the former theory has been mistakenly attacked by the concerns over the latter one. In fact, these two theories are essentially different. The parity of information theory focuses on the problem of information asymmetry, and demands that in a market transaction, all information, public or nonpublic, held by one party must be disclosed to the other party. Under this theory, a trading party possessing material nonpublic information has an affirmative duty to share the information with the other parities.221 It would apply generally to any trade on the basis of material nonpublic information, whether by an insider or an outsider, and whether or not in breach of a fiduciary duty. The rationale behind this theory is that from the perspective of fairness, market participants should respect their trading partners’ decision-making autonomy by not withholding relevant information.222 Firstly, it is argued that information is central to rational deliberation and thus withholding information is violative of autonomy.223 The second step, then, is directed at the key issue of why market participants have the obligation to be concerned with their trading partners’ autonomy. Some have held that the market is a cooperative venture premised upon the parities respecting one another’s autonomy, because in the context of market transactions, the parties are not strangers but partners in a cooperative enterprise.224 This in effect means that all market participants are under a duty to disclose relevant information to their trading partners. Thus, the parity of information theory condemns any transaction in which one party possesses information unknown to the other side. 221.

See e.g, Ian B. Lee, ‘Fairness and Insider Trading’ (2002) 2002 Columbia Business Law Review 119, 151. 222. Ibid 150–158 (advocating the parity of information theory based on this rationale). 223. Strudler and Orts, above note 120, 410 (arguing that nondisclosure of material facts in an exchange is morally wrong because it compromises the autonomy of the ignorant party); Lee, above note 221, 151 (contending that exploiting a party’s informational disadvantage is thought to be contrary to respect for his or her autonomy). 224. Strudler and Orts, above note 120, 414 (arguing that the parties to a market transaction are not strangers and this may generate duties to respect their counterparty’s autonomy); Lee, above note 221, 158 (opining that even in the faceless securities market, fairness still means respecting the autonomy of the other participants).

Theories of Insider Trading Liability

171

This theory has both serious theoretical and practical problems. It is a stretch to say that the legal status of market participants could be seen as partnership in nature and thus generate a fiduciary-like duty between them. This is clearly inconsistent with the long-established ‘caveat emptor’ doctrine that in a market transaction, participants generally stand as strangers and mere nondisclosure is not enough to sustain a fraud action.225 The theory becomes even more strained in the impersonal securities market where participants usually do not know with whom they are trading. Further, the fatal practical weakness of the parity of information theory is that it discourages legitimate and desirable information gathering efforts. Information is not a free good. It is socially valuable but costly to produce. Consequently, there should be some reward to encourage the production of information. It is widely accepted that an equal information rule could undermine the incentives to search for valuable information for trading stock.226 This concern has led most commentators on insider trading, including those sympathetic to the regulation of insider trading, to reject this theory as a ‘utopian’ position.227 Indeed, the parity of information theory clearly contradicts the business reality that almost all securities trading permits certain types of informational advantages, such as those that come from differences in diligence or intelligence. For this reason, no country follows this theory in practice. In contrast, the equality of access theory focuses on equal access to information and the duty to disclose arises from the inequality of access to information, as opposed to the imparity of information itself.228 Under this theory, trading becomes unfair if one party has access to information unknown to another. To be sure, equal access to information does not mean equal information because the equality of access theory does permit legitimate information production. As Justice Blackmun stated in his dissenting opinion in Chiarella,

225. For more discussion of this principle, See below §5.IV.B.2. 226. See e.g., Easterbrook, above note 22, 329–30 (‘if information must be equalized, there will be precious little to go around’); Kenneth E. Scott, ‘Insider Trading: Rule 10b-5, Disclosure and Corporate Privacy’ (1980) 9 J. Legal Stud. 801, 812 (‘a requirement of free disclosure destroys incentives to produce information’)(emphasis in original); United States v. Chestman, 947 F.2d 551, 576–577 (2d Cir. 1991) (Winter, J., concurring in part and dissenting in part) (‘If the law fails to protect property rights in commercial information, therefore, less will be invested in generating such information’.); Anthony T. Kronman, ‘Mistake, Disclosure, Information, and the Law of Contracts’, (1978) 7 J. Legal Stud. 1, 2 (‘a legal privilege of nondisclosure is in effect a property right’ but only ‘where special knowledge or information is the fruit of a deliberate search . . . [T]he assignment of a property right of this sort is required in order to insure production of the information as a socially desirable level’); but See Lee, above note 221, 175–186 (arguing that the information-producing incentive concern is overstated because (1) there is no necessary relationship between the social value of information and the private value of prior knowledge of that information; (2) other mechanism, such as contractual solutions, could be used to provide incentives for investment in information). 227. See e.g, Brudney, above note 6, 339–340 (describing parity of information as an ‘egalitarian utopian’); James D. Cox, ‘Insider Trading and Contracting: A critical Response to the “Chicago School” ’ (1986) 1986 Duke L. J. 628, 631 (describing parity of information as a ‘utopian dream’). 228. For a detailed discussion of why the inequality of access to information may give rise to a duty to disclose, See below §5.IV.B.2.

Chapter 5

172

[T]here is a significant conceptual distinction between parity of information and parity of access to material information. The latter gives free rein to certain kinds of information advantages that the former may foreclose, such as those that result from differences in diligence or acumen.229 Professor Brudney has further developed the equality of access theory, arguing that unequal access to material, nonpublic information is unfair because it can generate ‘unerodable’ informational advantages that no amount of insight, luck, or diligent research can overcome.230 Thus, the equality of access theory is free from the parity-of-information-related concern that the incentives to produce information would dry up. In short, the equality of access theory may well preserve the incentives of outsiders to search for valuable information while precluding those who obtain inside information by virtue of their privileged access from exploiting it. However, it seems that the two theories are quite confusing.231 As discussed above, the US Supreme Court has twice rejected the equality of access theory.232 Even though the Chiarella Court was conscious that the Second Circuit’s theory was the equality of access theory, as distinct from the parity of information theory,233 it seemed to have nevertheless confused the two theories. In Chiarella, the Court stated: The use by anyone of material information not generally available is fraudulent, this theory suggests, because such information gives certain buyers or sellers an unfair advantage over less informed buyers and sellers.234 229. 230. 231.

232.

233.

Chiarella v. United States, 445 U.S. 222, 252 n. 2 (1980) (Justice Blackmun, dissenting) (emphasis in original). Brudney, above note 6, 354-355. One commentator, for instance, even knowingly mixed the two theories together by using the term ‘parity of information’ to refer to ‘parity of access to information. Nagy, above note 57, 1230 n. 26 (‘In the interest of brevity, this Article uses the phrase ‘parity of information’ with the understanding that the focus is to be on the parity of access to information rather than the parity of information per se’.) Then, the ‘parity of access to information’ was attacked with the defects of the ‘parity of information’ approach. Ibid 1307 (‘Although a parity of information rule may engender even greater public confidence in the securities markets, the rule would come with costs that are too dear . . . might chill legitimate and socially useful investment behaviour, such as diligent searches for information by investment analysts and other market participants’.). See Chiarella v. United States, 445 U.S. 222, 234–235 (1980) (‘we See no basis for applying such a new and different theory of liability in this case’); Dirks v. SEC, 463 U.S. 646, 658 n.16 (1983) (citing Chiarella, 445 U.S. at 233). See also Gevurtz, above note 14, 77 (‘the United States Supreme Court rejected the equal access approach in Chirarella v. United States). The Second Circuit stated: Anyone—corporate insider or not–who regularly receives material non-public information may not use that information to trade in securities without incurring an affirmative duty to disclose. United States v. Chiarella, 588 F.2d 1358, 1365 (2d Cir. 1978) (emphasis in original). The Court distinguished this from the parity of information theory by stating that ‘the [Second Circuit] said that its test would include only persons who regularly receive material, non-public information. Chiarella v. United States, 445 U.S. 222, 231 (1980) (citing United States v. Chiarella, 588 F.2d 1358, 1366 (2d Cir. 1978)).

234.

Chiarella v. United States, 445 U.S. 222, 232 (1980) (emphasis added).

Theories of Insider Trading Liability

173

Clearly, the Court focused on ‘the use of non-public information’, rather than ‘access to information’. The confusion of the two theories has also been illustrated elsewhere. For example, the Court attacked the equality of access theory, holding that ‘a duty to disclose under §10(b) does not arise from the mere possession of nonpublic information’.235 Further, in Dirks, the Court stated that ‘[i]n effect, the SEC’s theory of tippee liability in both cases appears rooted in the idea that the antifraud provisions require equal information among all traders’.236 Indeed, one of the justifications for the Court to reject the equality of access theory appears to be that the theory formulates ‘such a broad duty’ that it ‘should not be undertaken absent some explicit evidence of congressional intent’.237 The ‘such a broad duty’ here is ‘a general duty between all participants in market transactions to forgo actions based on material, non-public information’.238 It seems that ‘such a broad duty’ is the duty under the parity of information theory, which is much broader than that under the equality of access theory and is certainly unacceptable. Thus, the Court appears to have used the concerns of the parity of information theory to reject the equality of access theory. 2.

Common Law Principles

As discussed above, it may be that the US Supreme Court has mistakenly rejected the equality of access theory because of the concerns over the parity of information theory (that is, the duty to disclose is too broad). However, this argument alone may not be enough to justify the equality of access theory. Under the equality of access theory, there is a general duty between all market participants ‘having access to confidential material information that is not legally available to others’.239 This duty, though narrower than that of the parity of information theory, might be already broad enough to be contrary to the ‘the established [common law] doctrine that duty arises from a specific relationship between two parties’,240 and thus absent express Congressional intent, formulation of ‘such a broad duty’ should not be accepted.241 Thus, in deciding whether the duty under the equality of access theory is really in contradiction with common law as suggested by Chiarella, it is to the common law that we must first turn.

235. Ibid 235 (emphasis added); See also Ibid 233 (‘We cannot affirm petitioner’s conviction without recognizing a general duty between all participants in market transactions to forgo actions based on material, non-public information’) (emphasis added). 236. Dirks v. SEC, 463 U.S. 646, 657 (1983) (emphasis added). 237. Chiarella v. United States, 445 U.S. 222, 233 (1980). 238. Ibid (emphasis added). 239. Ibid 251 (Blackmun, J. concurring) (emphasis added). 240. Ibid 233. 241. Ibid 233–234 (1980) (‘Formation of such a broad duty . . . should not be undertaken absent some explicit evidence of congressional intent’.).

174

Chapter 5

Although Section 10(b) and Rule 10b-5, as broad antifraud provisions, are not entirely coextensive with common law doctrines of fraud and deceit,242 the US courts have traditionally looked to the common law in determining the types of ‘manipulative or deceptive’ conduct under them.243 In the context of insider trading, the US Supreme Court developed the fiduciary-duty-based theories on the basis of the common law,244 holding that at common law, a duty to disclose is a required element of fraud and there is an established doctrine that a duty to disclose only comes from a fiduciary relationship between the parities.245 However, as discussed below, there are several exceptions to this doctrine. Under common law, a valid cause of action for fraud must be: (1) a false or misleading statement of fact; (2) made with knowledge of its falsity; (3) intended by the marker to induce the listener’s reliance; (4) which justifiably induces such reliance; and (5) damages were incurred by the listener.246 In general, an affirmative statement is required for a plaintiff to bring a fraud action, and mere nondisclosure, by itself, was held not to be enough.247 This rule was derived from the principles of ‘caveat emptor’.248 However, there are a limited number of exceptions to this general rule. In other words, in certain circumstances, a defendant’s ‘pure silence’ may also constitute fraudulent conduct. One such circumstance occurs when there is a fiduciary relationship between the parties to a transaction. The fiduciary relationship contains such a degree of trust that a party can justifiably rely on his fiduciary to bring all significant facts 242. 243.

244. 245. 246.

247. 248.

See e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 388–89 (1983); Meyers v. Moody, 693 F.2d 1196, 1214 (5th Cir. 1982) (noting that ‘the common law of fraud is generally more stringent in its requirements than the elements of Rule 10b-5 . . . ’). Louis Loss, Fundamentals of Securities Regulation (Boston, Little, Brown and Company, 2nd ed., 1988), pp. 712–25 (discussing the similarities of Rule 10b-5 to common law fraud); Frank F. Coulom, Jr. Note, ‘Rule 10b-5 and the Duty to Disclose Market Information: It Takes a Thief’, (1980) 55 St. Jone’s L. Rev. 93, 102 (‘The earliest decisions interpreting the rule indicated that 10b-5 was merely a federal codification of the common-law action for deceit to be applied in securities fraud cases’.); Basic, Inc. v. Levinson, 485 U.S. 224, 253 (1988) (White, J., concurring in part and dissenting in part) (stating that ‘[i]n general, the case law developed in this court with respect to §10(b) and Rule 10b-5 has been based on doctrines with which we, as judges, are familiar: common law doctrines of fraud and deceit’). Chiarella v. United States, 445 U.S. 222, 234–235 (1980) (‘Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud’.). The Court cited two common law sources to support its position: one is Restatement (Second) of Torts §551(2)(a) (1976), the other is James & Gray, ‘Misrepresentation – part II’, 37 Md. L. Rev. 488, 523–27 (1978). Chiarella v. United States, 445 U.S. 222, 228 n. 9 (1980). See W. Page Keeton et al., Prosser and Keeton on the Law of Torts (West Group, 5th ed., 1984), p. 728; See also Restatement (Second) of Torts §525 (1976) (to be liable for fraud under tort law, the plaintiff must prove that the defendant: ‘fraudulently [made] a misrepresentation of fact, opinion, intention or law for the purpose of inducing [the plaintiff] to act . . . upon it . . . [causing] pecuniary loss . . . by his justifiable reliance upon the misrepresentation’). Keeton et al., above note 246, 737; W. Page Keeton, ‘Fraud, Concealment and Nondisclosure’ (1936) 15 Tex. L. Rev. 1. Keeton et al., above note 246, 737; Keeton, above note 247, 5 (‘[T]he whole doctrine of caveat emptor . . . resulted primarily from the individualistic attitude of the common law in its early stages’.).

Theories of Insider Trading Liability

175

to his attention.249 Consequently, a party has a duty to disclose ‘matters known to him that the other is entitled to know because of a fiduciary or other similar relation of trust and confidence between them’.250 The Court developed the classical theory of insider trading liability precisely on the basis of this exception: absent a fiduciary duty,251 or one derived from it,252 a party to a transaction has no duty to disclose. However, the problem with the classical theory is that it seems to suggest that the above circumstance is the only exception to the general rule. Justice Blackmun, in his dissenting opinion, correctly stated: I, of course, agree with the Court that a relationship of trust can establish a duty to disclose under §10(b) and Rule 10b-5. But I do not agree that a failure to disclose violates the Rule only when the responsibilities of a relationship of that kind have been breached.253 Indeed, there are many other well-recognized exceptions to the general rule. Other situations where an affirmative duty to disclose may arise include: (1) when one party actively conceals information from another party; (2) when one party’s previously truthful statement has become materially misleading in light of subsequent events; (3) when one party makes a half-true or ambiguous statement; and (4) when one party has special facts which are not discoverable upon reasonable inspection by the other party.254 The last category – undiscoverable facts upon reasonable 249. Keeton, above note 247, 12 (‘this is a relationship existing between parties prior to the time of the negotiation out of which the purpoted fraud arose’.); Austin W. Scott, ‘The Fiduciary Principles’, (1949) 37 Cal. L. Rev. 539, 540–541, 555 (noting that the fiduciary relationships are based upon the principle of loyalty). 250. Restatement (Second) of Torts §551(2)(a) (1977). The Restatement (Second) of Contracts contains a similar provision, stating that nondisclosure of a fact amounts to a representation ‘where the other person is entitled to know the fact because of a relation of trust and confidence between them’). Restatement (Second) of Torts §161(d) (1979). 251. The Chiarella Court stated: [T]he duty to disclose arise when one party has information ‘that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them’. Chiarella v. United States, 445 U.S. 222, 228 (1980) (quoting Restatement (Second) of Torts §551(2)(a) (1976) and citing James & Gray, Misrepresentation – part II, 37 Md. L. Rev. 488, 523–527 (1978)). 252.

Dirks v. SEC, 463 U.S. 646, 659 (1983) (‘the tipper’s duty to disclose or abstain is derivative from that of the insider’s duty’). 253. Chiarella v. United States, 445 U.S. 222, 247 (1980) (Blackmun, J., dissenting) (emphasis added); Many commentators have criticized the Court’s disregard for other exceptions to the general rule. See Anderson, above note 126, 351(noting that while ‘the Court appeared to be determined in Chiarella to incorporate the common law of misrepresentation, the existence of a duty to disclose is not limited to situations involving pre-existing fiduciary relationships’); Donald C. Langevoort, ‘Insider Trading and the Fiduciary Principle: A Post-Chiarella Restatement’ (1982) 70 Cal. L. Rev. 1, 12 n. 44 (‘the Court’s principal citation for its conclusion is Restatement (Second) of Torts §551(2)(a) (1976), which lists a number of common law bases for compelling affirmative disclosure in addition to the existence of a fiduciary relationship . . . ’). 254. Keeton et al., above note 246, 737–740; Fleming James, Jr. and Oscar S. Gray, ‘Misrepresentation–Part II’ (1978) 37 Md. L. Rev. 488, 523 (explaining several exceptions

176

Chapter 5

inspection – is most relevant to the issue whether a duty to disclose arises from unequal access to information, because insider trading cases premised on the equality of access theory involve the use of ‘unerodable’ informational advantages that reasonable inspection cannot overcome. The rationale of the ‘special facts’ exception is clear. If facts are discoverable upon reasonable inspection, the party with knowledge of those facts has no duty to disclose to the other party.255 The purpose of this rule is to encourage parties to seek out and benefit from legitimate information advantages, such as by deliberate search.256 It is a fair game for more information because the information is legally available to both parties. However, this is not true when the information is undiscoverable upon reasonable inspection to the other party. It is simply unfair to punish the other party for failing to discover the information which is undiscoverable. Worse, it would be a sorry story if one can keep silent and profit from illegitimate information advantage. This may actually encourage people to acquire information advantages through wrongful or even illegal means.257 The ‘special facts’ exception has been embraced by the Restatement (Second) of Torts. According to Section 551(2)(e) of the Restatement of Torts, a party has a duty to disclose ‘facts basic to the transaction, if he knows that the other is about to enter into it under a mistake as to them, and that the other, because of the relationship between them, the customs of the trade or other objective circumstances, would reasonably expect a disclosure of those facts’.258 The official comments to the Restatement (Second) of Torts have given an example to illustrate that nondisclosure would constitute a fraud in transactions if the undisclosed fact is not discoverable upon reasonable inspection: A is engaged in the business of removing gravel from the bed of a navigable stream. He is notified by the United States government that the removal is affecting the channel of the stream, and ordered to stop it under threat of legal proceedings to compel him to do so. Knowing that B is unaware of this notice,

255. 256. 257.

258.

to the general rule that there is no affirmative duty to disclose between parties dealing at arm’s length); Nicola W. Palmieri, ‘Good Faith Disclosures Required During Precontractual Negotiations’, (1993) 24 Seton Hall L. Rev. 70, 120–141 (discussing a variety of circumstances under which the general rule is inapplicable). Keeton, above note 247, 30 (‘The statement is frequently made that where the matter concealed was readily discoverable, or else equally available to both parties, there is no duty to speak’.). This is precisely the distinction between the equality of access theory and the parity of information theory. See below §5.IV.B.1. For an analysis of the existence of disclosure obligations where the information advantages were unlawfully obtained, See Nagy, above note 57, 1289–1292; see also John F. Barry III, ‘The Economics of Outside Information and Rule 10b-5’ (1981) 129 U. Pa. L. Rev. 1307, 1364 (‘[A] privilege to exploit information improperly obtained would reduce the incentive to invest in legitimate information production by exacerbating free rider problems and by placing on producers the risk of misappropriation. Less information would be produced, because at least some producers would shift resources from additional production to theft of what others have produced’.). Restatement (Second) of Torts §551(2)(e) (1979).

Theories of Insider Trading Liability

177

could not reasonably be expected to discover it and would not buy it if he knew, A sells the business to B without disclosing the fact. A is subject to liability to B for his pecuniary loss in an action of deceit.259 The law of contract also recognizes a duty to disclose on the part of a party with information which is not legally discoverable. Under Section 161(b) of the Restatement (Second) of Contracts, 260 if one party to a contract knows that the other has a mistaken belief as to a basic assumption concerning the transaction, the party with knowledge is expected to disclose the fact. In a securities transaction which is essentially a contract to trade stock, there exists a basic assumption that both parties have equal access to information.261 Thus, if one party has unequal access to a fact that the other could not possibly know by reasonable inspection, then he/she must disclose that fact. To be sure, the other party lacks access to the fact that, if known, would negate his/her willingness to conclude the transaction. In the US, courts have recognized this exception of ‘special facts which are undiscoverable upon reasonable inspection’ in a wide range of business transactions. As Justice Blackmun stated in his dissenting opinion in Chiarella, Steps have been taken towards application of the ‘special facts’ doctrine in a broader array of contexts where one party’s superior knowledge of essential facts renders a transaction without disclosure inherently unfair.262 In sum, to the extent that the ‘special facts’ doctrine has already been accepted by common law, the argument loses its force that a duty to disclose arises only when there is a fiduciary relationship between trading parties. Rather, there is a duty to disclose on the part of a party who has unequal access to facts which are not legally available to the other party. This provides a very compelling case for the equality of access theory under which trading securities on the basis of undisclosed information are viewed as a fraud against those who cannot discover the information upon reasonable inspection. 3.

The Widespread Acceptance of the Equality of Access Theory

In practice, the superiority of the equality of access theory has been confirmed by the widespread acceptance of the theory worldwide. The US insider trading law,

259. Ibid §551, cmt. 1, illus. 10. 260. Restatement (Second) of Contracts §161(b) (1979). This provision states that A person’s nondisclosure of a fact known to him is equivalent to an assertion that the fact does exist . . . where he knows that disclosure of the fact would correct a mistake of the other party as to a basis assumption on which that party is making the contract and if nondisclosure of the fact amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing. 261. Ronald F. Kidd, ‘Insider Trading: The Misappropriation Theory versus An “Access to Information” Perspective’ (1993) 18 Delaware Journal of Corporate Law 101, 130. 262. Chiarella v. United States, 445 U.S. 222, 248 (1980) (Blackmun, J., dissenting) (citing Lingsch v. Savage, 213 Cal. App. 2d 729, 735–737, 29 Cal. Rptr. 201, 204–206 (1963);

Chapter 5

178

premised on the conception of fiduciary duty, has proven unduly complicated and problematic. As one US commentator stated, the US insider trading law ‘at times fails to accord fair treatment to market participants and impedes commercial certainty’, and thus ‘countries abroad may be ill-served by embracing the US model’.263 Indeed, many countries have soundly rejected the fiduciary-duty-based theories, and instead opted for the equality of access theory. Further, even in the US, the SEC has been working hard to revive the equality of access theory. a.

Blossoming Overseas

While the equality of access theory was discarded by the US, it has thrived elsewhere in the world. Although many nations have followed the US’s lead to prohibit insider trading, they have declined the US fiduciary-duty-based theories, and have instead chosen the equality of access theory to establish their insider trading regimes. 264 For instance, the United Kingdom, France, Germany, Italy, (Ontario) Canada, Mexico, Japan and Australia have basically all adopted the equality of access theory.265 Australia is a good example. In stark contrast to the US, Australia replaced its previous US style fiduciary-duty-based insider trading theory with the equality of access theory in 1991.266 Prior to 1991, like the US regime, the Australian insider trading law prohibited trading on inside information only by those connected with corporations whose stock they traded.267 The 1991 revision extended insider trading liability to any person who possesses information that is ‘material’ and ‘is not generally available’.268 In order to prevent this approach from being reduced to the

263. 264. 265.

266.

267. 268.

Jenkins v. McCormick, 184 Kan. 842, 844–845, 339 P.2d 8, 11 (1959); Jones v. Arnold, 359 Mo. 161, 169–170, 221 S. W. 2d 187, 193–194 (1949); Simmons v. Evans, 185 Tenn. 282, 285–287, 206 S. W. 2d 295, 296–297 (1947)). Steinberg, above note 40, 635. Ibid 667 (stating that ‘many countries opt for an insider trading proscription premised on the “access” doctrine’). Ibid 667–668; see also Gevurtz, above note 14, 77 (discussing the adoption of the equality of access theory by Australia and the EU Directive); Eugenio Ruggiero, ‘The Regulation of Insider trading in Italy’ (1996) 22 Brook. J. Int’l L. 157 (concluding that Italy adopts an equal access approach); Tomoko Akashi, Note, ‘Regulation of Insider Trading in Japan’, 89 Colum. L. Rev. 1296, 1312–1313 (1989) (stating that the Japanese law of insider trading ‘is premised on the traditional notion of “unfairness” ’ and ‘will reach persons with a duty to disclose information or to abstain from trading simply because they know that they possess certain material non-public information’). Report of the House of Representative Standing Committee on Legal and Constitutional Affairs, Fair Shares for All: Insider Trading in Australia (11 October 1990, Australia). This report rejected the notion that the scope of the insider trading laws should be limited to some concept of fiduciary duty or a theory of misappropriation. The Securities Industry Act 1980 (repealed, Australia), Section 128(8). The group of connected persons under this provision corresponds to the traditional insiders and constructive insiders in the US under the classical theory. Corporations Act 2001 (Australia), ss 1042A, 1043A.

Theories of Insider Trading Liability

179

parity of information theory, Australia has taken a number of important steps such as limiting the scope of inside information,269 carving out some exceptions.270 There is an alternative to avoid the potential over-breadth of a simplistic equality of access rule: confining the prohibition to the most common situations. One such example is the EU directive which demands that it is prohibited to trade on material, non-public information by directors or shareholders; by those who obtain the information through their employment, profession or duties; and by those who obtain the information from persons in the prior categories.271 Japan has also adopted this approach.272 With the additional person connection requirement, this approach effectively narrows down the equal-access based insider trading law, and is able to cover the vast bulk of trades involving unequal access. However, as will be discussed in more detail in the following chapter, this approach can be more difficult to apply in practice and less certain than that one adopted by Australia.273 This international trend is not a chance event, but instead suggests that from a practical viewpoint, the equality of access theory can more effectively support insider trading liability. This has led one US commentator to observe that: Australia’s experience with an equal access rule might prove that from a policy perspective, there may have been no reason for the [US] Supreme Court to reject the equal access approach in Chiarella.274 b.

Revival in the US

Support for the equality of access theory is not only found in jurisdictions outside the US, but also within the US. Indeed, the theory has received both official and

269. Under Australian insider trading law, deductions, conclusions or inferences made on the basis of publicly available information are not inside information. Corporations Act 2001 (Australia), s 1042C. In general, Australian insider trading law centres on the definition of inside information and the scope of insider follows as a consequence of that. For more analysis of this issue, see Chapter 6, §5.III.B. 270. For example, Australia also makes exceptions for knowledge of a person’s own intentions or activities, and thus the acquiring company can safely enter into the transaction with the knowledge of its intent to make a premium price tender offer for stock in the target corporation. Corporations Act 2001 (Australia), s 1043H. 271. European Council Directive 89/592 of November 13, 1989 Coordinating Regulations on Insider Dealing, 1989 O.J.(L 334) Art. 30. 272. In Japan, the insider trading prohibition reaches corporate related parties, including directors, officers, employees, shareholders, as well as persons associated with a corporation through either a contract or a government supervisory role, who obtain material non-public information by virtue of their relationship with the company. Shokentorihiki Ho [Securities and Exchange Law], Law No.25 of 1948, Art. 190-2(1). In addition, the Japanese insider trading law clearly does not include the misappropriation theory as its underlying basis. See Akashi, above note 265, 1312 (1989) (stating that Japanese law ‘is not intended to reach insider trading cases where the misappropriation theory is the only basis for finding a violation’). 273. For a more detailed comparison between the EU Insider Trading Directive and the Australian law, See below §6.III. 274. Gevurtz, above note 14, 97.

180

Chapter 5

academic support within the US. Even though the equality of access theory has been clearly rejected by the US Supreme Court, the SEC has never given up its efforts to restore the theory. Over years, the SEC, acting ostensibly within its rulemaking authority, has sought to minimize restrictive Supreme Court law. For instance, the SEC promulgated Rule 14e-3 in the tender offer context on the basis of the equality of access theory.275 Another example is Regulation FD which seeks to prohibit company selective disclosure, a practice closely resembling insider tipping.276 Moreover, many prominent academics, including Professor Brudney, Dean Seligman, have advocated the equality of access theory.277 In addition, it seems that the misappropriation theory has ironically functioned as a carrier for the equality of access theory. As one commentator said, ‘the misappropriation theory is only a pretext for enforcing the parity of information theory that was rejected in Chiarella and Dirks’.278 The SEC also appears to share this view. The former SEC commissioner Charles Cox acknowledged that the misappropriation theory could be seen as ‘merely a pretext for enforcing equal opportunity in information’.279 Indeed, the O’Hagan Court predicated the misappropriation theory precisely on the equal-access-related concerns. The Court stated that: The misappropriation theory is thus designed to ‘protec[t] the integrity of the securities markets against abuses by ‘outsiders’ to a corporation who have access to confidential information that will affect th[t] corporation’s security price when revealed, but who owe no fiduciary or other duty to that corporation’s shareholders’.280 Further, the Court used exactly the arguments for the equal access theory to support the misappropriation theory, holding that: Although informational disparity is inevitable in the securities market, investors likely would hesitate to venture their capital in a market where trading based on 275. 276. 277.

See above §5.III.C.1.a. See above §5.III.C.2.a. See e.g., Brudney, above note 6, 376 (proposing a ban on trading based on ‘unerodable informational advantages’); Seligman, above note 124, 1137–1138 (suggesting a general prohibition on trading while in possession of material, nonpublic information, with certain exceptions, such as exempting potential takeover bidders from the disclose or abstain rule); Kidd, above note 261, 125 (advocating the access to information theory); Painter et al., above note 22, 221 (‘Congress could establish a pre-United States v. Chiarella equality of access approach, even for outsiders, and then carve out exceptions . . . ’). 278. Nagy, above note 57; see also Elliott J. Weiss, ‘United States: Pragmaticsm Returns to the Law of Insider Trading’ (1998) 23 J. Corp. L. 395 (arguing that O’Hagan is premised on equal access-related concerns). 279. Charles C. Cox & Kevin S. Fogarty, ‘Bases of Insider Trading Law’ 49 Ohio St. L.J. 353, 366 (1988); see also Bainbridge, above note 76, 24 (positing that ‘the SEC used the misappropriation theory as a means of redirecting the prohibition back towards the direction in which Texas Gulf Sulphur had initially set it’). 280. United States v. O’Hagan, 521 U.S. 642, 653 (1997) (quoting brief of amici curiae for United States 14).

Theories of Insider Trading Liability

181

misappropriated non-public information is unchecked by law. An investor’s informational disadvantage vis-à-vis a misappropriator with material, non-public information stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill.281 In conclusion, it appears that in O’Hagan, the US Supreme Court itself has realized the merits of the equality of access theory, and tried to resurrect it under the guise of the misappropriation theory because of its unwillingness to overturn Chiarella, its own previous decision. If this is the case, perhaps it is better to directly adopt the equality of access theory. 4.

China’s Local Circumstances: the Equality of Access Theory is More Appropriate

As discussed above, the equality of access theory has been widely accepted outsider the US, and there are also continuing efforts to revive it inside the US. This bodes well for its adoption in China. Indeed, the case for the equality of access theory is even stronger in China for reasons set out below. Firstly, the equality of access theory is more consistent with the purpose of the Securities Law. Article 1 of the Securities Law states: This law is enacted in order to standardize the issuing and trading of securities, protect the lawful rights and interests of investors, safeguard the economic order and public interests of society and promote the development of the socialist market economy.282 These goals in relation to investor protection and market integrity are better served by the equality of access theory. As discussed above, the fiduciary-duty-based theories suffer serious problems and have significant loopholes. Indeed, because the equality of access theory is not based on the notion of fiduciary relationship, and instead recognizes that a party has a duty to disclose if he/she has access to information which is not legally available to the other party, it closes the gaps in the fiduciary-duty based theory. More specifically, while the classical theory may fail to account for a vast number of insider trading cases where insiders sell stock to prospective shareholders, and where non-equity securities are traded,283 the equality of access theory would easily handle them; although non-fiduciary misappropriators and brazen fiduciaries would all escape liabilities under the misappropriation theory,284 they would be held accountable under the equality of access theory.

281. Ibid 658–659 (1997) (citing Brudney (an advocate of the equal access theory), above note 6, 356). 282. Securities Law, Art. 1. 283. See above §5.IV.A.1. 284. See above §5.IV.A.2.

Chapter 5

182

In addition, under the misappropriation theory, investors are not viewed as deceived victims, and this would frustrate private actions for compensation.285 Thus, the equality of access theory would punish equally culpable behavior in a consistent manner. Regardless of an individual’s status as an insider, quasi-insider, tippee or outsider, trading securities on the basis of material non-public information is equally culpable from the perspective of investors. Indeed, the harm to investors comes from the objective use of illegitimate information advantages by those with whom they trade. To premise investor protection on anything else, such as the breach of fiduciary duties between traders as required by the classical theory, the fraud on the source of information as required by the misappropriation theory, are not only illogical, but also inconsistent with the investor protection goal of the Securities Law. Another important factor to support the equality of access theory is that it may be both technically and politically easier to accept the theory in China. Indeed, by adhering to a fiduciary relationship, the fiduciary-duty-based theories unduly complicate an already complex area. Under the fiduciary-duty-based theories, one has to make many vexing inquiries. For instance: is there a fiduciary duty present? What types of relationships are deemed to be fiduciary or one of trust and confidence? Who is a temporary-insider and under what circumstances? What constitutes a ‘personal benefit’ for tipping liabilities to attach? What must be established for there to be misappropriation of the subject information? As one commentator pointed out, To leave these inquiries to ad hoc adjudication and occasional SEC rulemaking may be tolerable for the United States with its zest for litigation and its abundance of lawyers, regulators, and judges. Such an [fiduciary-duty based] approach, representing the antithesis of cost-effectiveness, justifiably garners little support elsewhere.286 The situation is even more difficult in China. As discussed above, inquiries into the fiduciary-duty related issues are especially difficult in China where the conception of fiduciary duty is not yet developed.287 In addition, the team of lawyers, regulators and judges in China is much weaker and less-resourced than its US counterparts.288 If it is hard in the US to make these inquiries, it will be even harder in China. Moreover, the market fairness and equality rationale of the equality of access theory renders it more politically acceptable in China. The equality of access theory is intended to ensure fair and effective functioning of the securities market by demanding equal access to information. This notion of fairness and equality is the very principle of the Securities Law: Securities shall be issued and traded in line with the principles of openness, fairness and equitability.289

285. See above §5.IV.A.2. 286. Steinberg, above note 40, 666. 287. See above §5.IV.A.3.a. 288. See above §5.IV.A.3.b. 289. Securities Law, Art. 3 (emphasis added).

Theories of Insider Trading Liability

183

The parties involved in the issuing and trading of securities shall have equal legal status and adhere to the principles of voluntariness, compensation and good faith.290 More broadly, as a socialist state, China is more ideologically inclined to accept legal rules directly premised on fairness and equality.291 Indeed, the straightforward reasoning of the equality of access theory can be more easily understood and accepted than the circuitous reasoning of the fiduciary-duty-based theories.292 §5.V.

CONCLUSION

In the foregoing chapter, it was suggested that China should regulate insider trading because of its harmful effects. This chapter then began to address how to effectively regulate insider trading. Before examining the details of insider trading regulation, it is necessary to discuss the underlying theories for regulating insider trading because they provide the foundation for the design of the insider trading regime. There are basically two types of theories for regulating insider trading worldwide. One is the equality of access theory; the other is the fiduciary-duty-based theories, including the classical theory and the misappropriation theory. The theory underlying China’s insider trading regulation is unclear. Hastily importing experience from overseas, notably the US, without critical and careful thinking, China seems to have stuffed its insider trading regulation with theories that are in fact mutually contradictory. This has resulted in confusion in applying and interpreting provisions, and adversely affected the efficacy of the insider trading regime in China. In order to regulate insider trading credibly, China needs a clear underlying theory. The fiduciary-duty-based theories suffer serious problems. In the US, the classical theory imports the common law concept of fiduciary duty into insider trading law, and thus permits those who are not standing in such a relationship to escape. To remedy this overly narrow net of insider trading liability, the misappropriation theory has been developed to hold outsiders accountable. However, in many respects, the misappropriation theory poses more new questions than it addresses old ones. It makes a dubious reasoning to account for outsider trading to the extent that it is focused on the fraud on the information’s source who may have nothing to do with securities transactions. More importantly, by conditioning insider trading liability on the breach of fiduciary duties, it leaves many significant loopholes. Finally, the unsuitability of transplanting the theories into China is exacerbated by the fact that the notion of fiduciary duty is yet to be developed in China.

290. Ibid Art. 4. 291. See e.g., Constitution Law, Art. 33 (‘All citizens of the People’s Republic of China are equal before the law’.). 292. See above §5.IV.A.2.a (critiquing the dubious reasoning of the misappropriation theory).

184

Chapter 5

It is submitted that China should adopt the equality of access theory. The theory closes the gaps of the fiduciary-duty-based theories without discouraging legitimate information gathering activities. In addition, the legal reasoning of the equal access theory is more logical and coherent because it punishes all equally culpable perpetrators. This theory is also consistent with common law principles underlying the action of nondisclosure. For these reasons, while the US changes from the equality of access theory to the fiduciary-duty-based theories, almost all other nations with insider trading prohibition have chosen the equality of access theory. Finally, the case for the equality of access theory is even stronger in China. Due to its simplicity and fairness rationale, the theory is more technically comprehensible and more politically acceptable in China.

Chapter 6

Some Basic Elements of Insider Trading

§6.I.

INTRODUCTION

In the previous chapter, it was recommended that China should adopt the equality of access theory to establish its insider trading regime. Based on this, this chapter will address in detail some basic elements of the insider trading prohibition, including who is an insider, what constitutes inside information, and how the state of mind of the insider affects liability, and what securities are covered under the prohibition. More specifically, Part II examines the content of China’s insider trading law. This is followed by a critical analysis of the notion of insider in Part III. This issue is closely connected with the equality of access theory and it is argued that insiders should be defined solely according to their possession of relevant inside information. Then, Part IV discusses the scope of inside information. Subjective elements are examined in Part V. Compared to other aspects of the insider trading law, this issue is much less researched especially in China. Part VI reviews the types of securities that are subject to China’s insider trading law. §6.II.

THE CONTENT OF CHINA’S INSIDER TRADING LAW

As discussed in Chapter 5, the Chinese law of insider trading is heavily influenced by its US counterpart. In general, China’s insider trading law centres upon primary insider trading situations, and extends liability to those who trade on the basis of misappropriated information. Aside from trading, tipping and procuring are also prohibited. Further, the Chinese legislation includes a short-swing trading prohibition.

Chapter 6

186

A.

THE OVERALL FRAMEWORK

Article 73 of the Securities Law generally prohibits a person with knowledge of inside information on securities trading from using such inside information to trade securities.1 As discussed in Chapter 5, based on the equality of access theory, this article necessarily casts a broad net. However, it has been significantly restricted by other articles. Article 74 lists some specific types of persons which are considered to be ‘persons with knowledge of inside information’. They include: 1. Directors, supervisors, and senior management persons of an issuer; 2. Shareholders who hold no less than 5 percent of the shares in a company as well as the directors, supervisors, and senior management persons thereof, or the actual controller of a company as well as the directors, supervisors, and senior managers thereof; 3. The holding company of an issuer as well as the directors, supervisors, and senior managers thereof; 4. Persons who are able to obtain material company information concerning the trading of its securities by virtue of the positions they hold in the company; 5. Staff members of the securities regulatory authority, and other persons who administer securities trading pursuant to their statutory duties; 6. The relevant staff members of public intermediary organizations, including sponsors, underwriters, stock exchanges, securities registration and clearing institutions and securities trading service organizations; and 7. Other persons specified by the securities regulatory authority under the State Council.2 According to this list, statutory insiders can be categorized into several groups. The first group is corporate directors and officers, including directors, supervisors, managers, deputy managers and other senior management persons of the corporation3 and its holding corporation.4 In addition, the CSRC has made it clear that secretaries of the board of directors fall within the ambit of ‘senior management persons’.5 As the reported insider trading cases have suggested, these types of insiders are most likely to commit insider trading in China.6

1. Zhonghua Renming Gongheguo Zhengquanfa [Securities Law of the People’s Republic of China] (promulgated on 29 December 1998 and effective from 1 July 1999, amended in 2004 and 2005) (hereinafter Securities Law), Art. 73. 2. Ibid Art. 74. 3. Ibid Art. 74(1). 4. Securities Law, Art. 74(3). 5. Guanyu Yinfa Jinwai Shangshi Gongshi Dongshihui Mishu Gongzhuo Zhiyin de Tongzhi [Notice on the Promulgation of Guidelines to the Work of Secretaries of the Board of Directors of Companies Listed Overseas] (8 April 1999). 6. See above §2.III.C.1.

Some Basic Elements of Insider Trading

187

Secondly, apart from the members of senior management, lower-level employees are also deemed insiders if they have obtained inside information in connection with their employment.7 This category may represent the largest number of insiders. Thirdly, substantial shareholders are also insiders for the purpose of insider trading law.8 In China, a shareholder with five percent or more of the shares issued by a listed company is considered to be a substantial shareholder and thus subject to certain obligations, including shareholding reporting requirements9 and the prohibition of short-swing trading.10 This type of insider trading has been well illustrated by the China Qingqi Group Co Ltd case where a holding company traded the shares of its subsidiary on the basis of inside information.11 The above three groups are all traditional corporate insiders, but the insider trading prohibition is not limited to them. There are two more groups of persons who are nominal outsiders but nevertheless subject to the prohibition. One group are so called temporary or constructive insiders, namely a group of nominal outsiders who participate in securities trading pursuant to their statutory duties or private contracts, such as underwriters, accountants, lawyers, consultants and the staff members of securities registration and clearing institutions.12 The Xiangfan Shangzhen case provides a good example as to this point, where a securities company was charged with insider trading as it acquired material non-public information from its client during a business meeting and then traded on it.13 The other group are regulatory officials, namely persons who have regulatory authority over securities trading.14 The officials of the CSRC fall squarely within this category. Some staff members of stock exchanges may also be categorized into this group because stock exchanges have statutory duties in co-regulating the securities market in China.15 The Gao Fashan case, where a regulatory official traded securities on the basis of inside information, has demonstrated the necessity of setting out this group of insiders.16 Apart from the above primary insider trading instances, this legislation also reaches cases where the misappropriation theory is the only basis for finding a violation.17 Under Article 76, a person who has illegally obtained material nonpublic information has an insider’s duty and thus is prohibited from trading on

7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

Securities Law, Art. 74(4). Ibid Art. 74(2). Ibid Art. 86. Ibid Art. 47. For a detailed account of this case, See above §2.III.A.1. Ibid Art. 74(6). In the US, this group of people is identified as insiders by a famous footnote in Dirks and is referred to as temporary or constructive insiders. For a detailed discussion of this issue, See above §5.III.C.2. For a detailed account of this case, See above §2.III.A.1. Securities Law, Art. 74(5). Ibid Art. 115. For a detailed account of this case, See above §2.III.A.2. For discussion of the misappropriation theory, See above §5.III.C.3.

188

Chapter 6

the basis of the information.18 In this sense, the term ‘insider trading’ is now something of a misnomer, since a wide range of persons, including nominal outsiders, are subject to the insider trading prohibition. The introduction of the misappropriation theory had an important impact on the development of insider trading law in China. Originally, a list of persons who were deemed to be insiders appeared in Article 6 of the 1993 Provisional Measures of the Prohibition of Securities Fraud (‘Provisional Measures’),19 which has been largely reproduced in the predecessor to Article 74 of the Securities Law in 1999. Although similar in appearance, there are some noticeable differences between Article 6 of the Provisional Measures and Article 74 of the Securities Law. One of the most important changes is that the following category of insiders contained in the former provision has not been inherited by its successor: . . . individuals who, on the basis of his occupation, or who, by means of a contractual or employment relationship with the issuer, may encounter or obtain inside information, including news reporters, magazine editors, radio or television directors and printers.20 It may be that this section was drafted in response to the US experience of two important cases, namely Chiarella where an employee of a financial printer traded on misappropriated inside information,21 and Carpenter v. United States involving the misuse of misappropriated information by a financial reporter.22 Since at that time the misappropriation theory had not yet been judicially adopted in the US,23 China did not explicitly introduce the misappropriation theory in the Provisional Measures. In order to deal with insider trading cases such as Chiarella and Carpenter, this section was inserted into Article 6 of the Provisional Measures. Clearly, this section is no longer needed after the misappropriation theory was introduced into the Securities Law in 1999. Furthermore, the circumstances where an insider can violate insider trading law are set out in order to secure greater efficacy of the prohibition. Under Article 76, the prohibited conduct by persons in possession of inside information includes not only trading, but also tipping and procurement.24 Firstly, a person is prohibited from trading affected securities if he or she possesses material non-public information acquired as an insider (the trading prohibition). This applies no matter whether the insider is a buyer or a seller of securities. Secondly, it is prohibited for an insider to divulge to third parties the information in his or her possession (the tipping prohibition). Finally,

18. Securities Law, Art. 76. 19. Jinzhi Zhengquan Qizha Xingwei Zanxing Banfa [Provisional Measures for the Prohibition of Securities Fraud] (2 September 1993) (PRC) (hereinafter Provisional Measures). For an overview of the development of China’s insider trading law, See above §5.II.A. 20. Ibid Art. 6(4). 21. Chiarella v. United States, 445 U.S. 222 (1980). 22. Carpenter v. United States, 484 U.S. 19 (1987). 23. For details about the development of the US insider trading law, See above §5.III. 24. Securities Law, Art. 76.

Some Basic Elements of Insider Trading

189

insiders are prohibited from procuring another person to trade securities, when such procurement is based on material non-public information in their possession (the procurement prohibition). By the tipping and procurement prohibitions, the insider trading law can effectively avoid easy circumventions. In these two instances, according to Article 76, it is not essential that there be trading for liability to attach.25 Put another way, an insider will be held liable for merely tipping the information or procuring the transaction, even if there has been no transaction. Hence, whether or not the tippee or the person procured to trade actually trades is irrelevant to the liability of the insider. In contrast, under the US law, a tipper is not subject to Rule 10b-5 liability if no trading takes place, because any violation of Rule 10b-5 must be ‘in connection with the purchase or sale of securities’.26 The theory behind this is that no harm is done to the market if there is no trading, and that communication of material non-public information is beneficial to market efficiency. China’s legislators, however, might have tended to believe that the irrelevance of trading in the tipping and procuring contexts could prophylactically discourage tipping and procuring activities which may potentially lead to actual trading. It should be noted that the above insider trading provisions cover both natural persons and entities. As discussed in Chapter 2, one striking feature of the incidence of insider trading in China is that entities are responsible for a considerable proportion of insider trading cases.27 In particular, insider trading may occur when issuers themselves buy or sell their own securities. The Zhangjiajie Tourism Development Co Ltd case is a perfect example in this area.28 The need to prohibit issuer insider trading has also been well recognized in the US.29 In order to curb this situation, it is necessary to extend liability beyond natural persons to entities. Article 180(2) of the Criminal Law expressly applies to entities, stating that: If the crimes [of insider trading] mentioned in the preceding paragraph are committed by a entity, the entity in question shall be fined, and the individual 25. Ibid Art. 76. 26. 15 U.S.C. §78j(b) (2001). See generally, William K.S. Wang & Marc I. Steinberg, Insider Trading (Aspen Publishers, 1996) §4.4.5. For a case indicating that the SEC’s power under the ‘in connection with’ locution may be broader than that for private plaintiffs, see SEC v. Rana Research, 8 F.3d 1358 (9th Cir. 1993). 27. See above §2.III.C.1. 28. For a detailed account of this case, See above §2.III.A.1. 29. See e.g., Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991), vol. VIII, 3592 (stating that the issuer attempting to repurchase its own shares should be deemed an insider). Professor Langevoort observed that, Conceptually, extending the insider trading prohibition to instances of issuer insider trading makes perfect sense. The effect of nondisclosure of material information when the issuer transacts with its shareholders is to allocate the ‘wealth opportunity’ to the remaining or other shareholders. This favouring of one class over another is inconsistent with basic principles of corporate governance, since it is the functional equivalent of the issuer’s managers ‘tipping’ one group of shareholders while denying the information to the other.

190

Chapter 6 directly in charge of it or people who are directly responsible shall be sentenced to not more than five years in prison or criminal detention.30

Thus, in the cases that insider trading is committed on behalf of or to the benefits of entities as opposed to individuals, both the entities and the individuals directly in charge would be criminally penalized. Because individuals would be held liable whether they act on their own behalf or on behalf of their entities, it would create a strong deterrence to those who want to commit insider trading under the cover of the corporate veil. Conceptually, the extension of insider trading liability to entities may pose difficulties to multi-service securities companies when one department has material non-public information about the securities of a client company and another department has traded the affected securities in ignorance of the information. Because the knowledge of one department of a company will be normally imputed to the company, the company would be in danger of being charged with insider trading, regardless of the fact that another department trading in the affected securities was actually unaware of the information. This would force multi-service firms to split into separate brokerage and underwriting organizations, leading to expensive duplication of the research facilities commonly employed in both operations – a cost that would probably be passed on to the investors. This problem could be generally addressed by the introduction of the Chinese Wall system.31 Indeed, Chinese Walls provide a convenient, if not always successful, solution to the problem of conflict of interest in large professional organizations.32 It tries to balance public confidence in the advisory professions against the commercial needs of those professions to operate as larger entities. In Western countries such as the US and Australia, Chinese Walls have long been relied upon as a defence to insider trading allegations.33 In China, Article 136 of the Securities Law provides that,

30. 31. 32.

33.

Donald C. Langevoort, Insider Trading: Regulation, Enforcement, and Prevention (West Group) (looseleaf) §3.02[1][d], p. 7. Criminal Law, Art. 180(2). For more discussion of the Chinese Wall system, See above §3.III.A.1. Norman S. Poser, International Securities Regulation (Boston, Little, Brown and Company, 1991), p. 196 (‘The fundamental question . . . is how to resolve these conflicts of interest in a way that adequately protects the integrity of the markets, the customers and corporate clients of securities firms, and the business interests of the firms themselves . . . the Chinese Wall has played a pivotal role in the attempt to achieve a resolution of these sometimes competing interests); see also Ashley Black, ‘Policies in the Regulation of Insider Trading and the Scope of Section 128 of the Securities Industry Code’ (1988) 16 Melbourne University Law Review 633; Martin Lipton and Robert B. Mazur, ‘The Chinese Wall Solution to the Conflict Problems of Securities Firms’ (1975) 50 New York University Law Review 459. In the US, the Congress enacted the Insider Trading Sanctions Act of 1984, providing that sanctions under the Act will not apply merely because an employee of the firm is liable under the Act. In Australia, the current Chinese Wall provisions in relation to insider trading conduct are found in ss 1043F and 1043G of the Corporations Act 2001. For more analysis of the use of

Some Basic Elements of Insider Trading

191

A securities company shall establish and improve an internal control system, adopt effective measures of separation so as to prevent any interest conflict between the company and its clients or between different clients thereof. A securities company shall undertake its operations of securities brokerage, underwriting, self-operation and asset management in a separate manner but not in a mixed manner.34 As discussed in Chapter 3, the CRSC has basically endorsed the use of Chinese Wall to resolve the conflicting duties of a broker-dealer, although the exact requirements of the procedures is less clear.35 However, the Securities Law does not formally provide for the establishment of Chinese Walls as a defense in insider trading cases. Further, to date, no courts have addressed whether Chinese Walls can be used by multi-service firms to avert securities law liability. Thus, it remains unclear to what extent Chinese Walls are available to securities companies as a defence against liability for insider trading. The Chinese insider trading law also makes a number of exceptions in certain circumstances where as a matter of business, the use of material non-public information is unavoidable. For example, Article 76(2) explicitly exempts trading without disclosure of one’s own intentions in the tender offer setting.36 Moreover, the insider trading prohibition does not apply where the communication of inside information to a securities company is solely for the purpose of procuring the company to enter into an underwriting agreement.37 As discussed at length in Chapter 3, although the Securities Law provides administrative and criminal penalties for insider trading, it has not made civil remedies available to the aggrieved party by a person who has engaged in insider trading.38 Briefly speaking, Article 202 of the Securities Law sets out administrative liability and makes reference to Article 180 of the Criminal Law which provides for criminal liability. However, no specific provisions in the Securities Law have been devoted to civil damages. As will be discussed in more detail in Chapter 7, the unavailability of civil remedies has caused growing concerns and China is currently considering introducing private civil liability for insider trading.39

34. 35. 36. 37. 38. 39.

Chinese Walls in Western countries, see Norman S. Poser, ‘Chinese Wall or Emperor’s New Clothes? Regulating Conflicts of Interest of Securities Firms in the US and the UK’ (1988) 9 Mich. Y.B Int’l Legal Stud. 91; Roman Tomasic, ‘Chinese Walls, Legal Princile and Commercial Realtiy in Multi-service Professional Firms’ (1991) 14(1) UNSW Law Journal 46. Securities Law, Art. 136. See above §3.III.A.1. Securities Law, Art. 76(2). Ibid Art. 23 (‘To underwrite securities, the securities company shall enter into an agreement with the issuer for underwriting as an agent or as a sole agent’). For a more detailed discussion on the liability framework for insider trading in China, See above §3.III.C.1. See below §7.II.

Chapter 6

192

B.

THE SHORT-SWING TRADING PROHIBITION

In addition to the ordinary insider trading prohibition, Article 47 of the Securities Law, modelled after Section 16(b) of the US 1934 Securities and Exchange Act,40 prohibits so-called short-swing trading. Specifically, it requires directors, supervisors, senior managers and substantial shareholders of a listed corporation (a shareholder holding five percent or more of the outstanding shares) to disgorge to the corporation any short-swing profits, namely profits made from any purchase and sale (or sale and purchase) of the corporation’s equity securities in any six month period.41 Prior to the 2005 revision, the predecessor to Article 47 of the Securities Law provided for short swing trading laibility for substantial shareholers without mentioning other people. At first glance, this provision appeard to be significantly different from its US counterpart to the extent that corporate directors and other senior officers were not prescribed therein. However upon closer examination of the then corporate law system in China as a whole, this was not the case. In fact, the reason why corporate directors and other senior officers were not included in the predecessor to Article 42 of the Securities Law lies in Article 147 of the old Company Law which provides that: Directors, supervisors and managers shall declare their numbers of shares held by them to the company, and shall not transfer such shares during their term of office.42 Thus, before the new Company Law came into effect on 1 January 2006, in China, directors and senior officers had been strictly prohibited from selling their company shares during their term in office. In light of this blanket ban on directors and other senior officers, it could be argued that it was not necessary to list them again under the short-swing trading prohibition.43 However, Article 147 of the old Company Law has long been severely criticized on the ground that although this prohibition might help to align the interests of management with the interests of shareholders and encourage managers to focus on the long-term growth of

40. 15 U.S.C. §78p(b) (1994). 41. Securities Law, Art. 47. 42. Company Law, Art. 147 (before 2005 revision). 43. However, some commentators have contended that in spite of the blanket ban, corporate directors and other senior officers should nevertheless be specified in short-swing trading provisions. See e.g., Peng Jiang, ‘A Brief Analysis of Disgorgement of Insider Short-swing Trading Profits’ (2001) 39 Fazhi yu Shehui Fazhan [Legal System and Social Development] 66, 67. Furthermore, it has been argued that the relatives of directors and other officers should be specified in the short-swing trading prohibition because they may have access to inside information by virtue of their familial relationship with directors. See e.g., Qian Zhu, ‘Several Legal Issues on the Short-swing Trading Prohibition: Article 42 of China’s Securities Law’ (2000) 5 Fashang Yanjiu [Law and Commerce] 110, 111.

Some Basic Elements of Insider Trading

193

the company, it seemed to have gone too far and been too draconian.44 In 2005, the new Company Law replaced the old Article 147 with Article 142 which significantly relaxes the previous restriction on the right of directors and other senior managers to transfer shares. Accordingly, Article 47 of the new Securities Law adds directors, supervisors and other senior managers into the list of people subject to the short-swing trading liability. The short-swing trading prohibition is supported by a number of disclosure provisions which oblige corporate insiders to disclose their ownership of securities in their own company and report changes therein. Under Article 86(1) of the Securities Law, shareholders are required to report their shareholdings, within three days of becoming substantial shareholders, to their company which in turn sends the report to the CSRC and the stock exchange on which the company is listed.45 Apart from this initial report of ownership, substantial shareholders are also obliged to report any material change in their ownership. Article 86(2) of the Securities Law provides that substantial shareholders should report and make announcement of any five percent increase or decrease in their shareholdings within three days after the change takes place.46 In addition, the CSRC sets reporting requirements for corporate directors and other senior officers. Listed companies should disclose in periodic reports (including interim reports, annual reports) the relevant information with respect to the shareholdings of their directors, supervisors and managers, including the number of securities held, change in ownership, the nature of change, and reasons why the change took place.47 Although directors and other senior officers must make information disclosure through their companies, the principal obligation to report falls on the insiders rather than on their companies. All the above reports are made available for public inspection both at the CSRC and at the relevant stock exchanges. These reporting requirements provide an effective means of monitoring trade by corporate insiders. After a short-swing 44.

See e.g., Liang Yang, Neimu Jiaoyi Lun [Insider Trading] (Beijing, Beijing University Press, 2001), p. 241 (arguing that the prohibition unreasonably deprives corporate directors and other senior officers of legal rights to freely trade shares). 45. Securities Law, Art. 86(1). 46. Ibid Art. 86(2). Article 86 is intended to serve in the takeover context and in order to reduce the costs of takeover, it sets a five percent change threshold for the reporting duty to occur. However, this threshold may be too high for the purposes of the short-swing trading prohibition. Indeed, insiders can make a sizeable profit by short-swing trading shares less than five percent. In contrast, in the US, the reporting requirement as to the changes to substantial shareholders’ ownership in the takeover context is separa. te from that in the setting of the insider trading prohibition. Specifically, the former requirement, as provided in Section 13(d) of the Securities Exchange Act, 17 CFR 240. 13d-2 (1996), set a reporting threshold of one percent change while the latter requirement, as provided in Section 16(a), 15 U.S.C. §78p(a) (1994), does not employ such a threshold and demands reporting ‘any change’ in the shareholdings. 47. Guanyu Jiaqiang Dui Shangshi Gongsi Dongshi Jianshi Jinli Chiyou Bengongsi Gufeng Guanli de Tongzhi [Notice on strengthening the administration of the shareholdings by the directors, supervisors and manager of their companies] (promulgated by the CSRC on 22 April 1996).

Chapter 6

194

trading violation is detected, the board of directors of the affected company can make a claim on the profit. If the board fails to take reasonable steps to recover the short-swing profit from the insider, the shareholders of the company have the right to require the board to do so in thirty days.48 Where the board causes losses to the corporation as a result of its failure to recover the short-swing profit, the directors responsible would bear joint and several liabilities for the losses.49 As discussed in Chapter 2, there has been one short-swing case in China to date.50 §6.III.

INSIDERS

A.

