Know your companyInsider trading and secondary markets—when the cat is away, the mice will play
In the 1987 movie Wall Street, Gordon Gekko (played by Michael Douglas), says, “Greed, for lack of a better word, is good. Greed is right, greed works.” Greed is one of the major emotions driving financial markets. The other is fear. Arguably, greed is essential for capitalism to work. At the same time, it can be argued that capitalism fosters greed. Whatever the case, excess greed is never good.
Take insider trading. Typically, CEOs, directors and senior officers of a publicly traded company are treated as insiders. This can be expanded to include low-level employees, their relatives and friends, bankers, financial planners, you name it. In short, whoever has access to material and non-public information is an insider, and they cannot act on it before the information is disseminated to the public.
Not all insider trades are illegal, however. Insiders are legally permitted to buy and sell shares of their employer. But this needs to be done with proper registration with the proper authorities. At the other end of the spectrum, some want insider trading to be made legal. Period. No less a luminary than the late Nobel laureate Milton Friedman supported more insider trading, not less. The