A CRITIQUE OF THE DEFINITION OF INSIDER IN CHINA

As discussed earlier, China’s insider trading law has adopted a closed-ended definition of ‘insiders’ by specifically listing certain persons that are deemed to be insiders for the purposes of insider trading regulation.51 Further, apart from the possession of relevant inside information, China has set up an additional ‘person connection’ test to define insiders, requiring that there must be a causal link between an insider’s position and the acquisition of the information. Those ‘persons with knowledge of inside information’ would therefore be prohibited from trading only if they have access to the information by virtue of their connection with the company whose securities are affected,52 by virtue of their office53 or profession.54 While this approach has the virtue of providing some bright-line rules, it has its costs. Firstly, the ‘person connection’ test can be difficult to apply in practice and thus unduly complicates an already complex area. The EU Insider Trading

48. Securities Law, Art. 47(2). Before the 2005 revision, derivative suit system was absent in China, which has significantly undermined the effectiveness of this provision. See Hui Huang, ‘Research on the Shareholder Derivative Suit System’ (2001) 7 Commercial Law Review [Shangshifa Lunji] 332. The new Company Law has introduced derivative suit system in 2005, so if directors fail to act in accordance with the request of shareholders, shareholders can bring derivative suit for the benefit of the company. 49. Securities Law, Art. 47(3). 50. See above §2.III.A.1. 51. See above §6.II.A. It is worth noting that there is a delegation clause in Article 74 which tries to provide some flexibility by empowering the CSRC to specify other persons as insiders. See Securities Law, Art. 74(7). However, in practice, the CSRC has failed to effectively use its interpretive power to fulfil the legislative purpose. See e.g., Charles Zhen Qu, ‘An outsider’s view on China’s insider trading law’ (2001) 10 Pacific Rim Law and Policy Journal 327, 342 (stating that ‘the CSRC seldom exercises its discretion to broaden the definition of “insider’’ ’). 52. Securities Law, Arts. 74(1) (directors and officers of the issuing company), 74(2) (substantial shareholders), 74(3) (senior officers of the holding company of the issuing company), 74(4) (corporate employees). 53. Ibid Art. 74(5) (regulatory officials). 54. Ibid Art. 74(6) (market professionals and intermediaries).

Some Basic Elements of Insider Trading

195

Directive contains such a test to define insiders.55 In relation to this directive, one commentator has observed: One may consider the case of an employee who has no access to inside information in the exercise of his job but hears by chance during his working time an item of inside information. Shall he be considered a primary insider? The answer is unclear. Apparently, he does not have access to the information by virtue of the exercise of his employment, since he did not receive the information in order to perform a particular task. On the other hand, one could argue that had he not been in the office he would have never got the information and that in this sense he had access to it by virtue of the exercise of his employment.56 Hence, the ‘person connection’ test is so uncertain that it could produce conflicting outcomes. In the US, this issue is also notoriously unsettled. The SEC has brought an enforcement action in a case where a corporate director received inside information outside the course of his employment.57 This stance, however, has been questioned by some commentators.58 The second problem is that defining insiders by means of enumeration could potentially be narrowing, thereby inviting loopholes in an unintended manner. Indeed, many persons who possess inside information may circumvent the prohibition and trade affected securities with impunity. The following three types of persons are illustrative of this problem. To begin with, under Article 74, it seems that corporate directors or officers would not be viewed as insiders after they resigned from a company. This may potentially leave a loophole in the law, since resigned officers may still hold some inside information and take advantage of it. This issue is well addressed overseas. In Japan, there is a statutory category of insiders who are called ‘former corporaterelated parties’.59 This phrase refers to persons who were corporate directors, officers and so on, and who are still within one year of termination of their

55.

56. 57. 58. 59.

Under Article 1 of the EU directive, a primary insider is any person who possesses inside information: (1) by virtue of his membership of the administrative, management or supervisory bodies of the issuer (of the securities to which the inside information relates); (2) by virtue of his holding in the capital of the issuer; or (3) because he has access to such information by virtue of the exercise of his employment, profession or duties. See European Council Directive 89/592 of November 13, 1989, Coordinating Regulations on Insider Dealing, 1989 O.J. (L 334) 30, Art. 1 [hereinafter EU Insider Trading Directive]. C Estevan-Quesada, ‘The Implementation of the European Insider Trading Directive’ (1999) 10 European Business Law Review 492, 494. SEC v. Finamerica Corp., Sec. Reg. & L. Rep. (BNA) No. 594, at A-5 (D.D.C. March 11, 1981). See e.g., Langevoort, above note 29, §3.02[2], 8–10 (contending that ‘the duty to disclose extends only to information received as a result of acting in the fiduciary capacity’). Shokentorihiki Ho [the Japanese Securities and Exchange Law], Law No. 25 of 1948, Art. 190-2 para. 1.

196

Chapter 6

relationships with the corporation.60 Thus, if corporate directors and officers have resigned from a corporation less than a year ago, the insider trading prohibition would still be applicable to them. The US employs an even broader approach to this issue. In the US, directors or officers who resign from a corporation and subsequently trade stock will still have an insider’s duty, unless it can be established that these transactions were not made while they were still in possession of material non-public information.61 Put another way, as long as they possess material nonpublic information, retired corporate directors and officers will still be under an insider’s duty, regardless of when they resigned. Secondly, Article 74 only identifies regulatory officials as insiders; other governmental officials appear to fall outside this definition. This distinction makes little sense because other governmental officials may also have privileged access to material non-public information by virtue of their advantageous position. This is particularly so in China where the market is heavily influenced by government policies and thus more governmental officials are likely to commit insider trading on the basis of these policies. Several US cases have demonstrated that apart from market regulatory officials, other government officials may also commit insider trading. In the first case, an official of the Federal Reserve Board tipped another person about impending interest rate changes and then the tippee traded on this information.62 The second case involved a former consultant to the Navy Department who bought depository receipts of a defence contractor, knowing that the Navy was about to award it a large naval airship contract.63 In the third case, United States v. Bryan,64 the defendant was a former director of the West Virginia Lottery. On the basis of confidential information entrusted to him in his official capacity, Bryan purchased the stock of companies that were slated to receive contracts from the Lottery Commission.65 China’s current insider trading law would have difficulty handling all the above cases, because the government officials involved were not those prescribed in Article 74, that is, ‘staff member of the securities regulatory authority or other

60. Ibid. 61. Loss and Seligman, above note 29, vol. VIII, 3587. For case law in this area, See e.g., Polin v. Conductron Corp., 552 F.2d 797, 811 (8th Cir. 1977), cert. denied, 434 U.S 857 (resignations in 1967 while transactions in 1971); Dirks v. SEC, 463 U.S. 646 (1983) (a former corporate officer was analysed in the same way as would be current officers). 62. Blyth & Co., 43 S.E.C. 1037, 1038–1040 (1969) (holding the tippee liable). 63. SEC v. Mills, noted in 20 Sec. Reg. & L. Rep. (BNA) 1478 (D.D.C., 28 September 1988). 64. 58 F.3d 933 (4th Cir. 1995). In this case, the Fourth Circuit rejected the misappropriation theory and acquitted Bryan. Ibid at 944. However, the misappropriation theory was eventually adopted by the US Supreme Court in United States v. O’Hagan in 1997. See above §5.III.C.3 (discussing the development of the misappropriation theory). Had Bryan been heard after O’Hagan, Bryan would have been convicted of insider trading under the misappropriation theory. 65. Ibid 937–939.

Some Basic Elements of Insider Trading

197

persons who administer securities trading pursuant to their statutory duties’.66 This problem becomes more disturbing considering that since government intervention in the market in China is much stronger than in developed countries, the likelihood of government insiders committing insider trading can be much greater. Thirdly and most importantly, China’s insider trading law is silent on the issue of tippee liability. As discussed above, Article 76 of the Securities Law prohibits an insider as prescribed in Article 74 and any ‘other person who has illegally obtained inside information’ from communicating this information to others or encouraging others to trade on the information.67 However, tippees, namely those persons who have received material non-public information from insiders (tippers), are not subject to the same insider trading prohibitions (trading, tipping, recommending) as insiders.68 Plainly, this is a serious loophole.69 In contrast, almost all other jurisdictions prohibiting insider trading have provided that tippees are subject to the same prohibitions as insiders/tippers.70 B.

A REFORM PROPOSAL: THE AUSTRALIAN ‘INFORMATION CONNECTION’ ONLY APPROACH

As discussed above, China’s statutory definition of insiders is unduly complicated and may facilitate schemes to evade the law. In view of the complexity of insider trading, such a legislative approach to the definition of insiders is essentially problematic and any rigidity of the definition would result in the ineffectiveness of the law. To remedy this problem, it is advisable that China adopt the ‘information connection’ only approach as employed by some countries, most notably Australia.71 1.

The Strengths of the Australian Approach

In Australia, under Section 1043A of the Corporations Act, an insider is any person who possesses information and who ‘knows or ought reasonably to know’

66. Securities Law, Art. 74(5). 67. See above §6.II.A. 68. See e.g., Qu, above note 51, 338 (‘[the predecessor to Article 76 of the Securities Law] does not prohibit a tippee from trading on the inside information himself’). 69. This problem may be arguably ameliorated by Article 73 of the Securities Law, the general provision prohibiting insider trading, because tippees are also ‘persons with knowledge of inside information’. However, as discussed before, the broad nature of Article 73 may have been curbed by Article 74 which specifically lists various types of ‘persons with knowledge of inside information’. 70. See e.g., Franklin A. Gevurtz, ‘The Globalization of Insider trading Prohibitions’ (2002) 15 Transnational Lawyer 63, 76–85 (comparing the insider trading prohibitions in the US, under the EU Directive, in Australia and in Japan). 71. A number of countries such as Singapore and Malaysia have followed the Australian approach. See Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Discussion Paper (June 2001)’ s 1.64, n.88.

198

Chapter 6

that the information ‘is not generally available’ and ‘might have a material effect on the price or value’ of securities.72 Insiders are defined solely according to their possession of relevant inside information. The additional ‘person connection’ requirement is not applied. Under this ‘information connection’ only approach, there is no need to distinguish primary and secondary insiders (tippers/tippees). Clearly, if the ‘information connection’ test is satisfied, it makes no difference how, or from whom, the person has obtained the information. Thus, the definition of insider covers all persons who knowingly obtain inside information, even by chance.73 This approach would effectively overcome the loopholes and uncertainties that currently exist in the Chinese insider trading law. Individuals who are not explicitly listed in Article 74 of the Securities Law but who are in possession of inside information, such as, (as discussed earlier) retired corporate directors or officers, other governmental officials, and their tippees, would be held liable for trading on inside information. This ‘information connection’ only approach is inherently consistent with the equality of access insider trading theory.74 As discussed in Chapter 5, the equality of access theory is based on the notion of market fairness and efficiency. It focuses on whether the market provides a level playing ground, whether any party to a transaction has unequal access to material non-public information, and does not require any other tests, such as the existence of fiduciary duty, as a prerequisite for liability to attach.75 In accordance with this, the ‘information connection’ only approach defines insiders merely by reference to their possession of inside information, making it irrelevant whether the perpetrator has some direct or indirect connection with the company whose securities are traded. Indeed, it is the use of inside information, not a person’s connection with the company whose securities are traded or some other entity, which can harm the market. From the perspective of market fairness and efficiency, it can be difficult to justify the additional ‘person connection’ requirement that would allow insider trading activities to be carried out by some persons armed with inside information.76 In essence, the ‘person connection’ test is a remnant of the fiduciary-duty-based theories for the prohibition of insider trading and thus incompatible with the equality of access theory. As argued in Chapter 5, China should adopt the equality of access theory, which paves the way for the adoption of the ‘information connection’ only approach. Furthermore, this approach is more conceptually straightforward and thus assists market participants to understand insider trading law. Historically, Australia applied the additional ‘person connection’ test before 1991. This approach was abolished in 1991 after it received severe criticism regarding the technicalities and potential gaps involved in the definition of insider. It was held 72. 73. 74. 75. 76.

Corporations Act 2001 (Australia), s 1043A. Corporations and Markets Advisory Committee (Australia), above note 71, s 1.62. For a detailed analysis of the equality of access theory, see Chapter 5. For a detailed discussion of this issue, see Chapter 5. Corporations and Markets Advisory Committee (Australia), above note 71, s 1.73.

Some Basic Elements of Insider Trading

199

that ‘the prohibition requiring the person to be connected to the corporation which is the subject of the information unnecessarily complicates the issue’.77 Indeed, as discussed earlier, it is difficult to apply the ‘person connection’ test.78 Under the ‘information connection’ only approach, the whole insider trading regime can be established with simplicity and certainty. As pointed out by one commentator: Nothing more needs to be said other than that an insider is a person in possession of inside information. In other words, the definitional burden in the legislation should fall on deciding what is inside information and the definition of insider should follow as a secondary consequence of this primary definition . . . The proposal that insiders should be defined as those in possession of inside information would to some extent reduce uncertainty, because the only question that would have to be asked is whether the individual was in possession of inside information and the additional question of whether the individual met the separate criteria for being classed as an insider would be irrelevant.79 It is worth noting that in a recent comprehensive review of insider trading law conducted by the Australian Corporations and Markets Advisory Committee (CAMAC), the ‘information connection’ only approach was recommended to be retained on the basis of its abovementioned strengths.80 At the Corporate Law Teachers’ Association Conference 2005 held in Sydney, John Kluver, the executive director of the CAMAC, expressed his full support for the proposal advanced in this author’s conference paper that the Australian ‘information connection’ only approach provides an appropriate alternative for China to reform its insider trading law.81 2.

Concerns with the Australian Approach

Although the ‘information connection’ only approach can bring simplicity and inclusiveness to insider trading law, there are concerns about its possible overbreadth. From a comparative perspective, this approach has been deemed to be one

77. Report of the House of Representatives Standing Committee on Legal and Constitutional Affairs (Australia), Fair Shares for All: Insider Trading in Australia (11 October 1990) (hereinafter Fair Shares for All), para. 4.3.5. 78. See above §6.III.A. 79. Paul L. Davies, Gower’s Principles of Modern Company Law (Sweet & Maxwell Ltd, 6th ed., 1997), pp. 464–465. 80. Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Report (November 2003)’ Recommendation 18. 81. John Kluver, ‘Insider Trading’ (Paper presented at the Corporate Law Teachers’ Association Conference 2005, Sydney, 7–8 February 2005). The conference paper presented by this author won the Prize for Best Conference Paper and has been published. See Hui Huang, ‘The Regulation of Insider Trading in China: A Critical Review and Proposals for Reform’ (2005) 17 (3) Australian Journal of Corporate Law 281.

200

Chapter 6

of the broadest in the world, and is described as ‘expansive’,82 ‘extraordinarily broad’,83 and ‘unusually broad’.84 This is readily understandable because it is easy to get such an impression at the first blush. As discussed in Chapter 5, the US approach towards the insider trading prohibition begins with a narrow classical theory and then expands to the misappropriation theory.85 In contrast, the Australian approach is broad at the outset, and then gradually narrows down its scope. In order to prevent the approach from being reduced to the parity of information theory,86 Australia has taken a number of important steps, such as limiting the scope of inside information,87 carving out some particular exceptions,88 and so on. Thus, the Australian law effectively sticks to the equality of access theory in the sense that people with an informational advantage, if discovered by research or legitimate means, would not be exposed to liability.89 Indeed, although the Australian approach may look very broad, no solid evidence has been presented so far to suggest that it is in fact too broad or overinclusive, thereby hindering the effective functioning of securities markets.90 This is not surprising because, as discussed above, the theoretical basis of the approach is sound and by defining inside information or carving out exceptions one could – as Australia has done – readily deal with possible over-breadth therein. Recall the example quoted earlier: an employee who has no right of access to inside 82. 83. 84. 85. 86. 87.

88.

89. 90.

Marc I. Steinberg, ‘Insider Trading, Selective Disclosure, and Prompt Disclosure: A Comparative Analysis’ (2001) 22 University of Pennsylvania Journal of International Economic Law 635, 668. Gevurtz, above note 70, 67. Interview with Professor Donald C. Langevoort (19 July 2002, the University of Sydney, Sydney Australia). See above §5.III.C. Indeed, the broadness of the Australian approach has led some commentators to say that Australia has adopted the parity of information theory. See e.g., Steinberg, above note 82, 668. The Australian law excludes deductions, conclusions or inferences made from publicly available information from the scope of inside information, and thus eliminates the danger of discouraging legitimate information gathering. See Corporations Act 2001 (Australia), s 1042(1)(c). For example, Australia makes exceptions for knowledge of a person’s own intentions or activities, and thus the acquiring company can safely enter into the transaction with the knowledge of its intent to make a premium price tender offer for stock in the target corporation. Corporations Act 2001 (Australia), s 1043H. For comparison of the equality of access theory and the parity of information theory, See above §5.IV.B.1. The over-breadth problem with the Australian approach did not become fully apparent until after the Financial Services Reform Act (FSRA) amendments to the Corporations Act came into effect in March 2002. Those amendments extended the insider trading legislation from securities and equity-related futures markets to a much broader range of financial markets, in furtherance of the harmonisation objectives of the FSRA to apply uniform laws to financial products. The additional products now regulated include commodity products, reciprocal purchase agreements, negotiable instruments, forward rate agreements, interest rate swaps and options, foreign exchange and electricity contracts. This could create over-regulation problems for transactions on OTC markets and transactions in the securities of unlisted entities. See Corporations and Markets Advisory Committee (Australia), above note 80, s 4.1.

Some Basic Elements of Insider Trading

201

information in his or her position but hears, by chance, of that information while at work.91 This scenario is clearly covered by the Australian insider trading law, which may suggest that the Australian ‘information connection’ only approach is too broad. However, this is not convincing since the employee would be caught under other approaches as well. Indeed, the employee is not only caught under the Australian law, but also under some other insider trading laws adopting an additional ‘person connection’ test. For example, under the EU Insider Trading Directive, it is possible that the employee would be treated as a primary insider.92 Even assuming that under a strict interpretation of the ‘by virtue of employment’ requirement, it may be successfully argued that the employee cannot be a primary insider, he or she would not escape liability as a secondary insider (tippee) because the inside information was directly or indirectly received from a primary insider.93 Hence, the employee would be held liable in any event under the EU Insider Trading Directive. Moreover, whether the employee is treated as a primary insider or a secondary insider is irrelevant because either violation, as a primary insider or as a secondary, carries the same penalty.94 From other perspectives, some commentators have voiced their concern over the Australian ‘information connection’ only approach. It has been argued that the EU Insider Trading Directive is preferable to the Australian law because there are ‘uncertainties’ under the Australian law.95 This commentator, however, did not go further and point out what the uncertainties are, which greatly reduces the force of his assertion. On the contrary, as discussed above, certainty is precisely one of the advantages of the Australian approach. Another more reflective concern is that under the Australian approach, the regulators’ image may be at risk to the extent that due to resource constraints, regulators would be unable to catch all insider trading activities covered by the broad law.96 On this view, the Australian approach is too broad, not because some of the activities that are covered are not theoretically punishable but because as a practical matter, regulators cannot possibly catch them due to resource constraints, thereby jeopardizing their reputation. The merit of this argument is that legislation should be drafted in a realistic way so as to ensure effective enforcement, and regulators should devote their limited resources to 91. 92. 93. 94. 95. 96.

See above note 53 and accompanying text. Ibid. EU Insider Trading Directive, Art. 4. EU Insider Trading Directive, Art. 4. Gevurtz, above note 70, 78. Indeed, resource constraints are a universal problem for all regulators. The SEC, for example, is probably the most-resourced regulatory body in the world, yet it has argued that it does not have sufficient resources to enforce insider trading law. See e.g., H.R. Rep. No. 100–910, at 14 (1988) (citing testimony at legislative hearing on Insider Trading and Securities Fraud Enforcement Act of 1988 of SEC Chairman David S. Ruder). On the other hand, due to the secret nature of insider trading, the costs in manpower and resources of investigation and litigation are extremely high in this area. See Langevoort, above note 29, §1.04, 1–24.

202

Chapter 6

deal with more common or serious breaches. Indeed, it is meaningless or even harmful to make laws that are doomed to be unenforceable. However, this argument may not be strong enough to negate the Australian approach. Firstly, it does not rebut the theoretical case for the Australian approach. Society would not narrow down the scope of laws prohibiting murder if, due to resources limits, police could not successfully detect every murder case. For example, it would be less than sensible to provide that criminal laws only cover very serious cases of murder. In this sense, this argument seems to be a variant of the untenable argument, as refuted in Chapter 4, that because the enforcement of insider trading law is costly and ineffective, insider trading should not be regulated.97 Secondly, it is doubtful that the enforcement problem would significantly damage a regulator’s reputation. It has been argued that all rules are inherently over-inclusive and thus need flexible application.98 As a matter of fact, whether in Australia or in any other countries, including the US which adopts a more restrictive approach, regulators face the same problem of enforcing insider trading laws and are inevitably and necessarily selective in deploying their limited resources.99 Thus, the enforcement problem is nothing new to insider trading, nor peculiar to the Australian approach. This view has been supported by officials from the Australian Stock Exchange (ASX).100 They have stated that the regulator’s reputation would not be damaged particularly by a failure to detect some insider trading cases, because that kind of failure happens everyday in every area of law and is well understood by the public. On the contrary, some of these officials believe that the Australian approach can help to enhance law enforcement because it gives regulators more room to maneuver and enable regulators to strategically allocate limited regulatory resources. One of them referred to the recent widely-publicized Rivkin case where a prominent broker was criminally punished for a relatively light insider trading offence. This case has reportedly generated a strong deterrence to potential insider trading perpetrators,101 and that official stated that the successful prosecution of this case demonstrates the advantage of the broad Australian approach. Furthermore, one

97. 98.

See above §4.II.C. See e.g., Julia Black, Rules and Regulators (New York, Oxford University Press, 1997), pp. 27–29. 99. Langevoort, above note 29, §1.04, 1–24. Professor Langevoort observed that: Acknowledging their lack of resources, the SEC and federal prosecutors have tended to focus their attention on special situations: examples of very high volume trading prior to a major corporate announcement, organized trading rings, and – because of the attendant publicity involved, which makes for greater visibility for the enforcement program – instances where the subjects of the inquiry are well-known public figures . . . In a very real sense, much of insider trading enforcement is intentionally ‘symbolic’. 100. Interview with officials of the ASX (31 July 2002, The Australian Stock Exchange, Sydney Australia). 101. For a detailed discussion of this case, See above §2.III.C.3.

Some Basic Elements of Insider Trading

203

official said that the Australian approach, based on an egalitarian principle, is quite easy to understand and thus the law, by its very existence, serves an educational and deterrent function. §6.IV.

INSIDE INFORMATION

A.

AN OVERVIEW

As discussed above, the definition of inside information is central to the insider trading prohibition. In general, inside information is characterized as both ‘material’ and ‘nonpublic’. This is readily understandable since insiders cannot be unfairly better-positioned to make a profit when they trade whilst in possession of information which is common knowledge or trivial.102 Article 75(1) of the Securities Law generally defines what constitutes ‘inside information’ in China, providing that: Inside information is information that is not made public because, in the course of securities trading, it concerns the company’s business or financial affairs or may have a major effect on the market price of the company’s securities.103 However, this broad standard may be too vague and indeterminate, making it potentially very difficult to resolve litigation, and for insiders to decide whether they must disclose information before trading. In order to give some guidance and facilitate its application, Article 75(2) itemizes those types of facts that are regarded as inside information, 1. the major events listed in the second paragraph of Article 67 of this law; 2. company plans concerning distribution of dividends or increase of registered capital; 3. major changes in the company’s equity structure; 4. major changes in security for the company’s debts; 5. any single mortgage, sale or write-off of a major asset used in the business of the company that exceeds thirty percent of the asset concerned; 6. potential liability for major damages to be assumed in accordance with law as a result of an act committed by a company’s director(s), supervisor(s), manager(s), deputy manager(s) or other senior management person(s); 7. plans concerning the takeover of listed companies; 8. other important information determined by the securities regulatory authority under the State Council to have a significant effect on the trading prices of securities.104 102. Langevoort, above note 29, §5.01, 1. 103. Securities Law, Art. 75(1). 104. Ibid Art. 75(2).

Chapter 6

204

As the first item states, the ‘major events’ listed in Article 67 also fall within the scope of inside information. Under the regime of continuous information disclosure, Article 67 contains a laundry list of ‘major events’ that a company is obligated to disclose, by submitting an ad hoc report on those events to the CSRC and to the stock exchange where it is listed. The ‘major events’ under this article include: 1. A major change in the company’s business guidelines or scope of business; 2. A decision by the company concerning a major investment or major asset purchase; 3. Conclusion by the company of an important contract which may have an important effect on the company’s assets, liabilities, rights, interests or business results; 4. Incurrence by the company of a major debt or default on an overdue major debt; 5. Incurrence by the company of a major deficit, or incurrence of a major loss; 6. A major change in the external conditions of the company’s production or business; 7. A change in the chairman of the board of direction, not less than onethird of the directors or the manager of the company; 8. A considerable change in the holdings of shareholders who each hold not less than five percent of the company’s shares; 9. A decision made by the company to reduce its capital, to merge, to divide or dissolve, or to apply for bankruptcy; 10. Any major litigation involving the company, or where the resolution of the general meeting of shareholders or the board of directors have been cancelled or announced invalid; or 11. Where the company is involved in any crime, which has been filed as a case as well as investigated into by the judiciary organ, or where any director, supervisor or senior manager of the company is subject to compulsory measures as rendered by the judiciary organ; or 12. Other matters as specified by the securities regulatory authority under the State Council.105 As suggested by Articles 67 and 75, inside information is any material, nonpublic information, regardless of whether it is derived from within the company whose securities are traded or not. Put another way, inside information includes both ‘corporate information’ which is internally generated by the issuer of the subject security, and ‘market information’ which is externally generated but nevertheless has a major effect on the stock price of the issuer. Clearly, it appears that the Chinese law places an emphasis on ‘corporate information’. Article 75(1) specifically highlights information concerning the ‘business or

105.

Ibid Art. 67.

Some Basic Elements of Insider Trading

205

financial affairs’ of the issuer,106 and the vast majority of the enumerated types of information fall within this category, such as making a major investment, concluding an important contract, changing senior executives, changing corporate capital and so on. In contrast, the listed types of ‘market information’ are relatively few, including the occurrence of a takeover bid on the issuer. However, many other kinds of information may potentially fall within the scope of ‘market information’. For example, in so-called ‘front-running’ situations where stockbrokers trade on their own behalf before implementing their client’s instructions, the client’s instructions may be regarded as material information, provided the client’s order of transaction is great enough to have a major effect on the price of the securities traded. This can happen particularly when subject securities are thinly traded. In other words, front-runners possess material information that a client has placed an order that may significantly impact on the market price of the securities in question. Thus, the practice of front-running can be viewed as an insider trading violation in China. Moreover, it appears that the definition of inside information is not confined to information that specifically relates to one or more companies or securities. A literal reading of Article 75 implies that any confidential pricesensitive information would be deemed inside information, regardless of whether it is related to securities specifically or generally. This should be immediately relevant to the status of government policies which always have a general market application, affecting all or at least a whole sector of companies or securities in the market. If a government policy, for example, changes in interest rates, has a major effect on the price of the affected securities, it would constitute inside information in China. This treatment is very important in China since as discussed in Chapter 3, government policies are fast-changing and frequently abused by those with privileged access to make money in the market.107 Finally, there is a specific exemption for research and analysis that takes the form of deductions, conclusions or inferences made or drawn from generally available information.108 It is widely accepted that market research and analysis are

106. Ibid Art. 75(1). 107. See above §3.III.A.1. There are currently two conflicting views on this issue worldwide. Some countries, notably the UK, require inside information to relate to particular securities or to a particular issuer of securities or to particular issuers of securities. See e.g., Criminal Justice Act 1993 (UK), s 56 (1)(a). In contrast, some countries do not impose such a restriction. In the US, for example, the SEC has brought an enforcement action in a case involving the information of impending interest rate changes leaked by an official of the Federal Reserve Board. See Blyth & Co., 43 S.E.C. 1037, 1038–40 (1969); Langevoort, above note 29, §5.02[2], 12 (‘Nor must the information necessarily relate to the issuer’s actual business operations’). 108. Jinzhi Zhengquan Qizha Xingwei Zanxing Banfa [Provisional Measures for the Prohibition of Securities Fraud] (2 September 1993) (PRC), Art. 5.

Chapter 6

206

fundamental to ensuring an efficient market.109 However, market research and analysis could technically be seen as inside information before public disclosure because they can cause a major price movement in affected securities, especially when the analyst is influential. This would prohibit the use or communication of research results, which is clearly inconsistent with the reality of business. In order to deal with this problem, market research and analysis should be treated as public if it is based on publicly available information, therefore falling outside the scope of inside information. However, market analysts are generally prohibited from trading before publishing their research findings, a practice sometimes referred to as ‘scalping’.110 Indeed, a person conducting research may seek to profit through buying [selling] securities in advance of releasing positive [negative] research results or recommendations concerning those securities. It is believed that permitting such pre-publication trading would cause harmful consequences,111 such as undermining public confidence that the market is not open to manipulation.112 Thus, market analysts may choose either to trade on the basis of their research findings, but not publish their report, or to sell its findings to their clients without advance trading.

B.

MATERIALITY

1.

Standard of Materiality

One prong of the test for inside information is whether the information is material. Under Chinese law, the information would be taken as material if it ‘may have a major effect on the market price of the company’s securities’.113 This standard of materiality is focused on the impact of the information upon the security’s price,

109. The US Supreme Court has described the role of market analysts as ‘necessary to the preservation of a healthy market’. Dirks v. SEC, 463 U.S. 646, 658 (1983). For a theoretical discussion of the role of the investment analyst, see Daniel R. Fischel, ‘Insider Trading and Investment Analyst: An Economic Analysis of Dirks v. Securities and Exchange Commission’ (1984) 13 Hofstra L. Rev. 127. 110. For a discussion of scalping, See generally John F. Barry, ‘The Economics of Outside Information and Rule 10b-5’ (1981) 129 U. Pa. L. Rev. 1307, 1376–81; Joel Seligman, ‘The Reformulation of Federal Securities Law Concerning Nonpublic Information’ (1985) 73 Geo. L. J. 1083, 1124–1127. 111. See e.g., Jianjun Bai, Zhengquan Qizha ji Duice [Securities Fraud and Solutions] (Beiing, China Legal Publishing House, 1996), p. 29–31. 112. For this reason, some commentators have argued that scalping should be regarded as a form of market manipulation. See Shiyou Lu et al., Zhengquan Shichang yu Zhengquan Fanzui Tanlun [Securities Market and Securities Crime] (Beijing, Lixin Accounting Press, 1995), p. 156. 113. Securities Law, Art. 75.

Some Basic Elements of Insider Trading

207

so it may be labeled the ‘price-affective’ standard. Many countries, such as the UK114 and Australia,115 have also adopted this standard. It is noteworthy that the word ‘may’ indicates a degree of probability, more so than a degree of possibility. This is intended to avoid setting too low a standard of materiality which could lead to an avalanche of trivial information which in turn would interfere with informed decision-making. However, unclear is whether the word ‘price’ under Article 75 includes value. In the UK, the legislation has specifically pointed out that the word ‘price’ used therein covers value.116 Likewise, the statutory definition of inside information in Australia refers to information ‘that . . . if generally available, a reasonable person would expect it to have a material effect on the price or value of securities of a body corporate’.117 As a practical matter, in the stock market, the intrinsic value of a share may not be fully reflected in its price which is directly determined by the relationship between its supply and demand. It is quite possible that the market price of a share has increased significantly without its value changing correspondingly, and vice versa. Hence, for the purpose of Chinese law, the word ‘price’ under Article 75 should be interpreted to include value in line with the international norm. In contrast, some countries, notably the US, have adopted the ‘mindaffective’ standard, that is, any information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in making his/her investment decision.118 It is important to note that under this standard, the material information need not be outcome-determinative, that is, ‘it need not be important enough that it would have caused the reasonable investor to change his vote’.119 Rather, the standard would be sufficiently met by the showing of a 114. Criminal Justice Act 1993 (UK), s 56 (1). More broadly, the ‘price-affective’ standard is endorsed by the EU Insider Trading Directive, which results in the standard being employed by many European countries. See EU Insider Trading Directive, Art. 1(1). 115. Corporations Act 2001 (Australia), s 1042(A). 116. Criminal Justice Act 1993 (UK), s 56 (3). 117. Corporations Act 2001 (Australia), s 1042A (emphasis added). 118. Basic Inc. v. Levinson, 485 U.S. 224, 231 (1988) (quoting TSC Industries, Inc. v. Northway, 426 U.S. 438, 449 (1976) (concerned with an action in the proxy-solicitation context)). In TSC Industries, Inc. v. Northway, the US Supreme Court stated that: An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to [act] . . . Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available. 119.

426 U.S. 438, 449 (1976). TSC Industries, Inc. v. Northway, 426 U.S. 438, 449 (1976). see also SEC v. Mayhew, 121 F.3d 44, 51 (2d Cir. 1998) (‘[t]o be material, the information need not be such that a reasonable investor would necessarily change his investment decision based on the information, as long as a reasonable investor would have viewed it as significantly altering the total mix of information available’); Folger Adam Co. v. PMI Indus., Inc., 938 F.2d 1529, 1553 (2d Cir.), cert. Denied, 502 U.S. 983 (1991) (‘it is well established that a material fact need not be outcome-determinative . . . ’).

208

Chapter 6

substantial likelihood that the information ‘would have assumed actual in the deliberations of the reasonable shareholder’.120 Put another way, as long as a reasonable investor would have considered the information significant at the time of his/her decision, the information may be held material, even if the investor would have made the same decision with the information. In most cases, these two standards should lead to the same result. As one commentator stated: After all, by and large, investors find facts important because the fact might impact the stock’s price, and if investors find a fact important in deciding whether to buy or sell, the investors’ purchase and sale decisions will impact the stock’s price.121 This point is also supported by economic theory that price of exchange-listed and other widely traded securities typically reflects a consensus among investors about its fair value based on all available information. Indeed, it seems that the two standards have been often interchangeably used in China. For example, the CSRC has promulgated a regulation to guide information disclosure with regard to prospectus, providing that ‘any information which would have a significant influence on investors’ investment decision-making should be publicly disclosed . . . ’.122 The ‘mind-affective’ standard also appears in another CSRC’s regulation concerning information disclosure on listing announcement of publicly-held companies which states that ‘any information which happens during the period from the date of disclosing prospectus to the date of issuing listing announcement and would have a significant effect on investors’ investment decision-making should be publicly disclosed . . .’123 Although there is no substantial difference between the two standards, it seems that from the perspective of law enforcement, the price-affective standard is more commendable. First of all, the price-affective standard is conceptually more relevant to insider trading. As Professor Langevoort persuasively stated: The [price-affective] test is particularly apt because it relates back directly to the purpose of the [insider trading] prohibition: removing the profit that comes when a fiduciary trades with foreknowledge of a major movement in the price of a stock.124

120. TSC Industries, Inc. v. Northway, 426 U.S. 438, 449 (1976). 121. Gevurtz, above note 70, 74. See also Langevoort, above note 29, §5.02[1], 2–3 (describing the mind-affective standard as the standard definition of materiality while the price-affective standard as a shorthand definition). 122. Gongkai Faxing Gupiao Gongsi Xingxi Pilu Neirong yu Geshi Zhunze (No.1 ZhaoGu Shuomingshu) [Rules on Content and Form of Information Disclosure of Publicly-held Companies (No.1 Prospectus)] (promulgated by the CSRC on 15 March 2001) (PRC), Art. 3. 123. Gongkai Faxing Gupiao Gongsi Xingxi Pilu Neirong yu Geshi Zhunze (No.7 Shannshi Gonggaoshu) [Rules on Content and Form of Information Disclosure of Publicly-held Companies (No.7 Listing Announcement)] (promulgated by the CSRC on 15 March 2001) (PRC), Art. 3. 124. Langevoort, above note 29, §5.02[1], 4 (emphasis added).

Some Basic Elements of Insider Trading

209

In contrast, the mind-affective standard seems too amorphous, encompassing much information that though arguably ‘significant’ to a typical investor, is in fact not the sort that would, if disclosed, have a major market effect. This problem has led to the suggestion that the US should change its current mind-effective standard to the price-affective standard.125 Secondly, as a practical matter, the price-affective standard has more predictability and certainty. It has been argued that the advantage of the price-affective standard is that: it places an emphasis on reasonable and objective contemplation of possible effects on security prices, rather than . . . concentration on what might happen if there were public disclosure of the information.126 Indeed, the price-affective standard provides an objective and thus relatively predictable rule for determining whether the information is material. In contract, the mind-affective standard seems to be more subjective and less certain. For example, in the US where the mind-affective standard applies, courts always have to look at a variety of indirect factors in determining the materiality of the information, such as the actual reaction of the market, trading by the insiders, and the way the information is handled by the issuer.127 This process of making materiality determinations depends in a great measure on how courts see the factors. Furthermore, the uncertainty of the mind-affective standard is exacerbated by the fact that it is unclear what a ‘reasonable investor’ really means.128 A few US courts have adopted a ‘mosaic’ approach to the materiality question, holding that even if information is not by itself important, this information may still be material if the defendant, taking the information together with other information previously made available, would create a significant ‘mosaic’ and change his assessment of the value of the stock. In Elkind v. Liggett & Myers, Inc.,129 the court stated: A skilled analyst with knowledge of the company and the industry may piece seemingly inconsequential data together with public information into a mosaic which reveals material non-public information.130 Under this approach, it seems that the ‘reasonable investor’ is defined as the ‘skilled analyst’. This is also consistent with the efficient market theory under which price movements are largely the product of institutional trading, directly and promptly caused by analyst recommendations.

125. Ibid §13.03[4], 12. 126. Bailey, ‘Insider, Inside information and the Securities Industry Act 1975’ 5 Austl. Bus. L. R. 269, 276 (1977) (emphasis added). 127. See Wang & Steinberg, above note 26, 131–133. 128. See e.g., Langevoort, above note 29, §11.02, 12. 129. 635 F.2d 156 (2d Cir. 1980). 130. Ibid 165 (footnote omitted). This ‘mosaic’ concept has been followed by State Teachers Retirement Bd. v. Fluor Corp., 566 F. Supp. 945 (S.D.N.Y. 1983).

Chapter 6

210

However, there are views to the contrary. In re Dirks,131 for instance, the SEC opined that: We have long recognized that an analyst may utilize non-public inside information which in itself is immaterial in order to fill in ‘interstices in analysis’. That process is legitimate even though such ‘tidbits’ of inside information ‘may assume heightened significance when woven by the skilled analyst in the matrix of knowledge obtained elsewhere’ thereby creating material information.132 And in Dirks v. SEC, the US Supreme Court was reluctant to regulate analyst use of material nonpublic information obtained from insiders because analysts are ‘necessary to the preservation of a healthy market’.133 Indeed, in order to encourage basic research activities, the threshold for materiality should be set high enough and thus it is tempting to define the ‘reasonable investor’ as the ‘average investor’ rather than the ‘skilled analyst’.134 In short, the mosaic theory has generated considerable uncertainty over who a ‘reasonable investor’ is under the mind-affective standard.135 Thus, compared to the mind-affective standard, the price-affective standard appears objective and more certain. The enhanced certainty in the definition of inside information under the price-affective standard is very important particularly in light of the criminal nature of insider trading. 2.

Precision of Inside Information

The Chinese insider trading law adopts the price-affective standard to define what material information is, with no additional requirement for the information to be specific or precise. Under Article 75 of the Securities Law, the scope of material information is not limited to verifiable facts; it includes any sort of information that might significantly affect securities prices. Thus, information could be regarded as material even if it is somewhat vague or uncertain, as long as it may have a major price impact. For example, projections and estimates regarding income and earnings, plans concerning the takeover of listed companies, plans concerning distribution of dividends or increase of capital, are listed as inside

131.

47 S.E.C. 434 (1981), Exch. Act. Rel. No. 17480, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶82, 812 (22 January 1981), affd. Sub nom. Dirks v. SEC, 681 F.2d 824 (D.C. Cir. 1982), revd. On other grounds, 463 U.S. 646 (1983). 132. 47 S.E.C. at 444; [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶82,812, at 83,947 (dictum)(footnotes omitted). 133. Dirks v. SEC, 463 U.S. 646, 658 (1983). 134. Langevoort, above note 29, §11.02[2], 11–12. It should be noted that the average investor is not equal to a prudent or conservative investor, rather, he may well be speculative. See SEC v. MacDonald, 699 F.2d 47, 51 (1st Cir. 1983). 135. Dennis, ‘Materiality and the Efficient Capital Market Model: A Recipe for the Total Mix’ (1984) 25 Wm. & Mary L. Rev. 373, 415 n.205 (1984).

Some Basic Elements of Insider Trading

211

information under Article 75.136 This dictates that the price impact should be considered on an ex ante basis. In other words, the materiality of the information must be examined in light of the facts as they then existed, not with the hindsight that the projected or planned transaction did or did not come to fruition. This approach to uncertain future events is similar to the American probability/magnitude test for materiality, namely, assessing the likelihood that an event will occur against its magnitude if it should occur.137 In contrast, the EU Insider Trading Directive requires that inside information be of a precise nature.138 This requirement is intended to exclude rumors, suspicions, conjectures or speculation from the ambit of inside information.139 However, as a practical matter, this would make the proof of a contravention to the insider trading regulation more difficult. In some instances, it is virtually impossible to identify the precise information that a defendant possesses. Rather, the prosecution may need to rely on evidence of the defendant’s access to information and inferences from that person’s conduct. Apart from the practical evidentiary difficulty associated with it, the additional precision requirement can be questioned from the theoretical perspective. Conceptually, the materiality definition of ‘inside information’ is already sufficient to measure the level of informational asymmetry, thereby obviating the need for any further requirement that the information be precise. Indeed, when determining whether the information is too uncertain to form a basis for an insider trading prohibition, one needs to do nothing more than apply the price-affective materiality test, namely, whether the information would have a major effect on securities prices. This point has been well articulated in the following commentary: To introduce an additional ‘specific or precise’ requirement [to the definition of material information] could unduly narrow the application of the legislation and create artificial distinctions between what does and what does not constitute inside information.140 Thus, there is no pressing need for China to introduce the additional requirement that inside information be precise. This requirement may create unnecessary problems in regulating insider trading to the extent that it is required to make a separate and very difficult determination of whether the information is precise or a mere rumor.

136. Securities Law, Art. 69. 137. This test was first set out in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969), and then endorsed by the US Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224, 238 (1988) (stating that a determination of materiality needs ‘a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activities’). 138. EU Insider Trading Directive, Art. 1. 139. Commission Proposal for a Council Directive Coordinating Regulation on Insider Trading, Art. 6, 1987 O.J (C 153) 8; Gil Brazier, Insider Dealing: Law and Regulation (Cavendish Publishing Limited, 1996), pp. 108–109. 140. Corporations and Markets Advisory Committee (Australia), above note 80, para. 3.7.3.

Chapter 6

212

C.

WHEN INFORMATION BECOMES PUBLIC

1.

Information Disclosure and Dissemination

Conceptually, it is straightforward that inside information must be non-public, that is, not generally available to the investing public. In practice, it might be difficult however to ascertain when information becomes public. In order to provide some predictability and certainty for the business community with respect to what is effective disclosure, the Securities Law states that: Announcements to be made in accordance with laws or administrative regulations shall be published in the newspapers, periodicals or the dedicated gazette specified by the relevant department of the State. In addition, such announcements shall be made available at the company’s domicile and the stock exchange for the public to consult.141 Further, the CSRC has exercised its rule-making power to make it clear that listed companies must disclose their information through the nationwide media as specified by it.142 To date, seven newspapers and one periodical have been officially specified as proper disclosure media, including Shanghai Zhengquan Bao (Shanghai Securities News), Zhongguo Zhengquan Bao (China Securities News), Zhengquan Shibao (Securities Times), Jingrong Shibao (Finance Times), Zhongguo Gaige Bao (China Reform News), Jingji Ribao (Economy Daily), Zhongguo Ribao (China Daily), and Zhengquan Shichang Zhoukan (Securities Market Weekly).143 Listed companies may choose one or more of the specified media at their own discretion to disclose information, and other organizations and individuals should not intervene.144 Thus, in general, the information would be deemed effectively disclosed only if it is announced via the specified media. Specificity of information is also an important factor in determining if disclosure has been effective. A good illustration of this point can be found in Shenshen Fang,145 a recently reported criminal insider trading case in China. There, an insider was held liable for trading on information that she received concerning the completion of a major investment. The defendant claimed that the information was already public because the company had disclosed the schedule of the investment before. The court disagreed, holding that although some general information had been disclosed to the public, the specific information regarding the actual 141. Securities Law, Art. 70. 142. Gupiao Faxing yu Jiaoyi Guanli Zanxing Tiaoli [Provisional Regulations on the Administration of Stock Issuance and Trading] (22 April 1993) (PRC) Art. 63. 143. Guanyu Zhiding Baokan Pilu Shangshigongsi Xinxi Shoufei Wenti de Tongzhi [Notice on the Issue of Charge for the Information Disclosure of Listed Companies on the Specified Newspapers and Periodicals] (promulgated by the CSRC on 5 June 1995) (PRC). 144. Gongkai Faxing Gupiao Gongsi Xingxi Pilu Shishi Xize (Shixing) [Detailed Rules for the Implementation of Information Disclosure of Publicly-held Company (Tentative)] (promulgated by the CSRC on 12 June 1993) (PRC) Art. 26. 145. For a detailed discussion of this case, See above §2.III.A.2.

Some Basic Elements of Insider Trading

213

completion of the investment had not been publicly disseminated and thus constituted inside information. Thus, the fact that rumors or other soft information were floating around in the market about a forthcoming major investment would not permit insiders who know that the transaction is a certainty to trade in the affected securities. However, it appears that the Chinese insider trading law does not require a post-announcement waiting period, that is, insiders may act immediately upon disclosure of the information. This is problematic because it would damage market confidence if insiders gain an unfair advantage from the dissemination of information before the market has had a reasonable time to absorb that information. Indeed, mere public announcement of the information does not necessarily amount to public availability and the insider must therefore wait a reasonable period during which the investing public can evaluate the information thoroughly. For this reason, it is necessary that even after adequate public disclosure of information, insiders may not trade or tip until the information is absorbed by the investing public. As properly stated in a famous US case: Where the news is of a sort which is not readily translatable into investment action, insiders may not take advantage of their advance opportunity to evaluate the information by acting immediately upon dissemination.146 Thus, it is advisable that China introduce the post-announcement waiting period requirement. Nevertheless, determining exactly how long the waiting period should be is very difficult. In the US, for example, there have been differing views on this issue. Some commentators argue that the period be fifteen minutes after the public announcement.147 The American Stock Exchange provides that the period is twenty-four hours after publication of a release in a national medium or fortyeight hours when publication is not so widespread.148 The American Law Institute’s proposed Federal Securities Code establishes a rebuttable presumption that a fact is generally available one week after it is disclosed by means of a filing or press release or in any other manner reasonably designed to bring it to the attention of the investing public. This shifts the burden of proof to the defendant to show that a shorter period is appropriate.149 The efforts to seek a bright-line rule to judge the waiting period may be vain and dangerous, because there are great variations in the rapidity of assimilation that occur because of differences in types of issuers, markets and information. Rather, the issue should be determined by market practices and the surrounding circumstances relating to the form of dissemination and the complexity of the information. For instance, according to the Trading Rules of the Shanghai and Shenzheng Stock Exchange, the stock exchanges will halt for half a trading day 146. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 854 n. 18 (2d Cir. 1968). 147. 2 Alan R. Bromberg and Lewis D. Lowenfels, Bromberg and Lowenfels on Securities Fraud and Commodities Fraud (West Publishing Company, 2nd ed., 1998) §7.4, p. 482. 148. American Stock Exchange, Disclosure Policies 16–17 (1970). 149. American Law Institute, Federal Securities Code §202(64).

214

Chapter 6

after material information is announced in the exchange.150 Moreover, based on the so-called efficient market hypothesis, one effective method to determining when information has been effectively assimilated by the stock market is to examine how soon the price leveled off after disclosure.151 In sum, the Chinese approach is laudable to the extent that it provides some concrete guidance of proper disclosure by specifically prescribing a number of disclosure procedures. By contrast, in the US, there is no specific rule with respect to when information becomes public for insider trading purposes, and each determination is made by the surrounding circumstances on a case-by-case basis. This has led to some criticism of the SEC’s failure to set forth sufficient guidance. For example, in his dissent in Dirks v. SEC,152 Justice Blackmun stated: I agree that disclosure in this case would have been difficult. I also recognize that the SEC has been less than helpful in its view of the nature of disclosure necessary to satisfy the disclosure or refrain duty. The Commission tells persons with inside information that they cannot trade on that information unless they disclose; it refuses, however, to tell them how to disclose. This seems to be a less than sensible policy, which it is incumbent on the Commission to correct.153 However, on the other hand, the Chinese approach may be too rigid and formalistic, which is probably the main reason for the SEC’s refusal to formulate a clear-cut rule for proper disclosure. For example, it is doubtful that disclosure through the eight specified nationwide media can always and invariably be effective. Moreover, in ascertaining to whom the information should be made available in order to be deemed public, China tends to focus on the general investing public. This approach largely ignores the fact that the securities market is characterized by the intervention of professional intermediaries. In contrast, there are generally two approaches to determining when material information becomes public in developed countries, such as the US and the UK. In the US,154 the first approach is that information is public when it has been disseminated and absorbed by the general investing public. This approach, which has clearly been adopted by China, essentially requires some form of dissemination of the information via nationwide media. According to the second approach which is 150. Shanghai Shenzhen Zhengquan Jiaoyisuo Jiaoyi Guize [Trading Rules of the Shanghai and Shenzhen Stock Exchanges] (promulgated on 31 August 2001 and effective as of 31 November 2001) (PRC) Art. 91. 151. See e.g., Langevoort, above note 29, §5.03, 16. 152. 463 U.S. 646 (1983). 153. Ibid at 677 (Blackmun, J., dissenting). 154. Wang & Steinberg, above note 26, 153. The UK also adopts both of these two approaches. On the one hand, information is made public if it is published in accordance with the rules of a regulated market for the purpose of informing investors and their professional advisers. Criminal Justice Act 1993 (UK), s 58(2)(a). On the other hand, information may be treated as public even though it is communicated to a section of the public and not to the public at large. Criminal Justice Act 1993 (UK), s 58(3)(b).

Some Basic Elements of Insider Trading

215

based on the efficient market hypothesis, information is deemed public when it is known by the active investment community, even if it is not really available to all investors. The theory of this approach is that, if information is in the hands of a sufficient number of active investors such as institutional investors, the market price of the security will reflect the information and deprive the insider of any opportunity for illegal profit. As insightfully stated by the US Court of Appeals for the Second Circuit: We agree that information may be considered public for Section 10(b) purposes even though there has been no public announcement and only a small number of people know it. The issue is not the number of people who possess it but whether their trading has caused the information to be fully impounded into the price of the particular stock.155 Under this approach, information can be regarded as public even though it has not yet been formally disseminated via nationwide media, as long as a sufficient number of active investors have had knowledge of it.156 Thus, there is no need to specifically prescribe the ways of disclosing information. Rather, the functional question one needs to ask is whether the information has been fully reflected in the stock price. This approach has been praised as ‘theoretically appealing and sound’.157 Indeed, it draws upon the mechanisms of market efficiency and relates directly to profit opportunity of insider trading. It is therefore submitted that China should consider adopting this approach to gain some flexibility in determining when information becomes public. 2.

Readily Observable Matter: the Australian Debate

Apart from the publishable information test as discussed above, the present Australian insider trading legislation has another test for determining what information is generally available and can therefore lawfully be used in trading. This test is called ‘readily observable matter’ test, under which information is generally available if it consists of readily observable matter.158 Investors can trade immediately on the basis of readily observable matter. Unlike the publishable information test, 155. United States v. Libera, 989 F.2d 596, 601 (2d Cir. 1993). 156. It should be noted that this second approach is not intended to promote the practice of selective disclosure, which is considered to be a form of insider trading. Rather, it suggests that the dissemination period could be shorter if the published information has reached a sufficient number of active investors, albeit not all investors, and has been effectively incorporated into security prices. For more analysis of selective disclosure, See above §5.III.C.2. 157. Langevoort, above note 29, §5.03, 17. 158. Corporations Act 2001(Australia), s 1042(1)(a). The publishable information test is to be found in s 1042(1)(b). The Singaporean definition of generally available information, which faithfully follows the Australian definition, also includes ‘readily observable matter’. See Securities and Futures Act (Singapore), s 215(a). Also, the UK insider trading provisions have concepts somewhat analogous to readily observable matter. Information shall be deemed to be made public if it can be readily acquired by those likely to deal in any securities to which

216

Chapter 6

there is no requirement for reasonable dissemination period. This test was introduced as an amendment to an earlier draft of the 1991 insider trading amendments in Australia, for the reasons given below: Concerns was expressed that in consequence of the adoption of this definition [that is, the publishable information test] in the exposure draft, information directly observable in the public arena would not be regarded as generally available, as it had not been ‘made known’. It has considered that a person could be liable for insider trading where he/she traded in securities on the basis of, for example, an observation that the body corporate had excess stocks [e.g., of cars] in a yard. This was not the intention of the provisions.159 However, the legislation does not define what exactly a ‘readily observable matter’ is. This has given rise to serious confusion surrounding the readily observable matter test, which is well demonstrated in two related cases, R v. Kruse160 and R v. Firns.161 The relevant facts in both cases were that the value of a particular Australian listed company’s shares would be materially affected by a judgment handed down in an appeal case in the Supreme Court of Papua New Guinea. Both defendants were officers of the appellant company. They traded the company’s shares immediately after the outcome of the appeal was known. The ASX had not yet been advised of the decision and no Australian or other media had reported on the decision prior to their trading. Both defendants were charged with breach of the Australian insider trading provisions and were given separate trials. Both of them argued that the Papua New Guinea Court judgment was a readily available matter under the Australian law and therefore no dissemination period was required before they traded the securities. Interestingly enough, the two defendants received diametrically opposite judgments in their separate trials in the same court of first instance. In R v. Kruse, the New South Wales District Court ruled that ‘readily observable matter’ was not limited to information the source of which was in Australia, and directed the jury to acquit the defendant on the readily observable matter ground. This was to be sharply contrasted with R v. Firns where the New South Wales District Court held that the readily available matter element was confined to matters occurring within Australia. The defendant was convicted and then appealed. The New South Wales Court of Criminal Appeal, by majority, reversed the conviction, ruling that the the information relates or any securities of an issuer to which the information relates. See Criminal Justice Act (UK), s 58(2)(c). In addition, information may, but not necessarily will, be regarded as being public ‘even though . . . it can be acquired only by observation’. See Criminal Justice Act (UK), s 58(3)(c). Furthermore, FSA Code of Market Conduct April 2001, Annex B para. 1.4.8 refers to the example of a train passing a burning factory and a passenger calling his broker using his mobile telephone to sell shares in the company that owns the factory. 159. Explanatory Memorandum para. 326. 160. New South Wales District Court, December 1999. 161. First instance: New South Wales District Court, November 1999. On appeal: New South Wales Court of Criminal Appeal (2001) 38 ACSR 223.

Some Basic Elements of Insider Trading

217

announcement of a judgment in an open Papua New Guinea court was a readily observable matter under the Australian legislation and the defendant did not breach the insider trading provisions by purchasing shares immediately thereafter. Thus, the readily observable matter test can create considerable uncertainty about when persons may lawfully trade. It applies to matters that are readily observable. However, as indicated by the abovementioned two cases, it is unclear what constitutes readily observable matter. More specifically, at least three questions remain open here, including (1) observable to whom; (2) how observable; and (3) where observable. The Australian Corporations and Markets Advisory Committee (CAMAC) has examined these issues in a recent extensive review of insider trading law.162 Clearly, the CAMAC was deeply concerned with the decision of R v. Firns, because it permits corporate officers to trade immediately after they become aware of any readily observable matter affecting their company and before the market is advised of that matter, for instance, through a press release or a continuous disclosure notice.163 In other words, the decision of R v Firns results in too wide a test of when information is deemed to be in the public arena. This creates an under-regulation problem and thereby defeats the equal access goal of insider trading laws. Thus, the current law on the readily observable matter, as reflected in R v. Firns, needs to be changed. The CAMAC sought submissions on the three elements of the readily observable matter test, and the views of the respondents differed.164 On the one hand, the Australian Securities and Investments Commission submitted that the matter must be observable by a cross-section of investors; the matter must be readily observable without resort to technical assistance beyond that likely to be used by a cross-section of investors; the matter would have to be observable at least by investors in Australia. On the other hand, the Law Council of Australia contended that it would suffice if the matter either is disclosed in a public arena or can be observed by the public without infringing rights of privacy, property or confidentiality; a matter is readily observable even if other users of the market cannot obtain it because of limitations on their resources, expertise or competence or it is only available on payment of a fee; a matter is readily observable even if it is only available outside Australia. However, the majority view of the CAMAC rejected both of the two approaches put forward in submissions, stating that: The two approaches . . . could either greatly narrow or indefinitely widen the readily available matter test, without in either case necessarily creating any greater precision in how that test would apply in particular instances.165

162. Corporations and Markets Advisory Committee (Australia), above note 71, ss 2.1–2.50. 163. Ibid s 2.24. 164. Corporations and Markets Advisory Committee (Australia), above note 80, s 1.11. 165. Ibid s 1.11.4.

218

Chapter 6

The CAMAC also considered another reform alternative. Under this alternative, certain persons such as corporate directors and other senior officers would be excluded from relying on the readily observable matter test in regard to any trading by them in the company’s financial products. This would still allow, say, innocent tourists or keen researchers to trade on the basis of the readily observable matter test. The CAMAC acknowledged that this option has some appeal, but nevertheless discarded it on the ground that it ‘could itself create anomalies or avenues for avoidance’.166 In effect, this option rolls back to the additional ‘person connection’ requirement for the definition of insider, which has previously been considered to be inappropriate.167 Consequently, it can create imprecise and arbitrary boundaries, and thus run the serious risk of making insider trading less enforceable. Finally, the CAMAC proposed to abolish the current published information and readily observable matter tests, and introduce a new test of generally available information. This new test is more directly linked to the disclosure standards in financial markets, requiring that the insider information is disclosable information or announceable information pursuant to any legal or regulatory regime.168 Then, information is generally available only if it: (a) is accessible to most persons who commonly invest in [relevant] financial products of a kind whose price or value might be affected by the information, or (b) consists of deductions, conclusions or inferences made or drawn from any information referred to in paragraph (a). . . . information is deemed to satisfy paragraph (a) if it is disclosed pursuant to any prescribed disclosure procedure.169 This new simplified test would overcome complexities and ambiguities in the current test of when information is generally available. Under this new test, the R v. Firns scenario would be covered because the Papua New Guinea judgment clearly comes within the ambit of disclosable or announceable information.170 Moreover, the insider trading law would adjust to, and reinforce, disclosure requirements as they develop over time in financial markets. The new test is somewhat similar to the Chinese law to the extent that it provides that any information is deemed to be generally available if it has been disclosed in any prescribed disclosure measure such as widely circulated print 166. Ibid s 1.11.4. 167. See above §6.III.B. 168. As discussed earlier, the Australian insider trading regulation has been extended to various financial markets since March 2002, which gives rise to an over-regulation problem. See above note 85. In the view of the CAMAC, to link the insider trading provisions directly to the disclosure standards could effectively deal with the over-regulation problem. The reform strategy of the CAMAC is to first solve the over-regulation problem and then deal with the under-regulation problem associated with the readily observable matter test. Ibid s 4.7. 169. Ibid Recommendation 38. 170. ASX Listing Rule 3.1.

Some Basic Elements of Insider Trading

219

or broad cast media. This would provide some solid guidance on when information becomes public, but like China, it does not include a dissemination requirement. Insiders can gain an undue advantage from the dissemination of information before the market has a realistic opportunity to learn of the information, even if the information is disclosed in widely circulated media. This may be contrary to the concept of market fairness that underlies the insider trading provisions. Of course, it may be said that the language ‘accessible to most persons’ in the first section of the recommendation implies a dissemination period. But again as with the Chinese law, this focuses on the general investing public when determining the length of the dissemination period, ignoring the fact, as recognized by the US and UK law, that insiders would no longer have profit opportunity of insider trading once the information has reached a sufficient number of active investors and has been effectively integrated into securities prices.171 §6.V.

SUBJECTIVE ELEMENTS

A.

INTRODUCTION

Insider trading is in nature a hidden form of misconduct and thus very hard to detect and prosecute due to the burden of proof.172 In particular, it is very difficult to regulate insider trading because there are serious evidentiary problems with proving the subjective elements of insider trading. Those nations with insider trading laws have long been wrestling with this problem and have developed various solutions. Due to its high incidence of insider trading, China has a pressing need to address this problem for the purposes of improving the efficacy of insider trading regulation. Therefore, this section aims to evaluate those solutions on the merits and then make relevant recommendations for China. The importance of this issue has been well demonstrated by a recent influential insider trading case, Shenshen Fang.173 As discussed before, this case is the first criminal insider trading case in China, where an insider allegedly divulged material nonpublic information concerning a major investment to a third party who in turn traded on the information. One of the important issues raised by this case deals with the subjective elements of insider trading, in particular, how to prove the communication of information. The accused’s defense lawyer argued that there was no evidence that the defendant disclosed the information. However, the court simply dodged this argument, failing to express a clear opinion on how to prove the defendant’s possession of inside information, and whether a

171. 172.

See above §6.IV.C.1. See e.g., Mark Stamp and Carson Welsh, International Insider Trading (Sweet & Maxwell Ltd, 1996), p. 9. 173. For a detailed account of this case, See above §2.III.A.2.

220

Chapter 6

rebuttable presumption is acceptable. Clearly, the lack of clarity of these issues would adversely affect the regulation of insider trading in the future. In fact, the failure of the court to deal with the subjective elements of insider trading is ultimately due to corresponding loopholes in the statutes, because China, as a civil law country, requires its judges to enforce rather than make laws. Indeed, as will be shown, China’s insider trading regime has paid inadequate attention to the issue of subjective elements. In the Securities Law, there are no provisions devoted specifically to addressing the subjective elements of insider trading. Although some inferences about subjective elements could be painstakingly made from the literal reading of some articles, they may be incomplete and incorrect. This is because these articles are intended to deal with other aspects of insider trading and as such might not have been carefully worded in terms of their implications for the issue of subjective elements. More specifically, the frequently used expression ‘persons with knowledge of inside information’ in the Securities Law may suggest that the actual possession of information is required to establish insider trading liability.174 However, it does not tell us anything about the issue of how to prove the possession of inside information. Furthermore, it is silent on whether liability arises only if insiders actually knew that their possessed information was inside information. Lastly, in respect of the ‘possession vs. use’ question, there appears to be some confusion generated by the conflicting inferences of different articles.175 In short, China’s insider trading regime has failed to adequately address the issue of subjective elements, and its efficacy has been greatly undermined as a result. Furthermore, this issue seems to have been very little researched to date, as most of the papers with respect to insider trading are focused on other issues such as the definition of insiders or inside information. Thus this part is dedicated to analyzing the problems to do with the subjective elements of insider trading, with a view to filling the loopholes currently in existence in China’s insider trading law. This part proceeds as follows. Firstly, it will briefly discuss the scienter requirement as a general principle of subjective elements. Then, the issues regarding the possession of inside information as well as the knowledge of inside information will be examined, as both of them are required for insider trading liability to occur. After this, it will focus on the question of whether it is required further that insiders must have actually used the possessed information, also known as the ‘possession vs. use’ debate in the US. The analysis here is not limited to the US debate, but is instead carried out from an international perspective. The differing legal responses to this issue in various jurisdictions will be fully investigated and categorized. This analysis aims to paint a whole picture of the international developments of this issue on a comparative basis, with a view to recommending the most appropriate solution for China.

174. This expression appears in Articles 73, 74 and 76 of the Securities Law. 175. See below §6.IV.A.

Some Basic Elements of Insider Trading B.

AWARENESS OF INSIDE INFORMATION

1.

The Scienter Requirement

221

In China, the Criminal Law generally circumscribes criminal liability by requiring the perpetrator’s scienter as to the existence of the facts and intentionality to engage in illegal behaviour.176 Insider trading liability is no exception.177 In principle, scienter may include actual intent and recklessness, demanding that ‘the crime is constituted as a result of clear knowledge that one’s own act will cause socially harmful consequences, and of hope for or indifference to the occurrence of those consequences’.178 However, there is no exact definition of scienter, especially in the context of insider trading which has only recently been criminalized in China.179 Similarly, in Ernst&Ernst v. Hochfelder,180 the US Supreme Court held that scienter, that is, intent to deceive, manipulate, or defraud, is required in a private cause of action for damages under Section 10(b) of the Securities Exchange Act 1934 and Rule 10b-5 promulgated thereunder.181 Subsequently, in Aaron v. SEC,182 a case involving injunctive relief, the Court reaffirmed this scienter requirement.183 In the context of insider trading, this position has also been upheld.184 Although the Court has asserted that scienter ‘refers to a mental state embracing intent to deceive, manipulate, or defraud,’185 the term ‘scienter’ has never been clearly defined by the courts, particularly in the context of insider trading.186 Nor is the term ‘scienter’ defined in the federal securities law.187 This has led one commentator to observe that: Inherently an elusive concept, scienter suffers particular problems in insider trading. It has to fit many different versions of the violation, some of them 176. Zhonghua Renming Gongheguo Xingfa [Criminal Law of the People’s Republic of China] (October 1997) (PRC) (hereinafter Criminal Law), Art. 14. The Criminal Law distinguishes between intentional crimes and negligent crimes. Criminal liability is to be imposed for negligent crimes only when the law explicitly stipulates. Ibid Art. 15. 177. Ibid Art. 180. 178. Ibid Art. 14. 179. For a detailed discussion of the development of the regulation of insider trading in China, see above §2.II.B. 180. 425 U.S. 185 (1976). 181. 425 U.S. 185, 193 (1976). 182. 446 U.S. 680 (1980). 183. Ibid 689–695. The Court stated that ‘scienter is a necessary element of a violation of §10(b) and rule 10b-5, regardless of the identity of the plaintiff and the nature of the relief sought’. Ibid 691. 184. See e.g., Dirks v. SEC, 463 U.S. 646, 663 n.23 (1983) (insider trading case, noting that ‘Scienter . . . is an independent element of a Rule 10b-5 violation’) (citing Aaron); SEC v. MacDonald, 699 F.2d 47, 50 (1st Cir. 1983) (en banc) (insider trading case, citing Aaron and Ernst & Ernst). 185. Ernst &Ernst v. Hochfelder, 425 U.S. 185, 193–194 n.12 (1976); see Aaron, 446 U.S. at 686 n.5. 186. Langevoort, above note 29, §3.04, 3–22, (1999) (stating that ‘the courts have never offered a clear definition of scienter’). 187. Ibid §7.4 (800) at 7:162 (‘[Scienter] appears nowhere in the 1933 or 1934 Securities Acts or their rules’).

Chapter 6

222

quite peculiar. Some of the standard articulations aren’t well suited to insider trading. And, perhaps as a result, courts struggling to find words that make sense in factual contexts use multiple expressions which are not always consistent . . . Moreover, scienter is described in very different terms, sometimes in the same court opinion.188 However, in general, actual intent will satisfy the subjective element requirement of insider trading, whereas it is generally held that mere negligence will not suffice to constitute a violation of Section 10(b) and Rule 10b-5.189 In Ernst & Ernst, the Court declined to decide whether recklessness is sufficient for the purposes of imposing liability under Section 10(b) and Rule 10b-5.190 In subsequent cases, almost all of the Courts of Appeal have concluded that recklessness could be enough to meet the scienter requirement in non-criminal cases,191 though these courts have set forth different versions of the definition of ‘recklessness’.192 The standard of recklessness adopted by the Seventh Circuit has been adhered to by a majority of circuits, stating that: [R]eckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.193 188. Bromberg and Lowenfels, above note 147, §7.4 (810) at 7:163. 189. Wang and Steinberg, above note 26, 171. 190. The Court stated: In certain areas of the law recklessness is considered to be a form of intentional conduct for purposes of imposing liability for some act. We need not address here the question whether, in some circumstances, recklessness behaviour is sufficient for civil liability under §10(b) and Rule 10b-5. Ernst &Ernst v. Hochfelder, 425 U.S. 185, 193–194 n.12 (1976). 191. Wang & Steinberg, above note 26, 168. For the relevant cases, See e.g., Rolf v. Blyth, Eastman Dillion & Co., 570 F.2d 38, 45–47 (2d Cir. 1978); cert. denied, 455 U.S. 938 (1982); Coleco Indus., Inc. v. Berman, 567 F.2d 569, 574 (3d Cir. 1977) (per curiam), cert. denied, 439 U.S. 830 (1978); Cox v. Collins, 7 F.3d 394, 396 (4th Cir. 1993); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1024 (6th Cir. 1979); Van Dyke v. Coburn Enters., 873 F.2d 1094, 1100 (8th Cir. 1989); Woods v. Barnett Bank, 765 F.2d 1004, 1010 (11th Cir. 1985). It should be noted that reckless may not suffice in a criminal case. See Depetris & Summit, ‘The Insider-Trading Panic: Overlooked Element of Scienter’ (1986) N.Y.L.J., Dec. 10, 1986, at 1, 6 (‘Whatever may be the case for civil liability, it seems clear that criminal liability for insider trading must be premised at the very least on knowledge of the fraud, not just reckless behavior’.). 192. See Johnson, ‘Liability for Reckless Misrepresentations and Omissions Under Section 10(b) of the Securities Exchange Act of 1934’ 59 U. Cin. L. Rev. 667, 674, 685–686, 736 (1991). For a discussion of the various definitions of ‘recklessness’ by the lower courts, see ibid at 685 – 696. see also Steinberg and Gruenbaum, ‘Variations of Recklessness After Hochfelder and Aaron’ (1980) 8 Sec. Reg. L.J. 179. 193. Sundstrand Corp. v. Sunchem. Corp., 553 F.2d 1033, 1045 (7th Cir.), cert. denied, 434 U.S. 875 (1977). This definition of recklessness has been endorsed by the Ninth Circuit in Hollinger v. Titan Captial Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) (en banc), cert. denied, 499 U.S. 976 (1991).

Some Basic Elements of Insider Trading

223

Despite the divergence between the US courts on the precise definition of scienter, it is generally accepted that the scienter requirement in the context of insider trading, amongst other things, demands the following three aspects: (1) the insider was actually aware of the inside information; (2) the insider knew that the information was undisclosed; and (3) the insider knew that the information was material.194 In the circumstances where recklessness is recognized as a form of scienter, the insiders could be held liable if they should have known that the information was both material and non-public.195 Further, the US statutory provision on insider trading has also adopted a recklessness standard as an element of ‘control person’ liability under §21A of the Securities Exchange Act of 1934, as a result of the Insider Trading and Securities Fraud Enforcement Act of 1988.196 This scienter requirement is essential for insider trading liability to attach. Thus, the scienter requirement basically contains the following two important components: First, whether the defendant actually possesses inside information; and second, whether the defendant knows that the information is material and non-public. These two questions will be examined in turn. 2.

Possession of Inside Information

It is readily understandable that the basic precondition to someone incurring insider trading liability is that he or she actually possessed (was aware of) inside information. This is because without inside information, one cannot possibly commit insider trading. Indeed, most jurisdictions require proof that the insider was subjectively aware of particular inside information. For example, in Australia, it is stipulated that the defendant possessed relevant information at the time of trading or procuring;197 in the UK insiders are also defined as those having inside information.198 However, the key question here is how to prove one’s possession of inside information. In practice, establishing that a person was actually in possession

194.

195. 196. 197. 198.

SEC v. Macdonald, 699 F.2d 47, 50 (1st Cir. 1983). In the US, other aspects of the scienter requirement vary depending on the context in which insider trading occurs and the theory under which the case is dealt with. The tippee liability under Dirks, for instance, requires that the tippee must know that the disclosure of inside information by the tipper is in violation of the tipper’s fiduciary duty. See Dirks v. SEC, 463 U.S. 646, 660 (1983). Likewise, for the tipper liability to apply, the tipper must know that tipping is a breach of fiduciary duty. See e.g., Elkind v. Liggett & Myers, Inc. 635 F.2d 156, 167 (2nd Cir. 1980), SEC v. Musella, 678 F. Supp. 1060, 1062–1063 (S.D.N.Y 1988). Sometimes, the tipper’s knowledge of the violation could sometimes be inferred. See United States v. Chestman, 947 F.2d 551, 580–581 (2nd Cir. 1991). See Elkind v. Liggett & Myers, Inc. 635 F.2d 156, 167 n.22 (2nd Cir. 1980). Securities Exchange Act of 1934 (US), §21A(b)(1)(A)and(B). Corporations Act 2001 (Australia), s 1043A(1)(a) (requiring that ‘a person (the insider) possess inside information’). Criminal Justice Act 1993 (UK) s 57(1) (providing that ‘a person has information as an insider if and only if . . . it is, and he knows that it is, inside information . . .’).

224

Chapter 6

of inside information always poses a considerable evidentiary obstacle in insider trading cases. It is very hard to directly prove one’s possession of relevant information, because the allegedly possessed information is peculiarly within the trader’s head and other people cannot metaphysically get into it to inspect. Proof of possession of inside information may sometimes be established by indirect evidence of participation in negotiations and discussions involving the said information.199 However, this indirect proving method may lose its force when some managers did not ostensibly take part in any such discussion, but nevertheless have secretly gained access to that information in other hard-to-prove ways. In France, in order to overcome this evidentiary problem, the courts have implied into the criminal insider trading law a presumption of possession of particular information in certain circumstances. Under this approach, any persons who were the directors of or who were otherwise involved with the management of a company and who traded in the securities of that company, are deemed to be in possession of relevant inside information that is derived from within that company when they conducted the transactions. However, the defendant can rebut this presumption of possession.200 Thus, this approach effectively reverses or partially reverses the onus of proof to the defendant. This rebuttable presumption of possession may assist in insider trading prosecutions against certain types of insiders, notably corporate directors and managers who are most likely to have privileged access to inside information. It is important to note that because the presumption typically applies only to traditional corporate insiders, the evidentiary problem remains in other circumstances. For example, it would not remove the evidential difficulties in proving possession in any proceedings against third persons who may have received inside information from corporate insiders. The mere existence of a relationship between a director and a third person would not usually in itself suffice to establish that the inside information had been passed on to the third party. Nevertheless, the French approach can help to deal with the evidentiary problem in the cases of insider trading committed by traditional insiders. In China, the statutory expression of ‘persons with knowledge of inside information’ (‘Zhixi Neimu Xinxi de Zhiqing Renyuan’) suggests that possession of inside information is required for insider trading liability to attach. In particular, Article 67 provides that ‘persons with knowledge of inside information on securities trading are prohibited to take advantage of such inside information to engage

199. This has been well illustrated in R v. Rivkin (2003) 45 ACSR 366, a recent well-know Australian insider trading case, where the defendant Rivkin was held to have traded in possession of relevant inside information. 200. Tribunal de Grande Instance de Paris, 3 December 1993, Gazette du Palais, 27–28 May 1994, pp. 28 ff. M Stamp & C Welsh (eds) International Insider Dealing (FT Law and Tax, 1996) at 166.

Some Basic Elements of Insider Trading

225

in securities trading’.201 However, the wording of Article 74 has produced some confusion. It provides that: The following persons are persons with knowledge of inside information on securities trading: 1. Directors, supervisors, and senior management persons of an issuer; 2. Shareholders who hold no less than 5 percent of the shares in a company as well as the directors, supervisors, and senior management persons thereof, or the actual controller of a company as well as the directors, supervisors, and senior managers thereof; 3. The holding company of an issuer as well as the directors, supervisors, and senior managers thereof; 4. Persons who are able to obtain material company information concerning the trading of its securities by virtue of the positions they hold in the company; 5. Staff members of the securities regulatory authority, and other persons who administer securities trading pursuant to their statutory duties; 6. The relevant staff members of public intermediary organizations, including sponsors, underwriters, stock exchanges, securities registration and clearing institutions and securities trading service organizations; and 7. Other persons specified by the securities regulatory authority under the State Council.202 A literal reading of Article 74 conveys the impression that all enumerated types of people are always and invariably insiders, whether or not they actually possess inside information. This has led one commentator to argue that China’s insider trading law may be over-inclusive because it will catch innocent people who appear on the list but do not actually possess inside information.203 Indeed, as some US courts have rightfully stated: A director or officer, or even the president of a corporation cannot always and invariably be classified as an insider. The analysis turns, instead, on the basis of what a party knows or reasonably should know considering the information to which he has access.204 Thus, Article 74 needs to be rephrased to make it clear that those listed people would be viewed as insiders as a result of their possession of material, non-public information.

201. Securities Law, Art. 73. 202. Ibid Art. 74. 203. Qu, above note 51, 338. 204. Harnett v. Ryan Homes, Inc., 360 F. Supp. 878, 886 (W.D. Pa. 1973), aff’d, 496 F.2d 832 (3d Cir. 1974); Jackson v. Oppenheim, 411 F. Supp. 659, 668–669 (S.D.N.Y. 1974), aff’d in part on other grounds, 533 F.2d 826 (2d Cir. 1976); Rodriguez v. Montalvo, 649 F. Supp. 1169, 1175 (D.P.R. 1986).

226

Chapter 6

Further, the Securities Law is silent on how to prove that a person possesses inside information. Under the default evidentiary rule in China, the onus of proof normally rests on the plaintiff or the prosecutor.205 This produces evidentiary obstacles in pursuing insider trading liability. It is recommended that China should consider the French experience and introduce a rebuttable presumption in respect of the possession of inside information, even though there may be some concerns with it. Some countries like Australia have considered adopting such positions but eventually have decided against it for the following two main reasons. Firstly, it was argued that ‘[s]tatutory rebuttable presumptions are contrary to the generally accepted requirement for the prosecution to prove all the elements of an offence’.206 The second reason was that a defendant may face considerable evidential problems in proving that he or she was unaware of the inside information.207 It is true that to introduce rebuttable presumptions into legislation that carries criminal as well as civil penalties is a serious matter. Legitimate concerns may arise from any alteration to the principles requiring the prosecution to prove all the elements of the offence. However, these concerns would be substantially diminished if as France does, the rebuttable presumption is applied in limited circumstances for senior officers, because they are the persons most likely to be aware of inside information. Moreover, the presumption would not operate unjustly to the extent that the defendant has a chance to prove lack of knowledge and more importantly, this task may not as difficult as the abovementioned second reason suggests. For instance, the directors and managers may claim the absence of knowledge if they are prevented from knowing the inside information by reasonably effective Chinese wall arrangements.208 Other reinforcement procedures such as restricted lists and watch lists can further protect corporate insiders from insider trading liability in cases that they otherwise would trade genuinely without knowing relevant inside information.209 This in turn would provide incentives for directors and managers to establish and reinforce compliance programs such as Chinese wall arrangements to prevent insider trading in the first place.

205. Zhonghua Renmin Gongheguo Minshi Susong Fa [Law of Civil Procedure of the People’s Republic of China] (promulgated on 9 April 1991) Art. 64 (‘litigants are obliged to present evidence for their assertions’). 206. Corporations and Markets Advisory Committee (Australia), above note 80, s 3.4.3. 207. Ibid s 3.4.3. 208. Chinese Wall arrangements consist of policies and procedures designed to control the flow of material, non-public information within large corporations. Many countries such as the US and Australia have given legislative support to the use of Chinese Walls. See e.g., Securities Exchange Act of 1934 (US) s 21A(b); Corporations Act 2001 (Australia) s 1043F. For more account of Chinese Walls, see Tomasic, above note 33; Poser, above note 33; Wang & Steinberg, above note 26, §13.5.2. 209. A restricted list identifies securities in which employee and proprietary trading is restricted or prohibited, and watch lists are often used to monitor and reinforce a Chinese Wall. For more account of these two lists, see Wang & Steinberg, above note 26, §13.5.3.2.

Some Basic Elements of Insider Trading

227

It would seem to follow that the concerns with the presumption are not strong enough to reject its great benefit of overcoming the considerable evidential difficulties. Indeed, as the recent review of insider trading law in Australia stated, obtaining corroborative evidence that a person was subjectively aware of inside information can be one of the most difficult aspects of insider trading law enforcement. 210 Moreover, this presumption may be particularly desirable in China for practical reasons. As discussed in Chapter 2, insider trading is currently serious in China and there is a pressing need to strengthen the regulation of insider trading.211 The presumption could well serve this overriding purpose to overcome the difficult evidential problems in existence in the insider trading law enforcement. 3.

Knowledge that the Information is Inside Information

It is generally accepted that, for insider trading liability to occur, the defendant must have knowledge as to the nature of the information that he or she possesses. More accurately, the defendant must know that the information in his/her possession is material and non-public. However, the criteria of meeting this requirement differ greatly according to various jurisdictions. In Australia, in order for liability to attach, it must be shown that the defendant ‘knew or ought to have reasonably known’ that the information was not generally available and was materially price-sensitive.212 This provides two tests for proving the defendant’s knowledge that the information is inside information, namely, the subjective knowledge test to prove the insider ‘knew,’ and the objective knowledge test to prove that the insider ‘ought to have reasonably known’. It should be noted that these two tests are not cumulative – you need only prove the subjective element or the objective element in Australia. In contrast, the UK and South Africa apply only the subjective knowledge test, that is, the defendant must ‘know’ that the information is inside information, specifically noting that ‘a person has information as an insider if and only if . . . it is, and he knows that it is, inside information . . . ’.213 There is no equivalent of the alternative objective knowledge test in these two countries. Not surprisingly, this has posed considerable difficulties in proving subjective knowledge and as such has been subjected to corrosive analytical criticism. One commentator has observed that: Thus, for example, if the accused thinks (no matter how unreasonably) that the information is public, then he does not commit the offence. The prosecution

210. Corporations and Markets Advisory Committee (Australia), above note 80, s 3.4.1. 211. See Chapter 2. 212. Corporations Act 2001 (Australia) s 1043A(1)(b). 213. Criminal Justice Act 1993 (UK) s 57(1) (emphasis added). The South African Insider Trading Act 1998 section 2(1) also refers to ‘any individual who knows that he or she has inside information’.

228

Chapter 6 will have to prove that this subjective requirement has been met and it is of concern that perpetrators may be able, too readily, to avoid prosecution on the basis of ‘lack of knowledge’.214

In practice, this evidential burden has resulted in the collapse of a number of insider trading prosecutions in the UK in the 1990’s.215 It is worth noting that Singapore has gone even further than Australia in this respect. To reduce the difficulty of proof, Singapore has introduced a rebuttable presumption of knowledge applicable to ‘connected persons,’ while non-connected persons are subject only to the subjective knowledge test. Thus, the tests vary according to different categories of persons. More specifically, the liability of connected persons 216 such as directors and other officers of a corporation for breach of insider trading provisions would depend on showing that they knew (subjective knowledge test) or ought reasonably to know (objective knowledge test) that the information in their possession with regard to their corporations was not generally available and was materially price-sensitive.217 More importantly, it is further provided that connected persons would be presumed to have satisfied the subjective knowledge test, unless they can prove otherwise: In any proceedings against a connected person for a contravention of [the trading, procuring or disclosing offences], where the prosecution or plaintiff proves that the connected person was at the material time (a)in possession of information concerning the corporation to which he was connected; and (b) the information was not generally available, it shall be presumed, until the contrary is proved, that the connected person knew at the material time that (i) the information was not generally available; and (ii) if the information were generally available, it might have a material effect on the price or value of securities of that corporation.218 On the other hand, the liability of non-connected persons will remain based on the subjective knowledge test, namely that they knew that the information in their possession was not generally available and was price-sensitive.219 214. R Jooste, ‘The Regulation of Insider Trading in South Africa – Another Attempt’ 117 South African Law Journal (2000) 284, 294. 215. Stamp & Welsh (eds), above note 173, 101. In the UK, this evidentiary problem is now to a significant extent ameliorated by the Market Abuse regime in the Financial Services and Markets Act 2000 (Part VIII), under which the Financial Services Authority enjoys extensive power to impose penalties in cases of market abuse such as insider trading. 216. The Securities and Futures Act 2001(Singapore) s 218(5) defines persons who are connected to a corporation to include: (1) any officer of that corporation or of a related corporation; (2) any substantial shareholder of that corporation or of a related corporation; (3) any person who occupies a position that may reasonably be expected to provide access to inside information by virtue of any professional or business relationship between the person (or the person’s employer) and that corporation or a related corporation, or through being an officer of a substantial shareholder of that corporation or a related corporation. 217. The Securities and Futures Act 2001(Singapore) s 218(1). 218. Ibid s 218(4) (emphasis added). 219. Ibid s 219(1).

Some Basic Elements of Insider Trading

229

In China, the problem regarding the knowledge of the nature of the information is yet to be solved. As noted before, the phrase ‘knowledge of inside information’ (‘Zhixi Neimu Xinxi’) is used in several articles in the Securities Law. This phrase is so simplistic that it is unclear which test, the subjective or the objective test, is applied to judge insiders’ knowledge that their possessed information is inside information. This uncertainty has seriously impeded the effective enforcement of China’s insider trading regulation in practice. It is submitted that China should learn from the Australian approach to the requirement of knowledge of inside information, which includes the subjective knowledge test as well as the objective knowledge test. Furthermore, the Singaporean experience to apply a rebuttable presumption of knowledge to connected persons who are highly likely to commit insider trading by virtue of their privileged positions also deserves serious consideration. This limited rebuttable presumption could greatly assist in insider trading prosecutions against directors and other connected persons by overcoming the considerable evidential difficulties of independently proving subjective knowledge of inside information. Again, it should be noted that the recent review of insider trading law in Australia finally rejected the Singaporean approach, on the grounds that it would be contrary to the presumption of innocence and it may be very difficult for the defendant to rebut the presumption.220 These reasons are much the same to those put forward to rebuff the French experience of introducing a rebuttable presumption with respect to the possession of inside information, and thus are subjected to the same critical examination. 221 More specifically, the rebuttable presumption for directors, officers and other connected persons can be justified on the basis of their role and responsibility in the corporation. It would reinforce the due diligence obligations of directors and other senior officers to fully inform themselves before trading their company’s securities. As the Monetary Authority of Singapore (‘MAS’) states, the presumption will introduce greater discipline for those in fiduciary positions.222 Further, the persons who are subject to the presumption can well protect themselves in many ways. For instance, after becoming aware of particular information, they may seek prior confirmation from the chief executive officer that the information was not non-public and material, or may simply choose not to trade if not fully certain whether the information can be legally acted upon. In short, the benefit of the rebuttable presumption seems to outweigh its costs. In addition, of considerable relevance is the US practice that scienter can be established by circumstantial evidence.223 Indeed, ‘proof in fraud cases is often a matter of inference from circumstantial evidence,’224 and ‘in a securities action, as in any other case, a plaintiff may establish a defendant’s intent

220. 221. 222. 223. 224.

Corporations and Markets Advisory Committee (Australia), above note 80, s 3.4.3. See above §6.V.B.2. MAS, The Securities and Futures Act 2001 Consultation Document (March 2001), p. 27. Wang and Steinberg, above note 26, §4.4.6, 185. Herman & Maclean v. Huddleston, 459 U.S. 375, 390 n. 30 (1983).

230

Chapter 6

by either direct or circumstantial evidence’.225 Particularly, in the context of insider trading, the US courts have held that ‘[t]he only evidence of scienter is often circumstantial,’ 226and ‘[c]ircumstantial evidence . . . may be considered on the scienter issue’.227 Thus, even though plaintiffs may prove their cases directly, circumstantial evidence plays a particularly important role in proving the subjective elements in insider trading cases where the misconduct is by nature a hidden one. The evidential problem with regard to the scienter requirement will be greatly eased if, as the US courts hold, ‘plaintiff[s] need not produce direct evidence of a defendant’s state of mind; circumstantial evidence will suffice if it supports an inference of intentional, knowing, or reckless behaviour’.228 In the US, various facts have served as circumstantial evidence in the reported insider trading cases, such as, an attempt to conceal transactions or make them less noticeable;229 spreading the trading among various accounts;230 a trade of large amounts of stock before an announcement of a material development;231 and borrowing substantial amounts to finance purchases or sales.232 Hence, the use of circumstantial evidence may achieve, to a great extent, the effect of the aforementioned Singaporean rebuttable presumption mechanism. Indeed, one American court has expressed its idea about the presumption on scienter: [I]nsiders . . . almost by definition have a degree of knowledge that makes them culpable if they trade on inside information. As officers, directors, or employees of a company, they are presumed to know when information is undisclosed. Because of their positions, insiders know when they have the kind of knowledge that is likely to affect the value of stock.233 More specifically, as far as the ‘connected persons’ are concerned, the use of circumstantial evidence would have substantially the same effect as the rebuttable presumption. On the other hand, the US approach of permitting the use of circumstantial evidence can also be conveniently used in the cases involving ‘non-connected persons’. Accordingly, the US practice is desirable especially in the circumstances under which the defendants are ‘non-connected persons’ and thus the Singaporean rebuttable presumption is inapplicable.

225. In re Leslie Fay Cos., Inc. Sec. Litig., 871 F. Supp. 693, 693 (S.D.N.Y. 1995). 226. SEC v. Unifund SAL, 910 F.2d 1028 (2d Cir. 1990). 227. SEC v. Musella, 678 F. Supp. 1060, 1063 (S.D.N.Y. 1988). 228. Filloramo v. Johnston, Lemon & Co., 697 F.Supp. 517, 521 (D.D.C. 1988). This approach has also been adopted by some other jurisdictions such as Australia. See e.g., R v. Hannes [2000] NSWCCA 503 (an inference to possession of the relevant information has been drawn from circumstantial evidence). 229. SEC v. Fox, 855 F.2d 247, 253 (5th Cir. 1988). 230. SEC v. Musella, 678 F. Supp. 1060, 1063 (S.D.N.Y. 1988). 231. In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, (9th Cir. 1994). 232. SEC v. Mario, 51 F.3d 623, 633 (7th Cir. 1995). 233. SEC v. Monarch Fund, 608 F.2d 938, 941(2d Cir. 1979) (emphasis added).

Some Basic Elements of Insider Trading C.

231

USE OF INSIDE INFORMATION: THE US ‘POSSESSION VS. USE’ DEBATE

As discussed earlier, the scienter requirement demands that insiders must possess inside information for liability to attach. This is followed by the question of whether mere possession of inside information at the time of trading is sufficient for one to invite liability, or more specifically, whether the imposition of liability presupposes a further showing that the insider actually used the information. In other words, is it required to prove a causal connection between the possessed inside information and the defendant’s trading? This issue has yet not been completely settled amongst courts and scholars in the US, and is well known as the ‘possession versus use’ debate.234 It is worth noting that even in the US few courts have directly addressed the ‘possession vs. use’ question.235 The reason behind this lies in the fact that in many cases it has not been necessary for the courts to address the issue: often there is no doubt that the insider used the information.236 Although the distinction between ‘use’ and ‘possession’ might be of limited significance in most cases, there are some situations in which the distinction might be critically important for the outcome of the cases. And as such, the issue is worthy of serious consideration, particularly given the stiff liability of insider trading. 1.

The Position of China’s Insider Trading Law

China’s insider trading law is unclear on the ‘possession vs. use’ question. There exist many inconsistencies within the Securities Law over whether the imposition of inside trading liability requires a causal connection between the inside information and the insider’s trading. On the one hand, Article 73 of the Securities Law provides that ‘persons with knowledge of inside information on securities trading are prohibited from 234.

See e.g., United States v. Smith, 155 F.3d 1051, 1066 (9th Cir. 1998) (discussing the ‘usepossession debate’); Donna M. Nagy, ‘The ‘Possession vs. Use’ Debate in the Context of Securities Trading by Traditional Insiders: Why Silence Can Never be Golden’ (1999) 67 U. Cin. L. Rev. 1129; Jennifer L. Neumann, ‘Insider Trading: Does ‘Aware’ Really Resolve the ‘Possession’ Versus ‘Use’ Debate?’ (2001) 7 Washington University Journal of Law & Policy 189; Allan Horwich, ‘Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?’ (1997) 52 Bus. Law. 1235; Karen Schoen, ‘Insider Trading: The ‘Possession versus Use’ Debate’ (1999) 148 University of Pennsylvania Law Review 239; John H. Sture & Catharine W. Cummer, ‘Possession vs. Use for Insider Trading Liability’ (1998) 12 No.6 Insights 3; Bryan C. Smith, Note, ‘Possession versus Use: Reconciling the Letter and the Spirit of Insider Trading Regulation Under Rule 10b-5’ (1999) 35 Cal. W. L. Rev. 371. 235. See SEC v. Adler, 137 F.3d 1325, 1334 (‘Surprisingly, few courts have directly addressed whether §10(b) [and] rule 10b-5 . . . require a causal connection between the material non-public information and the insider’s trading or whether knowing possession of material non-public information while trading is sufficient for liability’.). 236. Langevoort, above note 29, §3.04, 3–22 (stating that ‘in the typical case, these is no question that the insider traded in order to take advantage of material nondisclosed information’).

Chapter 6

232

taking advantage of such inside information to engage in securities trading’.237 It therefore appears that actual use of inside information is required for insider trading liability to occur in China.238 On the other hand, the wording of Article 76 in the Securities Law indicates that mere possession of inside information at the time of trading is sufficient to attract liability. Under Article 76, as long as one person is in possession of inside information, he or she cannot trade in the affected securities, divulge the information or procure another person to trade in such securities.239 These contradictory provisions would lead to serious practical problems in practice, and thus deserve careful attention. In the following discussion, I will offer my own analysis of the various legal responses to this question at the international level. The conventional treatment of this question typically lists only two standards, namely the use standard and the possession standard.240 However, in a more nuanced fashion, I will categorize the international experiences on the issue into four different standards: strict possession, strict use, modified use and modified possession standard. Then, I will conduct a comparative analysis of those standards and recommend which standard is most suitable for China. 2.

Various Approaches to the Debate

a.

The Strict Possession Standard

The first approach is the ‘strict possession standard,’ which merely requires proof that a person knowingly possessed inside information at the time of trading, no matter whether he or she had actually used the information. Some countries such as Singapore appear to have followed this simple possession standard, providing that ‘it is not necessary for the prosecution or plaintiff to prove that the accused person or defendant intended to use the [inside] information in contravention of the inside trading prohibition’.241 In the US the Securities and Exchange Commission (‘SEC’) adopted this standard in re Sterling Drug, Inc,242 where several directors sold stocks after being informed of decreasing sales before such information was released to the public. There at the board of directors meeting on 1 November 1974, the directors were given the detailed breakdown of the operating performance for the first months of 237. Securities Law Art. 73 (emphasis added). 238. See e.g., Liming Wang, ‘Perfection of Private Civil Liability Regime in China’s Securities Law’ (2001) 4 Faxue Yanjiu [Legal Study] 55, 61; Guo Feng, ‘Insider Trading and Private Remedy’ (2000) 2 Faxue Yanjiu [Legal Study] 91, 95. 239. Securities Law Art. 76. 240. The US ‘possession vs. use’ debate by definition contains these two standards. See e.g., Neumann, above note 235; Ryan D. Adams, ‘Where there is a will, there is a way’: the Securities and Exchange Commission’s adoption of Rule 10b-5’ (2001) 47 Loyola Law Review 1133, 1149. 241. The Securities and Futures Act (Singapore) s 220(1). 242. In re Sterling Drug, Inc., [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶81,570, at 80, 295 (Apr. 18, 1978).

Some Basic Elements of Insider Trading

233

1974. The breakdown showed that although Sterling’s overall sales were up by 13.3% and overall net income was up by 10.5%, the source of Sterling’s earnings had shifted during this accounting period from recent patterns as a result of belowaverage performance by two major domestic divisions and above-average performance by other divisions. Two directors sold shares after the meeting.243 In defence, the directors argued that the inside information and the sale of the shares were not connected.244 The SEC determined that it was irrelevant whether the two were connected and possession of material inside information at the time of trading was sufficient to sustain a violation of securities laws, noting that: Rule 10b-5 does not require a showing that an insider sold his securities for the purpose of taking advantage of material non-public information. Purchasers of securities in the public market should be able to rely upon information available to the public at the time of the transaction. If an insider sells his securities while in possession of material adverse non-public information, such an insider is taking advantage of his position to the detriment of the public.245 In 1993, the Court of Appeals for the Second Circuit also appeared to uphold the strict possession standard. In United States v. Teicher,246 two defendants convicted of securities fraud appealed, claiming that the district court incorrectly instructed the jury that proof of mere possession was enough to support a guilty verdict.247 While the Second Circuit avoided a direct ruling on the knowing possession test,248 the court broadly discussed the issue by listing several factors that favor the application of the knowing possession test. Firstly, the court noted that the ‘in connection with’ language as contained in Section 10(b) and Rule 10b-5 had been interpreted flexibly.249 Secondly, the court stated that a knowing possession test best comported with the ‘disclose or abstain rule’.250 Thirdly, it was held that by definition an insider trader had an 243. Ibid 80, 297. 244. Ibid 80, 298 (‘The three directors also maintain that their reasons for selling their Sterling stock were based on considerations completely independent of the performance of [the company]’). 245. Ibid 80, 298. 246. United States v. Teicher, 987 F.2d 112 (2d Cir. 1993). 247. Ibid 114. The defendants contended that ‘the district court’s jury charge erroneously instructed the jury that the defendants could be found guilty of securities fraud based upon the mere possession of fraudulently obtained material non-public information without regard to whether this information was the actual cause of the sale or purchase of securities’. Ibid. 248. Ibid 120 – 21. It is worth noting that the ‘possession versus use’ discussion in Teicher was purely dicta. Specifically, the court stated that ‘[v]iewing the jury in its entirety and based upon the record, we find that it is unnecessary to determine whether proof of securities fraud requires a causal connection, because any alleged defect in the instruction was harmless beyond a doubt’. Ibid 120. 249. Ibid 120 – 121. 250. Ibid. The so-called ‘disclose or abstain’ rule was established in an SEC ruling, dictating that corporate insiders are required to either disclose material non-public information they have or to abstain from trading on the information. Cady, Roberts & Co. 40 S.E.C. 907 (1961).

Chapter 6

234

informational advantage over other traders.251 Finally, the court contended that it would be extremely difficult for the SEC to prosecute under a use test.252 Further, this standard also seems to have been endorsed by two insider trading statutes in the US, namely, the Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 which added Sections 21A and 20A of the Securities Exchange Act, respectively.253 Both Sections 21A(a)(1) and 20A(a) refer to ‘any person who violates [or has violated] any provision of this title or the rules or regulation thereunder by purchasing or selling a security while in possession of material, non-public information. . . ’. This choice of language has led one commentator to argue that it was ‘an endorsement of the broader [‘possession’] test for insider trading liability’.254 b.

The Strict Use Standard

The second approach is the ‘strict use standard’. Under this approach, the prosecution must prove that insiders actually used the information. For example, before 1996, the Canadian federal legislation imposed liability on an insider only if that person ‘makes use of any specific confidential information for his own benefit or advantage’.255 Thus, prosecutors or private plaintiffs would have to bear the twofold burdens of proving not only that the defendant possessed material non-public information, but also that the trade was prompted by the information. c.

The Modified Use Standard

In order to alleviate the evidentiary difficulty associated with the strict use standard, the US Court of Appeals for the Eleventh Circuit introduced the ‘strong reference rule’ to amend the strict use standard in SEC v. Adler,256 and thus the

251. 252. 253. 254.

255.

256.

This rule was upheld by subsequent judicial opinion on the grounds that all investors trading on impersonal exchanges should be entitled to equal access to material information. SEC v. Texas Gulf Sulphur Co. 401 F.2d 833 (2nd Cir. 1968). United States v. Teicher, 987 F.2d 112, 120–121 (2d Cir. 1993). Ibid. 15 U.S.C §78u-1, §78t-1. Langevoort, above note 29, §3.04, 3–23. However, Professor Wang thought that the ‘while in possession of ‘ language might not reveal the statutory attitude towards the ‘possession vs. use’ debate because it was open to different interpretations. See Wang and Steinberg, above note 26, §4.4.5, 182–184 (arguing that ‘choice of the phrase ‘while in possession of’ could be either an endorsement of the broader standard or a refusal to choose between the two standards [possession and use standards]’). Ibid 184. Industry Canada, ‘Insider Trading Discussion Paper’ (February 1996), para. s [131]–[135]. In Canada, insider trading provisions were first introduced at the federal level in 1970 as part of the Canada Corporations Act and subsequently carried over into the Canada Business Corporations Act in 1975. SEC v. Adler, 137 F.3d 1325, 1337 (11th Cir. 1998).

Some Basic Elements of Insider Trading

235

‘modified use standard’ was born. Because this case took place in 1998, later than the above-mentioned Second Circuit year-1993 case United States v. Teicher, it may well represent the recent US judicial attitude towards the ‘possession vs. use’ debate. The court in Adler recognized that the choice between possession and use was difficult, but eventually chose to basically adopt the use standard.257 Meanwhile, acknowledging the difficulty the SEC would have under a strict use standard, the court held that the strong inference of use that arises from the fact that an insider traded whilst in possession of information could allay the evidential problem.258 In particular, the court stated: When an insider trades while in possession of material non-public information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence . . . that the information was not used.259 With this inference rule, the court rejected the proof concern expressed by the SEC, and concluded that the use test ‘best comports with’ the applicable statutes.260 Thus, the Alder decision is the mixture of the inference rule and the strict use standard. It is interesting to note that some other jurisdictions have chosen to amend the strict possession standard, rather than the strict use standard, to achieve virtually the same effect as Adler in the US. This is done by adding a general non-use defence into the strict possession standard which is in turn transformed into the modified use standard for the following two reasons. Firstly, the non-use defences effectively put focus on the actual use of inside information in the sense that no liability will occur as long as the defendant can prove the non-use of information for trading. Secondly, the evidentiary problem is solved by shifting the onus of proof onto the defendant. The UK provides a good example. It has no requirement for the prosecution to show that an accused used inside information, merely providing that ‘an individual, who has information as an insider’ will violate the law if ‘he deals in securities that are price-affected securities in relation to the information’.261 However, this ostensible possession standard is then transformed into the modified use standard by providing a general defence of non-use, namely, that the insider can argue that he or she did not use the information in the trading. Hence a person is not guilty of insider trading by virtue of trading in securities ‘if he shows that he would have done what he did even if he had not had the information’.262 This approach is essentially the modified use standard, because it demands that the actual use of inside information be a requisite element of liability. 257. Ibid (‘we believe that Supreme Court dicta and the lower court precedent suggest that the use test is the appropriate test’). This adjudication enjoyed the support of another circuit court in a subsequent case. See United States v. Smith, 155 F.3d 1051 (9th Cir. 1998). 258. SEC v. Adler, 137 F.3d 1325, 1340 (11th Cir. 1998). 259. Ibid. 260. Ibid 1338. 261. Criminal Justice Act 1993 (UK) s 52(1). 262. Ibid s 53(1)(c).

Chapter 6

236

d.

The Modified Possession Standard

In the US, Rule 10b5-1 was passed in August 2000 to resolve a longstanding debate on whether the ‘possession’ or ‘use’ of material non-public information is the proper standard for courts to use in cases of insider trading.263 The approach of Rule 10b5-1 can be called the ‘modified possession standard,’ in that it is based on the possession standard but at the same time embraces some defences to overcome the over-breadth of the strict possession standard.264 Rule 10b5-1 makes its clear that insider trading liability arises when a person is ‘aware’ of the material non-public information when they engage in a securities trade.265 At the same time, in order to avoid the overreach of a simple-minded standard based on awareness, Rule 10b5-1 also provides several affirmative defences under which a person could avoid liability. These defences permit persons to structure securities trading plans and strategies, which may be implemented at any future time, provided that those persons are not aware of material non-public information at the time of devising the plan, entering into a binding contract to trade securities or instructing an agent to do so, and have no discretion over the previously determined trading plan if they later become aware of any inside information.266 It should be noted that Rule 10b5-1 uses the term ‘aware’ instead of either the term ‘possession’ or ‘use’ as the proper standard for insider trading liability. This does not mean however that Rule 10b5-1 invents a totally new awareness standard. Rather, it appears that this is in fact the SEC’s tactical linguistic trick. The terms ‘aware’ and ‘possession’ are used interchangeably by the SEC and mean the same thing in the SEC’s lexicon.267 There is an interesting reason behind the SEC’s choice of the term ‘awareness’ rather than ‘possession’. It has been said that the introduction of Rule 10b5-1 was in fact the SEC’s counterattacking response to the recent unfavourable judicial decisions in SEC v. Adler and United States v. Smith where, as mentioned before, the courts were clearly opposed to adopting the possession standard and the prosecution was

263. 264. 265.

266. 267.

17 C.F.R §240.10b5-1 (2000); also see Final Rule: Selective Disclosure and Insider Trading, Release No. 33-7881, available at http://www.sec.gov/rules/final/33-7881.htm (last visited on 6 April 2005). For more analysis of why Rule 10b5-1 can be dubbed the modified possession standard, See below §6.V.C.4.b. 17 C.F.R §240.10b5-1(b). ‘[A] purchase or sale of a security of an issuer is ‘on the basis of’ material non-public information about that that security or issuer if the person making the purchase or sale was aware of the material non-public information when the person made the purchase or sale’. Ibid. (emphasis added). 17 C.F.R §240.10b5-1(c) (setting out a number of affirmative defences). Selective Disclosure and Insider Trading, Sec. Act Rel. 33-7787, 71 SEC Docket 7 (CCH) ¶7, at 746 (20 December 1999). Specifically, the Commission noted, ‘[w]e recognize that an absolute standard based on knowing possession, or awareness, could be overboard in some respects’.(emphasis added) Ibid.

Some Basic Elements of Insider Trading

237

defeated as a result.268 Understandably, in the face of these defeats, the SEC had to finesse its plan by some strategy to reintroduce its long-favoured possession standard, facilitating its regulatory mission. Therefore, the SEC wisely chose a new term ‘awareness’ out of the consideration that it could be more likely to be accepted by the courts who have expressly discarded the ‘possession’ standard before, although this seemingly new ‘awareness’ standard is virtually the previous ‘possession’ standard.269 The recent review of insider trading law in Australia has essentially followed this modified possession approach. In Australia, the literal reading of Section 1043A of the Corporations Act seems to favor the possession standard, under which the prosecution is not required to show that a person holding inside information actually used the information when trading in affected securities.270 However, the Australian government at the time of introducing 1991 amendments to its insider trading law took the view that, once the prosecution has proved that the person was in possession of the inside information and traded in the relevant securities, it was reasonable to assume that the person was motivated to trade by possession of that information.271 This governmental view was in nature the modified use standard, as opposed to the possession standard as adopted by the legislation, because it suggests that the defendant could be exonerated by adducing evidence to show non-use of inside information in the trade. Unfortunately, there is no case law concerning this issue available to provide more guidance. In order to dispel the above confusion, the issue has been examined in a recent review of insider trading law in Australia,272 and the final review report made a recommendation similar to Rule 10b5-1: . . . recommends an exemption for informed persons trading pursuant to a preexisting non-discretionary trading plan . . . Subject to this limited exception, the insider trading legislation should not have a use requirement or a defence of non-use.273

268. Adams, above note 241, 1150 (arguing that rule 10b5-1’s ‘awareness’ standard is virtually the court-rejected ‘possession’ standard, and ‘how this standard functions in an area that historically has developed through case law remains to be seen’). 269. Neumann, above note 235, 189 (concluding that rule 10b5-1 successful resolves the circuit split regarding the ‘possession’ versus ‘use’ debate). Of course, the defences introduced by Rule 10b5-1 turns the possession standard into the neo-possession standard. It seems premature to predict whether Rule 10b5-1 will end the ‘possession vs. use’ debate in the US, and only time can tell whether the SEC’s trick will work well in gaining the judiciary support. 270. Corporations Act 2001 (Australia) s 1043A(1)(a) (prohibiting a person from trading if he or she ‘possesses inside information’ without further ‘use’ requirement). 271. Government response to Report of the House of Representative Standing Committee on Legal and Constitutional Affairs, ‘Fair Shares for All: Insider Trading in Australia’ (11 October 1990) (Australia). 272. See Corporations and Markets Advisory Committee (Australia), above note 71, s 2.142–152. 273. Corporations and Markets Advisory Committee (Australia), above note 80, s 3.8 (Recommendation 23).

Chapter 6

238

3.

The Unsuitability of the Strict Possession and Strict Use Standard

a.

Arguments against the Strict Possession Standard

The strict possession standard is too wide and is therefore an unsuitable choice. In the US, considering whether Congressional intent required the use test, the Adler court noted that Section 10(b) and Rule 10b-5 prohibit deception, manipulation and fraud,274 and then expressed its fear that convictions based on mere possession of material non-public information would ‘prohibit actions that are not themselves fraudulent’.275 The Smith court subsequently shared the concern of Alder that liabilities based upon a strict possession test ‘would not be . . . limited to those situations actually involving intentional fraud’.276 The potential overreaching of the standard would likely frustrate legitimate commercial activities. Under this standard, even bona fide market participants may be unable to trade because of information that comes to their attention after they have made their trading decisions. As an example, the Smith court pointed out that an investor who engaged in a pre-existing plan to trade even after coming into possession of inside information, might be prosecuted under a strict possession test despite the fact that he or she did not ‘intend to defraud or deceive’.277 Conceptually, the mere possession of inside information is in itself not wrong; it is the further act of using inside information to trade that constitutes fraud. As the Smith court stated: [P]ersons with whom a hypothetical insider trades are not at a ‘disadvantage’ at all provided the insider does not ‘use’ the information to which he is privy. That is to say, if the insider merely possesses and does not use, the two parties are trading on a level playing field; if the insider possesses and does not use, both individuals are making their decision on the basis of incomplete information. 274.

SEC v. Adler, 137 F.3d 1325, 1333 (11th Cir. 1998). The court determined that ‘the language [of Section 10(b) and Rule 10b-5] suggests a focus on fraud, deception, and manipulation’. Ibid. 275. Ibid 1338. 276. United States v. Smith, 155 F.3d 1051, 1067–1068 (9th Cir. 1998). See also SEC v. Adler, 137 F.3d 1325, 1338 (11th Cir. 1998) (stating that ‘ we do not believe that the SEC’s knowing possession test would always and inevitably be limited to situations involving fraud’). 277. United States v. Smith, 155 F.3d 1051, 1068 (9th Cir. 1998). This problem would likely become much worse in Australia, given that the scope of the Australian insider trading prohibition is very board, extending beyond the traditional securities and equity-related futures products to a wide range of other financial products such as commodity products, reciprocal purchase agreements, negotiable instruments, interest rate swaps and options and so on. Corporations Act 2001 (Australia) s 1042A. The transactions of some of these additional products would be significantly affected or even para. lysed by the difficulty arising where an investor is unable to undertake a pre-planned trade after coming into possession of inside information.

Some Basic Elements of Insider Trading

239

There can be little doubt that a person would not feel deceived if they were convinced that the person with whom they were trading merely possessed but did not actually use inside information for the purpose of trading. However, it can be very difficult, if not impossible, to know whether the insider used or benefited from the inside information. As will be discussed, this problem demonstrates exactly the advantage of the modified possession standard.278 The over-breadth of the strict possession standard also raises due process concerns. Some commentators have argued that the use standard safeguards due process rights by prohibiting prosecution without proof of fraud.279 Due process implies the constitutional right of an individual to controvert with the proof of every material fact which bears on the question of right in the matter involved, and ‘if any question of fact or liability [is] conclusively presumed against him, this is not due process of law’.280 The strict possession standard may not ensure due process protection, because it could be satisfied merely by proving that an individual possessed inside information and traded, without any further proof of fraud. In other words, the strict possession standard would invite due process concerns because it conclusively presumes liability of fraudulent activity against an individual in possession of inside information.281 b.

Arguments against the Strict Use Standard

As previously discussed, insiders cannot do any harm if they have not used inside information. This makes the use standard more theoretically acceptable. However, the use standard has an insurmountable evidential problem which prevents it from being a suitable choice. Before looking at this point in greater detail, employment of the word ‘use’ in judicial decisions which has been argued as authority to support the use standard, will be discussed. i. Doubtful Reliance on Choice of Language in Previous Cases In the US, the Eleventh Circuit Court in SEC v. Adler was the first court to expressly advocate the use standard.282 Shortly after this case, the Ninth Circuit Court also chose to apply the use standard in United States v. Smith.283 These two courts regarded the employment of the word ‘use’ in previous insider trading cases as direct support for the use standard. Some commentators agreed, holding that the 278. See below §6.V.C.4.b. 279. David W. Jolly, ‘Knowing Possession vs. Actual Use: Due Process and Social Costs in Civil Insider Trading Actions’ (1999) 8 George Mason Law Review 233, 251–253. 280. TRM, Inc. v. United States, 52 F.3d 941, 943 (11th Cir. 1995) (citing Black’s Law Dictionary 500 (6th ed. 1990)) (emphasis added). 281. As discussed before, the neo-possession standard provides defences to the defendant and thus eliminates this due process concern. 282. SEC v. Adler, 137 F.3d 1325, 1337 (11th Cir. 1998) (‘we believe that Supreme Court dicta and the lower court precedent suggest that the use test is the appropriate test’.). 283. United States v. Smith, 155 F.3d 1051, 1051 (9th Cir. 1998). (‘we believe that the weight of authority supports a “use” requirement’).

240

Chapter 6

choice of language suggests that traders must have actually used the information to be liable for insider trading.284 The Adler court held that the use standard ‘best comports with the language of §10(b) and rule 10b-5, and with Supreme Court precedent’.285 The court first stated that the word ‘use’ was employed throughout the US Supreme Court’s opinions in Chiarella v. United States,286 Dirks v. SEC,287 and United States v. O’Hagan.288 For example, in Chiarella, the US Supreme Court stated that ‘a duty to disclose under §10(b) does not arise from the mere possession of non-public market information’;289 in Dirks, that ‘insiders [are] forbidden . . . from personally using undisclosed corporate information to their advantage’;290 in O’Hagan, that ‘the fiduciary’s fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities’.291 Then, the court argued that the Supreme Court’s use of language in those opinions ‘repeatedly emphasized [a] focus on fraud and deception,’292 and that the possession standard fails to embody such a focus.293 Similarly, the Ninth Circuit in Smith also concluded that ‘the weight of authority supports a use requirement’ by citing the Supreme Court’s employment of the word ‘use’ in O’Hagan, Dirks and Chiarella.294 284. Denis J. Block & Jonathan M. Hoff, ‘Insider Trading Liability: “Use v. Possession’’’, N.Y.L.J. 29 October 1998, 5; Harvey L. Pitt & Karl A. Groskqufmanis, ‘The Supreme Court Has Upheld the Misappropriation Theory, But How Far the SEC Will Take the Ruling Is Anything But Clear’, Nat’l L.J. 4 August 1997, B4. 285. SEC v. Adler, 137 F.3d 1325, 1338 (11th Cir. 1998) (emphasis added). 286. Chiarella v. United States, 445 U.S. 222 (1980). 287. Dirks v. SEC, 463 U.S. 646 (1983). 288. United States v. O’Hagan, 521 U.S. 642 (1997). 289. Chiarella v. United States, 445 U.S. 222, 235 (1980). Moreover, the word ‘use’ can be also found in many other places throughout the case. See e.g., ibid 229 (‘The federal courts have found violations of §10(b) where corporate insiders used undisclosed information for their own benefit’.(emphasis added)); ibid 230 (‘duty to disclose prior to trading guarantees that corporate insiders . . . will not benefit personally through fraudulent use of material, nonpublic information’(emphasis added)); ibid 231 (‘petitioner’s use of that information was not a fraud under §10(b) unless he was subject to an affirmative duty to disclose it before trading’.(emphasis added)). 290. Dirks v. SEC, 463 U.S. 646, 659 (1983) (emphasis added). The court also employed similar language in the opinion. See e.g., ibid 656 (‘requirement of a specific relationship between the shareholders and the individual trading on inside information’ (emphasis added)); ibid. (discussing ‘how a tippee acquires the Cady, Roberts duty to refrain form trading on inside information’ (emphasis added)). 291. United States v. O’Hagan, 521 U.S. 642, 656 (1997). (emphasis added). There are many other places involving the ‘use’ language. See e.g., ibid 655–656 (examining ‘the §10(b) requirement that the misappropriator’s deceptive use of information be ‘in connection with the purchase or sale of [a] security’’(emphasis added)); ibid 656 (referring to a ‘misappropriator who trades on the basis of material non-public information’ (emphasis added)). 292. SEC v. Adler, 137 F.3d 1325, 1338 (11th Cir. 1998). 293. Ibid (stating that ‘we do not believe that the SEC’s knowing possession test would always and inevitably be limited to situations involving fraud’). 294. United States v. Smith, 155 F.3d 1051, 1067 (9th Cir. 1998).

Some Basic Elements of Insider Trading

241

At first glance, those examples of the employment of the word ‘use’ seem to suggest that the US Supreme Court is in favour of the use standard. However, upon closer examination, it is revealed that reliance on the literal reading of those sentences in previous cases is doubtful and misplaced. First of all, the specific issue of the ‘possession vs. use’ debate was not put before the US Supreme Court in any of those cases, and thus the Court might not have carefully employed the word ‘use’ when addressing other aspects of insider trading. Indeed, it may be that because the ‘possession vs. use’ question was not at issue in these cases, the Court was not careful about, and thus imprecise in, its use of language.295 Thus, the employment of the word ‘use’ outside the ‘possession versus use’ context is barely meaningful as to the stance taken by the Court towards the debate. Further, because the same language could be used for different purposes in different contexts, we must put language into the context in which it appears when determining its exact implication.296 Indeed, we cannot take a fragment of language out of context to understand its meaning. For example, when the Court declared that ‘a duty to disclose under §10(b) does not arise from the mere possession of non-public market information,’297 the Court was actually referring to the notion that there is no fraud under Section 10(b) and Rule 10b-5, absent a fiduciary duty to disclose information before trading.298 In other words, this statement should be read as stressing the requisite duty to disclose for the imposition of liability on a person for trading while in possession of inside information, rather than upholding the use standard. Finally, the common feature of Chiarella, Dirks and O’Hagan is that all the defendants had clearly used the information they possessed,299 and thus it was natural for the Court to employ the word ‘use’ which was intended to state nothing more than what the defendants had done in those cases. Because the use standard is higher than the possession standard, the Court’s employment of the word ‘use’ could mean that insiders would be undoubtedly liable if using inside information to trade, and we cannot go further to argue that the Court has held that liability arises only if insiders actually used the information. Thus, the employment of the 295. Even the Adler and Smith courts acknowledged that the Supreme Court’s use of such language is merely dicta. See SEC v. Adler, 137 F.3d 1325, 1334 (11th Cir. 1998); United States v. Smith, 155 F.3d 1051, 1067 (9th Cir. 1998). 296. Schoen, above note 235, 267 (‘when analysing the language of the Supreme Court, one must also examine carefully the context of the Court’s statements and the point the Court was attempting to make’). 297. Chiarella v. United States, 445 U.S. 222, 235 (1980). 298. Ibid (‘when an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak’). 299. See Chiarella v. United States, 445 U.S. 222, 245 (1980) (referring to Chiarella’s testimony that he ‘use the information as a basis for purchasing stock’); Dirks v. SEC, 463 U.S. 646, 648 (1983) (asserting that Dirks ‘disclosed information to investors who relied on it in trading in the shares of the corporation’); United States v. O’Hagan, 521 U.S. 642, 648 (1997) (stating that O’Hagan ‘us[ed] for his own trading purposes material, non-public information regarding Grand Met’s planned tender offer’).

242

Chapter 6

word ‘use’ would by no means indicate that the Court favoured the use standard in the ‘possession vs. use’ debate.300 In sum, reliance on the employment of the word ‘use’ in previous cases seems to be misplaced, because the ‘possession vs. use’ issue was not specifically discussed in those cases and the US Supreme Court might not have been careful with the choice of language. Thus, those examples of the employment of the word ‘use’ do not shed light on the Court’s view of the ‘possession vs. use’ debate. ii. The Difficulty in Establishing Actual Use The foregoing section has discussed the doubtful reliance on the out-of-context reading of some sentences in previous cases decided by the US Supreme Court. Having made it clear that the US Supreme Court did not lend any meaningful support to the use standard, I will examine the strict use standard on merits here, and conclude that the fundamental problem with this standard is the difficulty in establishing actual use. Indeed, the use standard creates such an insuperable evidentiary problem that insiders could never be held liable. Under the use standard, prosecutors or private plaintiffs are required to establish not only that the defendant possessed material non-public information, but also that the trade was proximately caused by the information. This burden of proof is far too heavy to bear. As the Adler court conceded, ‘the motivation for the trader’s decision to trade is difficult to prove and peculiarly within the trader’s knowledge’.301 The SEC Enforcement Director William McLucas also pointed out that the government ‘cannot metaphysically get into someone’s head and discern what factors within their state of mind were directly causal’.302 The stringent two-fold evidential burden is so onerous that prosecutors rarely overcome it, thus inhibiting the prosecution of insider traders and impeding the effective enforcement of insider trading law. It has been argued that, due to the difficulty of proving actual use of information, the prosecutors’ ability and incentive to prosecute those who may have committed insider trading could be drastically reduced, inevitably creating significant social costs by undermining judicial efficiency and the deterrence of insider trading law.303 Indeed, the strict use standard would effectively paralyze insider trading laws. As the recent review of insider trading law in Australia stated: [a]ny requirement to prove that the non-public information, and not some other reason, was the predominant motivation for a trade would be unproductive. It would create a significant additional hurdle to effective enforcement of 300. Loss and Seligman, above note 29, vol. VII, 3504–3505 (arguing that ‘when there is no question that the inside information was actually used in trading – which is normally the case – it seems natural to speak in terms of not trading ‘on’ or ‘on basis of’ the information without necessarily implying that possession alone would not suffice’). 301. SEC v. Adler, 137 F.3d 1325, 1337 (11th Cir. 1998). 302. Phyllis Diamond, ‘Mclucas Hails O’Hagan Ruling, But Says Issuers over Reach of Theory Remain’, (1997) 29 Sec. Reg. & L. Rep. 1097, 1098. 303. Jolly, above note 280, 254.

Some Basic Elements of Insider Trading

243

the insider trading law and be contrary to at least the appearance of fairness in the capital markets. 304 In fact, the strict use standard seems to have lost its appeal even to those countries that adopt it. As noted before, the Canadian federal law applied the strict use standard, and in the 1996 insider trading law review, serious concern was expressed that it has created an insurmountable evidentiary obstacle and frustrated efforts to crack down on insider trading.305 In response to this, the relevant law has been amended in favour of the possession standard.306 Clearly, China should not introduce the strict use standard which has proven to be inappropriate. 4.

The Choice for China: the Modified Possession Standard is Preferable to the Modified Use Standard

As discussed above, neither the strict use standard nor the strict possession standard is suitable for China. In this section, I will examine both the modified possession standard and the modified use standard in search of a more suitable one. At first sight, they may look confusingly similar, because both are intended to solve the evidentiary problem of the strict use standard and the over-breadth of the strict possession standard. It has thus been argued that the two approaches achieve the same effect in practice.307 However, a closer examination reveals that the two approaches are in fact substantially different in two ways. One is the proof burden shifting effect; the other is the application of defences. After a careful analysis, it is submitted that the modified possession standard is preferable to the modified use standard. a.

Unclear Proof-Burden-Shifting Effect under the Modified Use Standard

In the US the modified use standard relies on the strong inference rule to shift the proof burden to defendants and thus alleviate evidentiary concerns. Recognizing the evidentiary difficulty of the strict use standard, the Alder court introduced the strong inference rule, under which the defendant is presumed to have used the information they possessed, but can attempt to rebut the presumption. Thus, as 304. Corporations and Markets Advisory Committee (Australia), above note 80, s 3.8.2. 305. See Industry Canada, ‘Insider Trading Discussion Paper’ (February 1996), para. s [131]–[135]. In February 1996, Industry Canada released a Discussion Paper on insider trading. The paper looked at whether the federal insider trading provisions were still needed and, if so, what changes could be made. 306. Canada Business Corporations Act (Canada) s 131(4) (stating that ‘An insider who purchases or sells a security of the corporation with knowledge of confidential information . . . is liable’) (emphasis added). 307. Jolly, above note 280, 220 (arguing that ‘the [Adler] court’s ultimate ruling, although the court did advocate the use standard within its discussion, correlates with Rule 10b5-1 . . . The Adler court’s concerns are met and resolved by Rule 10b5-1’). This observer concluded that ‘Rule 10b5-1 resolves the circuit split regarding the “possession” versus “use” debate’. Ibid 221.

244

Chapter 6

the Adler court stated, ‘the inference allows the SEC to make out its prima facie case without having to prove the causal connection with more direct evidence’.308 Clearly, the proof-concern alleviating mechanism of the inference rule is to shift the burden of proving non-use of inside information to the defendant. However, there are two serious questions about the proof burden shifting effect of the inference rule. Firstly, it is unclear whether the modified use standard really embraces the proof burden shifting mechanism. Even advocates of the modified use standard conceded that the Adler court only arguably supported shifting the burden of proof to the extent that the court did not explicitly shift the burden of proving non-use of information to the defendant once the prosecution satisfied the knowing possession element.309 Because the court failed to give a clear opinion as to whether the burden of proof should be shifted, the effect of the strong inference rule remains in doubt. In fact, even the court was not sure whether the strong inference would substantially reinforce the SEC’s ability to prosecute insider trading cases, and suggested that, if the SEC found the actual use standard ‘unduly frustrating,’ it could simply promulgate a rule adopting a knowing possession standard.310 This has led some commentators to worry about the future of the Adler judgment.311 Perhaps more importantly, the other problem is that the inference rule cannot be applied in the criminal context. In Smith, the court adopted the actual use standard presented in Adler.312 However, the court refused to apply the strong inference rule put forward by the Adler court because such a presumption in a criminal case would trigger due process concerns.313 Specifically, the court stated that: We deal here with a criminal prosecution, not a civil enforcement proceeding, as was the situation in Adler. We are therefore not at liberty . . . to establish an evidentiary presumption that gives rise to an inference of use.314 Thus, despite acknowledging that an actual use standard would render ‘criminal prosecutions marginally more difficult for the government to prove,’ the court discarded the effort of the Alder court to establish the strong inference rule. 308.

SEC v. Adler, 137 F.3d 1325, 1338 (11th Cir. 1998). Some commentators also gave complimentary commentary to the role of the inference rule. See e.g., Horwich, above note 235, 1270; Jolly, above note 280, 255. 309. Jolly, above note 280, 256. 310. SEC v. Adler, 137 F.3d 1325, 1337 n.33 (11th Cir. 1998). This suggestion might have played an important role in the SEC adopting Rule10b5-1. 311. Jolly, above note 280, 258 (stating that ‘Without the benefit of a canvas of litigation following the Adler rulings, it is difficult to say whether the Adler rule will be adopted swiftly’). 312. United States v. Smith, 155 F.3d 1051, 1067 (9th Cir. 1998). (‘we believe that the weight of authority supports a ‘use’ requirement’.) 313. Ibid 1069. 314. Ibid.

Some Basic Elements of Insider Trading

245

In sum, the proof burden shifting effect of the strong inference rule is largely uncertain in the civil context, and simply unavailable in the criminal context. Thus, the role of the rule in alleviating evidentiary concerns is rather limited. In contrast, the modified possession standard has no such problems. b.

Problems with the Defences under the Modified Use Standard

i. Scope of Defence As discussed above, the proof burden shifting effect of the strong inference rule is frustratingly unclear. Considered alone, such a problem might suggest that if the burden shifting effect had been clearly prescribed, the modified use standard would be fine. However, this is not the case because the modified use standard also suffers from other serious problems with its defensive mechanisms. Under the modified use standard, after the use of information is presumed, defendants can try to defend themselves by proving otherwise. The scope of the defences offered by the modified use standard is significantly different from that of the modified possession standard, which is a decisive factor in judging the superiority of the two standards. The UK legislation is a good example to look at. It adopts the modified use standard, but unlike Adler in the US, it unambiguously shifts the burden of proving non-use of information to the defendant. More specifically, it provides a general defence of non-use of inside information, providing that the defendants can avoid liability by showing that they would have acted in the same manner even without the information.315 Thus, the defendants can try their best to prove non-use of information in their possession. In contrast, the US Rule 10b5-1 only provides specific statutory defences with strict limits.316 The scope of the defences under the UK legislation is broader than that of Rule10b5-1 in a number of ways. The first is the time range of when defences are available. Rule10b5-1 requires that in order to be an effective defence, a written trading plan be adopted before the defendant becomes aware of inside information. In other words, if the defendant formulated the plan after being in possession of the inside information, the plan cannot effectively protect the defendant from liability, even if the defendant did not actually use the information to make the plan. Thus, once the defendant comes into possession of inside information, whether he or she actually used the information for trading purposes is irrelevant; there are simply no defences available under Rule 10b5-1. This explains why Rule 10b5-1 is essentially the modified possession standard. Under the UK legislation, however, defendants can defend themselves by arguing that they did not actually use the inside information, regardless of whether the trading plan was made before, or after they came into possession of the information. Put differently, defendants can invoke the defensive mechanisms

315. Criminal Justice Act 1993 (UK) s 53(1)(c). 316. See above §6.V.C.2.d.

246

Chapter 6

at any time, and be exonerated if the court is successfully convinced that they did not actually use the possessed information to draft the trading plan. Thus, the benchmark here is solely whether the defendant actually used the information, and this is the reason why the UK legislation is in nature the modified use standard. In short, the defence under the modified use standard (the UK legislation) is broader than that under the modified possession standard (Rule 10b5-1), because the latter is available only when defendants made the trading plan before their possession of inside information. Secondly, the types of effective defences vary between the modified use standard and the modified possession standard. More specifically, compared to the modified use standard, the modified possession standard is more stringent on what constitutes an effective defence. Rule 10b5-1 enumerates several specific situations under which defences might be available, including entering into a binding contract, instructing another person and adopting a written plan before becoming aware of the information.317 Further, the Rule imposes a requirement that the amount of securities to be traded and the price at which and the date on which the securities were to be traded must be specified or determined in the contract, instruction or plan.318 Moreover, it also requires that the insider has no discretion over the previously determined trading plan if she later became aware of any inside information.319 In contrast, the UK legislation contains no such restrictive provisions, but provides the defendants with a broad right to prove that they did not actually use the information. It follows that under this standard, the defendants can do the best they can to defend themselves by proving that there was no actual use of the inside information in their trading. Then, it is totally up to the court to consider all the evidence in front of it and draw its conclusion at its discretion. There is no need for the court to look at whether the situation meets some specific requirements as prescribed in Rule 10b5-1. In practice, the defence of non-use may be available to an insider who transacted in order to meet a pressing financial need or contractual obligation320 or who simply followed independent professional advice321 or a general trading strategy.322

317. 318. 319. 320.

Rule 10b5-1 (c)(1)(i)(A). Rule 10b5-1 (c)(1)(i)(B). Rule 10b5-1 (c)(1)(i)(B)(3). Paul L. Davies, Gower’s Principles of Modern Company Law (Sweet & Maxwell Ltd, 6th ed., 1997), p. 470. 321. Barry A. K. Rider and Michael Ashe QC, Guide to Financial Services Regulation (CCH Group Ltd, 3rd ed., 1997), pp. 234–235. 322. P Mitchell, Insider Dealing in UK Butterworths Corporate Law Service: Corporate Transactions, Chapter 8, para. 8.14 gives the following examples: X decides on strategic investment grounds to increase his portfolio exposure in European recovery stocks and selects shares in Y GmbH which are rising in value. X also has pricesensitive information about Y GmbH but does not buy the shares for that reason. The ‘lack of intention’ defence should apply . . . X decides that his property securities holdings are

Some Basic Elements of Insider Trading

247

ii. Problems with a General Non-use Defence As discussed above, the scope of defences under the modified use standard is broader than that under the modified possession standard. This does not tell us, however, which one, the broader or the narrower, is better. Thus, we need to go further to answer the question. It is submitted that the broader defence system under the modified use standard is problematic for the following two reasons. Firstly, a general defence would lead to a huge loophole because insiders could easily argue that they did not use the information, even if they actually had used it. Indeed, a broad non-use defence may enable the suspected insiders to erect plausible screens to disguise their real motivation for trading. As the SEC stated, ‘individuals who have actually traded on the basis of inside information frequently attempt to invent arguments that they traded for other reasons’.323 Thus, this general defence would open the floodgates on efforts to fabricate defensive pretexts in advance of trading on the basis of inside information. For example, as Adler has shown, a defendant could easily rebut the presumption of the use of information by showing that he or she only traded a small portion of his/her holdings in the affected security, because this trading pattern would be considered a move counterintuitive to an individual seeking to save their fortune by dumping shares that were about to drop drastically.324 It is quite possible however that the defendant intentionally traded a small portion of his/her holdings on the basis of inside information so as to prepare a defence and reduce the risk of liability. Thus, it would be contrary to the intention and spirit of insider trading law if the defendant can get away with such tricks, because the defendant actually benefited from the information, even if this benefit was small. This is particularly so when the defendant’s holding is so great that even its relatively small portion can be a considerable amount. Further, the defendant may tip the information to other people who in turn take the same trick to trade only a small portion of the subject securities they hold and thus also get away with their trading. The aggregate of the trades would be considerable even though each of them is small, and the overall damage to the market would be substantial. For this reason, the recent review of insider trading law in Australia has soundly rejected the general defence of non-use after careful deliberation, stating that: It may be a simple matter for a trader, with the benefit of hindsight, to suggest numerous reasons for trading other than the possession of inside information.

declining in value and that he must liquidate the entire portfolio. He has information about Z plc, which will cause its shares to fall even faster than the remainder of the market sector. The ‘inevitable transaction’ defence ought to apply here. 323. Proposed Language for Inclusion in Committee Report on Insider Trading Definition, 20 Sec. Reg. & L. Rep. 279, 280 (1998). 324. In Adler, the defendant argued that he only sold 20,000 of his 869,897 shares. See SEC v. Adler, 137 F.3d 1325, 1329 (11th Cir. 1998).

248

Chapter 6 This defence may also create unjustified anomalies, for instance, two persons selling when armed with the same inside information, with one of them arguing that, unlike the other, he or she was obliged to sell in any event because of, say, pressing financial commitments and therefore had not ‘used’ the inside information in trading.325

The other important reason is that the modified use standard also allows the defendant to benefit more or less from the possessed information, even if the main reason behind the defendant’s trading was not based on the information. It seems that the modified use standard equates ‘use of information’ with the ‘decisive reason for the transaction’.326 Thus, under the modified use standard, the defendant can unfairly benefit from the information, as long as the information was not used as the decisive reason for the trading. It is very difficult, if not impossible, to precisely assess the role information plays in a defendant’s trading. As the Teicher court observed, ‘[u]nlike a loaded weapon which may stand ready but unused, material information cannot lay idle in the human brain’.327 This has lead one commentator to argue that, even if the defendants can successfully prove that their transaction was basically motivated by legitimate reasons rather than the possessed information, it is highly likely, or even inevitable that the possessed information would in some way influence their trades.328 Suppose that a person has tentatively made a pre-existing plan to sell shares to pay for his/her daughter’s college tuition which could have also come from an alternative source of funds. There is a real probability that after coming into possession of inside information, he or she might become more determined to implement the plan to liquidate his or her shares for the money which might otherwise have been collected in other ways. He or she might even sell more shares than initially planned. This person could readily argue that his/her trading was based on the need for his/her daughter’s tuition and not the information, therefore keeping the profits that were actually derived from the informational advantage to some degree. It can thus be argued that the person unfairly benefited from the information, even though the information did not play a decisive role in the transaction. In contrast, the above two problems with the modified use standard could be eliminated under the modified possession standard. Under Rule 10b5-1, it is required that the plan should be adopted before the person came into possession of inside information. Because the defendant did not possess the information when drafting the trading plan, it is safe to say that the defendant did not truly use the information, and did not benefit from the information in any way. Meanwhile,

325. Corporations and Markets Advisory Committee (Australia), above note 80, s 3.8.3. 326. Criminal Justice Act 1993 (UK) s 53(1)(c) (stating that ‘[insiders] would have done what he did even if he had not had the information’.). 327. United States v. Teicher, 987 F.2d 112 (2d Cir. 1993). 328. Schoen, above note 235, 281.

Some Basic Elements of Insider Trading

249

Rule 10b5-1 prevents the defendant from having the chance to invent plausible pretexts to argue that after possessing inside information, he or she did not actually use it to trade. Nor does Rule 10b5-1 permit the defendant to benefit from the information in any way, even though the information was not the decisive reason for the defendant’s trading. Moreover, Rule 10b5-1 imposes strict conditions on the mechanisms which can be considered effective defences, and thus further ensures that the defensive mechanisms are applied for genuinely legitimate business purposes. In fact, when the SEC requested comments on the proposed Rule 10b5-1, some people expressed concern that the affirmative defences were too narrow.329 However, the SEC refused to broaden the affirmative defences in the final version because doing so would damage the clarity Rule 10b5-1 was meant to instill.330 Indeed, it is the clarity of Rule 10b5-1 that closes the loopholes of the modified use standard. For instance, Rule 10b5-1 requires that the trading plan should specify the amount of securities to be traded and the price at which and the date on which the securities were to be traded.331 This means that later on the defendant cannot revise the plan on the basis of inside information. D.

CONCLUSION

The issue of subjective elements of insider trading is an important but very little researched topic in the insider trading regulation. There are some problems with respect to this issue in China’s insider trading law. This section has carried out an in-depth analysis of these problems on the basis of overseas experience, and has put forward reform proposals for China. The scienter requirement is reviewed first and then applied as a principle to address the specific issues associated with the subjective elements of insider trading. To begin with, the question of whether insiders must have been in possession of material, non-public information for liability to apply and how to prove it was addressed. This is followed by the discussion of the question of whether insiders must also know that the information in their possession was inside information. It is submitted that insider trading liability occurs when the defendant was in possession of inside information and also knew the nature of the information. To overcome evidentiary obstacles, the adoption of rebuttable presumptions of both possession and knowledge is recommended. Then, the question of whether insiders should have actually used the information in trading for liability to attach was examined in great detail. I conducted a comparative analysis of the legal responses to this question in various jurisdictions.

329. Selective Disclosure and Insider Trading, Securities Act of 1933 No. 7881 [August 11, 2000– August 17, 2000 Releases] 73 SEC Docket (CCH) ¶1, at 19 (18 September 2000). 330. Ibid 19. 331. Rule 10b5-1 (c)(1)(i)(B).

Chapter 6

250

The conventional treatment of this issue, as suggested by the US ‘possession vs. use’ debate, lists only two standards, namely the use standard and the possession standards. I believe that a better approach is to categorize these standards into four different standards, namely the strict possession, the strict use, the modified use and the modified possession standards. After a careful comparison of these four standards, it is submitted that the modified possession standard is the most appropriate standard for use in China. §6.VI.

SECURITIES COVERED

According to Article 2 of the Securities Law, the Secuties Law is applicable to shares, corporate bonds and such other securities as are lawfully recognized by the State Council which are issued and traded within China.332 Shares are securities in which insider trading mostly takes place. As discussed in Chapter 2, all the reported insider trading cases involve trading in shares.333 However, other types of securities may also be susceptible to insider trading. Corporate bonds are potentially subject to the prohibition. Before the 2005 revision, the predecessor to Article 74(1) identified as insiders corporate senior officials either from companies which issue shares or from those which issue debentures, indicating that the prohibition was equally applied to insider trading in equity securities and debt securities. However, the predecessor to Article 74(3) extended the prohibition to senior officials of the holding company of a company that issues shares, but not to those of companies whose subsidiary issues debentures. As a response to this inconsistency, Article 74(3) is now revised to make it clear that senior officials of the holding company of an issuing entity are deemed to be insiders, irrespective of the types of securities the entity has issued. Apart from shares and corporate bonds, ‘other securities recognized by the State Council’ are also within the range of the prohibition. However, it is hard to know precisely what securities fall inside this category at present. It has been made clear that the listed trading of government bonds and units of securities investment funds are also subject to the Securities Law, unless there are special provisions in other laws or administrative regulations.334 Therefore, the insider trading prohibition may apply to government bonds and managed investment funds. In contrast, the application of the Securities Law does not extend to the issuance and trading of securities derivatives. Rather, they shall be governed by the special administrative regulations by the State Council.335 Plainly, what types of financial products are subject to the insider trading prohibition in a given country depends on its local situation, particularly the

332. Securities Law, Art. 2(1). 333. See above §2.III.A. 334. Securities Law, Art. 2(2). 335. Ibid Art. 2(2).

Some Basic Elements of Insider Trading

251

development of the existing financial instruments on the market. At the same time, the scope of financial products under the prohibition needs to be flexible enough to allow for the market development in the future. This point is illustrated by the delegation clause ‘other securities recognized by the State Council’ of Article 2. This is an open-ended category, and the State Council has the delegated power to decide what other securities are actually included. Despite some uncertainties, this provision has desirable flexibility to allow the prohibition to be more effective because it avoids potential loopholes in relation to the types of the securities covered by the Securities Law. This advantage is particularly important in China where the securities market is still at its early stage and many financial instruments are yet to be fully developed. For example, there has been no options market in China to date. Certainly, with the development of the market, new types of securities will surface in China’s securities market. Then, the State Council can efficiently respond to this, and put new types of securities under the prohibition if it believes necessary or appropriate for the protection of investors.

Chapter 7

Private Civil Liability for Insider Trading

§7.I.

INTRODUCTION

The purpose of this chapter is to investigate the issue of private civil liability for insider trading on the basis of foreign experience and then make relevant recommendations for China. To date, China has been relying entirely on governmental action to enforce the prohibition against insider trading. At present, persons allegedly harmed by such activity are unable to bring a suit forward to recover damages. This is one of the factors contributing to the brief that the enforcement of insider trading in China is inefficient. It is widely accepted that private enforcement is a necessary supplement to government enforcement to deter insider trading. In the open-market setting, however, private civil liability for insider trading has long raised some extremely difficult questions. As Professor Clark pointed out: Once a private right of action under Rule 10b-5 was implied and recognized, there was bound to be a period of painful growth, as the courts struggled to give shape and meaning to the standard list of elements of a tort action as applied to the new context. Who was to have standing to bring private actions? Who could be sued? What exactly would constitute the duty imposed? What would be needed to show a violation of the duty and causation of injury? What would the measure of damages be?1 The recognition that private rights of action are both important and complex justifies a chapter-length treatment of the subject. The previous chapter looked at some 1. Robert C. Clark, Corporate Law (Boston, Little, Brown and Company, 1986) §8.10, p. 316.

Chapter 7

254

basic elements of criminal and civil insider trading liability, such as the notion of insider, the scope of inside information and the required state of mind. This chapter focuses on the key elements peculiar to private actions for insider trading. In the area of private remedies for insider trading, there are two crucially important, and somewhat interrelated questions: first, to what class of plaintiffs are defendants liable; and second, what is the amount that each plaintiff will receive. Part II discusses the current situation and problems concerning private rights of action in China. Part III examines the measurement of damages in securities fraud actions. Part IV carries out an in-depth analysis of who should be entitled to bring a suit forward for damages. This is followed by a brief discussion of other relatively minor issues, including defenses and the statute of limitations in Part V. §7.II.

THE PRIVATE ENFORCEMENT OF INSIDER TRADING IN CHINA

To date, China’s methods of enforcement against insider trading have been through the use of criminal liability and administrative liability.2 Contravention of insider trading law is a criminal offence subject to imprisonment and/or a fine.3 The CSRC has the power to impose administrative penalties, such as suspension or revocation of license, confiscation of illegal gains and financial penalties.4 As a practical matter, civil remedies are not presently available to aggrieved persons in insider trading cases. In fact, Article 76 of the Securities Law provides for civil laiblity for insider trading in very general terms, stating that: Where insider trading activities cause losses to investors, the insider shall be subject to the liabilities of compensation in accordance with the law.5 However, the Securities Law does not set out any functional provisions to address civil remedies, such as standing requirements and measurement of damages. This may be because the issue of securities civil liability is very complicated and more research on the issue is needed.6 As a result, investors who are victimized by 2. For detailed discussion of this, see above §3.III.C.1. 3. Zhonghua Renming Gongheguo Xingfa [Criminal Law of the People’s Republic of China] (October 1997) (hereinafter Criminal Law), Art. 180. 4. Zhonghua Renming Gongheguo Zhengquanfa [Securities Law of the People’s Republic of China] (promulgated on 29 December 1998 and effective from 1 July 1999, amended in 2004 and 2005) (hereinafter Securities Law), Art. 202. 5. Ibid Art. 76. Article 232 of the Securities Law even gives preference to civil liability for market misconduct over other forms of liabilities, providing that If the property of a person, who violates the provisions of this Law and who therefore bears civil liability for damages and is required to pay a fine, is insufficient to pay both the damages and the fine, such person shall first bear the civil liability for damages. Ibid Art. 232. 6.

On 15 January 2002, the Supreme Court of the People’s Republic of China announced that private suits regarding securities misrepresentation would be accepted by the courts. See Zuigao

Private Civil Liability for Insider Trading

255

insider trading are left without compensation for their damages under the Securities Law. Further, although a private right of action could be brought forward in contract or tort law, it is extremely difficult, if not impossible, in terms of causation and reliance, to claim damages on those conventional grounds, given the impersonal and anonymous nature of the securities market. Therefore, although private civil liability has been given a preference over administrative financial penalties on paper, it is virtually unavailable in practice. The inability to bring private civil actions against insider traders has become an increasingly serious problem in China. Many Chinese scholars have argued that due to the absence of civil remedies, the Securities Law has failed to fulfill its stated purposes, namely that of protecting investors, deterring unlawful behavior, and promoting the healthy development of the market.7 In practice, since civil remedy is unavailable, private investors are unable and unwilling to assist the CSRC in combating insider trading.8 This is disturbing particularly as the CSRC does not have sufficient resources to be the sole monitor of insider trading activities and enforcer of the prohibition.9 In contrast, in the US, private remedies in securities cases are considered to have created important incentives for individuals to sue, and have been widely accepted as a necessary complement to government enforcement.10 Similarly, Australia allows private rights of action to be brought

7.

8. 9. 10.

Renmin Fayuan Guanyu Shouli Zhengquan Shichang yin XujiaChenshu yinfa de Minshi Qinquan Jiufeng Anjian Youguan Wenti de Tongzhi [Notice on Relevant Issues with regard to Hearing Civil Suits Caused by Misrepresentation in the Stock Market] (15 January 2002) (PRC). However, civil private rights of action are still unavailable in other types of securities fraud cases, notably insider trading cases, because it is considered that civil insider trading cases are far more complicated and the time is not yet ripe for courts to hear them. See Guoguang Li and Wei Jia, Zhengquan Shichang Xujia Chenshu Minshi Peichang Zhidu [Legal System of Civil Compensation for Securities Misrepresentation] (Beijing, Law Press, 2003), p. 37. See e.g., Liming Wang, ‘Perfection of Private Civil Liability Regime in China’s Securities Law’ (2001) 4 Faxue Yanjiu [Legal Study] 55, 56–58 (contending that private rights of action can help compensate victim-investors and strengthen the deterrent effect of the securities law;) Guo Feng, ‘Insider Trading and Private Remedy’ (2000) 2 Faxue Yanjiu [Legal Study] 91, 92 (opining that civil remedy can promote the goal of investor protection). Lin Ye, Zhongguo Zhengquan Fa [China’s Securities Law] (Beijing, Law Press, 1999), p. 414. For a discussion of resource constraints of the CSRC, see above §3.III.B.4. See e.g., Basic Inc. v. Levinson, 485 U.S. 224, 230 (1988) (‘Judicial interpretation and application, legislative acquiescence, and the passage of time have removed any doubt that a private cause of action exists for a violation of §10(b) and Rule 10b-5, and constitutes an essential tool for enforcement of the 1934 Act’s requirements’.); de Haas v. Empire Petroleum Co., 435 F.2d 1223, 1230 (10th Cir. 1970) (‘private enforcement of the securities laws is necessary due to the limited source of the SEC’); Donald C. Langevoort, ‘Capping Damages for Open-Market Securities Fraud’ (1996) 38 Arizona Law Review 639, 652 (assuming necessity of private action). It is important to note that in US securities class actions, the decision to sue is normally not made by members of the investor class, but by plaintiffs’ lawyers. Permitting investors to recover compensation for their market losses and allowing such claims to be aggregated through the class action device encourages private enforcement of the securities laws by entrepreneurial plaintiffs’ lawyers as a supplement to the government’s enforcement activity. See John C. Coffee, Jr., ‘Understanding the Plaintiff’s Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions’ (1986) 86 Colum. L. Rev. 669,

Chapter 7

256

forward in insider trading cases.11 In order to strengthen the regulation of insider trading and protect the public interest in the securities market, China is now contemplating introducing private civil liability for insider trading.12 This chapter supports such an introduction. §7.III.

DIFFERENT MEASURES OF DAMAGES IN SECURITIES FRAUD ACTIONS

A.

MEASURE OF DAMAGES IN FACE-TO-FACE TRANSACTIONS

There has been a multiplicity of methods of measuring damages in securities fraud cases in developed countries, most notably in the US. These remedies are traditionally fashioned for defrauded buyers and sellers in situations in which the parties deal directly with each other rather than through an impersonal market, and thus only some of them might be applicable in the context of insider trading. These measures are broadly classified as the ‘out-of-pocket’ measure, the modified ‘out-of-pocket’ measure, the ‘benefit-of-bargain’ measure, the measure of consequential damages, the cover measure, the measure of rescission or rescissory damages and the windfall-profits measure. It is important to note that punitive damages are generally not available for both policy and statutory reasons in the US.13 1.

The Out-of-Pocket Measure

The out-of-pocket measure is the most common measure of damages in securities fraud actions,14 typically formulated as ‘the difference between the contract price,

11.

12. 13.

14.

684–90; John C. Coffee, Jr., ‘Rescuing the Private Attorney General: Why the Model of the Lawyer as Bounty Hunter Is Not Working’ (1983) 42 Md. L. Rev. 215, 215–230. Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Report (November 2003)’ recommendation 9 (recommending that courts should be able to grant civil remedies to ‘aggrieved persons’). In the context of prospectus disclosure liability, Australia provides aggrieved investors with the right to recover for loss or damage, in order to create additional deterrent to relevant perpetrators. See Corporations Act 2001 (Australia) s 729. see above §2.III.C.3. Recent Development, ‘Damages For Insider Trading in the Open Market: A New Limitation on Recovery Under Rule 10b-5’ (1981) 34 Vand. L. Rev. 797, 810; Gould v. American-Hawaiian S.S. Co., 535 F.2d 761, 784 (3d Cir. 1976); de Haas v. Empire Petroleum Co., 435 F.2d 1223, 1230–1232 (10th Cir. 1970). In the US, state tort law may award some investors punitive damages, but this is too tangential for current purposes. See e.g., Hecht v. Harris, Upham & Co., 283 F. Supp. 417 (N.D. Cal. 1968), modified, 430 F.2d 1202 (9th Cir. 1970). See e.g., Hackbart v. Holmes, 675 F.2d 1114, 1121 (10th Cir. 1982) (‘the customary measure of damages in a Rule 10b-5 case is the out-of-pocket loss’); Randall v. Loftsgaarden, 478 U.S. 647, 662 (1986) (‘Courts have also generally applied this ‘out-of-pocket’ measure of damages in §10(b) cases involving fraud by a seller of securities . . . ’.); Robert B. Thompson, ‘The Measure of Recovery Under Rule 10b-5: A Restitution Alternative to Tort Damages’ (1984) 37 Vanderbilt Law Review 349, 356 (‘Out of pocket damages are the usual form of relief available for a rule 10b-5 violation’).

Private Civil Liability for Insider Trading

257

or the price paid, and the real or actual value at the date of sale’.15 This measure is derived from the traditional tort action of deceit, limiting recovery to the plaintiff’s actual loss. Consistent with causation limits on a tort recovery, it provides recovery only for damages caused by the fraudulent act, excluding damages from any other source, notably from general market change.16 The following example illustrates the out-of-market measure. A defendant fraudulently induces a plaintiff to buy stock for consideration worth $100 with the real value of the stock being only $80. Because the market generally declines after the transaction, the price of the stock is $60 at the time of corrective disclosure of the information. The damage would be the difference between the price paid and the real value, namely $20 ($100 minus $80). In other words, the plaintiff could not recover the $20 per share loss due to general market decline. Thus, by focusing on the actual value of the stock at the time of the transaction, the out-of-pocket measure transfers the risk of post-transaction market fluctuation onto the plaintiff. While the doctrinal statement of this measure is fairly straightforward, there is a considerable practical difficulty in determining actual value at the time of the transaction. In practice, for shares that are regularly traded on the stock market, what is readily available is the price line of the shares. Thus, we may easily know the price of the transaction and the price when corrective disclosure has been made. However, what is unknown is the real value at the time of transaction, the price at which the stock would have been traded in the absence of fraud. Great efforts have been made to determine the real value at the time of the transaction, but the result is far from satisfactory. The basic method in this area is the so-called ‘event study’ based on modern financial theory.17 In general, event studies start with the change in the share price after disclosure, and then, using regression analysis, isolate the effects of the withheld information from other factors (such as the general market change) that may have affected the stock price between the time of the purchase and the time of disclosure. Working backwards, the study can finally establish a hypothetical price for each day from the disclosure date to the transaction date. Thus, with these elaborate price lines and value lines over the life of a fraud and its correction, courts can apply the out-of-pocket measure. Serious difficulties, however, are involved in the use of this methodology because it 15.

Estate Counseling Serv., Inc. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 303 F.2d 527, 533 (10th Cir. 1962); see also Madigan, Inc. v. Goodman, 498 F.2d 233 (7th Cir. 1974) (articulating the out-of-pocket measure). 16. Sharp v. Coopers & Lybrand, 649 F.2d 175, 190 (3d Cir. 1981) (‘Our goal in formulating a damage instruction must be to compensate appellees precisely for the damage directly resulting from appellant’s wrongful acts’.)(emphasis added); Huddleston v. Herman & MacLean, 640 F.2d 534, 549 (5th Cir. 1981) (‘If the investment decision is induced by misstatements or omissions that are material and that were relied on by the claimant, but are not proximate reason for his pecuniary losss, recovery under the Rule is not permitted’.) (emphasis added). 17. See e.g., Bradford Cornell and R. Gregory Morgan, ‘Using Finance Theory to Measure Damages in Fraud on the Market Cases’ (1990) 37 UCLA Law Review 883, 899–900; Daniel R. Fischel, ‘Use of Modern Finance Theory in Securities Fraud Cases Involving Actively Traded Securities’ (1982) 38 Bus. Law. 1, 17–19.

Chapter 7

258

depends on various debatable factual assumptions.18 Choosing between competing assumptions would introduce an unacceptable level of uncertainty. 2.

The Modified Out-of-Pocket Measure

As discussed above, the out-of-pocket measure requires a determination of the real value of securities at the time of the transaction, which has posed frustrating practical and methodological difficulties. To resolve this problem, the out-of-pocket measure has been modified to allow for the measurement of the value of the securities at a more easily ascertainable date after the fraudulent transaction as a proxy for the value at the time of the transaction. In practice, the proxy date is either the date of public discovery of the fraud19 or the date that the plaintiff discovered or should have discovered the fraud.20 This has been labelled the ‘modified’ or ‘expedient’ out-of-market measure.21 Although the modified out-of-pocket measure springs from the pure out-of-pocket measure, there is a significant difference between them from a practical point of view. The difference lies in the allocation between the parties of the post-transaction change in the value of the security. The change may be partly caused by the fraud; other factors, such as general stock market movements since the transaction, may also contribute to the price change.22 By focusing on the true value at the time of the transaction, the pure out-of-pocket measure allows a plaintiff to recover only for the harm attributable to the fraud and excludes any additional harm resulting from other 18. Cornell and Morgan, above note 17, 894–97; Janet Cooper Alexander, ‘The Value of Bad News in Securities Class Actions’ (1994) 41 UCLA L. Rev. 1421, 1454–58. It has also been argued that the event study is inadequate because the price effect of the disclosure is not necessarily the same as the price effect of the withheld information. Janet C. Alexander, ‘Rethinking Damages in Securities Class Actions’ (1996) 48 Stanford Law Review 1487, 1492 n.12 (contending that the change in the stock price on disclosure may incorporate components other than the withheld information, such as the anticipation of litigation costs to the company, overreaction to unexpected disclosure of bad news). 19. See e.g., Harris v. American Investment Co., 523 F.2d 220, 227 (8th Cir. 1975), cert. denied, 423 U.S. 1054 (1976) (‘Harris [the plaintiff] may be able at the trial to establish an alternative basis for recovery by introducing evidence of his damages as of the date of public discovery of the fraud’.); 2 Alan R. Bromberg and Lewis D. Lowenfels, Bromberg and Lowenfels on Securities Fraud and Commodities Fraud (West Publishing Company, 2nd ed., 1998) §9.1, p. 228 (‘On an open market, the best evidence [of the ‘actual value’] is market value when the misrepresentation or omission is cured’.). 20. See e.g., Richardson v. MacArthur, 451 F.2d 35, 43–44 (10th Cir. 1971); Esplin v. Hirschi, 402 F.2d 94, 104–105 (10th Cir. 1968), cert. denied, 394 U.S. 928 (1969). 21. Thompson, above note 14, 361–365 (discussing the concept of ‘modified’ out-of-pocket measure); William K.S. Wang & Marc I. Steinberg, Insider Trading (Aspen Publishers, 1996) §4.8.2.2 (distinguishing ‘expedient’ out-of-pocket measure using market price after corrective disclosure, from ‘pure’ out-of-pocket measure using actual value at the time of the transaction). 22. In some situations, it may be that there has been no or negligible change in the non-fraud component of the price. If so, the market price after disclosure would equal, at least roughly, to the actual value at the time of transaction. Robert B. Thompson, ‘Simplicity and Certainty’ in the Measure of Recovery Under Rule 10b-5’ (1996) 51 Bus. Law. 1177, 1182.

Private Civil Liability for Insider Trading

259

factors. In contrast, the modified out-of-pocket measure, based on a post-transaction date, may permit the plaintiff to recover for the harm not caused by the fraud. There are conflicting views on the effect of the modified out-of-pocket measure. On the one hand, the measure has been criticized on the grounds that the recovery for the harm caused by factors other than the fraud constitutes an undeserved windfall for the plaintiff: While this [modified out-of-pocket measure] has the obvious attraction of providing a concrete figure for the true worth of a security absent the fraud, it completely disregards the many other factors which influence price fluctuation over time of stocks in general or of a particular stock. It therefore has the potential of creating a windfall recovery to a plaintiff in the nature of indemnification against the risks of the vicissitudes of the market, and at the same time saddling defendants with payments far out of proportion to the damage caused their fraud.23 Indeed, some of the courts adopting the modified out-of-pocket measure may have felt the same way, but then, acknowledging the practical difficulty of filtering out the effect of the overall market change on the individual stock’s price, have latched onto the market price after disclosure as an acceptable proxy for the real value at the time of the transaction.24 Put differently, the modified out-of-pocket measure has been used by these courts as a matter of expediency rather than logic. In this sense, it accepts the principle of the pure out-of-pocket measure – that the plaintiff is entitled only to the recovery for the harm resulting from the fraud – and thus is vulnerable to criticism of its over-compensation to the plaintiff. On the other hand, recovery for harm arising from overall market change has been theoretically justified on the basis that the subsequent market change is causally linked with the fraud. In some cases where the plaintiff was the defrauded seller, it was held that but for the fraud, the plaintiff would have held the stock and thus could have obtained the subsequent rise in price due to the general market movement.25 Because the subsequent market change was causally connected with the fraud, it was plausible to allow the plaintiff to recover for it. This logic can be equally applicable in cases where the plaintiff is the defrauded buyer. It could be argued that the plaintiff would not have bought the stock and as such could not have suffered from the subsequent decline in the market. Under this rationale, the practical difficulty of determining real value is not the only or primary reason to use the market price at a post-transaction date. It follows that even if the real value at the time of the transaction is determined, the risk of the subsequent market change should be borne by the defendant. This makes the modified out-of-pocket measure essentially depart from the pure out-of-pocket 23. Bonime v. Doyle, 416 F. Supp. 1372, 1384 (S.D.N.Y. 1976); see also In re Warner Communications Sec. Litig., 618 F. Supp. 735, 744–745 (S.D.N.Y. 1985). 24. Thompson, above note 22, 1182. 25. See e.g., Dupuy v. Dupuy, 551 F.2d 1005, 1024–25 (5th Cir. 1977), cert. denied, 434 U.S. 911 (1977); Myzel v. Field, 386 F.2d 718, 744–45 (8th Cir.), cert. denied, 390 U.S. 951 (1968).

Chapter 7

260

measure by theoretically acknowledging the propriety of awarding recovery for the harm caused by non-fraud factors. 3.

The Benefit-of-the-Bargain Measure

This measure awards the victim of fraud the difference between the price the victim received and the gain which the victim may have got had the misrepresentation been true. It differs from the out-of-pocket measure in that it focuses on the plaintiff’s potential gain rather than actual loss. This point is well illustrated by the following example: [I]f a defrauded shareholder in a tender offer sold stock that was represented to be worth $50 and that shareholder subsequently received $40 when the stock’s actual value was $45, the benefit-of-the-bargain measure would award plaintiff $10 per share ($50 minus $40). On the other hand, the out-of-pocket measure would have awarded plaintiff $5 per share ($45 minus $40), based upon the actual value of the security.26 In the US, while many states have adopted this measure in tort actions for deceit, federal courts have generally rejected it in securities cases for a number of reasons.27 The first reason for this is statutory interpretation. It has been argued that the benefit-of-the-bargain measure is inconsistent with the ‘actual damages’ language of Section 28 (a) of the Securities Exchange Act of 1934 because the measure extends beyond actual damages to the expected fruits of unrealized expectation.28 A more important concern is the speculative nature of this measure. As Professor Thompson properly pointed out, Securities by nature have a fluctuating and more uncertain value than other kinds of property subject to fraudulent transactions. Thus, measuring the value of the securities’ expected worth at completion of the unfulfilled contract may be more difficult than determining the value of tangible property and therefore too speculative to be the basis for damages.29 In certain situations, however, the courts allow the use of the benefit-of-the-bargain measure, provided that the expectancy damages in the transaction can be determined with ‘reasonable certainty’.30 These situations mainly include, but are not 26. Comment, ‘The Measure of Damages under Section 10(b) and Rule 10b-5’ (1987) 46 Md. L. Rev. 1266, 1274. 27. Thompson, above note 14, 358–360 (discussing reasons including statutory interpretation, history, and policy considerations). 28. See e.g., Astor Chauffeured Limousine Co. v. Rumfield Inv. Corp., 910 F.2d 1540, 1551–1552 (7th Cir. 1990); Levine v. Seilon, Inc., 439 F.2d 328 (2d Cir. 1971); Estate Counseling Serv., Inc. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 303 F.2d 527, 533 (10th Cir. 1962). 29. Thompson, above note 14, 360; Wang & Steinberg, above note 21, §4.8.2.6 (‘Due to its asserted speculative nature, the benefit of the bargain measure is applied by the courts less often than the out-of-pocket measure’). 30. See e.g., McMahan & Co. v. Wherehouse Entertainment Inc., 65 F.3d 1044, 1049–1050 (2d Cir. 1995) (‘the key to awarding benefit-of-the bargain damages is the degree of certainty to which

Private Civil Liability for Insider Trading

261

limited to, the context of tender offers.31 The measure is more likely to be employed if the courts see the objective of private suits as the avoidance of unjust enrichment on the part of the defendant rather than the prevention of actual harm to the plaintiff.32 However, in insider trading cases where there is typically no misrepresentation involved, this measure seems to be inappropriate.33 4.

Consequential Damages

Apart from the difference between the price paid and the real value at the time of the transaction, fraud may lead to other costs to the plaintiff, which can be recovered in the form of consequential damages. These costs may include, inter alia, the cost of investigating the contemplated deal;34 dividends on stock that the defrauded plaintiff has sold;35 capital gains tax;36 and brokerage fees paid in connection with the fraudulent transaction.37 Generally, consequential damages can be sought in conjunction with other measures of damages such as the out-ofpocket and rescissory damages. Despite the wide availability of consequential damages, there are generally two limits on it. First, based on the tort principle, consequential damages can be awarded only for the costs which are the proximate result of the fraud.38 So a plaintiff seeking consequential damages for fraud must establish the causal nexus with substantial certainty. Second, consequential damages would be denied if they duplicate the plaintiff’s recovery from some other measure of damages.39 It should be noted that consequential damages may in some circumstances permit the plaintiff to recover the loss due to a general decline in the market after the fraudulent transaction.40 The plaintiff, of course, needs to demonstrate a causal

31.

32. 33. 34. 35. 36. 37. 38. 39. 40.

they can be established’); Commercial Union Assurance Co. v. Milken, 17 F.3d 608, 614 (2d Cir.), cert. denied, 115 S. Ct. 198 (1994) (‘Benefit-of-the-bargain damages in a Rule 10b-5 action are not available unless they can be calculated with reasonable certainty’); Osofsky v. Zipf, 645 F.2d 107, 112 (2d Cir. 1981) (‘But, of course, giving the plaintiff benefit-of-the-bargain damages is appropriate only where they can be established with reasonable certainty’). Osofsky v. Zipf, 645 F.2d 107, 114 (2d Cir. 1981) (applying the benefit-of-the-bargain measure in a tender offer case); McMahan & Co. v. Wherehouse Entertainment Inc., 65 F.3d 1044, 1049 (2d Cir. 1995) (‘[w]e held that benefit-of-the-bargain damages, under Rule 10b-5, were particularly appropriate in the context of tender offers’). See Hackbart v. Holmes, 675 F.2d 1114, 1122 (10th Cir. 1982) (stating that the benefit-ofthe-bargain measure is necessary to prevent unjust enrichment). Wang & Steinberg, above note 21, §4.8.2.6, 244. Thompson, above note 14, 360. Glick v. Campagna, 613 F.2d 31 (3d Cir. 1979). Stevens v. Abbott, Proctor & Paine, 288 F. Supp. 836, 851 (E.D. Va. 1968). Rolf v. Blyth, Eastman, Dillon & Co., 570 F.2d 38, 50 (2d Cir.), cert. denied, 439 U.S. 1039 (1978). Thompson, above note 14, 360. Comment, above note 26, 1277. Thompson, above note 14, 361.

Chapter 7

262

link between the subsequent market decline and the fraud by asserting that but for the fraud, he or she would not have bought at all.41 5.

The ‘Cover’ Measure

The ‘cover’42 measure of damages allows a plaintiff to recover the difference between the price paid (or the consideration transferred) and the lowest value the stock reaches within a reasonable time after the fraud is discovered or should have been discovered.43 For example, a defrauded plaintiff paid $100 for stock worth $80 and then resold the stock at $60 within a reasonable time after corrective disclosure (the general market decline resulted in the $20 drop in the stock price). With the cover measure, the plaintiff can recover $40 ($100 minus $60). In contrast, the out-of-pocket measure would award the plaintiff only $20 ($100 minus $80). Thus, the cover measure differs from the out-of-pocket measure by transferring the risk of the subsequent market change to the defendant. The reason behind this treatment is also the causal connection between the subsequent market change and the fraud. The cover measure implicitly presumes that the plaintiff would not have bought in the absence of the defendant’s fraud.44 The leading US case adopting this measure of damages is Mitchell v. Texas Gulf Sulphur Co.45 In this case, the defendant Texas Gulf Sulphur had made a significant ore discovery but released a press statement to deny the find. Mitchell and other investors sold their stock in reliance upon this statement before the second statement acknowledging the discovery. The court stated: We believe the measure of damages used should award the reasonable investor the amount it would have taken him to invest in the TGS market within a reasonable period of time after he became informed of the [corrective] April 16 release . . . and its import to investment, a reasonable time lapse may be allowed 41.

42. 43.

44. 45.

See e.g., Garnatz v. Stifel, Nicolaus & Co., 559 F.2d 1357, 1361 (8th Cir. 1977), cert. denied, 435 U.S. (1978) (allowing the plaintiffs to recover damages resulting from a general market decline if they can establish that their investment decision was the ‘natural, proximate, and foreseeable consequence of defendants’ fraud’). The term ‘cover’ is borrowed from the measure of damages for conversion. See Thomas J. Mullaney, ‘Theories of Measuring Damages in Security Cases and the Effects of Damages on Liability’ (1977) 46 Fordham L. Rev. 277, 285. Conversely, in the case where a plaintiff is a defrauded seller, the damages would be the difference between the price the victim received and the highest value the security achieves within a reasonable time after the fraud is discovered or should have been discovered. It is worth noting that some commentators use the term ‘cover measure’ to describe the measure of damages for either a defrauded seller or a defrauded buyer. See e.g., Wang & Steinberg, above note 21, §4.8.2.3 (the cover measure is suitable for either a defrauded seller or a defrauded purchaser). In contrast, other commentators define the cover measure in such a way that it only applies to a defrauded seller. See e.g., Comment, above note 26, 1277 (‘the cover measure can only be invoked by a defrauded seller to recover . . . ’). The fact that the same term has been used in different ways is a source of confusion in the law relating to private remedies in securities cases. Wang & Steinberg, above note 21, §4.8.2.3, 232. Mitchell v. Texas Gulf Sulphur Co., 446 F.2d 90 (10th Cir.), cert. denied, 404 U.S. 1004 (1971).

Private Civil Liability for Insider Trading

263

to expire to permit the investor to decide wether or not he would reinvest and take advantage of a spiralling market . . . The award proposed would permit one to ‘cover’ by reinvestment and suffer neither loss nor forced sale . . . .The damage then should be based on the highest value of TGS stock between Monday, April 20 and a reasonable time thereafter.46 Thus, although it is willing to transfer the subsequent market risk to the defendant, the measure does not let the risk run indefinitely. Rather, in order to prevent unfair plaintiff speculation on the subsequent market change, the measure imposes on the plaintiff the obligation to mitigate damages by reversing his or her trade within ‘a reasonable time’ after corrective disclosure. In the hypothetical example provided above, the plaintiff was required to resell the stock to prevent an increase in the injuries. If the plaintiff failed to do so within a reasonable time and the price further declined to $50, then he or she could only recover $40 rather than $50 ($100 minus $50). In short, only that part of the market risk occurring within the reasonable time would be transferred to the defendant; the market risk after the point in time would remain on the plaintiff. This policy reflects a judicial concern for avoiding the imposition of a liability that is not commensurate with the injury caused by the defendant. Further, the task of determining how long ‘a reasonable time’ is has been a difficult one. There is no hard-and-fast rule as to this question, and the courts appear to make the determination on a case-by-case basis.47 Under US case law, the end of a reasonable time could be the date of dissemination and absorption of the information, the date of suit, the date of judgement, and so on, with the length of ‘a reasonable time’ranging from one day to two months.48 Further, it has been argued that the courts should not use an objective approach based on the investment decision of a reasonable investor, but rather a subjective approach tailored to the particular investors involved.49 Thus, in deciding what is ‘a reasonable time’, a court may need to take into account a number of factors including the sophistication of the plaintiff, the size of plaintiff’s investment, the type of fraud, the market conditions and so on.50 6.

Rescission, Restitution or Rescissory Damages

As an alternative to the commonly used out-of-pocket measure of damages, courts may allow a plaintiff to rescind a fraudulent transaction, and seek specific restitution or rescissory damages where specific restitution is impracticable or impossible because the plaintiff or defendant no longer possesses the security.51 This 46. Ibid 105. 47. Comment, above note 26, 1279. 48. Ibid 1278–1279. See e.g., Nye v. Blyth, Eastman, Dillon & Co., 588 F.2d 1189 (8th Cir. 1978) (two months); Baumel v. Rosen, 412 F.2d 571, 576 (4th Cir. 1969) (one day). 49. See e.g., Note, ‘The Measure of Damages in Rule 10b-5 Cases Involving Actively Traded Securities’ (1974) 26 Stan. L. Rev. 371, 379 (distinguishing between long-term investors and short-term investors). 50. Arnold S. Jacobs, Litigation and Practice Under Rule 10b-5 (Deerfield, IL, Clark Boardman Callaghan, 2nd ed., 1981), pp. 15–40. 51. Thompson, above note 14, 365 (‘While the out of pocket measure is the usual standard for recovery in a rule 10b-5 action, most courts recognize that a plaintiff instead may choose rescission

264

Chapter 7

measure attempts to undo the fraudulent transaction and to return the plaintiff to his or her prior financial position as is far as possible. The predominant goal of rescission is to prevent unjust enrichment of the defendant who receives a benefit as a result of his or her unlawful conduct.52 So rescission is fundamentally different from the out-of-pocket measure in that it looks to the defendant’s gain rather than the plaintiff’s loss as the basis of the measure of recovery. Several consequences flow from an election of rescission.53 First, rescission can be permitted even absent a showing that the defendant’s misrepresentation caused the plaintiff’s economic loss. Second, the defendant’s intent to defraud is not a prerequisite to recovery based on rescission and thus a defendant may be subject to rescission even if he or she has innocently made a misrepresentation. Finally, as with the cover measure, a rescission remedy has the effect of allowing a plaintiff to shift to the defendant the risk of the post-transaction decline in the market. From a practical viewpoint, the shifting of the market risk makes rescission similar to the cover measure and different from the out-of-pocket measure. By unwinding the transaction and returning to each party what they transferred, the fraudulent seller, for example, would get back the stock originally transferred due to fraud, and the defrauded buyer would retrieve the consideration paid for the stock. Thus, if since the transaction the market value of the stock has decreased because of the overall market decline, then the plaintiff would escape not only the harm due to the fraud, but also the harm due to the falling market conditions. The following hypothetical is illustrative of this point. Suppose that a plaintiff bought stock at $100 when its real value was $80 and then the stock dropped to a value of $60 due to the declining market within a reasonable time after discovery. Under the out-of-pocket measure, the plaintiff could recover $20 ($100 minus $80); under the cover measure, the amount of damages could rise to $40 ($100 minus $60); rescission would allow the plaintiff return the stock worth $60 to the defendant and get back $100, which amounts to granting the plaintiff $40 in monetary damages. The concern that rescission will allow the plaintiff to recover beyond the extent of the fraud has created incentives for courts to impose several constraints upon this remedy. The most important requirement is that plaintiffs bring suits for rescission promptly after the discovery of the fraud.54 Again, this is analogous to or a money judgement that is the financial equivalent of rescission’); see also Jordan v. Duff and Phelps, Inc., 815 F.2d 429, 441–442 (7th Cir. 1987) (stating in dictum that there are two standard measures of damages in security cases and that one is the ‘rescissionary’ measure’); Glick v. Campagna, 613 F.2d 31, 37 (3d Cir. 1979) (If the defendant no longer owns the stock or [rescission] is otherwise unavailable . . . then the court may award rescissory damages . . . ); Blackie v. Barrack, 524 F.2d 891, 909 (9th Cir. 1975) (‘While out of pocket loss is the ordinary standard in a [Rule] 10b-5 suit, it is within the discretion of the district judge in appropriate circumstances to apply a rescissory measure’.). 52. Thompson, above note 14, 366; see also Jordan v. Duff and Phelps, Inc., 815 F.2d 429, 441–442 (7th Cir. 1987) (‘The ‘rescissionary’ measure of damages is based on the defendant’s gain. The court reverses the transaction and compels defendants to return the purchase price or disgorge any gains they received’); Recent Development, above note 13, 806. 53. See generally Thompson, above note 14, 366–370. 54. See e.g., Baumel v. Rosen, 412 F.2d 571 (4th Cir. 1969) (rescission denied because of a threeyear-long delay between the discovery of the fraud and the suit); Hickman v. Groesbeck, 389

Private Civil Liability for Insider Trading

265

the requirement of mitigation of damages. Indeed, the plaintiff may delay a suit while speculating on a subsequent market change on the theory that it is a no-lose situation because if the market declines, he may recover; if the market rises, he will keep the security and the profit. Thus, with the prompt suit requirement, the courts can minimize the risk of the plaintiffs’ unfair speculation, a common concern that runs through all measure of damages situations.55 Further, many courts require that there be a contractual relationship between the parties.56 As discussed below, stock market insider trading plaintiffs are commonly not in contractual privity with the defendant.57 The privity requirement, therefore, renders rescission unavailable in most insider trading cases. 7.

The Windfall-Profits Measure

Under this measure, a defrauded seller may recover the profits made by the defendant on a subsequent resale of the fraudulently acquired stock. As with the rescission recovery, this measure is based on unjust enrichment principles and focuses on the defendant’s gain. The leading US case in this area is Janigan v. Taylor.58 In Janigan the plaintiffs sold their stock to their corporation’s president for approximately USD 40,000. Less than two years later, the president sold the stock for USD 700,000. The court allowed the plaintiffs to recover the defendant’s net profit on the resale, holding that ‘[i]t is more appropriate to give the defrauded party the benefit event of windfalls than to let the fraudulent party keep them’.59 This clearly reflects the court’s reliance on an unjust enrichment rationale under which the plaintiff may recover the defendant’s gain even if it exceeds the plaintiff’s loss in the transaction. By awarding the plaintiffs the windfall profit, the measure promotes the deterrent effect of private suits in securities cases. 60 Based on the relationship between the defendant’s gain and the fraud, limits to the windfall-profits recovery have been imposed to ensure that it would not deprive the defendant of some part of the gain falling outside the concept of unjust enrichment. In Janigan, the court noted that a defendant would not have to disgorge any profits directly attributable to his personal efforts that were unconnected to the

55.

56. 57. 58. 59. 60.

F. Supp. 769 (D. Utah 1974); Michael J. Kaufman, ‘The Real Measure of Damages Under Rule 10b5’ (1989) 39 Cath. Univ. L. Rev. 29, 101–102. See e.g., Hoxworth v. Blinder Robinson & Co., 903 F.2d 186, 203 n.25 (3d Cir. 1990) (‘this circuit has expressed clear disapproval of a damage theory that would insure defrauded buyers against downside market risk unrelated to fraud’(citation omitted)); Myzel v. Fields, 386 F.2d 718, 740 n.15 (8th Cir. 1968), cert. denied, 390 U.S. 951 (1968). Huddleston v. Herman & MacLean, 640 F.2d 534, 554 (5th Cir. 1981) (‘Use of the rescissional measure is usually limited to cases involving either privity between plaintiff and defendant or some specific fiduciary duty owed by brokers to their customers’.); Kaufman, above note 54, 101–102. See below §7.IV.A. Janigan v. Taylor, 344 F.2d 781 (1st Cir. 1965), cert. denied, 382 U.S. 879 (1965). Ibid 786. This view has been shared by other courts. See e.g., Thomas v. Duralite, 524 F.2d 577, 589 (3d Cir. 1975). See Nelson v. Serwold, 576 F.2d 1332, 1339 (9th Cir. 1978), cert. denied, 439 U.S. 970 (1978) (‘To allow violators of the Act to profit by their misconduct would undermine the deterrence that the Act was intended to effect’.)

266

Chapter 7

fraud.61 To illustrate this point the court stated that ‘[i]f an artist acquired paints by fraud and used them in producing a valuable portrait we would not suggest that the defrauded party would be entitled to the portrait, or to the proceeds of its sale’.62 The above ‘fraud-unconnected personal efforts’ exception, however, has proven so strict that only extraordinary effort or talent on the part of the defendant may suffice to preclude unjust enrichment recovery. Subsequent cases illustrate the difficulty which a defendant may experience in seeking to establish the exception. In Rochez Brothers, Inc. v. Rhoades,63 Rhoades and Rochez were equal owners of a company. Rhoades purchased Rochez’s stock and later sold the company at a substantial profit. Although Rhoades was characterized as an aggressive entrepreneur and Rochez a riskaverse investor who had a depreciating effect on the company, the court refused to allow Rhoades any reduction for his entrepreneurship under the Janigan exception.64 However, the decision in SEC v. MacDonald65, a stock market insider trading case, did put an important limit on the windfall-profits measure. In this case, the defendant was the chairman of an ailing investment trust, who purchased stock in the trust on the basis of inside information that the trust was about to enter into a favourable lease.66 The SEC brought suit under Rule 10b-5, and the trial court required the defendant to disgorge the profits that he had gained on the resale of the stock.67 The First Circuit reversed the trial court’s measure of restitution. On appeal, the court held that the defendant must disgorge ‘an amount representing the increased value of the [purchased] shares at a reasonable time after public dissemination of the information’.68 This ‘reasonable time’ requirement effectively limits the total disgorgement measure established in Janigan. The introduction of the ‘reasonable time’ limitation is the result of judicial efforts to prevent plaintiffs from speculating on the market at defendants’ expense. Indeed, under the disgorgement measure, all risks of change in the market are shifted to the defendants, so that the plaintiffs may wait to sue and allow damages possibly to increase. The MacDonald court therefore addressed the concern over plaintiffs’ unfair speculation by transferring back to plaintiffs the risk arising from market changes which occur after a reasonable time.69 As a result, defendants are protected from plaintiff’s speculation because they are only liable for the risk of market changes within a reasonable period in any event. Clearly, the shorter the reasonable period, the more advantageous it is to the defendant. This limitation, however, has been subject to criticism. It has been argued that by imposing the limitation, the MacDonald court focuses too much on the connection between the plaintiff’s loss and the fraud as required for recovery 61. 62. 63. 64. 65. 66. 67. 68. 69.

Janigan v. Taylor, 344 F.2d 781, 787 (1st Cir. 1965), cert. denied, 382 U.S. 879 (1965). Ibid. Rochez Bros., Inc. v. Rhoades, 491 F.2d 402 (3d Cir. 1973). Ibid 412. SEC v. MacDonald, 699 F.2d 47 (1st Cir. 1983). Ibid 48. Ibid. Ibid 52 (emphasis added). Ibid 53.

Private Civil Liability for Insider Trading

267

in tort.70 Indeed, with the ‘reasonable time’ requirement, MacDonald, using restitution as the basis for recovery, comes to the same result of that of a tortbased measure such as the cover measure.71 Recall that under the cover measure, the plaintiff cannot recover the loss due to the market change beyond a reasonable time after the discovery of the fraud, because the plaintiff has an opportunity to reinvest and thus protect himself/herself from further damage. It seems to follow that the MacDonald court has improperly imported the limitation from contract and tort law into the measures where unjust enrichment is the basis for recovery: The Macdonald rule in effect incorporates into restitution various plaintiffbased recovery principles from contract and tort law, such as the avoidance of loss and mitigation of damages, which prevent the plaintiff from recovering for any harm he reasonably could have prevented. Yet these plaintiff-based principles simply are not as adaptable to restitution with its focus on the defendant as they are to contract and tort law, which look to the plaintiff’s harm.72 Thus, when awarding the disgorgement recovery, courts should emphasize the causal link between the defendant’s gain and the fraud, just as they always have in rescission cases. Further, the plaintiff’s speculation can be dealt with by requiring the plaintiff to bring suit straight after discovery of the fraud.73 If a plaintiff unreasonably delays a demand for rescission, he or she would be regarded as no longer innocent and thus the defendant’s gain traceable to the market change thereafter is no longer unjust. On the other hand, if a plaintiff promptly brings suit for rescission, the risk of any market change until the time of judgement should remain on the defendant, because the plaintiff does not speculate by delaying the suit. Of course, from a practical perspective, if the time of suit is coincidentally selected as the reasonable time, the MacDonald limit may result in little difference; otherwise, the difference would be substantial. Unfortunately the reality appears to be the latter situation. Indeed, as is typically the case in practice, the phrase ‘reasonable time’ is interpreted to mean the time it takes for the market to absorb the information after disclosure, with empirical studies suggesting that this amount of time tends to be rather short.74

70. Thompson, above note 14, 386–391. 71. Some commentator even argued that the MacDonald court ‘apparently endorsed the cover measure’. Wang & Steinberg, above note 21, §4.8.2.5, 241. 72. Thompson, above note 14, 386. 73. Ibid 388. 74. The rationale behind this interpretation is that from the time of information-absorption onwards, the insider could have legally traded and thus any subsequent gains are no longer ill-gotten. See e.g. Jeffry L. Davis, ‘Disgorgement in Insider Trading Cases: A Proposed Rule’ (1994) 22 Securities Regulation Law Journal 283 (arguing that the currently used length of the reasonable time for information absorption is too long, and that courts should look at empirical studies to decide the time). This view focuses on the causality between the defendant’s gain and the fraud, but is purely speculative. Instead, the defendant should have the responsibility of taking the necessary action by actually buying an additional number of shares in the same company if he or she could have legally traded. See e.g., Thompson, above note 14, 389.

268

Chapter 7

It should be noted that Australia even goes further to apply an out-of-pocket style measure to calculate the defendant’s gain in insider trading cases, thereby utterly rejecting any inclusion of windfall-profits made by the defendant in recoveries. Currently in Australia an insider has a maximum potential civil liability of the actual profit made or loss avoided, assessed as the difference between the transaction price and the notional price for which the securities would have been traded if the inside information had been generally available at the time of trading.75 This effectively limits recovery to only the defendant’s gain directly derived from the fraud, excluding the defendant’s gains due to any other sources such as general market change, not to mention the defendant’s personal efforts. As with the out-of-pocket measure, this measure has considerable practical difficulty in determining the notional price if the inside information had been generally available when the insider trading took place. A recent review of insider trading law in Australia has examined this issue. Recognizing that possible complexity or uncertainty could arise under the current rule in determining a notional price, the review nevertheless recommended that the existing measure for assessing the profit made or loss avoided should remain.76 The final review report rejected the formula used in the Canadian legislation, which requires the courts to use an ‘average market price’ formula to assess compensation to each eligible claimant, being: (1) if the claimant is a purchaser – the price paid by the claimant for the security less the average market price of the security in the 20 trading days following general disclosure of the inside information; (2) if the claimant is a vendor – the average market price of the security in the 20 trading days following general disclosure of the inside information less the price received by the claimant for the security. 77 The reason for the rejection is that it ‘would run the risk of the price being influenced by external factors occurring within the 20 trading day period’.78 This is questionable, however. Indeed, it is unclear why external factors should be completely precluded from the defendant’s gain, given that the disgorgement measure is based on an unjust enrichment rationale. As discussed above, the defendant’s gain resulting from external factors occurring within a reasonable time after public dissemination of the information can be properly calculated into recoveries. Therefore, the key problem with the Canadian legislation is not that it allows external factors to affect the measurement of the defendant’s gain. Rather, the Canadian legislation seems problematic because the 20 post-disclosure trading day period is too arbitrary and too rigid to properly account for the full range of cases in practice.

75. Corporations and Markets Advisory Committee (Australia), above note 11, para. 3.18.1. 76. Ibid Recommendation 34. 77. Ibid para. 3.18.2. 78. Ibid para. 3.18.3.

Private Civil Liability for Insider Trading B.

269

ANALYSIS OF THE MEASUREMENT OF RECOVERY

As the preceding discussion shows, there are a number of measures of recovery that a plaintiff may pursue to remedy fraud in securities transactions. This area of law has been said to be quite confusing and in great need of clarification.79 This is largely because the law relating to remedies available under Rule 10–5 has been fashioned piecemeal due to the ‘catch-all’ nature of the rule.80 Indeed, the US courts have followed an ad hoc approach by seeking the most appropriate remedy based on the particular circumstances of the case at hand, without articulating a coherent body of law governing the measure of recovery. Section 28(a) of the Securities Exchange Act of 1934 limits recovery to ‘actual damages’: [N]o person permitted to maintain a suit for damages under the provisions of this chapter shall recover, through satisfaction of judgement in one or more actions, a total amount in excess of his actual damages on account of the act complained of.81 In Affiliated Ute Citizens of Utah v. United States, the US Supreme Court held that this section provides the ‘correct measure of damages’ in securities fraud cases.82 It, however, did not clarify what ‘actual damages’ refers to. As no clear guidance as to the meaning of ‘actual damages’ is found anywhere else, its actual meaning remains unclear.83 In practice, the courts have diverged in their interpretation of ‘actual damages’, which has resulted in various measures of damages. Perhaps even more troublesome is that inconsistent standards govern measures which as a result, overlap each other in terms of practical outcomes. The distinction between measures is sometimes more theoretical than real, with the same case being referred to as the authority of different measures. The measure of recovery in the well-known Janigan v. Taylor case,84 for example, has been described as the benefit-of-the-bargain measure,85 the modified out-of-pocket measure,86 the rescission measure,87 and the windfall profits measure.88 In addition, confusion is compounded by the fact that the same terms are often utilized with radically different meanings.89

79. Thompson, above note 14, 350; Recent Development, above note 13, 798–799. 80. Thompson, above note 22, 1179 (describing the measure of recovery as ‘an afterthought’ in Rule 10b-5 case law). 81. 15 U.S.C. §78bb(a) (emphasis added). 82. Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 155 (1972). In the US, the first case implying a private civil cause of action under Rule 10b-5 is Kardon v. National Gypsum Co., 69 F. Supp. 512 (E.D. Pa. 1946). 83. Wang & Steinberg, above note 21, §4.8.2, 225 (‘neither the [1934 Act] nor the legislative history provides clear guidance as to the meaning of “actual damages’’’). 84. Janigan v. Taylor, 344 F.2d 781 (1st Cir. 1965), cert. denied, 382 U.S. 879 (1965). 85. See e.g., Rochez Bros., Inc. v. Rhoades, 491 F.2d 402, 415 (3d Cir. 1973). 86. See e.g., Myzel v. Fields, 386 F.2d 718, 747 (8th Cir. 1967). 87. See e.g., Gottlieb v. Sandia Am. Corp., 304 F. Supp. 980, 990 (E.D. Pa. 1969). 88. See e.g., Thomas v. Duralite, 524 F.2d 577, 589 (3d Cir. 1975). 89. Thompson, above note 22, 1179. The term of ‘cover measure’ is a good example. see above note 43 and accompanying text.

Chapter 7

270

1.

Shifting of Post-transaction Market Risks

In order to overcome the confusion referred to above, it is necessary to look at the practical differences between those measures. Indeed, the propriety and the scope of the damages a plaintiff can claim vary according to different measures. The measures essentially diverge in the allocation of the post-transaction change in the value of the stock between the plaintiff and the defendant. To understand this point, consider the recovery of a defrauded buyer in a declining market. On the one hand, measures such as the out-of-pocket remedy would only give the plaintiff the amount due to the fraud measured on the date of the transaction. Here, the risk of post-transaction market declines falls on the plaintiff. On the other hand, under those measures which use a post-transaction date, the plaintiff recovers both the price change resulting from the fraud and the change due to the declining market. This effectively shifts to the defendant the risk of change in the market that occur between the transaction and the post-transaction date used for the measurement, while risks of market changes after the measurement date remain on the plaintiff. In this sense, all measures based on a post-transaction date have similar effects of shifting market risks: [P]ractical distinctions among the out-of-pocket rule as modified, the [cover] measure, and the rescissory damages measure . . . often evaporate, so that regardless of the theoretical underpinnings of an award, the court calculate it as the difference between the fair market value of the security upon discovery of the fraud (or the resale price if plaintiff sells prior to this discovery) and the consideration paid or received. In this way, courts compensate plaintiffs for post-transaction declines or appropriation in their manipulated securities.90 Hence, in terms of practical market-risk-shifting effects, the measures of recovery can be loosely classified into two groups: non-market-risk shifting measures such as the strict out-of-pocket measure; and market-risk-shifting measures such as the modified out-of-pocket measure, the cover measure, and rescission. In the latter larger group, the market-risk-shifting effects of different measures may be different in degree, because the post-transaction measurement date can vary depending on particular measures. As discussed before, the modified out-of-pocket measure tends to use the date of public discovery of the fraud, or a date soon after curative disclosure is made. In contrast, under the cover measure, the plaintiffs are required to mitigate losses within a reasonable time after curative disclosure, and a court is likely to select a later date to measure damages because it would take time for plaintiffs to reverse their transactions after curative disclosure.91 Apparently, in the above situation, the later the measurement date, the more the recovery to the plaintiff. It should be noted that the shifting of the risk of post-transaction market changes to the defendant does not necessarily benefit the plaintiff. In cases such as 90. Recent Development, above note 13, 812–813; see also Thompson, above note 22, 1185 (stating that the modified out-of-pocket measure ‘has the same effect as rescission in shifting market risk’). 91. see above §7.III.A.5; Wang & Steinberg, above note 21, §4.8.2.3, 236 (discussing that the cover measure is likely to use a later calculation date than the modified out-of-pocket measure).

Private Civil Liability for Insider Trading

271

the above example where a seller’s fraud occurs in a declining market, the plaintiff buyer is a beneficiary of the shift because he or she can recover the loss due to the decline in the market. If, however, a positive market change comes to pass after the fraud, risk-shifting would permit the positive change in the market to offset the negative change due to the fraud. In this case, the plaintiff would be better off choosing a measure without the risk-shifting effect such as the out-of-pocket measure. Two examples illustrate this point. First, a defrauded investor bought stock for $100 but the stock’s real value was $80 at the time of transaction, and that within a reasonable time thereafter the stock was worth only $60 due to the general market decline. Here, non-risk-shifting measures would award the plaintiff only $20 ($100 minus $80) while risk-shifting measures $40 ($100 minus $60). The second example differs in that instead, the market was rising, and within a reasonable time after the transaction the stock returned to $100. Under non-riskshifting measures, the plaintiff could still recover $20 ($100 minus $80) while risk-shifting measures would award nothing to the plaintiff ($100 minus $100). This dichotomy is also true of a buyer’s fraud, but the respective effects of the rising market and the declining market are precisely opposite to those in the case of a seller’s fraud. More specifically, if a fraudulent buyer acts in a rising market, it is to the advantage of the defrauded seller to apply a risk-shifting measure such as rescission, because he or she can recover the market gain. However, if the buyer’s fraudulent activity is followed by a declining market, rescission would allow the negative change from the market to reduce the buyer’s gain from the fraudulent activity. In contrast, the out-of-market measure, a measure without the risk-shifting effect, would be a better choice for the plaintiff in this example because it covers the entire amount gained by the defendant from the fraud activity. The following two hypotheticals illustrate this point. First, a defrauded investor sells stock for $100 when the actual value is $120, and within a reasonable time thereafter the stock reaches a value of $140 due to the rising market. Non-risk-shifting measures would yield $120 damages ($120 minus $100) while risk-shifting measures $40 ($140 minus $100). The second hypothetical is similar to the first one except that the fraud takes place in a declining market and the stock is still valued at $100 within a reasonable time after the transaction. The damages would still be $20 ($120 minus $100) under a non-risk-shifting measure but zero under a risk-shifting measure ($100 minus $100). Thus, whether the risk-shifting effect is beneficial to the plaintiff depends on both the type of the fraudulent activity (a seller’s fraud or a buyer’s fraud) and the direction the market takes subsequent to the fraudulent transaction. The first hypothetical, namely a seller’s fraud in a falling market, is most commonly discussed in academic literature, and is also most typically found in practice. This will form the basis for further discussion of measures of recovery in this Chapter, unless otherwise indicated. It should be noted that in the US, Section 101(b) of the Private Securities Litigation Reform Act of 199592 added a new section 21D(e) to the Securities 92.

Pub. L. No. 104–67, 109 Stat. 737 (1995).

272

Chapter 7

Exchange Act of 1934.93 It sets a cap on any measure that ‘seeks to establish damages by reference to the market price of a security’.94 The maximum is ‘the difference between the purchase or sale price paid or received . . . and the mean trading price of that security during the 90-day period beginning on the date’ of corrective disclosure.95 According to the Congress’s Conference Report, this provision is based on the concern that due to the market’s panic overreaction to the corrective information, the market price after correction of the fraud will not be representative of the stock’s real value free of fraud.96 The post-disclosure 90-day period is thus intended to allow stock to bounce back from any initial market overreaction. Clearly, this legislation does not have the effect of separating the price change due to the market and the change due to the fraud, even though its stated purpose is to limit damages to ‘losses caused by the fraud and not by other market conditions’.97 Indeed, it actually permits courts to shift onto the defendant the market decline during the period between the transaction and 90 days later after corrective disclosure. However, because it is not a new type of measure, but just a cap, courts still have discretion over excluding the market changes from the measure of recovery. Therefore courts are likely to continue to struggle with the various different measures of recovery already in use before the reform. 2.

The Application of Measures of Recovery and the Open Market Problem

In general, plaintiffs have been permitted to choose between a measure with market-risk-shifting effects and a measure without (e.g., between out-of-pocket damages and rescission) provided that they do so promptly, and of course that the remedies are both available and overlap each other.98 Having selected one, the plaintiff cannot later seek a better return under another measure if the subsequent market changes do not run as expected. This is due to the fact that the plaintiff would reap speculative profits at the defendant’s expense. The election of remedies seems appropriate for the purpose of compensating victims and deterring violators. It means that the plaintiff can always choose 93. 15 U.S.C.A. §78U-4 (West Supp. 1996). 94. This suggests that the US Congress has implicitly recognized measures of damages based on the market price of the security. Wang & Steinberg, above note 21, §4.8.2.3, 237. 95. 15 U.S.C.A. §78U-4(e) (West Supp. 1996). 96. H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess. 42 (1995). 97. H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess. 42 (1995). For a detailed discussion of this point, see Thompson, above note 22, 1193–1199. 98. Estate Counseling Serv., Inc. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 303 F.2d 527, 532 (10th Cir. 1962) (stating that a buyer plaintiff may claim rescission if loss was imminent or to disclaim rescission if profit was apparent; requiring prompt election). Louis Loss, Fundamentals of Securities Regulation (Boston, Little, Brown and Company, 2nd ed., 1983), p. 1133. Of course, in any given case, not all of the measures may be applicable, and if so, there can be no selection of remedies. As discussed earlier, rescission usually applies to situations in which there is a contractual link between the defendant and the plaintiff, and not to transactions on the open market. see above §7.III.A.6.

Private Civil Liability for Insider Trading

273

a favourable remedy, no matter how the overall market changes after the transaction: if the market goes down, the defendant must pay for the market losses; if the market goes up, the defendant must forgo the market gain. This would provide greater compensation to the plaintiff and a greater deterrence to the defendant. Further, in securities cases, this mechanism is justified by the high standard of the defendant’s state of mind. As one commentator stated, Securities law, which requires a reckless or intentional act to defraud, provides a stronger case for this choice [of remedies] than other contexts where defendant liability requires less culpability.99 Thus, no uniform measure exists, nor should there be any attempts to create one.100 Indeed, due to the vast diversity of securities cases, no single measure of recovery can properly account for the broad spectrum of fraudulent activity in connection with securities transactions. To select an appropriate measure of damages in a given situation, one must balance the desire to compensate the plaintiff against the risk of imposing excessive hardship on the defendant. For instance, fraud in the issuance of securities is significantly different from fraud in the aftermarket for the purposes of seeking appropriate remedies.101 In fraudulent issuance of stock, the defendant issuer reaps a gain as a result of the fraud. In contrast, in typical cases involving fraud in the aftermarket, the defendant makes misleading statements to the market but does not trade directly with the plaintiff; the plaintiff’s losses is matched with the gains realized by other investors who lawfully traded with the plaintiff. This suggests that recovery for fraud in the aftermarket should be more modest than that for the fraud in the issuance of securities.102 The US law of remedies in securities cases appears to have taken account of this. Section 11103 and Section 12(a)(1)104 of the Securities Act of 1933, applying to the fraud associated with issuance of registered and exempted securities respectively, have basically adopted the rescission remedy.105 In Rule 10b-5 cases which are mostly found in the aftermarket, the out-of-pocket measure is the traditional measure of damages. As discussed above, if the defendant’s fraudulent sale of stock is followed by a falling market, as is the typical case in practice, rescission 99. Thompson, above note 22, 1183–1184. 100. Comment, above note 26, 1292. 101. Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law (Cambridge, Harvard University Press, 1991), pp. 335–344 (discussing separa. tely the optimal measure of recovery for the fraudulent issuance of stock and for the fraud in the aftermarket). 102. Some commentators even argue that compensatory damages are inappropriate in cases where the misrepresenting defendants do not directly trade in the market. See e.g., Alexander, above note 18, 1502–1504. 103. 15 U.S.C. §77k (1994 & West Supp. 1996). Strictly speaking, the measure of damages under this section is a modified rescission, which is similar to the out-of-pocket measure: plaintiffs can recover the difference between the price paid (up to the original offering price) and the value (or price) when the suit was filed, minus any amount that the defendants prove was not traceable to the fraud. 15 U.S.C. §77k(e) (1994 & West Supp. 1996). 104. 15 U.S.C.A. §77l(a) (West Supp. 1996). 105. Thompson, above note 22, 1186–1189.

Chapter 7

274

would be harsher than the out-of-pocket damages in that rescission throws the subsequent market decline onto the defendant. A far more important point here is that the measures of damages used in faceto-face situations may not be suitable in the open market setting. Courts can achieve the dual goals of compensation and deterrence relatively easily in face-to-face transactions, since the plaintiff’s losses are normally equivalent to the defendant’s gains in direct deals. However, in open market insider trading cases, this balance is often disrupted and thus the goal of reasonable deterrence may collide with the policy of compensating each individual plaintiff fully.106 Indeed, as discussed below, by far the largest problem with the application of any of the conventional measures of damages in the open market situation is the potential for recoveries far out of proportion to either the defendant’s gain or his/her wrongdoing, since to compensate each plaintiff’s loss during the period of nondisclosure could result in staggering sums. In order to resolve this problem, some possible solutions have been set forth to limit recoveries in open market insider trading cases and seek the proper group of plaintiffs. Analysis of these solutions is carried out in the next section. §7.IV.

ELIGIBLE PLAINTIFFS

The task of determining the proper class of plaintiffs that might be allowed to sue an insider trader has been a very difficult one. The difficulty lies in the complexity of causation in the securities market and the identification of the harm caused by insider trading. This is further compounded by policy considerations, namely that there is a clear need to limit recoveries for insider trading in the open market in order to avoid individual injustice and compensatory remedies that are vastly disproportionate to the activity committed by the defendant. This section will discuss three main approaches to the issue of who are eligible group of claimants, and recommend the most appropriate. A.

VARIOUS APPROACHES

1.

The Privity Traders Approach

This approach is based on the requirement of showing privity between the parties. Under this approach, only those persons who have traded with the insider are thought to be victims of insider trading and thus could have standing to bring suit. In other words, the plaintiffs must have been in a direct contractual relationship with the insider. This is the essence of the opinion in the following US case, Fridrich v. Bradford.107 This approach has also been basically adopted in

106. Note, ‘Rule 10b-5 Damages: The Runaway Development of a Common Law Remedy’ (1975) 28 U. Fla. L. Rev. 76, 79. 107. Fridrich v. Bradford, 542 F.2d 307 (6th Cir. 1976).

Private Civil Liability for Insider Trading

275

Australia. Under the current Australia insider trading law, only a counterparty to a person trading when aware of inside information has standing to sue for damages.108 a.

Fridrich v. Bradford

In this case, James Bradford Sr. was the director of Old Line Insurance Company (‘Old Line’), and for this reason served as the principal negotiator for a proposed merger involving Old Line. Before the merger negotiations were publicly announced on 29 June 1972, Bradford and his son purchased shares of Old Line in April 1972. The plaintiffs, including Fridrich and other investors in Old Line stock, had sold their stock in June shortly before the public announcement of the merger plans, and thus had failed to benefit from the subsequent price increase.109 The District Court found the Bradfords liable under Section 10(b) and Rule 10b-5 because of their trading in Old Line stock while in possession of material nonpublic information. More importantly, the District Court held that all purchasers during the period of nondisclosure could seek recovery in accordance with the ‘cover’ measure of damages.110 The Six Circuit reversed the District Court’s judgment and held that privity was required for causation and thus for liability.111 In analyzing causation, the court stressed that the defendants did not purchase the plaintiff’s stock; nor did their actions in any way affect the plaintiffs’ decision to trade.112 Thus, in the court’s view, the defendants’ trading without disclosing may well have been a violation of Rule 10b-5. It did not however cause any compensable harm to the plaintiffs.113 The Sixth Circuit also supported its holding with policy considerations. The court stated that the primary purpose of private actions under Section 10(b) is compensation, and doubted the argument that imposing private civil liability increases the deterrent effect of the securities laws.114 The court’s construction of the causal link required between the defendants’ actions and the plaintiffs’ injury seems to have been driven by its concern over the enormous potential liability for the defendants. The court held that, Where private civil actions under Rule 10b-5 have been employed in essentially face-to-face situations, the potential breadth of the action was usually contained. However, extension of the private remedy to impersonal market cases where plaintiffs have neither dealt with defendants nor been influenced in their trading decisions by any act of the defendants would present

108. Corporations Act 2001 (Australia), ss 1043L(3), (4). 109. Fridrich v. Bradford, 542 F.2d 307, 309–311 (6th Cir. 1976). 110. Ibid 310–311. 111. Ibid 318–319. 112. Ibid 318. 113. Ibid. According to the court, the harm caused by the defendant’s trading is simply that it ‘impairs the integrity of the market’. Ibid. The court concluded that this harm makes the trading illegal and could be addressed by government enforcement. Ibid 322. 114. Ibid 320. The court observed that the Exchange Act provides for non-compensatory sanctions to deter insider trading. Ibid 322.

Chapter 7

276

a situation wholly lacking in the natural limitations on damages present in cases dealing with face-to-face transactions.115 Thus, the court here was concerned that defendants engaged in transactions on an impersonal market would be exposed to liability for damages ‘almost unlimited in their potential scope’, if the privity requirement were abandoned in private suits.116 b.

The Concurring Opinion of Judge Celebrezze

In Fridrich, Judge Celebrezze concurred with the majority, but took a different approach to the private right of action.117 On the one hand, he was opposed to the privity requirement because it is extremely difficult or virtually impossible to identify the party in privity with the insider trader in an open market.118 He argued that this practical difficulty would effectively prevent private rights of action which he saw as a necessary supplement to SEC actions.119 On the other hand, Judge Celebrezze agreed that some restriction of liability is needed in the open-market setting, and also that there must be some causal link between the defendants’ breach 115. Ibid 321 (emphasis added). Some commentators have interpreted this to mean that either causation or privity is necessary for recovery, and that causation and privity are essentially coincidental. See e.g., Robert N. Rapp, ‘Fridrich v. Bradford and the Scope of Insider Trading Liability Under SEC Rule 10b-5: A Commentary’ (1977) 38 Ohio St. L.J. 67, 86 (‘Reintroduction of an element tantamount to traditional common-law privity . . . is clear in Fridrich’.); George W. Dent, Jr., ‘Ancillary Relief in Federal Securities Law: A Study in Federal Remedies’ (1983) 67 Minn. L. Rev. 865, 931 n.299 (‘ . . . apparently demanding proof of some privity or causation . . . ’); Case Note, ‘Securities–Rule 10b-5–Traders with Inside Information on the Impersonal Market Are not Liable to Those Persons Trading After the Insider Has Ceased Trading but Before Public Disclosure’ (1977) 8 Tex. Tech. L. Rev. 742, 745 (1977) (‘This standard required the plaintiff to show that either the insider purchased shares of stock from the plaintiff, or that the insider’s act of trading affected the plaintiff’s decision to sell . . . ’). This opinion has been shared by some US district judges. See O’Connor & Assocs. v. Dean Witter Reynolds. Inc., 559 F. Supp 800, 804 (S.D.N.Y. 1983); Backman v. Polaroid Corp., 540 F. Supp. 667, 672 (D. Mass. 1982). There are different views, however. Some commentators have read this to mean that the court has adopted both privity and causation as de jure requirements for recovery. See e.g., Frankel, ‘Implied Rights of Action’ (1981) 67 Va. L. Rev. 553, 557 n.123 (‘[T]he Six Circuit has refused to dispense with the privity requirement as a prerequisite for insider trading liability’); Comment, ‘Securities Law–Rule 10b-5 Standing–Pledge of Securities in a Loan Transaction Held to Constitute a Sale–Mallis v. Fdic’. (1977) 52 N.Y.U. L. Rev. 651, 657 n.41 (‘privity must be shown’). Some commentators have concluded that causation is both a necessary and sufficient condition. See e.g., Wang & Steinberg, above note 21, 463 (‘if the plaintiff can demonstrate harm caused by the defendant’s conduct, the plaintiff should recover . . . even the party in privity should not recover if he or she cannot demonstrate causation’.); Donald C. Langevoort, ‘Insider Trading and the Fiduciary Principle: A Post-Chiarella Restatement’ (1982) 70 Cal. L. Rev. 1, 36 (‘The Sixth Circuit’s emphasis on causation, however, seems to prove too much. It suggests that in the typical case no one is deceived–even the person actually in privity with the insider’). 116. Fridrich v. Bradford, 542 F.2d 307, 321 (6th Cir. 1976). 117. Ibid 323–327 (Celebrezze, J., concurring). 118. Ibid 324 (6th Cir. 1976) (‘the mechanics of the market place make it virtually impossible to identify the actual investors with whom an insider is trading’). 119. Ibid.

Private Civil Liability for Insider Trading

277

and the plaintiffs’ harm, because otherwise ‘the number of . . . plaintiffs could be astronomical and the possible . . . damages . . . [could] be grossly disproportionate to the volume of the insider trading’.120 In an effort to strike a right balance between the need for private actions and the concern about disproportionate damages, Judge Celebrezze suggested that insider traders should be civilly liable to ‘contemporaneous’ traders.121 His reasoning was that those in privity must be amongst those engaging in the opposite-type transaction ‘contemporaneously’, and thus the class of contemporaneous traders could act as ‘surrogate plaintiffs for those who actually traded with the insiders’.122 Celebrezze recognized that the class of contemporaneous traders may be over-inclusive in the sense that it could include investors who were actually not involved in the insider transactions, but held that ‘to accomplish the deterrent and compensatory purpose of [Rule] 10b-5, it is better to be overinclusive in the definition of plaintiff class than underinclusive’.123 Even though he did not define precisely how long the ‘contemporaneous’ period would be, Celebrezze tended to believe that a period of weeks after the insider trade occurred was definitely too late, and thus concurred with the court’s denial of the plaintiffs’ standing to sue.124 2.

The Contemporaneous Traders Approach

Under this approach, plaintiffs are not confined to the party in contractual privity with the insider trader, but rather include all persons who have traded on the opposite side of the market to the insider at or about the same time as the insider, whether or not their orders were actually matched with those of the insider. The feature of this approach is that it is a response to the practical difficulty of identifying the party in privity with an insider trader, and it serves as a proxy for the privity requirement. In other words, since it is extremely difficult to identify the party in privity, those who might have been in privity could be a sensible group of plaintiffs. a.

Wilson and Subsequent Judicial Development

As discussed above, Judge Celebrezze’s concurring opinion in the US Sixth Circuit decision of Fridrich v. Bradford125 was the first judicial statement supporting the contemporaneous traders approach. Five years later, the Second Circuit adopted substantially the same approach in Wilson v. Comtech Telecomm. Corp.126 There, the plaintiff Wilson had purchased shares about a month after the insider 120. Ibid 323 (Celebrezze, J., concurring). 121. Ibid. 122. Ibid 326, n.11 (emphasis added). 123. Ibid. 124. Ibid 326 (‘they [the plaintiffs] entered the market weeks after Appellants [the defendants] had ceased trading, [and] none of the shares they sold could possibly have been purchased by Appellants’). 125. Ibid 307. 126. Wilson v. Comtech Telecomm. Corp., 648 F.2d 88 (2d Cir. 1981).

278

Chapter 7

traders’ sales but before disclosure of the nonpublic information.127 The court followed Judge Celebrezze in limiting eligible plaintiffs to contemporaneous traders, stating that [a]ny duty of disclosure is owed only to those investors trading contemporaneously with the insider; non-contemporaneous traders do not require the protection of the ‘disclose or abstain’ rule because they do not suffer the disadvantage of trading with someone who has superior access to information.128 Again, this opinion did not specify the meaning of ‘contemporaneous’. Nevertheless, because Wilson had traded a month after the insiders had sold their shares, the court stated that he had not traded contemporaneously.129 The contemporaneous traders approach has been subsequently endorsed by a number of courts in the US.130 As with the privity approach, the judicially developed contemporaneous traders approach is intended to address concern over enormous damages by limiting the scope of plaintiffs, because ‘to extend the period of liability well beyond the time of the insider’s trading . . . could make the insider liable to all the world . . . ’131. However, the case law has not yet satisfactorily solved the issue of when the class of contemporaneous traders opens and closes.132 To date, only a few US courts, mostly District Courts, have addressed the meaning of ‘contemporaneous’.133 In the first judicial opinion endorsing the contemporaneous traders approach, Judge Celebrezze set out in principle the scope of ‘contemporaneous traders’, suggesting that contemporaneous traders would be those who might have been on the other side of the insider trade.134 Further, he tended to believe that the ‘contemporaneous’ period would end soon after the insider trading.135 Thus, Judge Celebrezze provided no precise outline as to the contemporaneous trading requirement. Cases decided since then have added little to the knowledge of what exactly constitutes contemporaneous trading. It is not completely clear whether a person who trades immediately before the insider’s trade has standing to sue. In the US, several district courts have held that those trading before the insider trade cannot be deemed ‘contemporaneous traders’.136 In O’Connor,137 for example, the court dismissed a private action, even

127. Ibid 94–95. 128. Ibid 95 (citing Fridrich v. Bradford, 542 F.2d 307, 326 (6th Cir. 1976) (Celebrezze, J., concurring)). 129. Ibid. 130. See e.g., Neubroner v. Milken, 6 F.3d 666 (9th Cir. 1993); Laventhall v. General Dynamics Corp., 704 F.2d 407 (8th Cir.), cert. denied, 464 U.S. 846 (1983); Colby v. Hologic, Inc., 817 F. Supp. 204 (D. Mass. 1993); Abelson v. Strong, 644 F. Supp. 524 (D. Mass. 1986); Backman v. Polaroid Corp., 540 F. Supp. 667 (D. Mass. 1982). 131. Wilson v. Comtech Telecomm. Corp., 648 F.2d 88, 95 (2d Cir. 1981). 132. Wang & Steinberg, above note 21, 443 (concluding that ‘the meaning of “contemporaneous” remains unclear’). 133. Ibid 443. 134. Fridrich v. Bradford, 542 F.2d 307, 326 (6th Cir. 1976) (Celebrezze, J. concurring). 135. Ibid 324 n.5. 136. See e.g., Alfus v. Pyramid Technology Corp., 745 F. Supp. 1511, 1522 (N.D. Cal. 1990) (‘a plaintiff’s trade must have occurred after the wrongful insider transaction’.). 137. O’Connor & Assocs. v. Dean Witter Reynolds. Inc., 559 F. Supp 800 (S.D.N.Y. 1983).

Private Civil Liability for Insider Trading

279

though the plaintiff had traded just hours before the defendants.138 According to the court, the loss of those who traded prior to the defendants could not possibly be caused by the defendant’s unlawful behavior.139 Many other courts have taken a similar position.140 However, this stance has been questioned by some scholars.141 On the other hand, the concept of when the class of contemporaneous traders closes is even more indeterminate. As discussed above, in Wilson, the Second Circuit held that one month is clearly too long to be within the ‘contemporaneous’ period.142 Not surprisingly, the Ninth Circuit thought that ‘allegation of a three year period of contemporaneous trading is clearly insufficient to establish contemporaneity’.143 As to district courts, it seems that they have been increasingly strict in interpreting the contemporaneous trading requirement. It has been held that trades taking place four months,144 eight trading days,145 seven trading days,146 four trading days147 and even two trading days148 after the insider trade, are not sufficiently contemporaneous. Indeed, a number of recent cases have suggested that the plaintiff’s trading must take place on the same day as the defendant’s.149 There are some cases to the contrary, however.150 138. 139. 140. 141.

142. 143. 144. 145. 146. 147. 148. 149.

150.

151.

Ibid 802. Ibid 803. See e.g., Moskowitz v. Lopp, 128 F.R.D. 624 (E.D. Pa. 1989); In re VeriFone Sec. Litig., 784 F. Supp. 1471 (N.D. Cal. 1992). See e.g, Donald C. Langevoort, Insider Trading: Regulation, Enforcement, and Prevention (West Group) (ed. looseleaf) §9.02[1], p. 10 (‘In practical terms, there is no reason why [a person who trades immediately before the insider’s unlawful trading should not have standing to sue], since the informational disadvantage is the same, and literally, such trading is indeed “contemporaneous”.’). Wilson v. Comtech Telecomm. Corp., 648 F.2d 88, 94–95 (2d Cir. 1981). Neubroner v. Milken, 6 F.3d 666, 670 (9th Cir. 1993). Sanders v. Thrall Car Mfg. Co., 582 F. Supp. 945, 949–950 (S.D.N.Y. 1983). Colby v. Hologic, Inc., 817 F. Supp. 204, 215 (D. Mass. 1993). Kreindler v. Sambo’s Restaurant, Inc., [1981–1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) Para. . 98,312 at 91,960–91,961 (S.D.N.Y. 1981). State Teachers Retirement Board v. Fluor Corp., 589 F. Supp. 1268, 1270–1272 (S.D.N.Y. 1984). Backman v. Polaroid Corp., 540 F. Supp. 667, 669 (D. Mass. 1982). In re Aldus Sec. Litig., [1992–1993 Transfer Binder] Fed. Sec. L. Rep. (CCH) para. . 97,376 at 95,987 (W.D. Wash. 1993); In re Stratus Computer, Inc. Sec. Litig., No. 89–2075-Z, 1992 U.S. Dist. LEXIS 22481 (D. Mass. 1992); In re AST Research Securities Litigation, 887 F. Supp. 231, 234 (C.D. Cal. 1995). Some commentators even hold that ‘the ‘contemporaneous’ period would be quite short, perhaps one hour or even a few minutes after the insider trade’. Wang & Steinberg, above note 21, 442. See e.g., In re Cypress Semiconductor Sec. Litig., 836 F. Supp. 711, 714 (N.D. Ca. 1994) (‘a purchase within five days of an insider sale fulfils the contemporaneous requirement . . . ’); Feldman v. Motorola, Inc., [1993–1994 Transfer Binder] Fed. Sec. L. Rep. (CCH) para. . 98,133 at 98,974 (N.D. Ill. 1994) (‘trades within a four-day period, however, are considered contemporaneous’). Pub. L. No. 100–704, 102 Stat. 4677 (1988) [hereinafter ITSFEA] (codified at 15 U.S.C. §§78c(a), 78o, 78t-1, 78u(a), 78u-1, 78ff(a), 78kk, 80b-4a(1994)). Section 20A(a) provides that: [a]ny person who violates any provision of this chapter or the rules or regulations thereunder by purchasing or selling a security while in possession of material, non-public information shall be liable

Chapter 7

280

b.

Codification of the Contemporaneous Trader Approach

In 1988, the contemporaneous traders approach was adopted by the US Congress in the Insider Trading and Securities Fraud Enforcement Act of 1988 (‘ITSFEA’).151 While creating an express private right of action, the statute did not replace or restrict the implied right of action created by the courts.152 As to the express right of action, the statute deliberately refuses to define the term ‘contemporaneous’, leaving this task to the courts.153 The advantage of this is that it allows the courts to have the flexibility to develop the notion of contemporaneousness according to changing market practices and trading technologies. For example, one court implied that the period of contemporaneous trading in a heavily traded stock would be shorter than in a thinly traded stock.154 In short, while creating an express private right of action for insider trading, ITSFEA sheds no light on the question of who is entitled to the right. Some other jurisdictions such as South Africa have also adopted the contemporaneous trader approach, and the contemporaneous traders are confined to those who traded on the same day as the insider trading, whether before or after the time that the insider traded.155 An important development to do with the contemporaneous traders approach in the ITFEA is that the statute provides a cap on damages. It states that damages in a private right of action would be limited to the amount of profit gained or loss in an action in any court of competent jurisdiction to any person who, contemporaneously with the purchase or sale of securities that is the subject of such violation, has purchased (where such violation is based on a sale of securities) or sold (where such violation is based on a purchase of securities) securities of the same class. 15 U.S.C. §78t-1(a) (1994) (emphasis added). 152. 15 U.S.C. §78t-1 (1994). Section 78t-1(d) provides: Nothing in this section shall be construed to limit or condition the right of any person to bring an action to enforce a requirement of this chapter or the availability of any cause of action implied from a provision of this chapter. Thus, after 1988, investors can still bring suit under the implied right of action. See e.g., Neubroner v. Milken, 6 F.3d 666 (9th Cir. 1993); Alfus v. Pyramid Technology Corp., 745 F. Supp. 1511 (N.D. Cal. 1990). It is less clear, however, whether contemporaneous traders can claim double recovery through both an express action for damages under Section 20A and an implied action for damages under Rule 10b-5. For a discussion of this issue, see Wang & Steinberg, above note 21, 400–412. 153. See Report of the House Committee on Energy and Commerce on the Insider Trading and Securities Fraud Enforcement Act of 1988, H.R. Rep. No. 100–910, 100th Cong., 2d Sess. 27 (9 September 1988) (‘The bill does not define the term “contemporaneous”, which has developed through case law’.). 154. Kreindler v. Sambo’s Restaurant, Inc., [1981–1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) Para. . 98,312 at 91,961 (S.D.N.Y. 1981). 155. Insider Trading Act 1998 (South Africa) s 6(6). Under this provision, plaintiffs include: any persons who dealt in the same securities or financial instruments on the opposite side of the market to the insider on the same day (whether before or after the time) that the insider traded. Ibid.

Private Civil Liability for Insider Trading

281

avoided by the insider who traded.156 As discussed above, in addressing the concern over draconian liability to defendants, the case law primarily uses the contemporaneous trading requirement to limit the scope of plaintiffs without capping damages. Thus, in providing a cap on damages, the ITFEA has given an extra dose of cure to the problem of excessive potential damages. This has led one commentator to argue that by adopting both the contemporaneous trading requirement and the damage cap, the ITFEA may have narrowed the then-prevailing implied private right of action, and have hampered its own purpose of strengthening the enforcement of the insider trading prohibition.157 The combination of the contemporaneous trading requirement and damage caps, however, may be well justified on the following grounds. The rationale of the contemporaneous traders approach may be that the party in privity is the only proper plaintiff, but because that party is not practically identifiable, the class of contemporaneous traders, namely those who might have been in privity, could serve as surrogate plaintiffs.158 Such a compromise would solve the practical difficulty of identifying the party in privity, but at the cost of expanding the class of potential plaintiffs beyond the party in actual privity. In other words, the class of contemporaneous traders may well include some who have not actually traded with the insider and thus are not victims of the insider trade. Thus, because insider traders may still be subject to excessive liability, there is a need to place a cap on damages for which insider traders are liable.159 In this sense, the cap on damages is intended to strike a balance between the expansion of the class of plaintiffs and justice to the defendant. This belief of the purpose of the damage cap is reinforced by the US House Committee Report accompanying the ITSFEA. It specifically pointed out the inapplicability of the damage cap for non-contemporaneous traders:

156. 15 U.S.C. §78t-1(b)(1) (1994). Subsection (b) also reduces potential damages by any amount already disgorged by defendant to the SEC. Ibid. §78t-1(b)(2). 157. Veronica M. Dougherty, ‘A [Dis]semblance of Privity: Criticizing the Contemporaneous Trader Requirement in Insider Trading’ (1999) 24 Delaware Journal of Corporate Law 85, 126–127 (arguing that ‘Congress may have unintentionally restricted the potency of the private action’). 158. Fridrich v. Bradford, 542 F.2d 307, 326 n.11 (6th Cir. 1976) (Celebrezze, J., concurring); In re AST Research Securities Litigation, 887 F. Supp. 231 (C.D. Cal. 1995) (‘the “contemporaneous” concept acts as a proxy for common law privity’); Buban v. O’Brien, No. C94-0331 FMS, 1994 U.S. Dist. LEXIS 8643 (N.D. Cal. 1994) at *7 (‘The requirement of contemporaneousness developed as a proxy for the traditional requirement of contractual privity between plaintiffs and defendants’); Case Note, ‘Laventhall v. General Dynamics Corporation: No Recovery for Plaintiff-Option Holder in a Case of Insider Trading Under Rule 10b-5’ (1984) 79 Nw. U. L. Rev. 780, 806 (‘Shareholders who traded contemporaneously with the defendant had standing because the shareholders had the chance of being in privity . . . ’.); Dougherty, above note 157, 92 (‘Because it was difficult to identify that person [in privity] when trading took place on the open market . . . [t]he contemporaneous trader requirement became a proxy for privity’). 159. Clark, above note 1, 336–37 (‘A case may well arise in which, even given [Judge Celebrezze’s] semblance of privity limitation, an individual defendant will be held liable for damages vastly exceeding his illicit profits’.).

Chapter 7

282

The Committee recognizes that where the plaintiff demonstrates that he was defrauded by the defendant’s insider trading and suffered actual damages proximately caused by the defendant’s behavior, a cap of profit gained or loss avoided by the defendant, which is applicable for actions by contemporaneous traders, is not appropriate.160 Thus, in the circumstances where those individuals harmed by insider trading can be identified with reasonable precision, the damage cap, as a mechanism to avoid draconian liability for defendants under the contemporaneous traders approach, is no longer warranted. 3.

The Nondisclosure-Period Traders Approach

The phrase ‘nondisclosure-period traders approach’ is a term invented by this author. Under this approach, all those who have traded to their disadvantage during the period between the insider trade and dissemination of the inside information are eligible to bring suit. In the US, the leading case endorsing this approach is Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc.161 As discussed below, this approach abandons the privity requirement because it is seen as theoretically inappropriate, not just because it is hard to prove as a practical matter. This is to be contrasted with the contemporaneous traders approach which is by nature a proxy for privity due to the impracticality of proving it in the open-market setting. a.

Shapiro

In this case, the plaintiffs had purchased stock in a company traded on the New York Stock Exchange during the same period that several institutional investors were selling large blocks of shares in the company based on material, nonpublic information.162 In response to the plaintiffs’ demand for damages, the defendants argued that the claim should be dismissed for lack of proof that the plaintiffs had traded with them.163 Put differently, the defence was lack of causation between the plaintiffs’ loss and the insider trade. The Second Circuit disagreed, concluding that causation in fact had been established by the fact that the defendants had traded without disclosing the inside information.164 Clearly, in the court’s view, the defendant’s failure to disclose had caused the harm done to the plaintiffs,165 because had the information then been publicly

160. 161. 162. 163. 164. 165.

See Report of the House Committee on Energy and Commerce on the Insider Trading and Securities Fraud Enforcement Act of 1988, H.R. Rep. No. 100–910, 100th Cong., 2d Sess. 28 (9 September 1988). Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. 1974). Ibid 232–233. Ibid 236. Ibid 238. Ibid.

Private Civil Liability for Insider Trading

283

available, the plaintiffs would have altered their trading conduct.166 The Second Circuit held that the defendants had a duty to disclose the information while trading on it,167 and that the duty is owed: [N]ot only to the purchasers of the actual shares sold by defendants (in the unlikely event they can be identified) but to all persons who during the same period [as in the insider sale] purchased Douglas stock [the security involved] in the open market without knowledge of the material inside information which was in the possession of defendants.168 Thus, the court rejected the defendants’ argument that they owed no duty except to those in privity and caused damage only to those in privity.169 On remand, the district court held that traders ‘during the same period’ meant all those who traded between the insider trade and disclosure of the inside information because they are harmed by the nondisclosure.170 This approach is essentially different from the contemporaneous traders approach. The Shapiro court did not regard privity traders as the only proper plaintiffs, and then, acknowledging the practical difficulty with the privity requirement, extend the private right of action to contemporaneous traders as proxies for those in privity. Rather, it explicitly said the duty of disclosure is owed not only to the privity traders, but also to those who traded in the same period.171 This suggests that in the court’s view, all ‘nondisclosure period’ traders are victims of insider trading and are thus primary, not surrogate, claimants. In short, instead of creating a class of potential plaintiffs who might have traded with the insider, a group with ‘constructive privity’,172 the court squarely rejected the concept of privity and took the non-disclosure-period traders approach to the scope of plaintiffs. The Shapiro decision was later followed in a number of cases, most notably Elkind v. Liggett & Myers, Inc..173 There, a private action was brought against insider tipping.174 The Second Circuit held that the class of plaintiffs opens at the time the tippee trades, not at the time of the tip,175 and does not close until

166. Ibid 240 (‘the Rule 10b-5 causation in fact requirement is satisfied by plaintiff’s allegation that they would not have purchased Douglas stock if they had known of the information withheld by defendants’.). 167. Ibid 238 (‘the fraud is not, as defendants would have this Court rule, the act of trading . . . .The essence of the fraud was the nondisclosure of material information when defendants chose to make their sales’.). 168. Ibid 237 (emphasis added). 169. Ibid 239. 170. Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., [1975–1976 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶95,377, at 98,877–78 (S.D.N.Y. 1975). 171. Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, 237 (2d Cir. 1974). 172. Langevoort, above note 141, §9.02[1], 8. 173. Elkind v. Liggett & Myers, Inc., 635 F.2d 156 (2d Cir. 1980); see also Stromfeld v. Great Atl. & Pac. Tea Co., 496 F. Supp. 1084, 1088 (S.D.N.Y. 1980). 174. Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 161 (2d Cir. 1980). 175. Ibid 169 (‘no injury occurs until the information is used by the tippee’).

Chapter 7

284

disclosure of the information.176 This led one commentator to say that ‘the court apparently endorsed Shapiro’s broad class of plaintiffs’.177 Noteworthy is that in order to avoid exorbitant liability for defendants, the court placed a ceiling on damages awarded to plaintiffs, which might have been the predecessor of that subsequently enacted by the ITSFEA:178 [R]ecovery [is limited] to the amount gained by the tippee as a result of his selling at the earlier date rather than delaying his sale until the parties could trade on an equal informational basis . . . Should the intervening buyers, because of the volume and price of their purchases, claim more than the tippee’s gain, their recovery (limited to that gain) would be shared pro rata.179 b.

The ALI Federal Securities Code

In the Federal Securities Code (‘FSC’),180 the American Law Institute has essentially taken the nondisclosure-period traders approach to the scope of plaintiffs in private actions for insider trading.181 Section 1703 of the FSC sets up the private right of action for insider trading,182 and Section 1703 (b) classifies as eligible claimants any person: who buys or sells during the period beginning at the start of the day when the defendant first unlawfully sells or buys, and ending at the end of the day when all material facts . . . become generally available.183 Thus, this statement is basically equivalent to the view of the District Court in Shapiro, and extends the category of plaintiffs to everyone trading from the time of the insider trade until disclosure of the information.184 176. 177. 178. 179. 180. 181. 182. 183. 184.

Ibid 173. See William K.S. Wang, ‘Trading on Material Nonpublic Information on Impersonal Stock Markets: Who is Harmed, and Who can Sue Whom Under SEC Rule 10b-5?’ (1981) 54 Southern California Law Review 1217, 1275. Langevoort, above note 141, §9.02[2], 13 (suggesting that the Elkind decision was subsequently enacted into the ITSFEA). Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 172 (2d Cir. 1980). Federal Securities Code (ALI 1980) (US). See e.g., Dougherty, above note 157, 118 (‘the Code adopts the designation of the class of potential plaintiffs . . . assumed by the district court in Shapiro’); Wang, above note 177, 1307 (‘This classification is roughly equivalent to the Shapiro or Elkind class of plaintiffs’.). Federal Securities Code (ALI 1980) (US), s 1703. Ibid s 1703(b) (emphasis added). The FSC may include as plaintiffs those who have traded before the defendant, though on the same day, because the class of plaintiffs opens ‘at the start of the day when the defendant first unlawfully sells or buys’. Federal Securities Code (ALI 1980) (US), s 1703(b). As discussed before, many courts in the US have held that private rights of action should not be extended to those who trade before the insider trade. see above §7.IV.A.2.(1). In comparison, the judicial opinion seems more appropriate because in the words of one commentator, ‘[l]ogically, someone cannot be a victim of fraud until the fraudulent behaviour occurs’. See Wang & Steinberg, above note 21, 417.

Private Civil Liability for Insider Trading

285

The drafters of the FSC treated market transactions and non-market transactions differently, and deemed the privity requirement inappropriate for market transactions.185 The rationale for this, however, seems to be essentially different from that behind the contemporaneous traders approach. While the contemporaneous traders approach is basically a response to the practical difficulty of identifying those in privity, the FSC is based on the idea that the privity requirement suffers theoretical problems of the fortuitousness of matching trades in the open-market setting.186 The drafters of the FSC might have felt that since privity is fortuitous in open market transactions, allowing those in privity (even assuming that they can be identified) to recover would give them an undeserved windfall.187 Thus, the FSC soundly rejects ‘any concept of privity of contract’,188 rather than finding a proxy for privity as suggested by the contemporaneous traders approach. Furthermore, the comment following section 1703(b) explains why the FSC extends the time limit to disclosure of the inside information: For under that formula [the same day trading requirement] persons who bought on a day when the defendant sold and who later resold before the facts became generally available would have standing but normally would be unable to show damages . . . , whereas their buyers would be able to show damages if they held until the facts became generally available but would lack standing; and the result might be immunity for the defendant.189 Thus, the FSC clearly rejects the ‘same day’ trading requirement, a restrictive version of the contemporaneous trading requirement.190 According to the above comment, even assuming the party in privity (with contemporaneous traders as the surrogate) is initially harmed by an insider trade, the harm may be transferred to other investors if he or she conducts an offsetting transaction before disclosure of the inside information. As discussed earlier, both the privity requirement and its proxy – the contemporaneous trading requirement – are created in part to address concern over potentially enormous damages. Instead of adopting these approaches in order to limit the scope of plaintiffs, the FSC has adopted a much broader approach, namely the nondisclosure-period trading requirement. Therefore, as with the Elkind court, the FSC also applies a damage limitation in the open-market setting, because otherwise 185. Federal Securities Code (ALI 1980) (US), xlix(10). The FSC requires privity in face-to-face transactions. Ibid s 1702(a). 186. Ibid s 1702(e) cmt. 4(b) (‘[To] insist on . . . privity of contract between plaintiff and defendant . . . [would be] both impractical and nonsensical . . . ’.); Ibid xlix(10) (stating that open market transactions ‘would make the matching of buyers and sellers substantially fortuitous’.) 187. Ibid xlix(10) (stating that the tracing of transactional nexus in an organized market ‘produces an altogether fortuitus result’). 188. Ibid xliv(b) (‘any concept of privity of contract is meaningless’.). 189. Ibid 1703(b) cmt. 2. 190. see above §7.IV.A.2.a (discussing that the concept of ‘contemporaneousness’ serves as a proxy for privity, and some courts has restricted the private right of action to those who trade on the same day as the defendant).

Chapter 7

286

it would ‘subject the defendant to greater total liability with respect to market transactions than with respect to face-to-face transactions’.191 4.

Summary

As discussed above, there have been three main approaches to the scope of eligible plaintiffs in private actions for insider trading. This illustrates the struggle over the theoretical and practical legitimacy of extending private rights of action beyond face-to-face trading to open-market-trading situations. Recognizing both that private enforcement is a necessary and appropriate supplement to governmental enforcement and that those harmed deserve to recover damages,192 the US courts have gradually implied a private right of action for insider trading under Section 10(b). However, this has been faced with some extremely difficult conceptual problems posed by the complexity of causation in the open-market setting and the nature of the harm caused by insider trading. Indeed, the conception of the harm caused by insider trading seems to be pivotal to the scope of eligible plaintiffs in private suits.193 The confusion over this difficult question is reflected in the development of the three approaches. The privity traders approach is apparently based on the belief that those in contractual privity with the insider are harmed and that their losses have been sufficiently linked to the insider’s conduct.194 Under this approach, only those who have actually traded with an insider can bring suit. This should be readily understandable because the US courts initially implied the private action under the common law principle that anyone harmed by unlawful conduct has the right to sue for damages.195 Moreover, a policy consideration of this approach is that absent a privity requirement, a defendant might be subject to enormous damages for insider trading.196 However, due to the practical difficulties of proving privity and the fortuitousness of matching trades in the open-market setting, privity becomes an unwieldy and ineffective standard when trading takes place in open markets such as the securities market. If the strict privity requirement is inappropriate, there is a need to find a new way to set limits on who can bring private actions because otherwise ‘defendants could be held liable to all the world’.197 Both the contemporaneous traders approach

191. Federal Securities Code (ALI 1980) (US), xlix(11). 192. See e.g., Fridrich v. Bradford, 542 F.2d 307, 324 (6th Cir. 1976). Celebrezze also noted that private enforcement served both the compensation and the deterrence functions. Ibid 326. Indeed, the SEC itself has argued that it does not have sufficient resources to be the sole enforcer of the securities laws. See H.R. Rep. No. 100–910, at 14 (1988) (citing testimony at legislative hearing on Insider Trading and Securities Fraud Enforcement Act of 1988 of SEC Chairman David S. Ruder). 193. Clark, above note 1, §8.10, 316 (stating that ‘[The case law developments] illustrate the importance of having one conception or another of the harm by insider trading’). 194. see above §7.IV.A.1. 195. Jacobs, above note 50, §8.02[a]. 196. see above §7.IV.A.1. 197. Fridrich v. Bradford, 542 F.2d 307, 323 n.2 (6th Cir. 1976) (quoting Globus v. Law Research Serv., Inc., 418 F.2d 1276, 1292 (2d Cir. 1969)).

Private Civil Liability for Insider Trading

287

and the nondisclosure-period traders approach set out to address this issue, but take essentially different routes. In response to the practical difficulty of identifying the party in privity, the contemporaneous traders approach extends the private right of action to those who might have been in privity.198 Thus, this approach is based on the concept of constructive privity. It designates privity traders as the sole ‘proper’ plaintiffs, but then grants the private right of action to contemporaneous traders as proxies for those in privity because of the impracticalities of proving privity. As a result, even though it is far from settled, the notion of ‘contemporaneousness’ has been narrowly interpreted to exclude those who could not possibly have traded with the insider, with suggestions that for widely traded securities, standing might well be limited to those who traded within a day of the insider trade. In contrast, the nondisclosure-period traders approach does not extend the group of plaintiffs beyond those actually in privity merely because privity is hard to prove in practice. Under this approach, in the marketplace the duty of disclosure is not confined to those in privity with the insider, but is owed to all investors trading from the time the insider trade took place until disclosure of the information.199 Thus, all investors trading during the nondisclosure period, as opposed to only those in privity, are considered victims of insider trading and thus, as proper plaintiffs. In this sense, the nondisclosure-period traders approach departs sharply from the privity requirement. Although the contemporaneous traders approach and the nondisclosure-period traders approach are essentially different, it is easy to get them confused for the reasons set out below. For one thing, they look similar in appearance to the extent that they both set forth a time range for eligibility to sue for damages. This may give rise to a mistaken belief that the two approaches are different in degree, not in kind. Indeed, the nondisclosure-period traders approach has been described as ‘another, and even broader, contemporaneous dealing test’.200 Secondly and more importantly, in the US where the two approaches have developed, there is little explicit guidance as to what rationales they are based upon, what purposes they are meant to serve, and how they are to be applied.201 This lack of clarity over the distinction between the two approaches is illustrated by the following two examples. Firstly, as discussed above, in Elkind where the Second Circuit applied the nondisclosure-period traders approach, it adopted a ceiling on damages. This ceiling, however, has been readily transplanted into the contemporaneous traders approach by the ITSFEA, and applies to any implied cause of action by contemporaneous traders that may coexist with the express right of action created by the ITSFEA.202 198. see above §7.IV.A.2. 199. see above §7.IV.A.3. 200. Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Discussion Paper (June 2001)’ para. 3.40. 201. See e.g., Dougherty, above note 157, 95; Wang & Steinberg, above note 21, 442–443 (stating that the rationale behind the concurrence of Judge Celebrezze in Fridrich was not mentioned in Wilson, a pivotal decision for the establishment of the contemporaneous trader approach). 202. Wang & Steinberg, above note 21, 247–48.

288

Chapter 7

The other example is that the O’Connor case was cited in the legislative history of the ITSFEA for a definition of the contemporaneous trading requirement, but the case actually followed the nondisclosure-period traders approach.203 Indeed, O’Connor is famous for its role in setting up the rule that the class of contemporaneous traders does not open until the insider trades.204 However, O’Connor is clearly a proponent of the nondisclosure-period traders approach. In this case, the court specifically rejected the defendants’ argument that privity was required generally in a private action for damages, holding that ‘the liability of one who trades on inside information may extend to all those who trade between the date of the defendant’s sales and the date of public disclosure of the inside information’.205 Further, it explicitly stated that the difficulty of proving privity was not the primary reason to abandon the privity requirement, and that even if defendants could name those with whom they had actually traded, the action would still not be confined to those in privity.206 However, the above discussion does not mean that since Elkind and O’Connor essentially adopt the nondisclosure-period traders approach, any part of their decisions would be incompatible with, and thus can not be implanted into the contemporaneous traders approach. Rather, the point is that the contemporaneous traders and nondisclosure-period traders approaches are often confused, making it very difficult to assess their respective merits and demerits. In short, the difference between the two approaches is one of kind, not just of degree; without acknowledging this, the goal of seeking a proper class of plaintiffs would be diminished. B.

CAUSATION: INDIVIDUAL INVESTORS HARMED BY INSIDER TRADING

Insider trading is a form of securities fraud. The private right of action for insider trading rests on the definition of a violation that, while resembling certain common law concepts, differs in fundamental ways from common law approaches to compensation and deterrence.207 Indeed, although the antifraud prohibitions in Section 10(b) and Rule 10b-5 are not totally coextensive with common law doctrines of fraud,208 the US courts have traditionally looked to those common law causes of action for references.209 Securities fraud cases, including those involving 203. H.R. Rep. No. 100–910, at 27 n.22 (1988)(citing to Shapiro, Wilson and O’Connor). 204. see above §7.IV.A.2.a. 205. O’Connor & Assocs. v. Dean Witter Reynolds. Inc., 559 F. Supp 800, 803 (S.D.N.Y. 1983) (citing Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., [1975–76 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 95,377, at 98,878 (S.D.N.Y. Dec. 5, 1975)). 206. Ibid 805. 207. See e.g., Alexander, above note 18, 1488 (‘Securities class action litigation today has little in common with suits over the common law tors of fraud and misrepresentation . . . ’.). 208. See e.g. Meyers v. Moody, 693 F.2d 1196, 1214 (5th Cir. 1982) (‘the common law of fraud is generally more stringent in its requirements than the elements of Rule 10b-5 . . . ’). 209. Basic Inc. v. Levinson, 485 U.S. 224, 253 (1988) (White, J., concurring in part and dissenting in part) (‘In general, the case law developed in this Court with respect to §10(b) and Rule

Private Civil Liability for Insider Trading

289

insider trading, have adhered to the fundamental tort principle that in order to claim private remedies, plaintiffs must have been harmed by the defendant’s unlawful conduct which gives rise to the cause of action.210 Hence, courts have adopted various tort principles, such as reliance, causation and standing, in an attempt to grant private rights of action for insider trading. The struggle during this process has led to the development of the three approaches to the class of plaintiffs. In this regard, the nature of the harm caused by insider trading is the basic source of contention and confusion. As discussed in Chapter 4, insider trading may generally do harm to the market in the sense that it would undermine investor confidence and make investors less likely to enter the market. This can in turn decrease the volume and liquidity of the market, and ultimately, the ability of companies to raise capital for productive activities. However, at best, this may only justify governmental enforcement against insider trading; for the purposes of private actions, it is still necessary to answer the question of who precisely is harmed by a specific insider trade.211 As Professor Langevoort insightfully pointed out, In the context of an SEC enforcement action or a criminal proceeding brought by the Justice Department, it is rarely necessary to identify with any precision the persons actually defrauded by the defendant’s conduct; the existence of some person to whom a duty of disclosure was owed and breached can generally be presumed, and questions about whether the person has standing to sue or not are irrelevant with respect to the government’s case . . . A private action, by contrast, must answer the question of to whom the insider’s duty of disclosure was owed, for only those persons can claim that they were the victims of a fraud.212 Thus, the following section will deal with the difficult task of identifying those individual investors specifically harmed by insider trading. 1.

Insider Trading: Victimless Fraud?

It has been argued that the people commonly perceived as the victims of insider trading – those so-called losing traders who are on the other side of an insider trade – suffer no harm from the practice because they would have traded in any event.213 10b-5 has been based on doctrines with which we, as judges, are familiar: common-law doctrines of fraud and deceit’); Blue Chip Stamp v. Manor Drug Store, 421 U.S. 723, 744 (1975) (‘In considering the policy underlying [the purchaser/seller standing requirements for actions under Rule 10b-5], it is not inappropriate to advert briefly to the tort of misrepresentation and deceit, to which a claim under Rule 10b-5 certainly has some relationship’). 210. See Clark, above note 1, §8.10. 211. In fact, the issue of who is harmed by insider trading is of significance not only to private actions for insider trading, but more broadly, to the basic question of whether insider trading should be regulated. If no one is harmed by insider trading, then the argument that insider trading would undermine investor confidence cannot get off the ground. For discussion of the arguments for and against the regulation of insider trading, see Chapter 4. 212. Langevoort, above note 141, §9.01, 2 (emphasis in original).

Chapter 7

290

In other words, those losing traders’ losses are not caused by insiders, but rather simply the result of their own independent investment decisions. The argument even goes further to say that insider trading activity can in fact benefit losing traders to the extent that it may lead the stock price to move in the direction implied by the undisclosed information, making the price less disadvantageous to the losing traders.214 The following example illustrates this point. Suppose that a particular uninformed investor is considering purchasing an existing issue of securities, and is willing to pay the market price of $10 per share. While the investor effectuates the purchase at the market price, an insider in possession of negative material, nonpublic information, sells that issue to avoid a loss. After disclosure of the information, the share price slumps to $6. Even though the uninformed investor losses four dollar per share and the insider gains the same amount, the investor’s loss was not caused by the insider’s trade, because the investor would have traded and suffered the same loss had there been no insider trade. On the contrary, the insider’s sale may have caused the stock price to fall to some degree, and consequently the outside investor may have incurred a smaller loss than would be the case if the insider had not been in the market. Thus, the outsider investor’s loss does not result from the insider’s trade. This argument has serious flaws, however. Firstly, it seems to be an over-simplification that all outsiders’ investment decisions are truly independent of insider trading activity. Secondly and more importantly, this argument focuses on the trading aspect of insider trading, rather than the nondisclosure which is the very basis for the fraud nature of insider trading. These two points will be discussed in detail below. 2.

Victims of Insider Trading

The above argument that insider trading is a victimless fraud is based on the idea that outsiders make their transaction decision independently of the insider trade. This, however, proves too much. According to Professor Wang’s ‘Law of Conservation of Securities’, the securities sold by insiders would be held by outsiders.215 Therefore, the insiders pass on to some outsider investors the losses of the subsequent price fall as a result of the announcement of the bad news. In this sense, some of the shares that changed hands in trades with insiders would not have been traded and held by outsiders but for the insider trade.

213.

See e.g., Henry G. Manne, Insider Trading and the Stock Market (New York, the Free Press, 1966), pp. 99–103; Jonathan R. Macey, ‘Insider Trading: Economics, Politics, and Policy’ (The AEI Press, 1991), pp. 24–25; Saul Levmore, ‘Securities and Secrets: Insider Trading and the Law of Contracts’ (1982) 68 Va. L. Rev. 117, 125; Michael P. Dooley, ‘Enforcement of Insider Trading Restrictions’ (1980) 66 Va. L. Rev. 1, 33. This view has been shared by some courts. See e.g., Fridrich v. Bradford, 542 F.2d 307 (6th Cir. 1976). 214. For discussion of the role of insider trading as a means of information dissemination, see above §4.II.A.2. 215. Wang, above note 177, 1234–1235.

Private Civil Liability for Insider Trading

291

By carefully considering the actual dynamics of trading mechanisms in impersonal securities markets, Professor Wang significantly refines the analysis of who is harmed by an insider trade, concluding that the persons injured by insider trading activity are either induced traders or preempted traders.216 First, the so-called induced traders are those induced to make disadvantageous trades. These traders would not have traded in the absence of the insider trade. Second, the group of preempted traders includes those whose trades are preempted by the insider trade. They would have made advantageous trades had the insider not been in the market. To illustrate this point, suppose that, at a given point of time, the price of a particular stock is $10 per share, and that after an insider’s sale based on nonpublic bad news, the price might have fallen slightly to $9.95.217 Assume that Mr A was interested in purchasing some shares at a price less than $10. The reduced price may have induced him to buy the shares. As an induced purchaser, Mr A may be the victim of the insider’s sale. Alternatively, assume that Mr B owned some shares and was considering selling them at a price no less than $10. He may still hold the shares at the time of the public announcement of the bad news. As a preempted seller, Mr B may also be the victim of the insider’s sale. Moreover, there is arguably another class of victims, namely so-called ‘same type’ traders. These traders engage in the same type of trade as the insider and are harmed by the insider trade, because they obtain a less favorable price than if the insider was not in the market.218 In the above example, this group includes those outsiders who sold at $9.95, since without the insider trade they would have received $10 per share. However, this type of harm has elicited little sympathy.219 Indeed, along with the insider, they are fortuitously avoiding a loss, and the price change induced by the insider trade just reduces the amount of their undeserved windfalls. In addition, compensation for the harm requires a measurement of the extent to which the insider trading activity actually affected the price, which is 216.

Ibid 1230–41. See also William K.S. Wang, ‘Stock Market Insider Trading: Victims, Violators and Remedies– Including an Analogy to Fraud in the Sale of a Used Car with a Generic Defect’ (2000) 45 Villanova Law Review 27, 28–40; Wang & Steinberg, above note 21, §3.3. 217. In Professor Wang’s analysis, the pricing function of the market is primarily performed by intermediaries such as specialists and market-makers. See Wang & Steinberg, above note 21, §3.3.6 (discussing that an insider trade may directly or indirectly affect an intermediary’s inventory, and this in turn may precipitate a different pattern of price quotations to rebalance the inventory). Further, the effect of an insider’s trade may be magnified by trend-riding speculators. See Ronald J. Gilson and Reinier Kraakman, ‘The Mechanisms of Market Efficiency’ (1984) 70 Va. L. Rev. 549, 569–579 (explaining that the mechanisms of market efficiency include a group of sophisticated traders skilled in evaluating new information, including news about trading activity by others (especially insiders); such reactive trading by those ‘decoding traders’ accelerates the price movements caused by insider trading); Roy A. Schotland, ‘Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market’ (1967) 53 Va. L. Rev. 1425, 1453 (stating that insider trading is likely to help the tape-watching speculators by giving them data to guide speculation). 218. Wang & Steinberg, above note 21, §3.3.6, 69. 219. Ibid §3.3.6, at 71 (stating that ‘same-type’ trading victims are relatively unsympathetic figures).

292

Chapter 7

nearly impossible to determine.220 Thus, compensation for their reduced winnings is neither possible nor desirable. In sum, an insider trade could induce opposite type transactions that otherwise would not have occurred, or preempt trades of the same type that otherwise would have occurred. A possible objection to these two types of victims may be however that they are undeserving, rent-seeking speculators as opposed to long-term investors. For example, Professor Manne divides outsider investors into two categories: time-function traders and price-function traders.221 Time-function traders normally base the timing of their transactions exclusively on their pattern of savings and consumption over their life cycle, with little regard to the price movements in the market.222 Thus, time-function traders are not harmed by insider trading, because they would have traded anyway. In contrast, price-function traders make their investment decision on the basis of price signals by which they believe misvalued securities could be identified.223 They are victims of insider trading since they might have been misled by the price movements caused by the insider trade into perceiving that the security is misvalued. Conceptually, in comparison with time-function traders, price-function traders may tend to be essentially speculative. In real life, however, any trader’s investment decision is at all sensitive to price, and thus he or she is at the critical time a pricefunction trader.224 If that trader’s reservation price is close enough to the market price, such as in the cases of Mr A and Mr B as discussed above, whether his or her decision to trade would be put into action may critically depend on the price change caused by the insider trade. Indeed, the notion of purely price-insensitive traders seems to be an illusion and a market consisting entirely of such investors would not be an efficient market.225 Therefore, both induced traders and preempted traders can rightly claim that they are harmed by the insiders’ trades and thus deserve damages. Although induced traders and preempted traders are in theory sound victims of insider trading, identifying them requires subjective motivational analysis not only of all actual traders, but even of potential traders – clearly an extremely difficult or even impossible task.226 In order to trace marginal induced or marginal 220. Any losses suffered by the ‘same-type’ traders are caused by changes in market price resulting from the insider trading activity. There may often be no measurable change, and in any event the loss bears no relationship to the amount of the insider’s unlawful profit. 221. Manne, above note 213, 95–96. 222. Ibid. 223. Ibid. 224. Ian B. Lee, ‘Fairness and insider trading’ (2002) 2002 Columbia Business Law Review 119, 164. 225. See Gilson and Kraakman, above note 217, 569–579 (stating that the mechanisms of market efficiency require some price-sensitive speculators). 226. In unusual situations, one might be able to trace the transaction chain and identify the victim of an insider trade. The first type of such situations is the cases of huge block trading by institutions. See Louis Loss and Joel Seligman, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991), vol. V, pp. 2573–2577; Wang & Steinberg, above note 21, §3.3.7, 75. In addition, when the stock at issue is very thinly traded, transactions may be so isolated that one could argue persuasively that, he or she would not have traded absent the insider trade.

Private Civil Liability for Insider Trading

293

preempted traders, one must determine the extent to which the insider trade would have affected prices, and then assess how the investing public would have reacted to these price changes. In practice, these pieces of information are unknowable.227 Furthermore, the task may be compounded by the fact that, in many cases, an outsider trader’s investment decision might not have been a matter of all or nothing. The price impact of the insider trade may have increased incrementally the number of shares which the outsider was willing to buy or sell rather than simply inducing a transaction that otherwise would not have occurred at all, or preempting a transaction that otherwise would have taken place.228 In short, as a practical matter, the victims of an insider trade are unidentifiable. The above analysis is based on the idea that harm in insider trading is caused by the trading act of insider trading. In fact, as a type of securities fraud, the wrongness of insider trading is derived not only from the trading activity, but also from the accompanying nondisclosure of material nonpublic information. For example, suppose that Mr C is an insider while Mr D is an outsider, and that both of them sell the same amount of shares at the same time. As discussed above, the sale of Mr C might have induced someone to purchase or preempted someone’s sale or both. In terms of the price impact on the market, this is also true of the sale of Mr D. However, as a matter of law, we would treat Mr C and Mr D in totally different ways: Mr C is thought to have unlawfully harmed someone (induced traders or preempted traders) while Mr D has done nothing wrong – although his sale has generated exactly the same inducing or preempting effects as Mr C’s sale, it is perfectly lawful. The question is, why is there such a huge difference? Obviously, the difference is justified by the crucial fact that Mr C withheld the inside information when he was trading. Indeed, the losses suffered at the hands of Mr C are essentially different from those suffered at the hands of Mr D in that Mr C has exploited an unfair informational advantage and presented additional or abnormal investment risks to the market. Thus, the violation of insider trading is not simply ‘trading’, but rather ‘trading without disclosing’. This is consistent with the ‘disclosure or abstain’ rule: when an insider has material nonpublic information, the insider must either disclose such information before trading or abstain from trading until the information has been disclosed.229 Here, insiders have no affirmative duty to disclose per se, but if they choose to trade, the duty of disclosure would arise.230 In other words, trading on the basis of the inside information would trigger the duty to disclose. Causation, then, depends not just on whether a plaintiff would have traded in the absence of the insiders’ trade, but rather on whether a plaintiff would have 227.

Wang & Steinberg, above note 21, §3.3.7, 73–78 (discussing the practical difficulty of identifying the victims of stock market insider trade). 228. Lee, above note 224, 164–165, n. 118. 229. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d Cir. 1968). For an extensive analysis of the development of the rule, see above §5.III.B. 230. Alternatively, insiders could choose to abstain from trading and therefore would have no duty to disclose. In practice, this is often the only feasible option because most inside information needs to be kept secret for legitimate corporate purposes. see above §5.III.B.

294

Chapter 7

traded had the insiders disclosed the information. Clearly, the argument could be made that if the insiders had disclosed the information, the plaintiff would not have traded or at least not on the same terms.231 In this sense, the insiders’ illegal action (trading without disclosing) does have caused the transaction that resulted in harm to the plaintiff. Put differently, under this view, if the defendant has a duty to speak, the plaintiff can connect his trading loss to defendant’s breach by alleging that the plaintiff would not have traded at the price if he or she had possessed relevant information. However, what is less clear is to whom the duty of disclosure is owed.232 To date, the US courts have indicated that the duty to disclose could be owed to the party in privity with the insider, or all the uninformed investors trading during the same period. In his concurrence in Fridrich, Judge Celebrezze construes the ‘disclose or abstain’ rule to mean that the duty of disclose is owed only to those in privity with insiders.233 This belief is essentially derived from situations involving face-to-face trading. Indeed, if the insider could in advance identify and disclose to the potential party in privity in an open market, the latter either would have traded at a different price or not at all. This effect would eliminate the insider’s unfair informational advantage. However, this does not always happen in reality. Thus, Judge Celebrezze agreed with the majority that privity is an appropriate requirement, but would have granted a private right of action to proxies for those in privity because of the impracticalities of proving privity.234 In other words, he conceptually limited the duty of disclosure to those who had actually traded with the insider, but due to the practical difficulty of proving privity, extended the private right of action to contemporaneous traders who might have been in privity with the insider. By contrast, in Shapiro, the Second Circuit did not regard privity traders as the sole beneficiaries of the ‘disclose or abstain’ rule, but rather explicitly held that

231. See e.g., Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, 240 (2d Cir. 1974) (‘the Rule 10b-5 causation in fact requirement is satisfied by plaintiffs’ allegation that they would not have purchased Douglas stock if they had known of the information withheld by defendants’.); but see Thompson, above note 14, 393 (arguing that this nondisclosure based causation ‘will require reasoning that may substantially distort tort damages principles’). 232. According to Professor Wang, the duty to disclose could be owed to four classes of people: the party in privity with the insider trader; the individual to whom the party in privity transmits the harm, if the party in privity reinstates her original position by repurchasing or reselling; the victims of the insider trade itself; or the entire world. However, in each of these circumstances, there are theoretical problems and practical difficulties. See Wang, above note 177, 1248–1255; Wang & Steinberg, above note 21, §3.4. 233. Fridrich v. Bradford, 542 F.2d 307, 326 (6th Cir. 1976) (Celebrezze, J., concurring) (‘a duty to disclose is imposed to protect the anonymous investors trading with the insider’). It is argued that this view has been upheld by the US Supreme Court in Chiarella v. United States, 445 U.S. 222 (1980). See Wang, above note 177, 1270–71 (‘[Justice] Powell’s opinion strongly suggests that, in stock market inside[r] trades as well as face to face transactions, the duty to disclose is owed only to the party in privity with the inside[r] trader’). 234. Fridrich v. Bradford, 542 F.2d 307, 324–326 (6th Cir. 1976).

Private Civil Liability for Insider Trading

295

the duty of disclosure extends to those same period traders.235 The reason behind this is that limiting the duty to those in privity would effectively confine the function of the ‘disclose or abstain’ rule to non-market traders.236 Indeed, in face-to-face transactions, insiders could fulfill the duty by disclosing to their trading counterpart before trading.237 In the open market where insiders do not generally know who they are trading with, it is not feasible to require insiders to disclose only to their trading partner.238 Thus, the duty of disclosure must apply to all investors who would have altered their investment decision if the information had been disclosed.239 C.

A PROPOSAL FOR CHINA: ELIGIBILITY TO BRING FORWARD A PRIVATE ACTION

As discussed above, there are three different approaches to the question of who should be allowed to bring a private action against insider trading. Based on the previous examination of the harm caused by insider trading, this section will look at the relative merits of each of these tests and make a recommendation as to which one is most appropriate. 1.

Problems with the Privity Approach

This approach is based on the idea that the privity requirement is necessary because only those in privity are harmed by the insider’s trading.240 This is what the courts have attempted to do since they first implied the private action under tort principles.241 Indeed, the main advantage of this approach is that conceptually,

235. The court stated that: We hold that defendants owed a duty –for the breach of which they may be held laible in this private action for damages – not only to the purchasers of the actual shares sold by defendants (in the unlikely event they can be identified) but to all persons who during the same period purchased . . . stock in the open market without knowledge of the material inside information which was in the possession of defendants. Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, 237 (2d Cir. 1974) (emphasis added). 236. Ibid 236–237. 237. Ibid. Interestingly, one dilemma here is that disclosing inside information to one’s trading partner might itself be grounds for tipping liability. See Wang & Steinberg, above note 21, §3.4.3.1, 90–92. 238. Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, 236–237 (2d Cir. 1974). 239. Ibid. 240. see above §7.IV.A.1. 241. Dougherty, above note 157, 89.

296

Chapter 7

it is easy to understand, given people’s conventional legal knowledge of torts. Nevertheless, this approach has both serious theoretical and practical problems. First, the notion that the party in privity is the only proper plaintiff has been carried over from face-to-face trading situations, but makes little sense in the context of anonymous trading on the open market. The counterparty in a face-to-face transaction may be readily identifiable, but there are insurmountable practical difficulties in proving privity in the open-market setting. One commentary points out that: In the case of sales and purchases on-market, proof of contractual privity will almost always be difficult and will sometimes be impossible. There are several difficulties. One is that on some occasions a broker acting as principal (note merely as deemed principal) will stand between the plaintiff and the contravening defendant. Another is that the process of allocation of on-market transactions to clients is normally carried out in the back offices of the buying and selling brokers, who appear to have a discretion to set policies for the process of allocation . . . Further, the allocation may be carried out on a net basis, at least where institutional clients are involved. The result may be that, particularly where there has been active trading, the plaintiff will be unable to demonstrate contractual privity with the defendant even if all of the labyrinthine facts are before the court.242 Second, the view on the harm caused by insider trading under this approach has been challenged from a theoretical standpoint. As previously discussed, the persons injured by insider trading activity are either induced traders, preempted traders, or both.243 Thus, those in privity are not necessarily the ones harmed. More specifically, to permit those in privity (in the unlikely event they can be identified) to sue would not necessarily allow compensation to induced traders, since induced traders might have traded with other investors rather than the insider.244 It would, at the same time, fail to provide remedies to preempted traders even though they are also victims of the insider’s trade.245

242. H. A. J Ford, et al., Ford’s Principles of Corporations Law (loose leaf, Butterworths) at [9.690]; see also William H. Painter, ‘Inside Information: Growing Pains for the Development of Federal Corporation Law Under Rule 10b-5’ (1965) 65 Colum. L. Rev. 1361, 1372 (discussing that it is extremely difficulty or even virtually impossible for plaintiffs to prove privity); Wang, above note 177, 1284 (‘the major practical problem with the Fridrich approach is the impossibility of identifying the victims of the trade’). 243. see above §7.IV.B.2. 244. Those in privity with insiders are not necessarily those induced traders and thus not necessarily harmed by the insiders’ trades. For example, insiders may have traded with a market-maker who in turn might have traded with induced traders. For an excellent discussion of this issue, see Wang & Steinberg, above note 21, §§3.3.3–3.3.4. 245. As a matter of law, even if they can be identified, pre-empted traders are not allowed to sue for damages because of the ‘purchaser/seller’ requirement established by Blue Chip Stamp v. Manor Drug Store, 421 U.S. 723 (1975) (holding that a private plaintiff in a Section 10(b) and/or Rule 10b-5 suit for damages must be an actual purchaser or seller of securities).

Private Civil Liability for Insider Trading

297

Third, the fortuitousness of matching trades in the open-market setting may make it nonsensical to confine plaintiffs to those persons who have been in privity with the insider by chance. It would be a random matter whether a particular trader is matched with the insider or some other person in an open-market transaction. This has led some commentators to say that: If liability is limited to those who can trace their transactions to the insider, the plaintiffs who recover will be receiving a windfall due to the accident that their transactions could be traced to insiders.246 Indeed, the act of privity trading does not mean that this innocent investor’s loss is in any way different from that of a non-privity investor who traded during the fraudulent period. Consequently, any attempt to limit recovery in open-market insider trading cases by confining the plaintiff class to privity traders will necessarily entail a certain degree of fortuity and inequity. This appears to be the ultimate flaw in the privity approach. For these reasons, the privity traders approach is an inappropriate standard for eligibility to sue for insider trading in the open-market setting. As discussed above, Australia currently adopts this approach, but the privity requirement has been thought to be largely responsible for the inefficacy of the insider trading civil liability regime in Australia.247 As a matter of fact, there has only been a very small number of Australian civil insider trading cases, since obtaining civil remedies for insider trading can be ‘an extremely frustrating experience’ in Australia.248 Moreover, most of the recent Australian private insider trading civil litigation has arisen in the context of a commercial dispute, rather than a claim for compensation.249 For instance, in Crafter v. Singh,250 the defendant sought to avoid a contract to purchase shares on the ground that the counterparty had engaged in insider trading. In Exicom Limited v. Futuris Limited,251 a person sought to use an alleged breach of the insider trading provisions to restrain a second person from proceeding with an agreement to make a share placement to a third person in the context of a battle for corporate control of the second person. In Ampolex Ltd v. Perpetual Trustee Company (Canberra) Ltd,252 the allegation of insider trading arose in the context

246. David S. Ruder and Neil S. Cross, ‘Limitations on Civil Liability Under 10b-5’ (1972) 1972 Duke L. J. 1125, 1132; see also Wang & Steinberg, above note 21, §6.6, 463 (‘in many open market transactions, privity is fortuitous; allowing the party in privity to recover could give him or her an undeserved windfall’); Paul L. Davies, Gower’s Principles of Modern Company Law (Sweet & Maxwell Ltd, 6th ed., 1997), p. 457 (‘to give a civil remedy to the person who happened to end up with the insider’s shares and not to the others who dealt in the market at the same time in the security in question would be arbitrary . . . ’). 247. See e.g., Charles Zhen Qu, ‘The Efficacy of Insider Trading Civil Liability Regime in the Corporations Act’ (2002) 14 Australian Journal of Corporate Law 161, 174. 248. Ibid 161. 249. Corporations and Markets Advisory Committee (Australia), above note 200, para. 3.25, n. 310. 250. (1990) 2 ACSR 1. 251. (1995) 18 ACSR 404. 252. (1996) 20 ACSR 649.

298

Chapter 7

of a wider dispute regarding the conversion rate to be applied to certain convertible securities. This situation has been subject to a recent review of insider trading law in Australia, and the final review report recommends abandoning the rigid privity requirement, stating that ‘the legislation should enable a court to extend the range of civil claimants who have traded in the market beyond the insider’s immediate market counterparty, using the concept of “aggrieved persons’’’.253 It is worth noting that although the final report disfavors the privity approach, it does not put forward an alternative one. Rather, it simply suggests leaving the issue to be developed under case law, stating that ‘the court can determine when it is appropriate to extend the range of eligible civil claimants beyond the immediate market counterparty of an insider who is trading in an anonymous market’.254 Indeed, while discarding the privity approach, the final report refuses to recommend the contemporaneous traders approach on the grounds that ‘to amend the legislation to include specific categories of ‘contemporaneous traders’ may unduly complicate the law and may still result in artificial or anomalous outcomes in some instances’.255 It would seem that, the failure of the final report to deliver a clear opinion about the scope of plaintiffs may undesirably put the issue into an uncertain state and thus frustrate efforts to improve the efficacy of the insider trading civil liability regime. 2.

Problems with the Contemporaneous Traders Approach

As a solution to the practical difficulty of identifying the party in privity in open-market insider trading, the contemporaneous traders approach creates a class of plaintiffs who might have traded with the insider, a group with ‘constructive privity’.256 This approach may also overcome the problem of random matching of buy and sell orders on an anonymous market. However, this approach has a number of problems which are discussed below. To begin with, this approach is still based on the erroneous assumption that only the party in privity is the proper plaintiff and then, grants a right of action to proxies in recognition of practical difficulties. This exposes itself to same type of criticism that the privity traders approach receives. For example, even the class of contemporaneous traders excludes victims of insider trading such as pre-empted traders.257 It follows that if the privity traders approach makes no sense, then a proxy for it (i.e. the contemporaneous traders approach) can make no more sense. More importantly, the period of contemporaneousness is usually interpreted so strictly as to exclude those who could not possibly have traded with the insider,

253. Corporations and Markets Advisory Committee (Australia), above note 11, Recommendation 9 (emphasis added). 254. Ibid para. 1.10.3. 255. Ibid. 256. see above §7.IV.A.2. 257. Wang, above note 177, 1283.

Private Civil Liability for Insider Trading

299

which ignores the fact that the initial harm suffered by the party in privity can be transmitted to other traders until the market integrates the information into the share price. The party in privity with the insider may be harmed by insider trading, but if before disclosure of the information he or she resells or repurchases the stock, the harm would be passed along to someone else, who in turn may retransmit the harm.258 The person stuck with that stock when the information is disclosed and integrated into the market place is the one on whom the harm ultimately falls.259 Therefore, this person should have the right to bring a suit for damages, even though he or she may not be in privity with the insider. Hence, due to highly likely transferral of harm, it follows that the contemporaneous traders approach is both over-inclusive and under-inclusive. On the one hand, it may include traders who have actually suffered no harm. Because the harm caused by insider trading could flow beyond those who were (even who might have been) in privity with the insider, these people may not be harmed at all. On the other hand, the real victim who is finally left holding the stock at the time of disclosure of the information may be excluded from the class of plaintiffs. To be sure, one response to this problem may be that the private right of action initially granted to the party in privity can be transferred to a subsequent trader if the party in privity trades again and regains his or her original position prior to the time the information is disclosed.260 This process can continue further. The second person may also make a reverse trade before the information disclosure, in which case his or her right of action should transfer again, and so on. However, such a solution faces both legal and practical problems. First, it is unclear whether as a matter of law a claim for damages in securities cases can be automatically assigned upon the re-trading of a security.261 Second, even if a rule of automatic assignment is established, there would be formidable practical difficulties for the subsequent trader in identifying his or her counterparty after an anonymous transaction on the open market. This would result in there being a need to reconstruct a share-by-share trading history of the shares traded during the class period, which is a virtually impossible task. Indeed, the subsequent trader would have to discover his or her immediate counterparty, and it is highly likely that they would need to go further to trace the chain of all pre-disclosure trades back to the original holder of the right of action, namely the party in privity with the insider.262 If identifying the immediate counterparty is very difficult, then determining the person who initially had standing to sue is even more difficult, since it would require identifying all past trading partners in a possible long chain. This task may be further complicated by the fact that, in many

258. Wang & Steinberg, above note 21, §3.4.3.2. 259. Ibid. 260. Ibid §6.13. 261. Ibid §6.13.2 (stating that the US federal law on automatic assignment of Rule 10b-5 claims is unclear). 262. Ibid §6.13.3, 526.

300

Chapter 7

cases, the traders along the chain might have split up the total number of shares initially traded, and traded portions of them to different people.263 In short, this approach experiences enormous difficulty accounting for the case in which the harm initially suffered by the party in privity with the insider may pass along to someone else before the information is disclosed and incorporated into the price. 3.

The Suitability of the Non-disclosure-period Traders Approach

Under this approach, the class of potential plaintiffs includes all those who have traded on the opposite side of the market to the insider in the period between the insider trading and disclosure of the inside information.264 Compared to the above two approaches, namely the privity traders approach and the contemporaneous traders approach, this approach is more appropriate as it takes into account the harm caused by insider trading and the fraudulent nature of the unlawful behaviour. It eliminates the practical difficulty of identifying the party in privity and then tracing the chain of all pre-disclosure trades of the stock traded by the insider to locate the person on whom the harm finally came to rest.265 This has led many commentators on this issue to support this approach.266 The theoretical basis for this approach can be understood in two ways. As indicated in Shapiro, insiders may owe a duty of disclosure to all investors who have traded to their disadvantage from the time the insider traded until disclosure of the information.267 It would seem to follow that if insiders failed to disclose before trading, all those nondisclosure-period traders have been equally disadvantaged by the nondisclosure of the information and thus deserve damages.268 Apparently, the group of nondisclosure-period traders would include, inter alia, the person who is stuck with the stock traded by the insider when the information is disclosed. Alternatively, assuming that the harm may initially fall on the party in privity to whom the duty of disclosure is owed, this approach may well account for the fact that as discussed above, the party in privity may pass the harm along by trading the stock again prior to disclosure of the information. In this sense,

263. Dougherty, above note 157, 139 n.352. 264. Under this approach, pre-empted traders would still not be able to get compensated, but they were not identifiable anyway. see above §7.IV.A.3. 265. Under the contemporaneous trader approach, one practical problem is that the notion of contemporaneousness period is indeterminate and may vary depending on the circumstances of each particular case. see above §7.IV.A.2.a. 266. Wang, above note 177, 1311 (positively commenting on the American Law Institute’s Federal Securities Code which adopts the nondisclosure period approach); Dougherty, above note 157, 140 (advocating the nondisclosure period approach). 267. see above §7.IV.A.3.a. 268. This may in turn lend strong support to the equality of access theory for insider trading liability under which all investors trading on impersonal exchanges should have relatively equal access to material information. For detailed discussion of the equality of access theory, see above §5.III.B.

Private Civil Liability for Insider Trading

301

the class of nondisclosure-period traders can be seen as a proxy for those actually harmed who might be the last person holding the stock when the information is disclosed.269 A pure nondisclosure-period trading requirement, however, may suffer from such a serious practical problem that it could result in an enormous liability.270 Indeed, this approach may give rights of action to a large group of traders who might have laid between the insider and the last trader in the chain to have traded prior to disclosure, or who might have traded the same type of stock but not in that chain. Thus, the claims of all plaintiffs may be far in excess of any gains the insider made from his or her unlawful trading. This is especially so when trading in the security is active, and there is a significant delay between the insider trade and public announcement of the information.271 One possible response to this is to say that the extensive damages may be desirable or justified. It has been argued that it is better to be over-inclusive in the definition of plaintiffs than under-inclusive, given the deterrent and compensatory purpose of insider trading law.272 In addition, if we assume that insiders owe a duty of disclosure to all nondisclosure-period traders, it follows that in theory each of them should recover the amount necessary to fully compensate for their harm, even though this would subject the insider to enormous liability.273 However, this line of argument may be vulnerable to attack, because there is no doubt that a grossly disproportionate award of damages is undesirable, no matter how logical its computation. Yet, for the reasons given earlier, it is equally indubitable that

269. Dougherty, above note 157, 139–141. According to this understanding, the nondisclosure period approach and the contemporaneous approach seem to differ in degree, not in kind, in the sense that they are both proxies for those real victims. This may contribute to the blurred boundary between the two approaches. see above §7.IV.A.4. 270. Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, 242 (2d Cir. 1974) (stating that the nondisclosure period approach might create ‘Draconian liability’); also Wang, above note 177, 1283. 271. To be sure, this problem of draconian liability may also occur to the contemporaneous trader approach because the class of plaintiffs extends to those who traded in temporal proximity to the insider. Not every contemporaneous trader has actually traded with the insider and thus suffered losses. This concern, however, can be effectively alleviated, though not eliminated, by interpreting the concept of contemporaneousness strictly to limit the number of plaintiffs. see above §7.IV.A.2 (discussing that the contemporaneous trader requirement has been subject to increasingly strict interpretations). 272. Fridrich v. Bradford, 542 F.2d 307, 326 n.11 (6th Cir. 1976) (Celebrezze, J., concurring); Dougherty, above note 157, 141 (stating that extensive damages ‘was a risk defendant bore by choosing to trade in violation of law’). 273. Langevoort, above note 141, §9.02[2], 11 (‘while this could result in extremely large damage awards . . . it is the only measure that makes each person who was defrauded “whole’’ ’). This may in turn suggest that it is questionable to assume that the duty of disclosure can extend to all nondisclosure period traders. As Professor Wang argued, if the extensive damages seem unfair, the logical solution is to limit the extent of the duty, rather than arbitrarily capping the damages. Wang, above note 177, 1261. On the other hand, however, the capping of damages could be justified on the basis of unjust enrichment rationales. See Thompson, above note 14, 393.

302

Chapter 7

there should at least be some recovery for insider trading in the open market.274 The question, then, is how to keep the amount of recovery reasonable while at the same time achieving the goals of the securities law such as protection of investors and promotion of the integrity of the market. A more sensible solution would be to deal with the issue of draconian liability by limiting the extent of damages for which the insider is liable. Indeed, as previously discussed, concern over unlimited damages has been the driving force behind the privity approach and the contemporaneous-traders approach, both of which address the concern by allowing fewer people to sue.275 However, as discussed above, these two approaches are inappropriate for a number of reasons. It is thus more appropriate to deal with concern over disproportionate damages separately, through damage caps, rather than distorting the causation element to limit the scope of plaintiffs. As discussed above, the Federal Securities Code followed the nondisclosure-period traders approach, and adopted a damage cap to mitigate the potential harshness of the approach.276 The damage cap is generally set by reference to the defendant’s profit gained or loss avoided by use of the inside information, and is usually the amount of the defendant’s profit.277 A number of commentators have expressed their support for this solution, stating that: The [damage cap] approach properly limits recovery by placing a ceiling on the amount of damages. In this way, any reduction in compensation will be distributed evenly among all injured investors. Moreover, plaintiffs will in many cases be made whole . . . since the plaintiff class will not always be large and defendant’s profits will not always be disproportionate to plaintiffs’ losses.278 This solution, however, is not without defects. Indeed, it has attracted criticism for failing to fulfill both the deterrent and compensatory function of private actions. On the one hand, it is argued that the amount eventually awarded to each plaintiff will usually be a small fraction of their total losses, sometimes minuscule.279

274. see above §7.II. Note, it has been argued that simply eliminating the private cause of action may be an option in the face of the difficulties of identifying proper plaintiffs in insider trading cases. See e.g., Dennis S. Karjala, ‘Statutory Regulation of Insider Trading in Impersonal Markets’ (1982) 1982 Duke L. J. 627, 636 (arguing that ‘Compensation . . . is neither possible nor desirable, and the regulatory system need not be designed to compensate them’); but see Dougherty, above note 157, 137 (stating that ‘the problem with this option [no private right of action] is that private enforcement is considered to be a necessary supplement to SEC enforcement’). 275. see above §7.IV.A.4. 276. see above §7.IV.A.3.b. 277. See e.g., Elkind v. Liggett & Myers, Inc., 635 F.2d 156 (2d Cir. 1980) (limiting the plaintiffs’ recovery to the amount of the profit made by the defendants). This approach has been later adopted by the Insider Trading and Securities Fraud Enforcement Act of 1988. 278. Recent Development, above note 13, 828 (emphasis in original); Note, ‘Limiting the Plaintiff Class: Rule 10b-5 and the Federal Securities Code’ (1974) 72 Mich. L. Rev. 1389, 1429–1430 (suggesting that the FSC solution deserves serious consideration). 279. Karjala, above note 274, 640; Corporations and Markets Advisory Committee (Australia), above note 200, para. 3.40; Wang, above note 177, 1283.

Private Civil Liability for Insider Trading

303

As a result, private suits would be too non-remunerative to be worthwhile, and the small recovery may create a disincentive for a plaintiff to bring a private action.280 On the other hand, the disgorgement remedy might not be a sufficiently strong deterrent to insider trading.281 Indeed, by merely requiring defendants to disgorge ill-gotten profits, defendants incur no real penalty other than returning to their previous financial position. This could encourage insider trading because insiders may trade on the theory that if they are caught, they simply must hand back what they have gained; if they are not caught, they will make a handsome profit. Thus, if the dual purposes of a private cause of action for insider trading are compensation and deterrence, this solution appears to have fallen short on both scores. Notwithstanding these disadvantages, it seems that overall the employment of damage caps is the most equitable solution to the difficult problem created by conflicting interests. Professor Louis Loss, the Reporter for the Federal Securities Code recognized that damage caps may create some problems, but nevertheless held that they provide the best overall solution.282 Indeed, the apportioned damages approach does award the losers something, which although small is better than no recovery at all. Moreover, some commentators have submitted that deterrence rather than compensation should be the overriding concern of courts in open 280. In response to this problem, some commentators have suggested that the corporation whose securities were traded may be the appropriate plaintiff. See e.g., Karjala, above note 274, 641–644; David L. Ratner, ‘Federal and State Roles in the Regulation of Insider Trading’ (1976) 31 Bus. Law. 947, 957–960; Note, ‘A Re-Evaluation of Federal and State Regulation of Insider Trading on the Open Securities Market’ (1980) 58 Wash. U. L. Q. 915, 941–943. The US courts have been divided on this suggestion. The New York Court of Appeals adopted it in Diamond v. Oreamuno, 24 N.Y.2d 494, 301 N.Y.S.2d 78, 248 N.E.2d 910 (1969) on the basis of the corporate asset theory that inside information is a corporate asset and that by their abuse of this asset, the insiders breached their fiduciary duty to the corporation. However, other courts have generally refused to accept the Diamond doctrine. See e.g., Freeman v. Decio, 584 F.2d 186 (7th Cir. 1978); Schein v. Chasen, 313 So.2d 739 (Fla. 1975). The major problem with a corporation’s right to sue is that in most instances, any harm caused by insider trading is borne by relevant actual traders in the market, or the market generally, rather than the company whose securities were traded. The company could therefore obtain a windfall under the Diamond doctrine, given that it has not suffered any direct harm or loss. This is well reflected in the US case law that Rule 10b-5 plaintiffs must be actual traders of securities. See Blue Chip Stamp v. Manor Drug Store, 421 U.S. 723 (1975). However, in some other jurisdiction such as Australia, a company can recover any profits made or losses avoided by insiders in any transactions involving its securities, even where it is not counterparty to those transactions. See Corporations Act 2001 (Australia), ss 1043L(2), (5). This provision has been recently subject to review in Australia, but the final review report recommended retaining it on the grounds that ‘the right of recovery may provide an incentive for companies to monitor trading in their own securities’. See Corporations and Markets Advisory Committee (Australia), above note 11, s 3.19. New Zealand and Canada also permit the company whose securities were traded to seek civil remedies. See New Zealand Securities Amendment Act 1988 ss 7(2)(c), 9(2)(g), 11(2)(c), 13(2)(g), 18; Ontario Securities Act s 134(4). 281. Karjala, above note 274, 638; Wang, above note 177, 1283 n. 254. 282. See Federal Securities Code (ALI 1980) (US), §1703(b) cmt. 1; ibid, §1702(b) cmt. 2–3; see also Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 173 (2d Cir. 1980) (embracing the disgorgement measure after considering various alternatives).

Chapter 7

304

market transactions.283 This view is essentially followed by the damage cap solution which resolves the tension between full compensation and reasonable deterrence in favor of the latter. Moreover, the solution could be improved if some added deterrence and increased incentive to sue were provided by way of punitive damages.284 If there is a strong need to encourage private suits to deter future violations, the damage cap imposed could be multiplied accordingly. The multiple should be determined on the basis of the circumstances of the particular cases and more broadly the overall effectiveness of enforcement of the insider trading prohibition as indicated by the probability of detection and successful prosecution.285 For example, the initial official draft of the FSC approved by the American Law Institute limited the defendant’s liability to the damages which would be applied if ‘all the members of the class . . . had bought (or sold) only the amount of securities that the defendant had sold or (bought)’.286 At the request of the SEC, the FSC has been amended to give courts discretion to increase the limit to 150% of the amount of insiders’ profits.287 The multiple damages may increase the deterrent effect of private actions, and all investors may benefit as a result of the decreased incidence of insider trading. In short, the nondisclosure-period traders approach, coupled with a well-designed damage cap, can provide an adequate solution to the problem of determining the class of plaintiffs and avoiding draconian liability for defendants. It would encourage private actions against insider traders and redress injury in the best possible way. In the meantime, the damage cap could appropriately address the perceived unfairness of excessive damages, even though this has not come without costs. Thus, it appears that this approach is the most suitable of all available alternatives. §7.V.

CONCLUSION

Private suits may serve as a necessary and appropriate supplement to governmental enforcement of the insider trading prohibition. At the present time, this powerful weapon against insider trading is virtually unavailable in China. To promote the efficiency of the insider trading regulatory regime, China is currently considering introducing private civil liability for insider trading.

283. See e.g., Alexander, above note 18, 1487 (noting the problems with the compensatory basis of damage schemes and the advantages of deterrence basis); Note, above note 106, 100–01; Federal Securities Code (ALI 1980) (US), §1711(j), cmt 7 (a) (‘The theory, again, is compensation if practicable but in any event deterrence and avoidance of unjust enrichment’). 284. Some commentators have recommended punitive damages in order to provide added deterrence to securities fraud. Note, ‘Common Law Corporate Recovery for Trading on Non-public Information’ (1974b) 74 Colum. L. Rev. 267, 295–96; Recent Development, above note 13, 829; Ruder, above note 246, 69. 285. Clark, above note 1, §8.10.7, 339. 286. Federal Securities Code (ALI 1980) (US), §1708(b)(3). 287. Ibid §1708(b)(4)(c).

Private Civil Liability for Insider Trading

305

Private rights of action for insider trading, however, have led to several very difficult problems including problems to do with the correct measurement of damages and determination of plaintiffs. There is a multitude of ways to measure damages in securities cases. Efforts have been made to illustrate the confusion in this area and the practical differences amongst the measures in respect of the shifting of the post-transaction market risk. More importantly, the measurement of damages used in face-to-face situations may not be suitable in open market insider trading cases, because they can give rise to recoveries far out of proportion to either a defendant’s gain or to his or her wrongdoing. This leads to the issue of who should be eligible claimants. Indeed, it is very difficult to determine the proper class of plaintiffs in private suits against insider trading. This problem is basically created by the uneasy process of transplanting the traditional tort principles of causation and harm into the securities context. Furthermore, this task is compounded by the need to limit recoveries in open market insider trading cases in order to avoid a grossly disproportionate award of damages. There are three main approaches to the issue of who should be allowed to bring a suit forward for damages. The privity traders approach designates the party in privity as the one harmed, but nevertheless has great practical difficulty of proving privity. In order to solve this problem, the contemporaneous traders approach was developed to grant the private right of action to contemporaneous traders as proxies for those in privity. However, this approach still ignores the complexities of causation in the open-market setting and the nature of the harm caused by insider trading. In contrast, the nondisclosure-period traders approach as embraced by the American Law Institute in its Federal Securities Code, classifies as eligible claimants everyone who trades on the opposite side of the market to the insider from the insider trade until disclosure of the information. It accounts for the fact that the harm initially suffered by the party in privity may be passed along until the information is disclosed and integrated into the share price. Although this may result in a large number of plaintiffs and thus concern over inordinate damages, this concern is effectively exorcised by damages caps. In sum, the combination of the nondisclosure-period trading requirement and damage caps can best ensure that private actions serve as a necessary and appropriate force in the enforcement of insider trading law.

Chapter 8

Conclusion

Since the adoption of the economic reform and opening-up policy in the late 1970s, China has undergone enormous economic changes. China’s emergence as a world industrial power is one of the most significant and positive global developments of the past 25 years.1 Its rapid economic and industrial advancement has irreversibly altered international trade and investment at the global and regional level. It is against this background that China’s securities market was established and against which it has been growing at a great rate. However, the Chinese market is still in its early stages of development and is afflicted with many problems. The existence of insider trading in China is a clear example of this. At present, insider trading is considered to be very serious and as such, a major obstacle to the healthy development of China’s securities market. This book has reviewed all reported insider trading cases in China, and then, together with relevant empirical findings, analyzed the features of insider trading activity in China, including who are likely to be insider traders, types of insider trading, and situations where insider trading likely occurs. There has been no hesitation on China’s part to follow the international trend during the 1990s to regulate insider trading. The regulation of insider trading in China first occurred during the early stages of the development of the Chinese stock market. Legislative attempts to counteract insider trading have been impressive. This is hardly surprising given the fact that insider trading is widely regarded as harmful in China. This book has investigated the harmful and allegedly beneficial effects of

1. Department of Foreign Affairs and Trade (Australia), ‘Australia-China Free Trade Agreement Joint Feasibility Study’ (2003) available on http://www.dfat.gov.au/geo/china/fta/china_fta_ study_brochure.pdf (last visited on 30 March 2005).

308

Chapter 8

stock market insider trading both theoretically and empirically, concluding that insider trading is harmful and thus should be prohibited in China. Indeed, based on the ideas from a range of foreign sources, most notably the United States, China has made rapid progress in establishing its insider trading regulatory regime. In a short period of approximately ten years’ time, China’s insider trading regulation has developed from one simplistic statement denouncing insider trading to a relatively coherent body of provisions regulating insider trading in a rule-of-law based manner. In order to promote market confidence and attract more capital, China is determined to bring its securities law in line with international standards. However, even though the development of Chinese insider trading laws has been progressive, there are a number of problems which have significantly undermined the efficacy of the regulatory regime. This is because China has failed to critically examine foreign experiences before importing them in order to meet the urgent needs of the rapidly growing market. The Chinese government has come to believe that the successful development of China’s securities market is dependant on China being equipped with laws and regulations comparable to those in place in developed countries such as the United States. This has adversely affected the legislative process so as to preclude a sufficiently careful reflection on the necessity, coverage, and implications of the legislation in the Chinese context. This is strikingly illustrated by those loopholes found in the definition of insider, which are inherently related to the confusion around the underlying theory of insider trading liability. It appears that China has hastily imported conflicting insider trading theories, namely the equality of access theory and the fiduciaryduty-based theories which include the classical theory and the misappropriation theory. A careful analysis reveals that the fiduciary-duty-based theories, as adopted by the current US insider trading law, suffer from serious problems and more importantly are not suited to local Chinese conditions. In contrast, the equality of access theory, as adhered to by many other countries, is more appropriate for China. It is further submitted that the Australian ‘information connection’ only approach is both theoretically justifiable and practically manageable, and thus is worthy of serious consideration for the purposes of reforming the regulation of insider trading in China. This book has also examined other basic elements of insider trading. The materiality standard of information and the issue of when information becomes generally available are discussed. Furthermore, this book has canvassed the issue about subjective elements of insider trading. To date, these elements have received little research. This book has proposed that insider trading liability occurs when the defendant was in possession of inside information and also knew the nature of the information. To overcome evidentiary obstacles, the adoption of rebuttable presumptions of both possession and knowledge is recommended. This book has also discussed in great detail the question of whether insiders should have actually used the information in their possession, and made relevant recommendations for China. One chapter has been completely devoted to the issue of private civil liability for insider trading. This complicated issue is of immediate practical significance to China. Private suits may serve as a necessary and appropriate supplement to

Conclusion

309

governmental enforcement of the insider trading prohibition. To promote the efficiency of the insider trading regulatory regime, China is currently considering introducing private civil liability for insider trading. Private rights of action for insider trading, however, have long raised several very difficult problems such as what is the proper measure of damages and who are eligible plaintiffs. There is a multitude of ways to measure damages in securities cases. However, the measurement of damages used in face-to-face situations may not be suitable in open market insider trading cases, because they can give rise to recovery far out of proportion to either a defendant’s gain or to his/her wrong doing. This leads to the issue of who should be allowed to sue an insider trader for damages. After a detailed discussion of three different approaches to this issue, it is concluded that plaintiffs should be all those who have traded on the opposite side of the market to the insider in the period between the insider trading and disclosure of the inside information. It is important to note that China should take a comprehensive and holistic approach to the issue of insider trading. This book has conducted an in-depth analysis of why insider trading occurs in China, and has found that apart from legal problems, many non-legal factors, such as the socio-cultural fabric of society, political power, economic interests and institutional incapacity, influence the incidence of insider trading in China. For example, the professional ethics of the securities industry as a whole are quite poor, and the role of the government in the market is dubious. It is therefore suggested that the issue of insider trading in China can be better understood and addressed by reference to the context in which it takes place. At last, it is appropriate to conclude this book by pointing out the areas for future research. There are other problems surrounding China’s insider trading regulation. Several of these have been mentioned but not dealt with in this book due to space and time constraints. The changes advocated here would lay a solid foundation from which to consider and enact improvements to address these other problems. One question that should be addressed in the future is, as demonstrated by the recent Australian insider trading law review program,2 whether the insider trading law can be extended from traditional equity-related securities to other types of financial products such as commodity products and interest rate options, and if so, whether some adjustment is required to ensure that it works effectively and appropriately in various financial markets. It is reasonably expected that this line of issues will emerge in China, given its rapidly growing financial market and its increasing integration into the world economy.

2. Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Report (November 2003)’ Part 4.

Appendix 1

Methodology

I.

WHY ADOPTS QUALITATIVE RESEARCH?

This book adopts a primarily qualitative methodology, using semi-structured and in-depth interviews to obtain empirical data on insider trading in China.1 The interviews were conducted in China during September and October 2003. To date, there has been very little empirical research of this kind undertaken with respect to insider trading in China. This field work has provided a first-hand and deeper understanding of the incidence of insider trading in China.2 This book recognises the criticism directed at the use of qualitative methodology. Criticism is based on the belief that qualitative data generated by interviews is merely evidence of the ‘beliefs and opinions’ of a certain number of selected interviewees and ‘not of the fact’.3 However, although it does not produce concrete economic data, this method is nevertheless of great value in collecting useful information, especially in the area of insider trading. This is because insider trading is by nature a hidden form of misconduct and thus not readily susceptible to other forms of empirical analysis.

1. Semi-structured interviews are generally based on ‘a structured conversation in which the interviewer asks prearranged questions and records answers’. Michael Q. Patton, Qualitative Evaluation and Research Methods (Sage Publications, 3rd ed., 2001), p. 288. For more information on qualitative research, see S. Sarantakos, Social research (Palgrave Macmillan, 3rd ed., 2005); W. Lawrence Neuman, Social Research Methods: Qualitative and Quantitative Approaches (Allyn & Bacon, 5th ed., 2002). 2. Professor Roman Tomasic successfully used this method to investigate insider trading in Australia in 1988. See Roman Tomasic, Casino Capitalism? Insider Trading in Australia (National Gallery of Australia, 1991). 3. Ashley Black, ‘The Reform of Insider Trading Law in Australia’ (1992) 15(1) The University of New South Wales Law Journal 214, 218.

Appendix 1

312

Indeed, empirical research on insider trading is severely hindered by the subject’s illegality. As stated by one commentator, ‘the inherent secrecy involved with insider trading ensures that there will be no significant observable data’.4 The only possible source of data concerning illegal trades is the trading reports filed by corporate insiders, and it is unlikely that they would willingly report their own violations. Even if this were to occur, it is impossible that these insiders are the only violators of securities laws. As one commentator observed: [I]t is often extremely difficult to obtain a precise picture or interpretation of laws governing corporate and securities market merely from an examination of the somewhat flimsy case law that has developed in this area. Much of this body of law has not been adequately tested in the courts so the law reports are a poor guide to understanding these laws. It is therefore necessary to look elsewhere for an understanding of the ‘law in action’.5 Unlike homicides, robberies, and other commonly reported crimes, there are no regularly reported statistics on the incidence of illegal insider trading. Hence, qualitative data obtained through interviews may help to gain a great understanding of insider trading. Moreover, interviews are a particularly valuable tool in assessing the extent of insider trading and the success of prohibitions against insider trading. In this regard, the importance of people’s perceptions of the incidence of insider trading should not be underestimated: ‘Specifically, what determines the willingness of individuals to invest is not how much trading on inside information actually goes on, but rather how much of such trading prospective investors think is going on’.6 It follows that the prohibition on insider trading may succeed in encouraging investment if the prohibition creates the perception that there is less trading on inside information. In other words, an insider trading prohibition can fail to increase investor confidence if the perception is that insider trading remains widespread despite the prohibition. Therefore, for this purpose, interview data concerning the extent of insider trading may provide a more meaningful measure of success than a conventional study. II.

PREPARATION

Prior to the interviews being conducted, a comprehensive literature review was undertaken. This author also attended a specialized course offered by the Faculty

4. James D. Cox, ‘Insider Trading and Contracting: A critical Response to the “Chicago School’’’ (1986) 1986 Duke L. J. 628, 645. 5. Tomasic, above note 2, preface. 6. Franklin A. Gevurtz, ‘The Globalization of Insider trading Prohibitions’ (2002) 15 Transnational Lawyer 63, 92 (emphasis in original).

Methodology

313

of Arts & Social Science at UNSW on qualitative research methodology in 2003. The questionnaire used in the interviews was drafted in 2003 and reviewed by the following people: • Dr Deborah Oxley, School of Social Science & Policy, Faculty of Arts & Social Science, University of New South Wales • Angus Corbett, Faculty of Law, University of New South Wales • Ping Feng, PhD candidate, Faculty of Arts & Social Science, University of New South Wales • Dr Scott Calan, Faculty of Law, University of New South Wales Further, a number of pilot interviews were conducted in early September 2003. The final questionnaire was completed after incorporating comments from the pilot interviews. The majority of interviewees were approached before September 2002, from Australia. III.

SAMPLING

A total of 31 semi-structured interviews were conducted in China in the period between 28/August/2003 and 25/October/2003. Interviewees were chosen proportionately from different occupational groups. These included regulatory officials, judges, academics, brokers, lawyers, stock exchange officials, financial journalists and ordinary investors. For the purpose of gaining geographically balanced findings, the interviews were conducted in three major cities in different areas of China, including Beijing (Northern China), Shanghai (Central China) and Guangzhou (Southern China). Tables 1 and 2 show the occupational and geographical distribution of the interviewees respectively. Sampling of interviews was carefully designed with reference to a number of different criteria: • In the case of regulatory authorities, interviews were conducted with officials from different department of the CSRC, including the Department of Legal Affairs, the Department of Public Offering Supervision, the Department of Intermediary Supervision and the Second Enforcement Bureau. • Officials from the Shanghai Stock Exchange were from different divisions such as the Legal Affairs Department and the Market Surveillance Department. • Brokers interviewed for this project were from all three cities and came from the top ten firms in China. Merchant bankers and fund managers were also interviewed. It should be noted that, for the purpose of this project, these three occupations are referred to as ‘securities practitioner’. • Securities lawyers interviewed were chosen from major law firms in each of the cities. • Interviews were also conducted with senior judges at the level of intermediate courts and above (including the Supreme Court of the PRC) in Beijing and Shanghai.

Appendix 1

314

• A number of financial journalists were also interviewed. • One secretary of the board of directors of a large listed company in China was also interviewed. • Academics interviewed included high profile professors from leading universities and institutes in China. • Ordinary investors were evenly selected and interviewed in Beijing, Shanghai and Guangzhou. Table 1: Occupational designation of interviewees Occupational Designation Regulatory Officials (CSRC, Beijing) Stock Exchange Officials (Shanghai) Securities Practitioners Lawyers Financial Journalists Judges Academics Listed Company Ordinary Investors Total

Persons Interviewed 5 3 6 4 2 2 5 1 3 31

Table 2: Geographical distribution of interviews City Beijing Shanghai Guangzhou Total IV.

Persons Interviewed 14 12 5 31 THE CONDUCT OF INTERVIEWS AND THE APPLICATION OF DATA

Interviews usually lasted between one hour and two hours. Each interview was conducted individually and face to face. The locations of interviews differed to suit the convenience of each particular interviewee. Locations included the interviewee’s office, interviewee’s home, restaurants and other places. In response to concern over confidentiality and anonymity, tape recorders were not used. This allowed interviewees to speak more freely. As a result, note taking was the main method of recording interviews. Great efforts were made to take notes during the interviews and transcribe and check them immediately afterwards. In the case that notes appeared unclear, information was clarified with the interviewee by phone at a later date.

Methodology

315

Since the interviews were semi-structured, interview data was ex ante sorted into categories, including the incidence of insider trading, reasons for insider trading, the effects of insider trading, the elements of insider trading, liability for insider trading, government enforcement and compliance programs. These data were then used to support or reject theoretical arguments throughout this book. It is important to note that due to time and funding constraints, only a relatively small number of interviews were conducted. Thus, caution should be used when generalizing from such a small sample of interviews, despite the fact that the interviews produced a relatively clear picture of insider trading in China. Undoubtedly, this is a good starting point but more work could be done in the future. To support interviews, documentary materials were collected and considered in the process of drawing relevant conclusions. Interview data is therefore used in conjunction with documentary materials (including quantitative data) wherever possible to try to enhance the reliability of the analysis thereupon.

Appendix 2

The Summary of Reported Insider Trading Cases in China

Insiders

Securities company

substantial shareholder

Listed company

Securities company and listed company

Case Name

Xiangfan Shangzhen case

Baoan Shanghai, Baoan Huayang and Shengzhen Ronggang case

Zhangjiajie Tourism Development Co Ltd case

Nanfang Securities Co Ltd & Beida Chehang Joint Stock Company case

Capital increase; substantial investment

Resolution of dividend distribution

Takeover

Takeover

2 million and the value of 5,200 shares

Profits (unit USD, roughly)

1.4 million

Time of Handling

Profits confiscated; a September March fine of 0.25 million –November 1997 for the entities; 1996 business suspension for one month; warning for relevant personnel; fines of 4,000 or 6,000 for the personnel

September October 1993 1994

Tip inside a total of 9.7 Profits confiscated; a October October information million fine of 0.8 million for 1996–April 1999 and trade the entities; warning 1997 for relevant personnel; business suspension of

Trade

Time of Case

Profits confiscated; a September January fine of 0.25 million 1993 1994 for the entity; business suspension for two months

Punishment (unit USD, roughly)

Short swing The value of Return the profit to 246,000 the company shares

Trade on the basis of inside information (‘Trade’)

Information Activities

318

Appendix 2

Senior officer Reconstruction Trade

Director

Securities regulator

Yu Mengwen case

Gao Fashan case

Guan Weiguo case

Company listing

Takeover

Vice-general Takeover manager

Wangchuan case

Profit confiscated; a fine of 6,000

Profit confiscated; a fine of 12,500; warning

Profit confiscated; a fine of 20,000; warning

Profits confiscated; a fine of 0.6 million; lifetime business disqualification of one principal; business suspension of four principals for 3 years; fines of 4,000 or 6,000 for the personnel

Not charged with insider trading

The value of Profit confiscated; 2000 shares warning

9,756

74,390

81,776

3 million

Tip family 93,902 members to trade

Trade

Trade

Senior Reconstruction Trade management

Trade

Dai Lihui case

Annual report; takeover

Listed company

China Qingqi Group Co Ltd case

one principal for 6 months; fines of 4,000 or 6,000 for the personnel

1993

September 1994

June 1999 February 2000

March– June 1999 April 1998

February– October April 1998 1998

November May 1999 1997

November September 1996 1999 January 1997

Reported Insider Trading Cases in China 319

Substantial Earnings shareholder

Changjiang Konggu case

Trade

Tip insider information

Activities

Profit confiscated; a criminal fine of 100,000; three-year imprisonment

1.17 million Profit confiscated; a criminal fine of 12,500; three-year imprisonment

95,122

Profits (unit Punishment (unit USD, USD, roughly) roughly) March 2003

Time of Handling

November October 2000 2003

May 2000

Time of Case

Note: 1. The data were updated as of June 2004. 2. Where the entities were the traders, the punishments were imposed on the entities, unless otherwise indicated. 3. All the warnings and fines below were administrative rather than criminal penalties in character, unless otherwise indicated.

Major investment

Director

Shenshen Fang case

Information

Insiders

Case Name

320

Appendix 2

Bibliography

Acoba, Micah A., ‘Insider Trading Jurisprudence After United States v. O’Hagan: A Restatement (second) of Torts §551(2) Perspective’ (1999) 84 Cornell Law Review 1356 Adams, Ryan D., ‘ “Where there is a will, there is a way”: the Securities and Exchange Commission’s adoption of Rule 10b-5’ (2001) 47 Loyola Law Review 1133 Additional Consumer Protection in Corporate Takeovers and Increasing the Securities Act Exceptions for Small Businessmen: Hearings on S. 336 & S. 3431 Before the Subcommon Sec. of the Senate Common Banking and Currency, 91st Congress (1970) (US) Ainsworth, Janet E, ‘Categories and Culture: On the “Rectification of Names” in Comparative Law’ (1996) 82 Cornell Law Review 19 Akashi, Tomoko, ‘Regulation of Insider Trading in Japan’ (1989) 89 Colum. L. Rev. 1296 Aldave, Barbara Bader, ‘Misappropriation: A General Theory of Liability for Trading on Nonpublic Information’ (1984) 13 Hofstra L. Rev. 101 Alexander, Janet C., ‘The Value of Bad News in Securities Class Actions’ (1994) 41 UCLA L. Rev. 1421 Alexander, Janet C., ‘Rethinking Damages in Securities Class Actions’ (1996) 48 Stanford Law Review 1487 Anderson, Alison Grey, ‘Fraud, Fiduciaries, and Insider Trading’ (1982) 10 Hofstra L. Rev. 341 Anonymous, ‘Foreign Trade may Hit it USD 1.1 Trillion’ Zhongguo Ribao [China Daily] 1 November 2005 Anonymous, ‘Rivkin Deserves Jail: ASIC’ Illawarra Mercury 2 June 2003 Anonymous, ‘Entry to WTO Benefits Foreign Trades ’, Zhongguo Ribao [China Daily] 11 December 2002 Anonymous, ‘Rivkin: Witch-hunt or Justice Overdue’ Australian Financial Review 11 June 2003 Anonymous, ‘The Share Prices of the Loss-making Companies did not Decline; Those of the Profitable Companies Increased’ Zhengquan Shibao [Securities Times] 15 August 2002 Anonymous, ‘Kan Zhidong Talk about Nanfang Securities Company’ Zhengquan Shichang Zhoukan [Securities Market Weekly] 15 December 2003 Anonymous, ‘Turfing Insider-traders out’ Economist 16 July 1994 Anonymous, ‘Lukang Yiyao is Suspected of Falsifying Accounting Data, and One Informer is Sent to Jail’ Zhongguo Qingnian Bao [China Youth News] 21 February 2003 Anonymous, ‘Kan Zhidong and He Yun Become the New Leaders of Nanfang Securities Company’ Beijing Chengbao [Beijing Morning] 27 June 2002

322

Bibliography

Anonymous, ‘Rivkin Fined, Gets Periodic Detention’ Australian Financial Review 29 May 2003 Askew, Kate, ‘Cell, Cell, Cell: Rivkin Goes Inside’ Sydney Morning Herald 30 May 2003 Australian Securities and Investments Commission, 2002/03 Annual Report, available at http://www.asic.gov.au/asic/asic.nsf/byheadline/ Annual
reports?opendocument (last visited on 20 March 2005) Avino, Graig R., ‘China’s Judiciary: An Instrument of Democratic Change?’ (2003) 22 Penn State International Law Review 369 Ayres, Ian and Bankman, Joe, ‘Substitutes for Insider Trading’ (2001) 54 Stanford Law Review 235–294 Ayres, Ian and Braithwaite, John, Responsive Regulation (New York, Oxford University Press, 1992) Bai, Jianjun, Zhengquan Qizha ji Duice [Securities Fraud and Solutions] (Beijing, China Legal Publishing House, 1996) Bai, Jianjun, ‘An Empirical Study on the CSRC’S Sixty Punitive Decisions’ (1999) 11 Fa Xue [Legal Science] 55 Bailey, ‘Insider, Inside information and the Securities Industry Act 1975’ (1977) 5 Austl. Bus. L. R. 269 Bainbridge, Stephen M., ‘The Law and Economics of Insider Trading: A Comprehensive Primer’ 46, available at http://papers.ssrn.com/paper.taf? abstact_id261277 (last visited on 8 April 2005) Bainbridge, Stephen M., ‘The Insider Trading Prohibition: A legal and Economic Enigma’ (1986) 38 U. Fla. L. Rev. 35 Bainbridge, Stephen M., ‘Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition’ (1995) 52 Wash. & Lee L. Rev. 1189 Bainbridge, Stephen M., Securities Law: Insider Trading (West Publishing Company, 1999) Bainbridge, Stephen M., ‘Insider Trading Regulation: The Path Dependent Choice between Property Rights and Securities Fraud’ (1999) 52 SMU Law. Rev. 1589 Bao, Jinxuan, ‘Improve the Securities Regulatory and Self-regulatory Regime in China’ (1999) 3 Fashang Yanju [Study on Law and Commerce] 66 Barry, John F., ‘The Economics of Outside Information and Rule 10b-5’ (1981) 129 U. Pa. L. Rev. 1307 Bauman, Todd A., ‘Insider Trading at Common Law’ (1984) 51 The University of Chicago Law Review 838 Baumhaut, ‘How Ethical Are Businessman’? (1961) 39 Harv. Bus. Rev. 6 Bayne, David Cowan, ‘Insider Trading: The Demise of the Misappropriation Theory – And Thereafter’ (1997) 41 St. Louis U. L.J. 625 Bebchuk, Lucian A., ‘Managerial Power and Rent Extraction in the Design of Executive Compensation’ (2002) 69 U.Chi. L. Rev. 751 Beeson, Jonn R., ‘Rounding the Peg to Fit the Hole: A Proposed Regulatory Reform of the Misappropriation Theory’ (1996) 144 U. Pa. L. Rev. 1077 Bhattacharya, Utpal and Daouk, Hazem, ‘The World Price of Insider Trading’ (2000) available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id 200914 (last visited on 8 February 2005). Bhattacharya, Utpal, et al., ‘When an Event is not an Event: The Curious Case of an Emerging Market’ (2000) 55 Journal of Financial Economics 69 Black, Ashley, ‘Policies in the Regulation of Insider Trading and the Scope of Section 128 of the Securities Industry Code’ (1988) 16 Melbourne University Law Review 633

Bibliography

323

Black, Ashley, ‘The Reform of Insider Trading Law in Australia’ (1992) 15(1) The University of New South Wales Law Journal 214 Black, Ashley, ‘Regulating Market Manipulation: Sections 997–999 of the Corporations Law’ (1996) 70 The Australian Law Journal 987 Black, Bernard S., ‘The Legal and Institutional Preconditions for Strong Securities Markets’ (2001) 48 UCLA Law Review 781 Black, Bernard S. and Kraakman, Reinier, ‘A Self Enforcing Model of Corporate Law’ (1996) 109 Harvard Law Review 1911–1982 Black, Bernard S. and Kraakman, Reinier, ‘Delaware’s Takeover Law: The Uncertain Search for Hidden Value’ (2002) 96 Northwestern University Law Review 521–566 Black, Bernald S., et al., ‘Russian Privatization and Corporate Governance: What Went Wrong?’ (2000) 52 Stanford Law Review 1731 Black, Julia, Rules and Regulators (New York, Oxford University Press, 1997) Block, Denis J. and Hoff, Jonathan M., ‘Insider Trading Liability: “Use v. Possession” ’N.Y.L.J. 29 October 1998 Bogert, George G., ‘Confidential Relations and Unenforceable Express Trusts’ (1928) 13 Connell L. Q. 237 Brazier, Gil, Insider Dealing: Law and Regulation (Cavendish Publishing Limited, 1996) Bromberg, Alan R. and Lowenfels, Lewis D., Bromberg and Lowenfels on Securities Fraud and Commodities Fraud (West Publishing Company, 2nd ed., 1998) Brudney, Victor, ‘Insiders, Outsiders, and Informational Advantages Under the Federal Securities Law’ (1979) 93 Harv. L. Rev. 322 Brudney, Victor, ‘O’Hagan’s Problems’ (1997) Sup. Ct. Rev. 249 Carlton, Dennis W. and Fischel, Daniel R., ‘The Regulation of Insider Trading’ (1983) 35 Stanford Law Review 857 Cheffins, Brian R. and Thomas, Randall S., ‘The Globalization Trend for Executive Pay’ (Paper presented at the Corporate Governance Conference, Melbourne Australia, 13 February 2004) Chen, Hehong, et al., Guoyou Guquan Yanjiu [Study on State-owned Shares] (Beijing, China University of Law and Politics, 2000) Chen, Jianfu, Chinese Law: Towards an Understanding of Chinese Law, its Nature and Development (The Hague, Kluwer Law International, 1999) Chen, Xu and Liu, Yong, ‘Policy Suggestions and Empirical Analysis on the Efficacy of the Stock Market’ (1999) 3 Touzi Yanjiu [Investment Research] 34 Chin, Andrew, ‘Accurate Calculation of Short-Swing Profits Under Section 16(b) of the Securities Exchange Act’ (1997) 22 The Delaware Journal of Corporate Law 587 China Central Television, ‘The Bottom Line of the Securities Regulation’, Talk [Duihua], 17 February 2001, available at: http://www.people.com.cn/GB/jinji (last visited on 19 March 2004) China Confederation of Enterprise, ‘The Comments and Proposals from the Corporate Managers’ Zhongguo Jingji Shibao [China Economic Times] 2 September 1999 China Securities Regulatory Commission, Zhongguo Zhengquan Qihuo Tongji Nianjian [China Securities and Futures Statistical Yearbook] (Beijing, Baijia Publishing House, 2003) Chmiel, Michael J., ‘The Insider Trading and Securities Fraud Enforcement Act of 1988: Codifying a Private Right of Action’ (1990) University of Illinois Law Review 645 Choper, J., et al., Cases and Materials on Corporations (Aspen Publishers, 6th ed., 2004) Clark, Robert C., Corporate Law (Boston, Little, Brown and Company, 1986)

324

Bibliography

Coffee, John C., Jr., ‘From Tort to Crime: Some Reflections on the Criminalization of Fiduciary Breaches and the Problematic Line Between Law and Ethics’ (1981) 19 Am. Crim. L. Rev. 117 Coffee, John C., Jr., ‘Is Selective Disclosure Now Lawful?’ N.Y.L.J. 31 July 1997 Coffee, John C., Jr., ‘Rescuing the Private Attorney General: Why the Model of the Lawyer as Bounty Hunter Is Not Working’ (1983) 42 Md. L. Rev. 215 Coffee, John C., Jr., ‘Understanding the Plaintiff’s Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions’ (1986) 86 Colum. L. Rev. 669 Comment, ‘Securities Law – Rule 10b-5 Standing – Pledge of Securities in a Loan Transaction Held to Constitute a Sale–Mallis v. Fdic.’ (1977) 52 N.Y.U. L. Rev. 651 Comment, ‘Damages For Insider Trading in the Open Market: A New Limitation on Recovery Under Rule 10b-5’ (1981) 34 Vand. L. Rev. 797 Comment, ‘The Measure of Damages under Section 10(b) and Rule 10b-5’ (1987) 46 Md. L. Rev. 1266 Corbett, Angus, ‘The Rationale for the Recovery of Economic Loss in Negligence and the Problem of Auditors’ Liability’ (1994) 19 Melbourne University Law Review 814 Corbett, Angus, ‘The (Self) regulation of Law: a Synergistic Model of Tort law and Regulation’ (2002) 25 no. 3 The University of New South Wales Law Journal 616 Cornell, Bradford and Morgan, R. Gregory, ‘Using Finance Theory to Measure Damages in Fraud on the Market Cases’ (1990) 37 UCLA Law Review 883 Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Discussion Paper (June 2001)’ Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Proposals Paper’(September 2002)’ Corporations and Markets Advisory Committee (Australia), ‘Insider Trading Report (November 2003)’ Cox, Charles C. and Fogarty, Kevin S., ‘Bases of Insider Trading Law’ (1988) 49 Ohio St. L.J. 353 Cox, James D., ‘Insider Trading and Contracting: A critical Response to the “Chicago School’’’ (1986) 1986 Duke L. J. 628 Cox, James D., ‘An Outsider’s Perspective of Insider Trading Regulation in Australia’ (1990) 12 Sydney Law Review 456 Cox, James D, ‘United States Introduces Fair Disclosure and Insider Trading Reforms’ (2001) The Australian Law Journal 286–288 Cui, Min, ‘Some Thoughts on the Judiciary Reform’ (1998) 2 Susongfa Luncong [Procedural Law Review] 47 Cui, Shixin, ‘Do not Put the Fate of an Enterprise into One Person’s Hand’ Renmin Ribao [People’s Daily] 21 April 1998 Dalley, Paula J., ‘From Horse Trading to Insider Trading: The Historical Antecedents of the Insider Trading Debate’ (1998) 39 Wm. & Mary L. Rev. 1289 Daly, Brian, ‘Of Shares, Securities, and Stakes: The Chinese Insider Trading Law and the Stakeholder Theory of Legal Analysis’ (1996) 11 American University Journal of International Law and Policy 971 Davis, Jeffry L., ‘Disgorgement in Insider Trading Cases: A Proposed Rule’ (1994) 22 Securities Regulation Law Journal 283 Deng, Xiaoping, Excerpts from Talks Given in Wuchang, Shenzen, Zhuhai and Shanghai (Jan. 18–Feb. 21, 1992) in 3 Deng Xiaoping, Selected Works of Deng Xiaoping (The Bureau for Compilation and Translation of works of Marx, Engels, Lenin and Stalin under the Central Committee of the Communist Party of China trans.) (1994)

Bibliography

325

Dennis, ‘Materiality and the Efficient Capital Market Model: A Recipe for the Total Mix’ (1984) 25 Wm. & Mary L. Rev. 373 Dent, George W., Jr., ‘Ancillary Relief in Federal Securities Law: A Study in Federal Remedies’ (1983) 67 Minn. L. Rev. 865 Department of Foreign Affairs and Trade (Australia), ‘Australia-China Free Trade Agreement Joint Feasibility Study’ (2003) available on http://www.dfat.gov. au/geo/china/fta/china_fta_study_brochure.pdf (last visited on 30 March 2005) Depetris and Summit, ‘The Insider-Trading Panic: Overlooked Element of Scienter’ (1986) N.Y.L.J. 1 Dessent, Michael H., ‘Weapons to Fight Insider Trading in the 21st Century: A Call For the Repeal of Section 16(b)’ (2000) 33 Akron Law Review 481 Diamond, Phyllis, ‘Mclucas Hails O’Hagan Ruling, But Says Issuers over Reach of Theory Remain’ (1997) 29 Sec. Reg. & L. Rep. 1097 Ding, Pinyu, ‘How to Make Supervision Effective in State-owned Companies’ Renmin Ribao [People’s Daily] 9 June 1998 Dooley, Michael P., ‘Enforcement of Insider Trading Restrictions’ (1980) 66 Va. L. Rev. 1 Dougherty, Veronica M., ‘A [Dis]semblance of Privity: Criticizing the Contemporaneous Trader Requirement in Insider Trading’ (1999) 24 Delaware Journal of Corporate Law 85 Duggan, A, ‘The Insider Trading Laws-An Unsprung Trap’ (1997) 11 Commercial Law Quarterly 7 Dyer, Boyd Kimball, ‘Economic Analysis, Insider Trading, and Game Markets’ (1992) 1992 Utah L.Rev. 1 Easterbrook, Frank H., ‘Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information’ (1981) 1981 Sup. Ct. Rev. 309 Easterbrook, Frank H. and Fischel, Daniel R., The Economic Structure of Corporate Law (Cambridge, Havard University Press, 1991) Eckstein, T. Andrew, ‘The SEC’s New Regulation FD: A Return to The Parity Theory?’ (2001) 69 University of Cincinnati Law Review 1289 Editorial, ‘Properly Viewing the Current Stock Market’ Renmin Ribao [People’s Daily] 15 December 1996 Editorial, ‘Improving Confidence and Quickening Development’ Renmin Ribao [People’s Daily] 15 June 1999 Eisenberg, Melvin, ‘The Structure of Corporation Law’ (1989) 89 Colum. L. Rev. 1461 Elson, Charles M., ‘Director Compensation and the Management-Captured Board-The History of a Symptom and a Cure’ (1996) 50 SMU Law. Rev. 127 Estevan-Quesada, C, ‘The Implementation of the European Insider Trading Directive’ (1999) 10 European Business Law Review 492 Fama, Eugene F., ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 J. Fin 383 Fei, Xie, ‘Discussion on Some Issues about Insider Trading Legislations in China’ available at http://www.chinalawedu.com/news/2003_12%5C3121915365576.htm (last visited on 28 June 2004). Feng, Guo, ‘Insider Trading and Private Remedy’ (2000) 2 Faxue Yanjiu [Legal Study] 91 Feng, Tai, ‘It is not Harsh to Describe the Market as a Casino’ Zhongguo Jingji Shibao [China Economic Times] 15 February 2001 Financial Services Authority (UK), Updated Industry Regulator Guidelines: Guidelines for the Control and Releases of Price Sensitive Information by Industry Regulators 1,

326

Bibliography

available at the official website of the FSA: http://www.fsa.gov.uk (last visited on 21 October 2004) Fisch, Jill E., ‘Start Making Sense: An Analysis and Proposal for Insider Trading Regulation’ (1991) 26 Ga. L. Rev. 179 Fischel, Daniel R., ‘Use of Modern Finance Theory in Securities Fraud Cases Involving Actively Traded Securities’ (1982) 38 Bus. Law. 1 Fischel, Daniel R., ‘Insider Trading and Investment Analyst: An Economic Analysis of Dirks v. Securities and Exchange Commission’ (1984) 13 Hofstra L. Rev. 127 Fischel, Daniel R. and Ross, David J., ‘Should the Law Prohibit “Manipulation” in Financial Market?’ (1991) 105 Harvard Law Review 503 Fischer, Monroe Carl, The Relationship between Insiders’ Transactions, the Price of the Common Stock of their Respective Companies: the Standard and Poor’s Stock Price Index, and Price Stability (1965) Ford, H. A. J., et al., Ford’s Principles of Corporations Law (Australia, Butterworths, 12th ed., 2005) Frankel, ‘Implied Rights of Action’ (1981) 67 Va. L. Rev. 553 Frantz, Douglas, Levine & Co: Wall Street’s Insider Trading Scandal (Avon Books, 1987) Freeman, Milton, ‘Comments at the Conference on Codification of the Federal Securities Laws’ (1967) 22 Bus. Law. 793 Freeman, Mark A. and Adams, Michael A., ‘Australian Insiders’ Views on Insider Trading’ (1999) 10 Australian Journal of Corporate Law 148 Fried, Jesse M., ‘Reducing the Profitability of Corporate Insider Trading Through Pretrading Disclosure’ (1998) 71 S. Cal. L. Rev. 303 Fu, Jian, ‘Information Disclosure and Corporate Governance in Listed Companies in China: from Yinguangxia to Enron’ (2004) 17(1) Australian Journal of Corporate Law 48 Fu, Qulin and Shao, Tingjie, Zhongguo Zhengquan Jiaoyi Falu Zhidu Yanjiu [Study on the Legal Regime of Securities Exchange in China] (Beijing, Law Press, 2000) Gabaldon, Theresa A., ‘Unclean Hands and Self-Inflicted Wounds: The Significance of Plaintiff Conduct in Actions for Misrepresentation Under Rule 10b-5’ (1986) 71 Minn. L. Rev. 317 Gan, Wen, ‘Several Basic Issues regarding to Judicial Justice’ (1999) 5 Zhongguo Faxue [China Legal Science] Gang, An, ‘Report on the Trial of the Case of Qiong Minyuan’ Shenhuo Shibao [Life Times] 13 November 1998 Garner, Bryan A. (ed.), Black’s Law Dictionary (West Publishing Company, 8th ed., 2004) George, Richard T. De, Business Ethics (Prentice Hall, 4th ed., 1995) Gevurtz, Franklin A., ‘The Globalization of Insider trading Prohibitions’ (2002) 15 Transnational Lawyer 63–98 Gilson, Ronald J. and Kraakman, Reinier, ‘The Mechanisms of Market Efficiency’ (1984) 70 Va. L. Rev. 549 Grasmick, Harold G. and Bursik, Robert J., Jr., ‘Conscience, Significant Others, and Rational Choice: Extending the Deterrence Model’ (1990) 24 Law & Soc’y Rev. 837 Greenberg, Judith G., ‘Insider Trading and Family Values’ (1998) 4 Wm & Mary J. Women & L. 303 Gu, Mingkang and Art, Robert C., ‘Securitization of State Ownership: Chinese Securities Law’ (1996) 18 Mich. J. Int’l L. 115

Bibliography

327

Gu, Xiaorong and Du, Wenjun, ‘Private Civil Liability in Securities Cases: Based on the US Insider Trading Regulation Experience’ (2002) 1 Zhengzhi Yu Falu [Politics and Law] 29 Gu, Yuan, ‘The Former Chair of Shenshen Fang was Convicted of Insider Trading’ Zhengquan Ribao [Securities Daily] 30 June 2003 Haddock, David D. and Macey, Jonathan R., ‘A Coasian Model of Insider Trading’ (1986) 80 Nw. U. L. Rev. 1449 Haft, Robert J., ‘The Effect of Insider Trading Rules on the Interal Efficiency of the Large Corporation’ (1982) 80 Mich. L. Rev. 1051 Halverson, Karen, ‘China’s WTO Accession: Economic, Legal and Political Implications’ (2004) 27 Boston College International and Comparative Law Review 319 Hamilton, James, and Motley, James, A Guide to Short-swing Trading and Exemptions (CCH Incorporated, 2nd ed., 1997) Han, Zhiguo, ‘Eight Errors of the Plan to Sell State Shares’ Shanghai Zhengquan Bao [Shanghai Securities News] 5 November 2001 Hannigan, Brenda, Insider Dealing (Sweet & Maxwell Ltd, 1994) Hazen, Thomas Lee, ‘Corporate Insider Trading: Reawakening the Common Law’ (1982) 39 Wash. & Lee L. Rev. 845 He, Jia, et al., ‘Disclosure of Material Information and Anomalous Price Change on China’s Stock Market’ Zhengquan Shibao [Securities Times] 27 May 2002 He, Ling, ‘An Empirical Analysis of the Corporate Governance in Chinese Listed Companies’ (1998) 5 Jingji Yanjiu [Economic Research Journal] 45 He, Shaoqi, Neimu Jiaoyi de Falu Toushi [Legal Pespective on Insdier Trading] (Beijing, People’s Court Press, 2000) Heller, Harry, ‘Chiarella, SEC Rule 14e-3 and Dirks: “Fairness” Versus Economic Theory’ (1982) 37 Bus. Law. 517 Henning, ‘Between Chiarella and Congress: A Guide to the Private Cause of Action for Insider Trading Under the Federal Securities Laws’ (1990) 39 U.Kan.L.Rev. 1 Hill, Jennifer G., et al., ‘Corporate Governance and Executive Remuneration: Rediscovering Managerial Positional Conflict’ (2002) 25 no. 2 The University of New South Wales Law Journal 294 Hill, Jennifer G., ‘Deconstructing Sunbeam – Contemporary Issues in Corporate Governance’ (1999) 67 no. 4 University of Cincinnati Law Review 1099 Hilton, Anthony, City Without a State: A Portrait of Britain’s Financial World (London, I.B.Tauris & Co. Ltd., 1987) Holland and Hodgkinson, ‘The Pre-Announcement Share Price Behaviour of UK Takeover Targets’ (1994) 21 Journal of Business Finance and Accounting 46 Hong Wu et al., Zhongguo Zhengquan Shichang Fazhan de Falu Tiaokong [Legal Adjustment of the Development of China’s Securities Market] (Beijing, Law Press, 2001) Hopt, Klaus J., Insider Regulation and Timely Disclosure (The Hague, Kluwer Law International, 1996) Horwich, Allan, ‘Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?’ (1997) 52 Bus. Law. 1235 Hu, Guangzhi, Neimu Jiaoyi Jiqi Falu Kongzhi Yanjiu [Insider Trading and Its Legal Restraint] (Beijing, Law Press, 2002) Hu, Han, ‘The Drowned are Always Those Able to Swim’ Meiri Caijing [Daily Business] 29 August 2003 Huang, Hui, ‘Research on the Shareholder Derivative Suit System’ (2002) 7 Shangshifa Lunji [Commercial Law Review] 332

328

Bibliography

Huang, Hui, ‘China’s Takeover Law: A Comparative Analysis and Proposals for Reform’ (2005) 30 Delaware Journal of Corporate Law 145 Huang, Hui, ‘The Regulation of Insider Trading in China: A Critical Review and Proposals for Reform’ (2005) 17(3) Australian Journal of Corporate Law 281 Huang, Junfeng, ‘The First Case of Takeover by Tender Offer in China’s Stock Market’ Zhongguo Zhengquan Bao [China Securities News] 9 April 2003 Industry Canada, ‘Insider Trading Discussion Paper’ (February 1996) Ishizumi, Kanji, ‘Insider Trading Regulation: An Examination of Section 16(b) and A Proposal for Japan’ (1979) 47 Fordham Law Review 449 Jacobs, Arnold S., Litigation and Practice Under Rule 10b-5 (Deerfield, IL, Clark Boardman Callaghan, 2nd ed., 1981) James Fleming, Jr. and Gray, Oscar S., ‘Misrepresentation – Part II’ (1978) 37 Md. L. Rev. 488 Jennings, Robert, ‘Intraday Changes in Target Firm’s Share Price and Bid-Ask Quotes around Takevoer Annoucements’ (1994) 17 The Journal of Financial Research 255 Ji, Xiaolei, ‘Wu Jinglian, a Famous Chinese Economist, Thinks that the P/E Figure is Currently too High’ Renmin Ribao Haiwaiban [Peoples’ Daily Overseas Edition] 13 January 2001 Jia, He, et al., ‘Disclosure of Material Information and Anomalous Price Change on China’s Stock Market’ Zhengquan Shibao [Securities Times] 27 May 2002 Jia, Quan and Chen, Zhangwu, ‘An Empirical Study of the Efficiency of China’s Stock Market’ (2003) 7 Jingrong Yanjiu [Journal of Financial Research] 86 Jiang, Peng, ‘A Brief Analysis of Disgorgement of Insider Short-swing Trading Profits’ (2001) 39 Fazhi yu Shehui Fazhan [Legal System and Social Development] 66 Jin, D., Dangdai Zhongguo Zhengquan Shichang [Contemporary Securities Market of China] (Beijing, Economic Science Press, 1999) Jin, Lin, ‘The Figures of P/E and P/S are Getting Better’ Zhongguo Zhengquan Bao [China Securities News] 24 December 2003 Johnson, ‘Liability for Reckless Misrepresentations and Omissions Under Section 10(b) of the Securities Exchange Act of 1934’ (1991) 59 U. Cin. L. Rev. 667 Jolly, David W., ‘Knowing Possession vs. Actual Use: Due Process and Social Costs in Civil Insider Trading Actions’ (1999) 8 George Mason Law Review 233 Jones, Carol A.G., ‘Capitalism, Globalization and Rule of law: an Alternative Trajectory of Legal Change in China’ (1994) 3 Social & Legal Studies 195 Jooste, R, ‘The Regulation of Insider Trading in South Africa-Another Attempt’ (2000) 117 South African Law Journal 284 Jun, Xia, ‘Information Asymmetry: Optimal Enforcement of Stock Market Insider Trading Regulation’ (2001) 9 Zhongguo Guanli Kexue [Chinese Journal of Management Science] 16 Kahan, ‘Securities Laws and the Costs of “Inaccurate” Stock Prices’ (1992) 41 Duke L. J. 986 Kahn, Joseph, ‘World Trade Organization Admits China Amid Doubts’ N.Y. Times 11 November 2001 Karjala, Dennis S., ‘Statutory Regulation of Insider Trading in Impersonal Markets’ (1982) 1982 Duke L. J. 627

Bibliography

329

Karmel, Roberta S., ‘Outsider Trading on Confidential Information-A Breach in Search of a Duty’ (1998) 20 Cardozo L. Rev. 83 Karmel, Roberta S., ‘Transnational Takeover Talk – Regulations Relating to Tender Offers and Insider Trading in the United States, the United Kingdom, Germany, and Australia’ (1998) 66 U. Cin. L. Rev. 1133 Kasznik, Ron, ‘On the Association Between Voluntary Disclosure and Earnings Management’ available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id 15062 (last visited on 21 July 2004) Kaufman, Michael J., ‘The Real Measure of Damages Under Rule 10b-5’ (1989) 39 Cath. Univ. L. Rev. 29 Keeton, W. Page, ‘Fraud – Concealment and Nondisclosure’ (1936) 15 Tex. L. Rev. 1 Keeton, W. Page, et al., Prosser and Keeton on the Law of Torts (West Group, 5th ed., 1984) Kenny, Michael P. and Thebaut, Theresa D, ‘Misguided Statutory Construction to Cover the Corporate Universe: The Misappropriation Theory of Section 10(b)’ (1995) 59 Alb. L. Rev. 139 Keown and Pinkerton, ‘Merger Announcements and Insider Trading Activity: An Empirical Investigation’ (1981) 36 J. Fin. 855 Kidd, Ronald F., ‘Insider Trading: The Misappropriation Theory versus an “Access to Information” Perspective’ (1993) 18 Delaware Journal of Corporate Law 101 Klausner, Michael, ‘The Limits of Corporate Law Reform’ (Paper presented at the 21st Century Commercial Law Forum: Corporate Law Reform for a Global Competitive Economy, Beijing, 14–15 September 2002) Klock, Mark, ‘Mainstream Economics and the Case for Prohibiting Insider Trading’ (1994) 10 Ga. St. U. L. Rev. 297 Kluver, John, ‘Insider Trading’ (Paper presented at the Corporate Law Teachers’ Association Conference 2005, Sydney, 7–8 February 2005) Kostritsky, Juliet P., ‘Rationalizing Liability and Nondisclosure Under 10b-5: Equal Access to Information and United States v. Chiarella’ (1980) 1980 Wis. L. Rev. 162 Kraus and Sholl, ‘Price Impacts of Block Trading on New York Stock Exchange’ (1972) 27 J. Fin. 569 Krawiec, Kimberly D., ‘Fairness, Efficiency, and Insider Trading: Deconstructing the Coin of the Realm in the Information Age’ (2001) 95 Northwestern University Law Review 443 Kronman, ‘Mistake, Disclosure, Information, and the Law of Contracts’ (1978) 7 J. Legal Stud. 1 Lampe, Anne, ‘Rivkin Guilty but Vows Fightback’ Sydney Morning Herald 1 May 2003 Langevoort, Donald C., ‘Insider Trading and the Fiduciary Principle: A Post-Chiarella Restatement’ (1982) 70 Cal. L. Rev. 1 Langevoort, Donald C., ‘Words from on High about Rule 10b-5: Chiarella’s History, Central Bank’s Future’ (1995) 20 Delaware Journal of Corporate Law 865 Langevoort, Donald C., ‘Capping Damages for Open-Market Securities Fraud’ (1996) 38 Arizona Law Review 639 Langevoort, Donald C., ‘Rereading Cady, Roberts: The Ideology and Practice of Insider Trading Regulation’ (1999) 99 Colum. L. Rev. 1319 Langevoort, Donald C., Insider Trading: Regulation, Enforcement, and Prevention (West Group) (looseleaf) Lawson, Gary, ‘The Ethics of Insider Trading’ (1988) 11 Harv. J.L. & Pub. Pol’y 727 Lee, Ian B., ‘Fairness and insider trading’ (2002) 2002 Columbia Business Law Review 119

330

Bibliography

Levmore, Saul, ‘Securities and Secrets: Insider Trading and the Law of Contracts’ (1982) 68 Va. L. Rev. 117 Levmore, Saul, ‘In Defense of the Regulation of Insider Trading’ (1988) 11 Harv. J.L. & Pub. Pol’y 101 Li, Guoguang and Jia, Wei, Zhengquan Shichang Xujia Chenshu Minshi Peichang Zhidu [Legal System of Civil Compensation for Securities Misrepresentation] (Beijing, Law Press, 2003) Li, Oriana N., ‘Note, United States v. Smith: The Use-Possession Debate in SEC Enforcement Actions Under §10(b)’ (1999) 74 Wash. L. Rev. 395 Li, Qihua, ‘Informers Went to the CSRC with Their Real Identities’ Caijing shibao [China Business Post] 15 February 2003 Li, Xiuchi, ‘Research on the Incidence of Insider Trading and Market Manipulation in the Case of Takeover on China’s Stock Market’ (2003) (unpublished working paper of China Securities Research Co Ltd, on file with the author) Li, Xindan, et al., ‘Empirical Studies on the Trading Behaviors of Individual Investors on China’s Stock Market’ (2002) 11 Jingji Yanjiu [Economic Research] 54 Li, Yuwen, ‘Court Reform in China: Problems, Progress and Prospects’ in Jianfu Chen, Yuwen Li & Jan Michiel Otto (eds), Implementation of Law in the People’s Republic of China (The Hague, Kluwer Law International, 2002) Li, Zhiling, Jiedu Zhongguo Gushi [Understand China’s Stock Market] (Shanghai, Three United Bookshop, 2002) Lin, Jian, ‘The State Council has Decided to Stop Selling State Shares’ Shanghai Zhengquan Bao [Shanghai Securities News] 24 June 2002 Lipton, Martin and Mazur, Robert B., ‘The Chinese Wall Solution to the Conflict Problems of Securities Firms’ (1975) 50 New York University Law Review 459 Liu, Guangdi, et al., ‘Two Kinds of Relationships need to be Handled Properly to Ensure the Healthy Growth of the Stock Market’ in Task Force of the Association of Shanghai Securities News, Xunqiu Zhengquan Shichang Dazhihui [Seeking for the Truth of the Stock Market] (Beijing, Xuelin Press, 1997) 65 Liu, Junhai, ‘Prospect for China’s Corporate Law Reform after the Entry into WTO’ in Baoshu Wang, et al. (eds), Quanqiu Jingzheng Tizhi xia de Gongsifa Gaige [Corporation Law Reform for a Global Competitive Economy] (Beijing, Social Sciences Academic Press, 2003) Liu, Shaojia, ‘Ultimate Ownership, Shareholding Structure and Corporate Performance’ (2003) 4 Jingji Yanjiu [Economic Research] 51 Liu, Shulian and Hu, Yanhong, ‘An Empirical Analysis on the Cash Dividend Distribution of the Listed Companies’ (2003) 4 Kuaiji Yanjiu [Accounting Research] 29 Lobo, Gerald J. and Zhou, Jian, ‘Disclosure Quality and Earnings Management’ available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id265550 (last visited on 10 August 2004) Lorie, ‘Insider Trading: Rule 10b-5, Disclosure, and Corporate Privacy: A Comment’ (1980) 9 J. Legal Stud. 819 Loss, Louis, Fundamentals of Securities Regulation (Boston, Little, Brown and Company, 2nd ed., 1988) Loss, Louis and Seligman, Joel, Securities Regulation (Boston, Little, Brown and Company, 3rd ed., 1991) Lu, Shiyou, et al., Zhengquan Shichang yu Zhengquan Fanzui Tanlun [Securities Market and Securities Crime] (Beijing, Lixin Accounting Press, 1995)

Bibliography

331

Lu, Shen-Shin, Insider Trading and the Twenty-Four Hour Securities Market (The Christopher Publishing House, 1994) Ma, Chengguang, ‘Securities Law to Regulate Booming Sector’ Zhongguo Ribao [China Daily] 23 October 1998 Macey, Jonathon R., ‘From Fairness to Contract: The New Direction of the Rules Against Insider Trading’ (1984) 13 Hofstra L. Rev. 9 Macey, Jonathan R., Insider Trading: Economics, Politics, and Policy (The AEI Press, 1991) Macey, Jonathan R., ‘Securities Trading: A Contractual Perspective’ (1999) 50 Case Western Reserve Law Review 269 Macey, Jonathan R. and Miller, Geoffrey P., ‘An Economic Analysis of Conflict of Interest Regulation’ (1997) 82 Iowa Law Review 965 Manne, Henry G., Insider Trading and the Stock Market (New York, the Free Press, 1966) Manne, Henry G., ‘Insider Trading and the Law Professors’ (1970) 23 Vand. L. Rev. 547 Mannolini, J, ‘Insider Trading-The Need for Conceptual Clarity’ (1996) 14 Company and Securities Law Journal 151 Mcvea, Harry, Financial Conglomerates and the Chinese Wall: Regulating Conflicts of Interest (New York, Oxford University Press, 1993) Mei, Shengyang, ‘Who Leaked Information on the Opening of B-share Market’ Zhongguo Qingnianbao [China Youth Times] 21 February 2001 Mei, Shenshi, ‘The Roles of Supervisors and Supervisory Board in Modern Corporate Governance’ (1995) 1 Shangshifa Lunji [Commercial Law Review] 161 Mendelson, Morris, ‘The Economics of Insider Trading Reconsidered’ (1969) 117 U. Pa. L. Rev. 470 Meyer, ‘Fraud and Manipulation in Securities Markets: A Critical Analysis of Section 123 to 127 of the Securities Industry Code’ (1986) 4 C&SLJ 92 Mitchell, Lawrence E., ‘The Fairness Rights of Corporate Bondholders’ (1990) 65 N.Y.U. L. Rev. 1165 Moore, ‘What is Really Unethical About Insider Trading?’ (1990) 9 J. Bus. Ethics 171 Moran, ‘Insider Trading in the Stock Market: An Empirical Test of the Damages to outsiders’ (Center for the Study of American Business, Washington Univ., St. Louis, Working Paper No. 89, July 1984) Morgan, Richard J., ‘Insider Trading and the Infringement of Property Rights’ (1987) 48 Ohio St. L. J. 79 Mullaney, Thomas J., ‘Theories of Measuring Damages in Security Cases and the Effects of Damages on Liability’ (1977) 46 Fordham L. Rev. 277 Na, Huang, ‘Lang Xianpin: Costless Misconduct Means Hopeless Future’ available at http://news1.jrj.com.cn/news/2002-10-09/000000419248.html (last visited on 14 May 2004) Nagy, Donna M., ‘Reframing the Misappropriation Theory of Insider Trading Liability: a Post-O’Hagan Suggestion’ (1998) 59 Ohio St. L. J. 1223 Nagy, Donna M., ‘The “Possession vs. Use” Debate in the Context of Securities Trading by Traditional Insiders: Why Silence Can Never be Golden’ (1999) 67 U. Cin. L. Rev. 1129 Naylor, J, ‘The Use of Criminal Sanctions by UK and US Authorities for Insider trading’ (1990) 11 The Company Lawyer 53 Neuman, W. Lawrence, Social Research Methods: Qualitative and Quantitative Approaches (Allyn & Bacon, 5th ed., 2002)

332

Bibliography

Neumann, Jennifer L., ‘Insider Trading: Does “Aware” Really Resolve the “Possession” Versus “Use” Debate?’ (2001) 7 Washington University Journal of Law & Policy 189 Nnona, George C., ‘International Insider Trading: Reassessing the Propriety and Feasibility of the U.S. Regulatory Approach’ (2001) 27 North Carolina Journal of International Law and Commercial Regulation 185–253 Note, ‘Common Law Corporate Recovery for Trading on Non-public Information’ (1974) 74 Colum. L. Rev. 267 Note, ‘Limiting the Plaintiff Class: Rule 10b-5 and the Federal Securities Code’ (1974) 72 Mich. L. Rev. 1389 Note, ‘The Measure of Damages in Rule 10b-5 Cases Involving Actively Traded Securities’ (1974) 26 Stan. L. Rev. 371 Note, ‘Rule 10b-5 Damages: The Runaway Development of a Common Law Remedy’ (1975) 28 U. Fla. L. Rev. 76 Note, ‘A Re-Evaluation of Federal and State Regulation of Insider Trading on the Open Securities Market’ (1980) 58 Wash. U. L. Q. 915 Note, ‘Rule 10b-5 and the Duty to Disclose Market Information: It Takes a Thief’ (1980) 55 St. Jone’s L. Rev. 93 Note, ‘In Pari Delicto Under the Federal Securities Laws’ (1987) 72 Cornell L. Rev. 345 Note, ‘Insider Trading in Junk Bonds’ (1992) 105 Harv. L. Rev. 1720 Note, ‘Securities – Rule 10b-5 – Traders with Inside Information on the Impersonal Market Are not Liable to Those Persons Trading After the Insider Has Ceased Trading but Before Public Disclosure’ (1977) 8 Tex. Tech. L. Rev. 742 Note, ‘Laventhall v. General Dynamics Corporation: No Recovery for Plaintiff-Option Holder in a Case of Insider Trading Under Rule 10b-5’ (1984) 79 Nw. U. L. Rev. 780 O’connor, Marleen, ‘Toward a More Efficient Deterrence of Insider trading: The Repeal of Section 16(b)’ (1989) 58 Fordham L. Rev. 309 Orts, Eric W., ‘Shirking and Sharking: A Legal Theory of the Firm’ (1998) 16 Yale L. & Pol’y Rev. 265 Painter, Richard W., ‘Insider Trading: Insider Trading and the Stock Market Thirty Years Later’ (1999) 50 Case Western Reserve Law Review 305 Painter, Richard W., et al., ‘Don’t Ask, Just Tell: Insider Trading After United States v. O’Hagan’ (1998) 84 Va. L. Rev. 153 Painter, William H., ‘Inside Information: Growing Pains for the Development of Federal Corporation Law Under Rule 10b-5’ (1965) 65 Colum. L. Rev. 1361 Palmieri, Nicola W., ‘Good Faith Disclosures Required During Precontractual Negotiations’ (1993) 24 Seton Hall L. Rev. 70 Parker, Christine, The Open Corporation: Effective Self-Regulation and Democracy (Cambridge University Press, 2002) Patton, Michael Q., Qualitative Evaluation and Research Methods (Sage Publications, 3rd ed., 2001) Paul L. Davies, Gower’s Principles of Modern Company Law (Sweet & Maxwell Ltd, 6th ed., 1997) Pitt, Harvey L. and Groskqufmanis, Karl A., ‘The Supreme Court Has Upheld the Misappropriation Theory, But How Far the SEC Will Take the Ruling Is Anything But Clear’ Nat’l L.J. 4 August 1997 Poser, Norman S., ‘Chinese Wall or Emperor’s New Clothes? Regulating Conflicts of Interest of Securities Firms in the US and the UK’ (1988) 9 Mich. Y.B Int’l Legal Stud. 91

Bibliography

333

Poser, Norman S., International Securities Regulation (Boston, Little, Brown and Company, 1991) Posner, Richard A., Economic Analysis of Law (Aspen Publishers, 4th ed., 1992) Posner, Richard A. and Scott, Kenneth E., Economics of Corporation Law and Securities Regulation (Aspen Publishers, 1980) Prakash, Saikrishna, ‘Our Dysfunctional Insider Trading Regime’ (1999) 99 Colum. L. Rev. 1491 Pritchard, A. C., ‘United States v. O’Hagan: Agency Law and Justice Powell’s Legacy for the Law of Insider Trading’ (1998) 78 B.U. L. Rev. 13 Qu, Charles Zhen, ‘An Outsider’s View on China’s Insider Trading Law’ (2001) 10 Pacific Rim Law and Policy Journal 327 Qu, Charles Zhen, ‘The Efficacy of Insider Trading Civil Liability Regime in the Corporations Act’ (2002) 14 Australian Journal of Corporate Law 161 Qun, Wang, ‘Incentives and Behaviors: A New Explanation on the Insufficiency of the Compensation for the Managers of State-Owned Enterprises’ (2001) 8 Jingji Yanjiu [Economic Research] 71 Ramirez, Steven A. and Gilbert, Christopher M., ‘The Misappropriation Theory of Insider Trading Under United States v. O’Hagan: Why Its Bark is Worse Than Its Bite’ (1998) 26 Sec. Reg. L.J. 162 Ramsay, Ian M., ‘Allocating Liability in Corporate Groups: an Australian Perspective’ (1999) 13 no. 2 Connecticut Journal of International Law 329 Ramsay, Ian M., ‘Corporate Governance, Shareholder Litigation and the Prospects for a Statutory Derivative Action’ (1992) 15 The University of New South Wales Law Journal 149 Ramsay, Ian M., ‘Directors and Officers’ Remuneration: the Role of the Law’ (1993) July The Journal of Business Law 351 Rapp, Robert N., ‘Fridrich v. Bradford and the Scope of Insider Trading Liability Under SEC Rule 10b-5: A Commentary’ (1977) 38 Ohio St. L.J. 67 Ratner, David L., ‘Federal and State Roles in the Regulation of Insider Trading’ (1976) 31 Bus. Law. 947 Redmond, Paul, Companies and Securities Law: Commentary and Materials (Sydney, Lawbook Co., 4th ed., 2005) Redmond, Paul, ‘The Reform of Directors’ Duties’ (1992) 15 The University of New South Wales Law Journal 86 Ren, Zili, Zhongguo Zhengquan Shichang Weigui Yaoan Dianping [Comments on Important Cases in China’s Securities Market] (Beijing, Law Press, 2002) Report of the House Committee on Energy and Commerce on the Insider Trading and Securities Fraud Enforcement Act of 1988, H.R. Rep. No. 100–910, 100th Cong., 2d Sess. 27 (9 September 1988, US) Report of the House of Representative Standing Committee on Legal and Constitutional Affairs, Fair Shares for All: Insider Trading in Australia (11 October 1990, Australia) Ribstein, Larry E., ‘Federalism and Insider Trading’ (1998) 6 Sup. Ct. Econ. Rev. 123 Richards, Clay, ‘ “Selective Disclosure: ‘A Fencing Match Conducted on a Tightrope” and Regulation FD-The SEC’s Latest Attempt to “Electrify the Tightrope’’ ’ (2000) 70 Mississippi Law Journal 417 Rider, Barry A. K., Insider Trading (Jordan & Sons Ltd, 1983) Rider, Barry A. K. and Ashe, Michael QC, Guide to Financial Services Regulation (CCH Group Ltd, 3rd ed., 1997)

334

Bibliography

Rider, Barry A. K. and Ffrench, Leigh, The Regulation of Insider Trading (Oceana Publications, 1979) Rosenbaum, Robert D. and Bainbridge, Stephen M., ‘The Corporate Takeover Game and Recent Legislative Attempts to Define Insider Trading’ (1988) 26 Am. Crim. L. Rev. 229 Ruder, David S., ‘Securities Arbitration in the Public Interest: the Role of Punitive Damages’ (1997) 92 Northwestern University Law Review 69 Ruder, David S. and Cross, Neil S., ‘Limitations on Civil Liability Under 10b-5’ (1972) 1972 Duke L. J. 1125 Ruggiero, Eugenio, ‘The Regulation of Insider Trading in Italy’ (1996) 22 Brook. J. Int’l L. 157 Ryan, Harley E. and Wiggins, Roy A., ‘Differences in the Compensation Stuctures of the CEO and Other Managers’ (2000) 6 J. Bus. & Econ. Stud. 22 Salbu, Steven R., ‘The Misappropriation Theory of Insider Trading: A Legal, Economic, and Ethical Analysis’ (1992) 15 Harv. J.L. & Pub. Pol’y 223 Sarantakos, S., Social Research (Palgrave Macmillan, 3rd ed., 2005) Scheppele, Kim Lane, ‘“It’s Just Not Right”: The Ethics of Insider Trading’ (1993) 56 Law & Contemp. Probs. 123 Schipani, Cindy A. and Liu, Junhai, ‘Corporate Governance in China: Then and Now’ (2002) Colum. Bus. L. Rev. 1 Schoen, Karen, ‘Insider Trading: The “Possession versus Use” Debate’ (1999) 148 University of Pennsylvania Law Review 239 Schotland, Roy A., ‘Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market’ (1967) 53 Va. L. Rev. 1425 Schwert, William G., ‘Markup Pricing in Mergers and Acquisitions’ (1996) 41 Journal of Financial Economics 153 Scott, Austin W., ‘The Fiduciary Principle’ (1949) 37 Cal. L. Rev. 539 Scott, Kenneth E., ‘Insider Trading: Rule 10b-5, Disclosure and Corporate Privacy’ (1980) 9 J. Legal Stud. 801 Seligman, Joel, ‘The Reformulation of Federal Securities Law Concerning Nonpublic Information’ (1985) 73 Geo. L. J. 1083 Seligman, Joel, ‘A Mature Synthesis: O’Hagan Resolves “Insider” Trading’s Most Vexing Problems’ (1998) 23 Delaware Journal of Corporate Law 1 Semaan, Lori, et al., ‘Is Insider Trading a Necessary Evil for Efficient Markets?: An International Comparative Analysis’ (1999) 17 Company and Securities Law Journal 220 Shanghai Archives (ed), Jiuzhongguo de Gufengzhi [The Shareholding System of the Old China (1868–1949)] (1996) Shanghai Banking Association (ed), Minguo Jingji Shi [The Economic History of the Republic of China] (1948) Shi, Donghui and Fu, Hao, ‘The Regulation of Insider Trading in China: A Legal and Economic Study’ (paper presented at the Symposium on ‘ “Behavioral Finance and Capital Market” ’, Nanjing, China, 29–30 November 2003) Smith, Bryan C., ‘Possession Versus Use: Reconciling the Letter and the Spirit of Insider Trading Regulation Under Rule 10b-5’ (1999) 35 Cal. W. L. Rev. 371 Song, Hongmin and Jiang, Jie, ‘An Empirical Study of the Volatility of China’s Stock Market’ (2003) 4 Jingrong Yanjiu [Journal of Financial Research] 13

Bibliography

335

Stamp, Mark and Welsh, Carson (eds), International Insider Trading (Sweet & Maxwell Ltd, 1996) Steinberg, Marc I., ‘Insider Trading, Selective Disclosure, and Prompt Disclosure: A Comparative Analysis’ (2001) 22 University of Pennsylvania Journal of International Economic Law 635 Steinberg, Marc I., ‘Insider Trading Regulation – A Comparative Analysis’ (2003) 37 The International Lawyer 153 Steinberg, Marc I. and Gruenbaum, ‘Variations of Recklessness After Hochfelder and Aaron’ (1980) 8 Sec. Reg. L.J. 179 Stephen, J. Dormer III, ‘United States v. O’Hagan: The Misappropriation Theory Under Section 10(b) and Rule 10b-5 – Can the Judicial Oak Grow Any Higher?’ (1998) 102 Dick. L. Rev. 277 Stock Exchange Regulation: Hearings on H.R. 7852 and H.R. 8720 Before the House Common Interstate and Foreign Commerce, 73d Cong. 115 (1934) (US) Stout, Lynne A., ‘Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation’ (1985) 81 Va. L. Rev. 611 Strudler, Alan and Orts, Eric W., ‘Moral Principle in the Law of Insider Trading’ (1999) 78 Tex. L. Rev. 375 Sture, John H. and Cummer, Catharine W., ‘Possession vs. Use for Insider Trading Liability’ (1998) 12 No. 6 Insights 3 Sun, Min, ‘Domestic Stocks Open to Foreigners’ Zhongguo Ribao [China Daily] 5 November 2002 Sun, Yilin and He, Xuejie, An Analysis of the Result of the Merger and Acquisition of Listed Companies (2001) Sutter, Robert, ‘Why does China Matter’ (2003–4) 27(1) The Washington Quarterly 75 Tan, Shigui (ed), Zhongguo Sifa Gaige Yanjiu [Study on Judicial Reform in China] (Beijing, Law Press, 2000) Taylor, Ellen, ‘Teaching an Old Law New Tricks: Rethinking Section 16’ (1997) 39 Arizona Law Review 1315 Thel, Steve, ‘$850,000 in Six Minutes – The Mechanics of Securities Manipulation’ (1994) 79 Cornell Law Review 219 The Research Office of the Central Disciplinary and Supervisory Commission of the Communist Party of China, Information Database of the Party’s Anti-Corruption Work and Disciplinary Cases (Beijing, China Procuratorial Press, 1996) Thomas, Randall S., ‘Explaining the International CEO Pay Gap: Board Capture or Market Driven’ (Paper presented at the Corporate Governance Conference, Melbourne Australia, 13 February 2004) Thomas, Stephen C. and Ji, Chen, ‘Privatizing China: The Stock Markets and Their Role in Corporate Reform’ China Bus. Rev. 31(4) 1 July 2004 Thompson, Robert B., ‘The Measure of Recovery under Rule 10b-5: A Restitution Alternative to Tort Damages’ (1984) 37 Vanderbilt Law Review 349 Thompson, Robert B., ‘“Simplicity and Certainty” in the Measure of Recovery Under Rule 10b-5’ (1996) 51 Bus. Law. 1177 Thompson, Robert B., ‘Securities Regulation in an Electronic Age: The Impact of Cognitive Psychology’ (1997) 75 Washington University Law Quarterly 779 Thompson, Robert B., ‘Insider Trading, Investor Harm, and Executive Compensation’ (1999) 50 Case Western Reserve Law Review 291

336

Bibliography

Thompson, Robert B. and King, Ronald, ‘Credibility and Information in Securities Markets After Regulation FD’ (2001) 79 Washington University Law Quarterly 615 Tokley, I. A. and Ravn, Tina, Company and Securities Law in China (Thomson Professional Pub Cn, 1998) Tomasic, Roman, Casino Capitalism? Insider Trading in Australia (National Gallery of Australia, 1991) Tomasic, Roman, ‘Chinese Walls, Legal Princile and Commercial Realtiy in Multi-severce Professional Firms’ (1991) 14(1) UNSW Law Journal 46 Tomasic, Roman, et al., Corporations Law in Australia (The Federation Press, 2nd ed., 2002) Tomasic, Roman and Fu, Jian, ‘The Securities Law of the People’s Republic of China: An Overview’ (1999) 10 Australian Journal of Corporate Law 268 Tomasic, Roman and Pentony, Brendan, ‘Crime and Opportunity in the Securities Markets: The Case of Insider Trading in Australia’ (1989) 7 Company and Securities Law Journal 186 Tyler, Tom R., ‘Compliance With Intellectual Property Laws: A Psychological Perspective’ (1996–1997) 29 N.Y.U.J.Int’l L. & Pol. 219 Tyler, Tom R., ‘Public Mistrust of the Law: A Political Perspective’ (1998) 66 U. Cin. L. Rev. 847 Walton, Julie, ‘WTO . . . Year 4’ China Bus. Rev. 32(1) 1 January 2005 Wang, Baoshu and Cui, Qinzhi, Zhongguo Gongsifa Yuanli [The Principles of Chinese Corporate Law] (Beijing, Social Sciences Academic Press, 1998) Wang, Chunfeng, et al., ‘Insider Trading and the Regulation on China’s Stock Market: International Experience and China’s Response’ (2003) 3 Guoji Jingrong Yanjiu [International Finance Research] 57 Wang, Guogang, ‘Reforming the Planned Economy System and Protect Investor Interests’ Jingji Cankao Bao [Economy Guidance News] 29 January 2004 Wang, Jiahang, ‘How to Establish an Effective SASAC’ Jingji Shibao [Economy News] 19 February 2003 Wang, Lu, ‘The Restructuring Part of Changkong Company was Convicted of Crime of Swindling’ Shanghai Zhengquan Bao [Shanghai Securities News] 28 October 2003 Wang, Liming, ‘Perfection of Private Civil Liability Regime in China’s Securities Law’ (2001) 4 Faxue Yanjiu [Legal Study] 55 Wang, Qun, ‘Incentives and Behavior: A New Explanation of Why Compensation is Insufficient for the Managers of State-Owned Enterprises’ (2001) 8 Jingji Yanjiu [Economic Research Journal] 71 Wang, William K.S., ‘Trading on Material Nonpublic Information on Impersonal Stock Markets: Who is Harmed, and Who can Sue Whom Under SEC Rule 10b-5?’ (1981) 54 Southern California Law Review 1217 Wang, William K.S., ‘Stock Market Insider Trading: Victims, Violators and Remedies – Including an Analogy to Fraud in the Sale of a Used Car with a Generic Defect’ (2000) 45 Villanova Law Review 27 Wang, William K.S. and Steinberg, Marc I., Insider Trading (Aspen Publishers, 1996 & supp. 2002) Wei, Gang, ‘An Empirical Study of Cash Dividend Distribution of the Listed Companies in China’ (1998) 6 Jingji Yanjiu [Economic Research Journal] 30 Wei, Zhong, ‘The Lukang Yiyao Case is not Over and Informers Want to Sue the CSRC’ Jingji Guancha Bao [Economy Watch News] 10 March 2003

Bibliography

337

Weiss, Elliott J., ‘United States v. O’Hagan: Pragmatism Returns to the Law of Insider Trading’ (1998) 23 J. Corp. L. 395 Welle, Elaine A., ‘Freedom of Contract and the Securities Laws: Opting Out of Securities Regulation by Private Agreement’ (1999) 56 Wash. & Lee L. Rev. 519 Wen, Jiang and Hai, Sheng, ‘Shocking News about the Restructuring of Qiong Minyuan’ (2002) 8 Guoji Rongzi [International Finance] 34 Wilgus, H. L., ‘Purchase of Shares of a Corporation by a Director from a Shareholder’ (1910) 8 Mich. L. Rev. 267 Wu, Jinglian, ‘Slowly and Carefully Squeezing out the Bubbles in the Market’ available at http://news1.jrj.com.cn/news/2002-01-14/000000304190.html (last visited on 5 January 2005) Wu, Jianxiong, et al., ‘What is Wrong with Independent Directors: An Empirical Study of the Current Situation of Independent Directors in China’ Zhengquan Shibao [Securities Times] 10 January 2002 Wu, Wenfeng, et al., ‘The Impact of the Permission for Domestic Individual Investors to Access B Shares on the Market Segmentation of A Shares and B Shares’ (2002) 12 Jingji Yanjiu [Economic Research] 33 Xia, Yujin, et al. (ed), Sishu Wu jing Zhujie Xiandaiban [Annotated Confucian Classics in Modern Chinese] (Beijing, Xinchao Press, 1998) Xiang, Wenjian, ‘Taiguang Company is a Big Cheat and Who will Save Changkong Company’ 21 Shiji Jingji Baodao [21 Century Economic Reports] 1 December 2003 Xiao, Zuoji, ‘The Figures of P/E Vary Depending on the Markets’ Shanghai Zhengquan Bao [Shanghai Securities News] 5 March 2003 Xu, Chen and Yong, Liu, ‘Policy Suggestions and Empirical Analysis on the Efficacy of the Stock Market’ (1999) 3 Touzi Yanjiu [Investment Research] 34 Xu, Hui, ‘China’s Comparable P/E Figure of A shares may be under 13’ Nanfang Ribao [Southern China Daily] 2 December 2002 Xu, Xiaonian, ‘The Bubble of the Market must be Squeezed Out’ Beijing Qingnian Bao [Beijing Youth Daily] 14 February 2001 Xu, Xiaonian, ‘China’s Securities Market is now Experiencing Structural Change’ Zhongguo Zhengquan Bao [China Securities News] 29 November 2000

Yang, Chaojun and Xin, Jin, ‘An Empirical Study of Stock Price Movements on Shanghai Stock Exchange’ in Shanghai Stock Exchange (ed), Zhongguo Zhengquan Shichang Wenti de Shizheng Fenxi [Empirical Analysis of the Issues of China’s Securities Market] (Shanghai, Xuelin Press, 1997) 74 Yang, Liang, Neimu Jiaoyi Lun [Insider Trading] (Beijing, Beijing University Press, 2001) Yang, Zhihua, Zhengquan Falu Zhidu Yanjiu [Research on Securities Legal System] (Beijing, China University of Political Science and Law Press, 1995) Ye, Lin, Zhongguo Zhengquan Fa [China’s Securities Law] (Beijing, Law Press, 1999) Yermack, David, ‘Do Corporations Award CEO Stock Options Effectively?’ (1995) 39 J. Fin. Econ. 237 Yin, Fengting, ‘The Function of Supervisory Boards in listed Companies is in Urgent Need of Improvement’ Shanghai Zhengquan Bao [Shanghai Securities News] 4 December 2003 You, Sibing and Wu, Shentao, ‘An Empirical Study of Illegal Securities Cases in China’ (2001) 6 Zhengquan Shichang Daobao [Securities Market Guiding News] 16

338

Bibliography

You, Xudong, ‘The Dream of Stock Options’ Guoji Jinrongbao [International Finance Times] 28 April 2003 Yu, Ying, ‘Insider Trading by the Chair of One Listed Company’ Zhengquan Shichang Zhoukan [Securities Market Weekly] 2 June 2003 Yuan, Dong, Zhongguo Zhengquan Shichang Lun [China’s Securities Market] (Beijing, Oriental Press, 1997) Yuan, Zhaohui and Ju, Juan, ‘The Problems of the One-Year-Old QFII System’ Zhengquan Shichang Zhoukan [Securities Market Weekly] 17 July 2004 Zhang, Jianjin, ‘A Meaningful Debate on the Stock Market’ Jianghuai Chenbao [Jianghuai Morning] 18 February 2001 Zhang, Kaiping, Yingmei Gongsi Dongshi Falu Zhidu Yanjiu [Research on Director Duty at Common Law] (Beijing, Law Press, 1998) Zhang, Qizhai, Xin Jingji Shehui Xue [New Economic Sociology] (Beijing, China Social Science Press, 2001) Zhang, Rong and Jin, Xuejun, ‘An Analysis of Short-term Behaviours of Investors on China’s Stock Market’ (2003) 1 Shuliang Jingji Jishu Jingji Yanjiu [Quantitative Economic and Technological Economic Research] 68 Zhang, Shuguang (ed), Zhongguo Zhidu Bianqian de Anli Yanjiu [Research on the Cases in relation to China’s System Change] vol. I, (Shanghai, Shanghai People’s Press, 1996) Zhang, Weili, ‘China Needs More Excellent Judicial Talents’ Fazhi Ribao [Legal News Daily] 3 October 1997 Zhang, Wei, ‘It is a Fact that the Figure of P/E is too High’ Zhongguo Jingji Shibao [China Economic Times] 13 February 2001 Zhang, Wei and Li, Chu, Zhongguo Zhaiwu Wenti Yanjiu [Research on the Questions of China’s Debts] (Beijing, China Finance Press, 1995) Zhen, Shunyan, Zhengquan Shichang Budang Xingwei de Falu Shizheng [A Legal Analysis of Misconduct on the Securities Market] (Beijing, China University of Political Science and Law Press, 2000) Zhen, Shunyan, Zhengquan Neimu Jiaoyi Guizhi de Bentuhua Yanjiu [Localized Study on Securities Insider Trading Regulation] (Beijing, Beijing University Press, 2002) Zheng, Zhenlong, et al., Zhongguo Zhengquan Fazhan Jianshi [The History of China’s Securities Development] (Beijing, Economic Science Press, 2000) Zhou, Cunsheng and Yang, Yunhong, ‘The Rational Bubbles of China’s Securities Market’ (2002) 7 Jingji Yanjiu [Economic Research] 33 Zhou, Hanmin, ‘Consciousness is not the most Reliable Thing: Perspective on the Values of the Managers of State-owned Companies’ (1999) 1 Nanfeng Chuang [Window of South Wind] 6 Zhou, Jianbo and Sun, Jusheng, ‘Research on the Effects of Stock Option on Corporate Executives’ (2003) 5 Jingji Yanjiu [Economic Research] 74 Zhou, Qinye, et al., ‘A Survey of the Costs and Benefits of Information Disclosure’ (2003) 5 Kuaiji Yanjiu [Accounting Research] 3 Zhou, Yousu, et al., ‘The Situation of the Breach of Securities Regulations in Sichuan Province’ (1995) 2 Xiandai Faxue [Modern Legal Science] 81 Zhu, Qian, ‘Several Legal Issues on the Short-swing Trading Prohibition: Article 42 of China’s Securities Law’ (2000) 5 Fashang Yanjiu [Law and Commerce] 110 The website of Australian Securities and Investments Commission: www.asic.gov.au The website of Australian Stock Exchange: www.asx.com.au

Bibliography The website of London Stock Exchange: www.londonstockexchange.com The website of China Securities Regulatory Commission: www.csrc.gov.cn The website of Shanghai Stock Exchange: www.sse.com.cn The website of Shenzhen Stock Exchange: www.szse.cn The website of US Securities and Exchange Commission: www.sec.gov The website of UK Financial Services Authority: www.fsa.gov.uk The website of New York Stock Exchange: www.nyse.com

339

Table of Cases

I.

CHINESE CASES

Baoan Shanghai, Baoan Huayang and Shenzhen Ronggang case, . . . . . .

29–30, 46,47, 50–51 Changjiang Konggu case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35, 45, 47, 48, 51 China Qingqi Group Co Ltd case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31, 46, 51, 81, 187 Da lihui case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31–32, 51, 68 Gao Fashan case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33, 47, 51, 68, 187 Nanfang Securities Co Ltd and Beida Chehang Joint Stock Company case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30–31, 46, 48, 51, 53, 55–56, 58, 72 Qiong Mingyuan case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55, 77–78,89, 90, 91 Shenshen Fang case, . . . . . . . . . . . . . . . . . . . . . . . . . . 34–35, 47, 50, 51, 88, 212, 219 Wang Chuan case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32, 47, 51, 68 Xiangfan Shangzhen case, . . . . . . . . . . . . . . . . . . . . 28–29, 45, 46, 47, 48, 50, 51, 53, 58, 187 Yu Mengwen case, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32–33, 47, 51, 68 Zhangjiajie Tourism Development Co Ltd case, . . . 30, 46, 49, 51, 53, 80–81, 91, 189

II.

OVERSEAS CASES

Aaron v. SEC, 446 U.S. 680 (1980), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221 Abelson v. Strong, 644 F. Supp. 524 (D. Mass. 1986), . . . . . . . . . . . . . . . . . . . . . . 278 Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), . . . . . . . . . . 269 Aldus Sec. Litig., In re, [1992–1993 Transfer Binder] Fed. Sec. L. Rep. (CCH) para. 97,376 (W.D. Wash. 1993), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279 Alfus v. Pyramid Technology Corp., 745 F. Supp. 1511 (N.D. Cal. 1990), . . . 278, 280 Ampolex Ltd v. Perpetual Trustee Company (Canberra) Ltd, 20 ACSR 649 (1996), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 AST Research Securities Litigation, In re, 887 F. Supp. 231 (C.D. Cal. 1995), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279, 281 Astor Chauffeured Limousine Co. v. Rumfield Inv. Corp., 910 F.2d 1540 (7th Cir. 1990), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260 Backman v. Polaroid Corp., 540 F. Supp. 667 (D. Mass. 1982), . . . . . . . 276, 278, 279 Bailey v. Vaughan, 359 N.E. 2d 599 (W. Va. 1987), . . . . . . . . . . . . . . . . . . . . . . . . 131

342

Table of Cases

Basic Inc. v. Levinson, 485 U.S. 224 (1988), . . . . . . . . . . . . . 174, 207, 211, 255, 288 Baumel v. Rosen, 412 F.2d 571 (4th Cir. 1969), . . . . . . . . . . . . . . . . . . . . . . . 263, 264 Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975), . . . . . . . . . . . . . . . . . . . . . . . . . 264 Blue Chip Stamp v. Manor Drug Store, 421 U.S. 723 (1975), . . . . . . . . . . . . 134, 139, 289, 296, 303 Blyth & Co., 43 S.E.C. 1037 (1969), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196, 205 Bonime v. Doyle, 416 F. Supp. 1372 (S.D.N.Y. 1976), . . . . . . . . . . . . . . . . . . . . . . 259 Buban v. O’Brien, No. C94-0331 FMS, 1994 U.S. Dist. LEXIS 8643 (N.D. Cal. 1994), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281 Cady, Roberts & Co., In re, 40 S.E.C. 907 (1961), . . . . . . . . . 134, 136, 153, 154, 233 Carpenter v. United States, 484 U.S. 19 (1987), . . . . . . . . . . . . . . . 146, 158, 167, 188 Carpenter v. United States, 791 F.2d 1024 (2d Cir. 1986), . . . . . . . . . . . . . . . 139, 147 Chiarella v. United States, 445 U.S. 222 (1980), . . . . . . . . . . . . . 1, 96, 128–129, 135, 136–143, 146–147, 150–152, 154, 158, 164, 171–175, 177,179–181, 188, 240–241, 276, 294 Colby v. Hologic, Inc., 817 F. Supp. 204 (D. Mass. 1993), . . . . . . . . . . . . . . . . . . 278 Coleco Indus., Inc. v. Berman, 567 F.2d 569 (3d Cir. 1977) (per curiam), cert. denied, 439 U.S. 830 (1978), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 Commercial Union Assurance Co. v. Milken, 17 F.3d 608 (2d Cir. 1994), cert. denied, 115 S. Ct. 198 (1994), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 Cox v. Collins, 7 F.3d 394 (4th Cir. 1993), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 Crafter v. Singh, 2 ACSR 1 (1990), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 Cypress Semiconductor Sec. Litig., In re, 836 F. Supp. 711 (N.D. Ca. 1994), . . . . 279 De Haas v. Empire Petroleum Co., 435 F.2d 1223 (10th Cir. 1970), . . . . . . . . 255, 256 Diamond v. Oreamuno, 248 N.E.2d 910 (N.Y. 1969), . . . . . . . . . . . . . . . 105, 131, 303 Dirks v. SEC, 463 U.S. 646 (1983), . . . . . . . . . . . . . 97, 128, 141–146, 148, 151–152, 155–158, 172–173, 175, 180, 187, 198, 206, 210, 214, 221, 223, 240–241 Dupuy v. Dupuy, 551 F.2d 1005 (5th Cir. 1977), cert. denied, 434 U.S. 911 (1977), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259 Elkind v. Liggett & Myers, Inc., 635 F.2d 156 (2d Cir. 1980), . . . . 209, 223, 283, 284, 302, 303 Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), . . . . . . . . . . . . . 133, 221, 221, 222 Esplin v. Hirschi, 402 F.2d 94 (10th Cir. 1968), cert. denied, 394 U.S. 928 (1969), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258 Estate Counseling Serv., Inc. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 303 F.2d 527 (10th Cir. 1962), . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257, 260, 272 Exicom Limited v. Futuris Limited, 18 ACSR 404 (1995), . . . . . . . . . . . . . . . . . . . 297 Feldman v. Motorola, Inc., [1993–1994 Transfer Binder] Fed. Sec. L. Rep. (CCH) para. 98,133 (N.D. Ill. 1994), . . . . . . . . . . . . . . . . . 279 Filloramo v. Johnston, Lemon & Co., 697 F.Supp. 517 (D.D.C. 1988), . . . . . . . . . 230 Folger Adam Co. v. PMI Indus., Inc., 938 F.2d 1529 (2d Cir.), cert. denied, 502 U.S. 983 (1991), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 Freeman v. Decio, 584 F.2d 186 (7th Cir. 1978), . . . . . . . . . . . . . . . . . . 108, 131, 303 Fridrich v. Bradford, 542 F.2d 307 (6th Cir. 1976), . . . . 274, 275, 276, 277, 278, 281, 286, 287, 290, 294, 296, 301 Garnatz v. Stifel, Nicolaus & Co., 559 F.2d 1357 (8th Cir. 1977), . . . . . . . . . . . . . 262 Glick v. Campagna, 613 F.2d 31 (3d Cir. 1979), . . . . . . . . . . . . . . . . . . . . . . . 261, 264

Table of Cases

343

Globus v. Law Research Serv., Inc., 418 F.2d 1276 (2d Cir. 1969), . . . . . . . . . . . . 286 Gottlieb v. Sandia Am. Corp., 304 F. Supp. 980 (E.D. Pa. 1969), . . . . . . . . . . . . . . 269 Gould v. American–Hawaiian S.S. Co., 535 F.2d 761 (3d Cir. 1976), . . . . . . . . . . . 256 Hackbart v. Holmes, 675 F.2d 1114 (10th Cir. 1982), . . . . . . . . . . . . . . . . . . . 256, 261 Harnett v. Ryan Homes, Inc., 360 F. Supp. 878 (W.D. Pa. 1973), aff’d, 496 F.2d 832 (3d Cir. 1974), . . . . . . . . . . . . . . . . . . . 225 Harris v. American Investment Co., 523 F.2d 220 (8th Cir. 1975), cert. denied 423 U.S. 1054 (1976), . . . . . . . . . . . . . . . . . . . . 258 Hecht v. Harris, Upham & Co., 283 F. Supp. 417 (N.D. Cal. 1968), modified, 430 F.2d 1202 (9th Cir. 1970), . . . . . . . . . . . . . . 256 Herman & MacLean v. Huddleston, 459 U.S. 375 (1983), . . . . . . . . . . . . . . . 174, 229 Hickman v. Groesbeck, 389 F. Supp. 769 (D. Utah 1974), . . . . . . . . . . . . . . . . . . . 264 Hollinger v. Titan Captial Corp., 914 F.2d 1564 (9th Cir. 1990) (en banc), cert. denied, 499 U.S. 976 (1991), . . . . . . . . . . . . . 222 Hooker v. Midland Steel Co., 74 N.E. 445 (Ill. 1905), . . . . . . . . . . . . . . . . . . . . . . 152 Hotchkiss v. Fischer, 16 P.2d 531 (Kan. 1932), . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Hoxworth v. Blinder Robinson & Co., 903 F.2d 186 (3d Cir. 1990), . . . . . . . . . . . 265 Huddleston v. Herman & MacLean, 640 F.2d 534 (5th Cir. 1981), . . . . . . . . . 257, 265 Investors Management Co., In re, 44 S.E.C. 633 (1971), . . . . . . . . . . . . . . . . . . . . 143 Jackson v. Oppenheim, 411 F. Supp. 659 (S.D.N.Y. 1974), aff’d in part on other rounds, 533 F.2d 826 (2d Cir. 1976), . . . . . . . . . . . . . . . 225 Janigan v. Taylor, 344 F.2d 781 (1st Cir. 1965), cert. denied, 382 U.S. 879 (1965), . . . . . . . . . . . . . . . . . . . . . . . . . 265, 266, 269 Jordan v. Duff and Phelps, Inc., 815 F.2d 429 (7th Cir. 1987), . . . . . . . . . . . . . . . . 264 Kardon v. National Gypsum Co., 69 F. Supp. 512 (E.D. Pa. 1946), . . . . . . . . . . . . 134 Katz v. Oak Indus., 508 A.2d 873 (Del. Ch. 1986), . . . . . . . . . . . . . . . . . . . . . . . . 155 Kreindler v. Sambo’s Restaurant, Inc., [1981–1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) Para. 98,312 (S.D.N.Y. 1981), . . . . . . . . . . . . . 279, 280 Laventhall v. General Dynamics Corp., 704 F.2d 407 (8th Cir.), cert. denied, 464 U.S. 846 (1983), . . . . . . . . . . . . . . . . . 154, 278, 281 Leslie Fay Cos., Inc. Sec. Litig., In re, 871 F.Supp. 693 (S.D.N.Y. 1995), . . . . . . . 230 Levine v. Seilon, Inc., 439 F.2d 328 (2d Cir. 1971), . . . . . . . . . . . . . . . . . . . . . . . . 260 Madigan, Inc. v. Goodman, 498 F.2d 233 (7th Cir. 1974), . . . . . . . . . . . . . . . . . . . 257 Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017 (6th Cir. 1979), . . . . . . . . . . 222 Marhart, Inc. v. Calmat Co., No. 11820, 1992 WL 212587 (Del. Ch. 1992), . . . . . 153 McCormick v. Fund Am. Cos., 26 F.3d 869 (9th Cir. 1994), . . . . . . . . . . . . . . . . . 178 McMahan & Co. v. Wherehouse Entertainment Inc., 65 F.3d 1044 (2d Cir. 1995), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260–261 Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155 Meyers v. Moody, 693 F.2d 1196 (5th Cir. 1982), . . . . . . . . . . . . . . . . . . . . . 174, 288 Mitchell v. Texas Gulf Sulphur Co., 446 F.2d 90 (10th Cir. 1971), cert. denied, 404 U.S. 1004 (1971), . . . . . . . . . . . . . . . . . . . 262 Moskowitz v. Lopp, 128 F.R.D. 624 (E.D. Pa. 1989), . . . . . . . . . . . . . . . . . . . . . . 279 Moss v. Morgan Stanley Inc., 719 F.2d 5 (2d Cir. 1983), . . . . . . . . . . . . . . . . 139, 160 Myzel v. Fields, 386 F.2d 718 (8th Cir. 1967), cert. denied, 390 U.S. 951 (1968), . . . . . . . . . . . . . . . . . . . . . . . . . 259, 265, 269 Nelson v. Serwold, 576 F.2d 1332 (9th Cir. 1978), cert. denied, 439 U.S. 970 (1978), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265

344

Table of Cases

Neubroner v. Milken, 6 F.3d 666 (9th Cir. 1993), . . . . . . . . . . . . . . . . . . . . . . 278–280 Nye v. Blyth, Eastman, Dillon & Co., 588 F.2d 1189 (8th Cir. 1978), . . . . . . . . . . 263 O’Connor & Assocs. v. Dean Witter Reynolds. Inc., 559 F. Supp. 800 (S.D.N.Y. 1983), . . . . . . . . . . . . . . . . . . . . . 154, 276, 278, 288 O’Hagan, In re, 450 N.W.2d 571 (Minn. 1990), . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 Oliver v. Oliver, 45 S.E. 232 (Ga. 1903), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Osofsky v. Zipf, 645 F.2d 107 (2d Cir. 1981), . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261 Polin v. Conductron Corp., 552 F.2d 797 (8th Cir. 1977), . . . . . . . . . . . . . . . . . . . 196 R v. Firns, 38 ACSR 223 (New South Wales Court of Criminal Appeal 2001), . . . . 216 R v. Firns, New South Wales District Court (1999), . . . . . . . . . . . . . . . . . . . . 216–217 R v. Hannes, [2000] NSWCCA 503, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 R v. Kruse, New South Wales District Court (1999), . . . . . . . . . . . . . . . . . . . . . . . 216 R v. Rivkin, 45 ACSR 366 (2003), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49, 202, 224 Randall v. Loftsgaarden, 478 U.S. 647 (1986), . . . . . . . . . . . . . . . . . . . . . . . . . . . 256 Raymond L. Dirks, In the Matter of, 21 SEC Docket 1401 (1981), . . . . . . . . . . . . 142 Richardson v. MacArthur, 451 F.2d 35 (10th Cir. 1971), . . . . . . . . . . . . . . . . . . . . 258 Rochez Bros., Inc. v. Rhoades, 491 F.2d 402 (3d Cir. 1973), . . . . . . . . . . . . . 266, 269 Rodriguez v. Montalvo, 649 F. Supp. 1169 (D.P.R. 1986), . . . . . . . . . . . . . . . . . . . 225 Rolf v. Blyth, Eastman Dillion & Co., 570 F.2d 38 (2d Cir. 1978), . . . . . . . . . 222, 261 Rothberg v. Rosenbloom, 771 F.2d 818 (3d Cir. 1985), . . . . . . . . . . . . . . . . . 139, 147 Sanders v. Thrall Car Mfg. Co., 582 F. Supp. 945 (S.D.N.Y. 1983), . . . . . . . . . . . . 279 Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977), . . . . . . . . . . . . . . . . 158, 164 Schein v. Chasen, 313 So.2d 739 (Fla. 1975), . . . . . . . . . . . . . . . . . . . . . 105, 131, 303 SEC v. Falbo, 14 F. Supp.2d 508 (S.D.N.Y. 1998) SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998), . . . . . . . . . 231, 234–236, 238–245, 247 SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991), . . . . . . . . . . . . . . . . . . . . . . . . . 139, 147 SEC v. Clark, 915 F.2d 439 (9th Cir. 1990), . . . . . . . . . . . . . . . . . . . . . . . . . . 139, 147 SEC v. Finamerica Corp., Sec. Reg. & L. Rep. (BNA) No. 594 (D.D.C. 1981), . . . 195 SEC v. Fox, 855 F.2d 247 (5th Cir. 1988), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 SEC v. Lenfest, 949 F. Supp. 341 (E.D. Pa. 1996), . . . . . . . . . . . . . . . . . . . . . . . . 147 SEC v. MacDonald, 699 F.2d 47 (1st Cir. 1983), . . . . . . . . . . . 210, 221, 223, 266–267 SEC v. Mario, 51 F.3d 623 (7th Cir. 1995), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 SEC v. Mayhew, 121 F.3d 44 (2d Cir. 1998), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207 SEC v. Monarch Fund, 608 F.2d 938 (2d Cir. 1979), . . . . . . . . . . . . . . . . . . . . . . . 230 SEC v. Musella, 678 F. Supp. 1060 (S.D.N.Y. 1988), . . . . . . . . . . . . . . . . . . . 223, 230 SEC v. O’Hagan, 901 F. Supp. 1461 (D. Minn. 1995), . . . . . . . . . . . . . . . . . . . . . . 148 SEC v. Rana Research, 8 F.3d 1358 (9th Cir. 1993), . . . . . . . . . . . . . . . . . . . . . . . 189 SEC v. Sargent, 229 F.3d 68 (1st Cir. 2000), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 SEC v. Stevens, 48 SEC Docket 739 (1991), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 SEC v. Switzer, 590 F. Supp. 756 (W.D. Okla. 1984), . . . . . . . . . . . . . . . . . . . . . . 163 SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), . . . . . . . . 135, 136, 180, 211, 213, 234, 293 SEC v. The First Boston Corp., Fed. Sec. L. Rep. (CCH) para 92,712 (S.D.N.Y. 1986), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 SEC v. Unifund SAL, 910 F.2d 1028 (2d Cir. 1990), . . . . . . . . . . . . . . . . . . . . . . . 230 Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., [1975–1976 Transfer Binder] Fed. Sec. L. Rep. (CCH) 95,377 (S.D.N.Y. 1975), . . . . . . . . . . . . . . . . . . . . . . . . . . . 283, 284, 288

Table of Cases

345

Shapiro v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. 1974), . . . . . . . . . . . . . . . . . . 142, 282, 294, 295, 300, 301 Sharp v. Coopers & Lybrand, 649 F.2d 175 (3d Cir. 1981), . . . . . . . . . . . . . . . . . . 257 Slade v. Shearson, Hammill & Co., 517 F.2d 398 (2d Cir. 1974), . . . . . . . . . . . . . . . 75 Speed v. Transamerica Corp., 99 F. Supp. 808 (D. Del. 1951), . . . . . . . . . . . . . . . . 134 State Teachers Retirement Bd. v. Fluor Corp., 566 F. Supp. 945 (S.D.N.Y. 1983), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209 State Teachers Retirement Bd .v. Fluor Corp., 589 F. Supp. 1268 (S.D.N.Y. 1984), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279 State v. O’Hagan, 474 N.W.2d 613 (Minn. Ct. App. 1991), . . . . . . . . . . . . . . . . . . 148 Sterling Drug, Inc., In re, [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) 81,570 (1978), . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 Stevens v. Abbott, Proctor & Paine, 288 F. Supp. 836 (E.D. Va. 1968), . . . . . . . . . 261 Stratus Computer, Inc. Sec. Litig., In re, No. 89-2075-Z, 1992 U.S. Dist. LEXIS 22481 (D. Mass. 1992), . . . . . . . . . . . . . . . . . . . . . . . . . . . 279 Stromfeld v. Great Atl. & Pac. Tea Co., 496 F. Supp. 1084 (S.D.N.Y. 1980), . . . . . 283 Strong v. Repide, 213 U.S. 419 (1909), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153 Sundstrand Corp. v. Sunchem. Corp., 553 F.2d 1033 (7th Cir.), cert. denied, 434 U.S. 875 (1977), . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222 Thomas v. Duralite, 524 F.2d 577 (3d Cir. 1975), . . . . . . . . . . . . . . . . . . . . . . 265, 269 TRM, Inc. v. United States, 52 F.3d 941 (11th Cir. 1995), . . . . . . . . . . . . . . . . . . . 239 TSC Industries, Inc. v. Northway, 426 U.S. 438 (1976), . . . . . . . . . . . . . . . . . 207, 208 United States v. Bryan, 58 F.3d 933 (4th Cir. 1995), . . . . . . . . . . . . 147–148, 159, 196 United States v. Chestman, 503 U.S. 1004 (1992), . . . . . . . . . . . . . . . . . . . . . . . . . 278 United States v. Chestman, 947 F. 2d 557 (2d Cir. 1991), . . . . 158, 162–167, 171, 223 United States v. Chiarella, 588 F.2d 1358 (2d Cir. 1978), . . . . . . . . . . . . 112, 137, 180 United States v. Gamache, 156 F.3d 1 (1st Cir. 1998), . . . . . . . . . . . . . . . . . . . . . . 168 United States v. Libera, 989 F.2d 596 (2d Cir. 1993), . . . . . . . . . . . . . . . . . . . . . . . 215 United States v. Newman, 664 F.2d 12 (2d Cir. 1981), . . . . . . . . . . . . . . 139, 146, 147 United States v. O’Hagan, 521 U.S. 642 (1997), . . . . . . . 129, 139, 141, 146–151, 157, 161–162, 164, 180, 196, 240–242 United States v. O’Hagan, 92 F.3d 612 (8th Cir. 1996), . . . . . . . . . . . . . 139, 147–149 United States v. O’Hagan,, 117 S. Ct. 2199 (1997) (No. 96–842), . . . . . . . . . . . . . 150 United States v. Reed, 601 F. Supp. 685 (S.D.N.Y.), rev’d on other grounds, 773 F.2d 477 (2d Cir. 1985), . . . . . . . . . . 147, 159, 164–165, 167 United States v. Smith, 155 F.3d 1051 (9th Cir. 1998), . . 231, 235–236, 238–241, 244 United States v. Teicher, 987 F.2d 112 (2d Cir. 1993), . . . . . . . . . . . . . . 233–235, 248 United States v. Willis, 737 F. Supp. 269 (S.D.N.Y. 1990), . . . . . . . . . . . 158, 164, 166 Van Dyke v. Coburn Enters., 873 F.2d 1094 (8th Cir. 1989), . . . . . . . . . . . . . . . . . 222 VeriFone Sec. Litig., In re, 784 F. Supp. 1471 (N.D. Cal. 1992), . . . . . . . . . . . . . . 279 Ward La France Truck Corp., In re, 13 S.E.C. 373 (1943), . . . . . . . . . . . . . . . . . . . 134 Warner Communications Sec. Litig., In re, 618 F. Supp. 735 (S.D.N.Y. 1985), . . . 259 Wellman v. Dickinson, 475 F. Supp. 783 (S.D.N.Y. 1979), . . . . . . . . . . . . . . . . . . . 52 Wilson v. Comtech Telecomm. Corp., 648 F.2d 88 (2d Cir. 1981), . . . . . 277, 278, 279 Woods v. Barnett Bank, 765 F.2d 1004 (11th Cir. 1985), . . . . . . . . . . . . . . . . . . . . 222 Worlds of Wonder Sec. Litig., In re, 35 F.3d 1407 (9th Cir. 1994), . . . . . . . . . . . . . 230

Index

A A-shares, 11–13 abnormal price movements, 83 absence of functional owners of the state owned shares (Guoyougu Suoyouzhe Quewei), 15 administrative liabilities, 23, 24, 87–89 apprehension, low risk of, 79–87 evidentiary obstacles, 83 false trading names, 80–81 informers, lack of, 81–83 artificial market segmentation, 12 Australian approach concerns, 199–203 insider information, defined, 207 insider, defined, 197 readily observable matter test, 215–219 regulator’s reputation, 202 strengths, 197–199 Australian Corporations and Markets Advisory Committee (CAMAC), 217–218 Australian Securities and Investments Commission (ASIC), 49

B B-shares, 11–13 Baoan Shanghai, Baoan Huayang and Shenzhen Ronggang case, 29–30, 46, 47, 50–51 Beijing Stock Exchange, 7 Beijing Tianqiao Department Store Company, 9 beneficial effects of insider trading, see effects of insider trading benefit-of-the-bargain measure of damages, 260–261 bid-ask spreads, 107 bond market, 8–9

bonus shares (Songgu), 60 broker-dealer, conflicting duties of, 191 bull market, 50–53, 86 1993, 20 burden of proof, 219, 223–227 proof burden shifting effect, 243–245 bureaucracy, 86

C Cady, Roberts & Co, In re, 134–135 CAR, see Cumulative Abnormal Return (CAR) career damage, 91–93 cash dividends, 60 cause of action, 288–289 central governmental regulation, 17 centralized regulatory regime, after 1997, 19 centrally-planned economy, 8 market economy, transition to, 15 willingness to regulate insider trading, 24 Changjiang Konggu case, 35, 47, 51 Chiarella v. United States, 136–141, 151–152, 154, 158, 171–173, 180–181, 188, 240 China Qingqi Group Co. Ltd. case, 31, 46, 51, 81, 187 China Securities Regulatory Commission (CSRC), 18, 20 cases handled by, 28–33 disclosure, 212 ineffectiveness, 84–87, 167–168 informers, privacy and confidentiality for, 82–83 market manipulation and misrepresentation cases, 44–46 penalties imposed by, 29–33 reporting requirements, 193 surveillance system, 80, 81

Index

348 takeover by tender offer, 52 China Securities Regulatory Commission Official Bulletin (Zhongguo Zhengquan Jiandu Weiyuanhue Gonggao), 28 China’s securities market, 307–309 problems, generally, 3 speculative nature, 59–63 Chinese Constitution 1999 amendment, 14 Chinese insider trading law, generally, 185–194 Chinese legal system, 26 Chinese stock market, see stock market Chinese Wall compliance, 226 conflict of interest problem, 190–191 defined, 74 procedures, 74–76 Chinese Yuan (CNY), 11 incomplete convertibility, 12 circumstantial evidence, 83 civil liability, 21, 50, 87–89 absence of, 23, 169, 191 private, see private civil liability classical theory, 129, 131, 137–138 suitability to China, 152–157 CNY, see Chinese Yuan (CNY) Company Law of the People’s Republic of China (‘Company Law’), 20 Article 143, 53 Article 147, 192–193 fiduciary duty, 166 monitoring management, 73 stock options, feasibility of, 67 compensation corporate insiders, see corporate insiders incentive compensation mechanism, 97–100, 105, 113–115 insufficient, 66–68 stock options, 67 confidential relationship, 164–165 conflict of interest, 86, 190–191 Confucianism, 89 Congressional legislation after 1999, 22–23 connected persons person connection test, 194–195, 198–199 rebuttable presumption of knowledge, 228, 230 consequential damages, 261–262 constructive insiders, 47, 187 contemporaneous traders approach, 286–288 codification, 280–282 judicial development, 277–279 problems with, 298–300 contingent remuneration, 98 continuous disclosure regime, 126

contract-enforcing costs, 109 contract-negotiating costs, 109 corporate bonds, 250–251 corporate control transfer, 42 disclosure, 41 corporate governance, problematic, 73–74 corporate insiders, 1, 76, 186–187 compensation beneficial effects of insider trading, 96–100 harmful effects of insider trading, 105 insufficient, 66–68 reporting requirement, 80 signaling, 102 cost-benefit analysis for insider trading, 57–93 benefits, see benefits of insider trading costs, see costs of insider trading costs of insider trading, 71–93 apprehension, low risk of, 79–87 Chinese Wall, 74–76 contract-enforcing costs, 109 contract-negotiating costs, 109 corporate governance, problematic, 73–74 enforcement, 109 evidentiary obstacles, 83 false trading names, 80–81 high success rate, 78–79 inefficacy of information disclosure, 71–72 informers, lack of, 81–83 inter-personal relationships, 78 law-breaking costs, 79–93 low operating costs, 71–79 penalties, 87–93 ‘cover’ measure of damages, 262–263 crimes of opportunity, 79 Criminal Law of the People’s Republic of China (‘Criminal Law’), 21, 24, 50 Article 180, 21–22, 23, 88, 189–190, 191 case law, 33–37, 50 criminal liability, 21, 23, 24, 87–89, 221 CSRC, see China Securities Regulatory Commission (CSRC) Cumulative Abnormal Return (CAR), 41

D Dai Lihui case, 31–32, 51, 68 damages, measure of, see measure of damages Decision of the Central Committee of the Chinese Communist Party on Several Issues Concerning the Reform of Economic System, 9 Deng Xiaoping comments on stock market, 15 derivative duty theory, 143 detecting insider trading

Index electronic surveillance systems, 80–81 Dirks v. SEC, 141–146, 151–152, 155–157, 158, 180, 210, 214, 240 disclose or abstain rule, 135–136, 233, 293, 295 disclosure delaying, 104 dissemination, 212–215 duty to disclose, 137–138, 142, 193 equal access to information, 71 government policies, 77–78 inefficacy of, 71–72 information disclosure and dissemination, 212–215 major events, 126–127 material information, see material information media, 212 obligations, 52 post-announcement waiting period, 212 price sensitive information, see price sensitive information selective, 72, 144, 157 specificity of information, 212 stock prices, changes in, 42 takeovers, see takeovers timeliness, 71 dissemination of information, 212–215 dividends, cash, 60 domestic investors A-shares, 11–13 B-shares, 61 due process concerns strict possession standard, 239

E economic globalization, 12 economic growth in China, 2 economic reforms in the 1970s, 3, 8–9 effects of insider trading beneficial compensation to corporate executives, 96–100 direct monetary profits, 58–68 enhanced corporate performance, 68–69 enhancing market efficiency, 100–102 indirect personal benefits for entity insider trading, 68–69 maintaining good inter-personal relationships (Renji Guanxi), 69–70 smoothing stock price, 100–102 empirical findings, see empirical findings on effects of insider trading generally, 107–111 harmful, 102–107 employer, to, 102–103

349 investors, to, 106–107 listed corporations, to, 105–106 market, to, 102–104 plaintiffs, to, 274–295 electronic surveillance systems, 80–81 empirical findings of qualitative research, 37–46, 62, App. 1 analysis, 40–46 distribution of cash dividends, 60 insider trading and a successful market, 63–66 interviews, 38–46, 62 market segmentation, 13 short-term behavior, 62 speculative market, 59, 62 takeovers, 51 enforcement cost of, 109 private, 254–256 entity insiders, 46–47, 48, 189–190 benefit to entity, 68–69 entrepreneur, insider trading profits, 97–100, 105 enumeration legislative technique, 26 equal access to information, 71 equality of access theory, 127–129, 131, 134–136 blossoming overseas, 178–179 Cady, Roberts & Co, In re, 134–135 Chiarella v. United States, 136–141 common law principles, 173–177 information connection only approach, 198–203 parity of information vs., 170–173 revival in US, 179–181 SEC v. Texas Gulf Sulphur Co., 135–136 suitability to China, 169–184 widespread acceptance, 177–181 EU Insider Trading Directive, 194–195, 201, 211 evidentiary obstacles, 83, 219, 226 exchange-level regulation, 4 executive compensation, 67, 113–115 externality problem, 110–111

F face-to-face transaction measure of damages, see measure of damages false trading names, 80–81 faren gu (legal person shares), 13 Federal Securities Code (FSC), American Law Insititute (ALI), 284–286, 305 fiduciary duty enforcement framework, ineffective, 167–169 undeveloped concept in China, 163–167 fiduciary-duty-based theories, 141–146 classical theory, see classical theory misappropriation theory, see misappropriation theory

350 suitability to China, 151–169 fines, 24–25 foreign investors B-shares, 11–13 former corporate-related parties, 195–197 forms of insider trading activities, 21 fraud actions measure of damages, see measure of damages fraud on investors theory, 139 fraud on the source theory, see misappropriation theory Fridrich v. Bradford, 275–277 front-running situations, 205

G gaige kaifang (reform and opening up policy), 10 Gao Fashan case, 33, 47, 51, 68, 187 government policies capricious nature of, 77–78 intervention in market, 60–62, 77–78 governmental officials, insider trading by, 47, 77–78, 196 governmental regulation, 4, see also regulation of insider trading before 1999, 19–22 Guan Weiguo case, 35–36, 50, 51 guojia gu (state shares), 13

H H-shares, 17 harmful effects of insider trading, see effects of insider trading history, 1–5 insider trading regime, 19–28 after 1999, Congressional legislation, 22–23 before 1999, governmental regulations, 19–22 stock market, 7–10 Hong Kong Stock Exchange H-shares, 17

I incentive compensation mechanism, 97–100, 105 incentive to commit insider trading, 58–70 incidence of insider trading, 28–56 independent directors, 74 individual insiders, 45–49, 58, 68, 102 information advantage, 54 becoming public, 212–219

Index defined, 21 disclosure, see disclosure information connection only, 198–203 information-conveying mechanism, 01 informers, lack of, 81–83 innovative entrepreneur insider trading profits, 97–100, 105 inside information, 26, 27, 55, 203–219 access to, 71 analysts, 72 Article 75, 126 awareness, 221–230 defined, 203–206 information connection only approach, 198–203 knowledge that information is, 227–230 materiality, standard of, 206–211 possession, see material information; possession vs. use precision, 210–211 rumors, 46 scienter requirement, 221–223 subjective knowledge test, 227–230 use, see possession vs. use insider tipping, 69–70 Insider Trading and Securities Fraud Enforcement Act of 1988 (US), 26 Chinese Walls, 75 recklessness standard, 223 strict possession standard, 234 Insider Trading Sanctions Act of 1984 (ITSA), 26 Chinese Walls, 75 strict possession standard, 234 insider trading, defined, 1 insiders, 26, 46–47 Article 74, 128, 186–187 constructive, 187 corporate, see corporate insiders definition, Australia, 197–199 definition, critique of, 194–197 individual, 45–49, 47–49, 48, 58, 68, 102 information connection only, 198–203 scope of, 27 state of mind, 27 temporary, 187 institutional investors conducting insider trading, 45 intent, 221–223 inter-personal relationships (Renji Guanxi), maintaining, 69–70, 78 Yi Ren De Dao Ji Quan Shen Tian, 70 interest group politics, 18 international institutional investors B-shares, 13 investors confidence, 61, 103, 108 harm to, 106–107 plaintiffs, eligible, 274–305 short-term behavior, 63

Index J Jingan Branch of Shanghai Trust Investment Company, 9 joint stock companies, 9 judges, 26 ineffectiveness, 168–169 judiciary corruption, 86

351 state control, 73 localism, 86 long-term investments, 63–64 confidence of investors, 61 high P/E, effect of, 60 profitable, 59 loopholes liability, 161–163 subjective elements, 220

K M knowing possession test, 233 knowledge that information is inside information, 227–230

L Law of Conservation of Securities, 107 lawsuits eligible plaintiffs, 274–295 Legal Institute of the Sichuan Province Academy of Social Science research, 41 legal liabilities, 24 light, 87–89 social disgrace, 89 legal literacy, 46 legal person shares (faren gu), 13, 51 legislative system, 22–23 enumeration legislative technique, 26 liability administrative, see administrative liabilities civil, see civil liabilities classical theory, see classical theory criminal, see criminal liabilities legal, see legal liabilities non-connected person, 228 persons who have illegally obtained insider information, 128–129 persons with knowledge of insider information, see persons with knowledge of insider information possession of inside information, 223–227, 231 theories, see theories of liability, comparatively tipping, 142 license revocation or suspension, 91–92 liquidity, lower, 54 listed corporations committing insider trading, 65–66 corporate governance, 73–74 harm to, 105–106 reporting, 193 short-term behavior, 63

major events, 126–127, 204 management officers entity benefits, 68–69 insufficient compensation, 66–68 market capitalization, 10 H-shares, 17 N-shares, 17 market confidence, 1, 61, 103, 111, 117–120, 122–123, 213, 308 market economy centrally-planned economy transition to, 15 market efficiency decrease, 104 enhancing, 100–102 market makers, 107 market manipulation and misrepresentation, 38, 39, 40, 44–46, 54–56, 78–79 insider trading connected with, 53–56 market research and analysis, 205–206 market segmentation, 13 market-risk-shifting effects, 270–272 material information disclosure, 41–42, 54–55 waiting period after, 213–214 non-public, possession of, 1, 58, 71, 75, 96, 135–138, 140–146, 150–153, 163, 173, 179, 181–182, 187, 189, 190, 196–197, 223–227, 225 segregating underwriting departments, 75 materiality, 72, 206–211, 308 measure of damages, 256–268 benefit-of-the-bargain measure, 260–261 consequential damages, 261–262 ‘cover’ measure, 262–263 modified out-of-pocket measure, 258–260 out-of-pocket measure, 256–258 recovery, see measure of recovery rescission, restitution or rescissory damages, 263–265 windfall-profits measure, 265–268 measure of recovery, 269–274 application, 272–274 open market problem, 272–274

Index

352 shifting of post-transaction market risks, 270–272 Measures for Regulating Securities Trading in Shanghai (1990) Article 39, 20 Article 40, 20 Media dissemination of information, 214, 215, 219 proper disclosure media, 212 methodology, App. 1 mind-affective standard, 207–209 Ministry of Finance, 18 Ministry of Public Security Rules on the Standard of Prosecuting Economic Criminal Cases, 33–34 misappropriation theory, 128–129, 131, 138–140, 139, 187–188 dubious legal reasoning, 158–160 liability loopholes, 161–163 suitability to China, 157–163 United States v. O’Hagan, 146–151 modified out-of-pocket measure of damages, 258–260 modified possession standard, 236–237 modified use standard, 234–235 defences, 245–250 unclear proof-burden shifting effect, 243–245 moral hazard problem, 99, 105 multi-service securities companies, 190 Chinese Walls, 75

N N-shares, 17 Nanfang Securities Co. Ltd. and Beida Chechang Joint Stock Company case, 30–31, 46, 48, 51, 53, 55–56, 58, 72 National Economic System Reform Commission, 17 national legislation after 1999, 22–23 Securities Law, 25 National People’s Congress (NPC) criminal liability, 21, 25 legislations, 25 natural person insiders, 46–47 New York Stock Exchange (NYSE), 54 N-shares, 17 non-connected persons, 230 subjective knowledge test, 228 non-public material information, see material information non-tradable shares, 13–16, 51–52 nondisclosure fraud based on, 137–138, 158

victims, 293–294 nondisclosure-period traders approach, 282–288 Federal Securities Code (FSC), American Law Insititute (ALI), 284–286 Shapiro decision, 282–284 suitability of approach, 300–305 NPC, see National People’s Congress (NPC) NYSE, see New York Stock Exchange (NYSE)

O objective knowledge test, 228 Opium War in 1840, 7 OTC, see over-the-counter (OTC) market out-of-pocket measure of damages, 256–258 outside traders, benefit to, 100–102 over-the-counter (OTC) market, 9

P P/E ratio, see price to earnings (P/E) ratio parity of information equality of access v., 170–173 People’s Bank of China, 17 Provisional Measures for Regulating Securities Companies (1990), 19 People’s Daily (Renmin Ribao) influence on market, 61 person connection test, 194–195, 198–199 personal benefit test, 155–157 persons who have illegally obtained insider information, 128–129 persons with knowledge of insider information, 128–129, 194, 220, 224–225 Article 73, 231–232 Article 74, 128, 186–187 phantom stock, 98 plaintiffs, eligible, 274–305 policy market (Zhengce Shi), 60–62, 77–78 ‘pool,’ 54 possession vs. use, 220, 231–250 modified possession standard, 236–237 modified use standard, 234–235 defences, 245–250 unclear proof-burden shifting effect, 243–245 strict possession standard, 232–234 due process concerns, 239 unsuitability, 238–239 strict use standard, 234 difficulty establishing actual use, 242–243 unsuitability, 239–243 post-announcement waiting period, 212 pre-announcement share price run-up, 43

Index pre-publication trading, 103, 206 presumption of innocence, 229 presumption of possession, 224 price decoding, 101–102, 102 price gaps A-shares and B-shares, 11–13 price sensitive information disclosure, 71, 72, 82, 83, 104 knowledge of, 228 price to earnings (P/E) ratio, 59–60, 63 price-affective standard, 207–209, 210 price-function traders, 292 private agreement non-tradable shares, 51, 52 takeover by, 51–53 private civil liability, 27, 82, 106, 191, 254–305 cause of action, 288–289 contemporaneous traders approach, 277–282, 286–288, 298–300 Fridrich v. Bradford, 275–277 measure of damages, see measure of damages measure of recovery, see measure of recovery nondisclosure-period traders approach, 282–288, 300–305 plaintiffs, eligible, 274–305 private enforcement, 254–256 privity traders approach, 274–277, 286–288, 295–298, 304–305 private ordering theory, 108–109, 110 privity traders approach, 274–277, 286–288, 304–305 problems with approach, 295–298 procurement prohibitions, 185, 188–189 profits bonuses based on percentage of, 98 direct monetary profits, 58–68 insider trading profits, 97–98 prohibiting insider trading, theories for, see theories of liability, comparatively proof burden shifting effect, 243–245 property rights theory, 105, 108 Provisional Measures for Regulating Listed Companies in Shenzhen (1992) Article 93, 20 Article 103, 20 Provisional Measures for Regulating Securities Companies (1990) Article 17, 19 Provisional Measures for Regulating Securities Issuance and Trading in Shenzhen (1991) Article 43, 20 Provisional Measures for the Prohibition of Securities Fraud (‘Provisional Measures’), 21, 25 Article 3, 30, 31, 32, 33 Article 4, 21, 31

353 Article 5, 21 Article 6, 21, 188 Article 13, 21, 32, 33 Article 14, 21 bounties for informers, 82 fine, amount of, 24–25 Provisional Regulations on the Administration of Stock Issuance and Trading (‘Provisional Regulations’), 20 Article 3, 31 Article 4, 31 Article 38, 20, 29 Article 72, 20, 21, 32, 33 Article 77, 21 Article 78, 21 civil and criminal liability, 21 public disclosure, see disclosure public individual shares (shehui geren), 13, 51 public information, see disclosure public offer, 13 publishable information test, 215–216

Q QFII, see qualified foreign institutional investors (QFII) Qiong Mingyuan case, 55, 77–78, 89, 90 qualified foreign institutional investors (QFII) A-shares, access to, 12–13 qualitative research, App. 1, see also empirical findings of qualitative research

R R v. Rivkin, 49 readily observable matter test, 215–219 reasonable investor, defined, 209 recovery, see measure of recovery reform and opening up (gaige kaifang) policy, 10 regional governmental regulation, 17, 25 regional stock exchange centers, 10 regulation of insider trading Company Law, see Company Law of the People’s Republic of China (‘Company Law’) Criminal Law, see Criminal Law of the People’s Republic of China (‘Criminal Law’) CSRC, see China Securities Regulatory Commission (CSRC) history, 19–28 Securities Law, see Securities Law of the People’s Republic of China (‘Securities Law’)

354 takeover by private agreement, 52 takeover by tender offer, 52 theory and problems, 125–130 regulatory art (Jianguan Yishu), 87 regulatory framework of the stock market after 1997, centralized regulatory regime, 19 before 1992, dispersed regulatory regime, 17–18 1992–1997, transitional phase, 18 regulatory independence, 86 Renji Guanxi (inter-personal relationships), 69–70, 78 Renminbi (RMB), see Chinese Yuan (CNY) Renminbi Special Shares (Renminbi Tezhong Gupiao), 11 reporting requirements, 80, 114, 187, 193, see also disclosure reputation low levels of damage to, 89–91 regulator, Australia, 202 rescission, restitution or rescissory damages, 263–265 Restatement of Torts, 176 restricted foreign currency policy, 12 rights issuance, disclosure, 41 Rules on the Standard of Prosecuting Economic Criminal Cases, 33–34 rumors as inside information, 46 Russian privatization process, 15

S scalping, 206 scienter requirement, 221–223, 229–230 SCSC, see State Council Securities Commission (SCSC) SEC v. Texas Gulf Sulphur Co., 135–136 securities covered, 250–251 Securities Exchange Act of 1934 (US), 131 Section 10(b), 131–132, 131–134, 136–140, 144, 148, 157, 158–162, 174, 221–222 Section 16, 132–133 Section 20A, 234 Section 21A, 223, 234 Section 21D, 271–272 securities fraud actions measure of damages, see measure of damages securities fraud scandals in 1997, 19 Securities Law of the People’s Republic of China (‘Securities Law’), 4, 22 Article 1, 181 Article 47, 22, 192–194 Article 67, 126–127, 203–204, 224 Article 73, 22, 126–130, 186, 231–232

Index Article 74, 126–130, 186–187, 188, 195–197, 198, 225, 250 Article 75, 23, 46, 126–130, 203–205, 207, 210–211 Article 76, 23, 88, 126–130, 187, 188–189, 197, 232, 254 Article 85, 51 Article 86, 193 Article 101, 53 Article 136, 190–191 Article 139, 53, 75 Article 167, 85 Article 168, 85 Article 179, 28 Article 183, 23 Article 184, 28 Article 202, 23, 87, 191 Article 231, 88 civil liability, 27, 50 disclosure, 212 enumeration, 26 equality of access theory, 181 information disclosure, 71–72 inside information defined, 203–206 misappropriation theory, see misappropriation theory private civil liability, 27, 82 US assistance, 25 Shanghai Feile Acoustics Joint Stock Company, 9 Shanghai Huashang Zhenquan Jiaoyisuo, 8 Shanghai Stock Exchange (SSE), 3, 8, 9–10, 20, 54 Department of Listed Companies, 80 surveillance system, 80, 81 Shanghai Vacuum Electronic Appliance Joint Stock Company, 12 Shapiro decision, 282–284 share hand-changing rates, 62 shehui geren (public individual shares), 13 Shenchandui (team of production), 8 Shenshen Fang case, 34–35, 47, 50, 51, 212, 219 Shenzhen Stock Exchange, 3, 9–10, 20, 54 short swing transactions, 20, 30, 47, 192–194 Section 16 of the Exchange Act (US), 132–133 short-term behavior, 63 signaling function, 102 social tolerance for insider trading, 82 socialism with Chinese characteristics, 3 socialist market economy, 8, 14 specificity of information, 212 speculative market, 59–63 SSE, see Shanghai Stock Exchange (SSE) State Council Securities Commission (SCSC), 18, 20 CSRC, merged into, 19 State Development Planning Commission, 18 State Economic System Reform Commission, 18

Index state ownership, 14 state shares (guojia gu), 13, 14–16, 51, 52 absence of functional owners of the state owned shares (Guoyougu Suoyouzhe Quewei), 15 reducing (Guoyougu Jianchi), 16 trading restrictions, 14–16 state-owned enterprises, 9 stock market Deng Xiaoping comments on, 15 development of, 7–10 equity structure, 11 features, 10–17 fraudulent misconduct, 22 H-shares, 17 N-shares, 17 types of shares, 10–17 stock options, 67, 98 strict possession standard, 232–234 due process concerns, 239 unsuitability, 238–239 strict use standard, 234 unsuitability, 239–243 subjective elements, 219–251 awareness of inside information, 221–230 knowledge that information is inside information, 227–230 possession of inside information, 223–227 possession vs. use, see possession vs. use scienter requirement, 221–223 subjective knowledge test, 227–230 supervisory board, 73–74 Supreme People’s Procuratorate Rules on the Standard of Prosecuting Economic Criminal Cases, 33–34 surveillance system, 80–81

T takeovers, 42–43, 50–53, 205 team of production (Shenchandui), 8 temporary insiders, 187 tender offer Rule 14e-3, 141, 150, 162–163, 180 takeover attempts by, 16 takeover by, 51–53 tradable shares, 51 theories of liability, comparatively classical theory, see classical theory contradicting law, 126 derivative duty theory, 143 equality of access theory, see equality of access theory fiduciary-duty-based theory, see fiduciary-duty-based theory fraud on investors theory, 139

355 fraud on the source theory, see misappropriation theory misappropriation theory, see misappropriation theory persons who have illegally obtained insider information, 128–129 persons with knowledge of insider information, 128–129 Third Plenary Session of the 11th National People’s Congress reform policy, 1978, 8 Tianjin Stock Exchange, 8 time-function traders, 292 tipping prohibitions, 47, 69–70, 141–146, 155–157, 185, 188–189 tradable shares, 13–16, 51 trading prohibition, 185, 188 traditional theory, see classical theory two-tier corporate governance system, 73–74 types of insider trading, 47–48

U United States v. O’Hagan, 146–152, 159, 162, 180–181, 240 urban sector reform, 9 US regulation Chiarella v. United States, 136–140, 151–152, 154, 158, 171–173, 180–181, 188, 240 classical theory, see classical theory common law principles, 173–177 derivative duty theory, 143 Dirks v. SEC, 141–146, 151–152, 155–157, 158, 180, 210, 214, 240 disclose or abstain rule, 135–136 equality of access theory, see also equality of access theory Cady, Roberts & Co, In re, 134–135 Chiarella v. United States, 136–141 SEC v. Texas Gulf Sulphur Co., 135–136 Federal Securities Code (FSC), American Law Insititute (ALI), 284–286, 305 fiduciary-duty-based theories, 141–146 classical theory, see classical theory misappropriation theory, see misappropriation theory fraud on investors theory, 139 fraud on the source theory, see subhead misappropriation theory Fridrich v. Bradford, 275–277 Insider Trading and Securities Fraud Enforcement Act of 1988, 26 Chinese Walls, 75 Insider Trading Sanctions Act of 1984 (ITSA), 26

Index

356 Chinese Walls, 75 misappropriation theory, see also misappropriation theory United States v. O’Hagan, 146–151 Regulation FD, 144–146, 157 Restatement of Torts, 176 Rule 10b-5, 26, 131, 133–134, 135, 136–140, 144, 148, 157, 158, 161, 164–167, 174, 189, 221–222, 236–237, 245–246 Rule 14e-3, 141, 148, 150, 162–163, 180 SEC v. Texas Gulf Sulphur Co., 135–136 Securities Exchange Act of 1934, see Securities Exchange Act of 1934 (US) Shapiro decision, 282–284 United States v. O’Hagan, 146–152, 159, 162, 180–181, 240

Wang Chuan case, 32, 47, 51, 68 white-collar crime, 89–90 windfall-profits measure of damages, 265–268 World Trade Organization (WTO), 2, 12 WTO, see World Trade Organization (WTO)

X Xiangfan Shangzhen case, 28–29, 46, 47, 48, 50, 51, 53, 58, 187

Y Yu Mengwen case, 32–33, 51, 68

V victims of fraud, 289–295 volatility of market, 51

W wage market, 98 Waishang Shanghai Zhongye Gongsuo, 7 waiting period, post-announcement, 212

Z Zhangjiajie Tourism Development Co. Ltd. case, 30, 46, 49, 51, 53, 80–81, 91, 189

INTERNATIONAL BANKING AND FINANCE LAW SERIES 1. Jan Job de Vries Robbé, Innovations in Securitisation. Yearbook 2006. (2006) ISBN 90411-2533 - 7 2. Jim Bartos, United States Securities Law: A Practical Guide, Third edition. (2006) ISBN 90-411-2362-8 3. Hui Huang, International Securities Markets: Insider Trading Law in China. (2006) ISBN 90-411-2557-4

I N T E R N AT I O N A L B A N K I N G

AND

F I N A N C E L AW

SERIES

International Securities Markets: Insider Trading Law in China Hui Huang If China is to fulfil its promise as the world’s fastest growing economy, the development of a reliable Chinese securities market is essential. The scourge of insider trading, however – commonly thought to be enormously prevalent in China – poses a major obstacle to such development. The situation is not seriously challenged by China’s insider trading regulatory scheme, which leaves much to be desired in the way of deterrence and enforcement. This book offers the first detailed analysis of China’s insider trading law, explaining what constitutes insider trading in China and what the consequences of unlawful insider trading might be. More importantly, it suggests ways in which the law might prevent the occurrence of insider trading more effectively. Among the elements of the legal framework addressed by the author are the following: – – – – – – – –

rationales for prohibiting insider trading; who are insiders?; what is inside information?; subjective elements of insiders; liability for insider trading; persons entitled to compensation; prohibition on short swing profits; preventive measures against insider trading.

The author’s approach focuses on China’s readiness to adopt foreign ideas without adequately assimilating them into the local context. In this connection, he sets out valuable reform proposals, using authority from field interviews with Chinese stakeholders as well as from comparative case law. As an in-depth discussion of the relevant political, legal, economic and social context in which Chinese insider trading law operates, this highly informative and useful book will serve as a sterling legal guide to China’s securities market in general. It will be of great interest to many, including law students, lawyers, business people and market regulators who want to inform themselves about the important legal issue of insider trading, and who are interested in the Chinese securities market.

ISBN 90-411-2557-4

KLUWER LAW INTERNATIONAL

IBFL 3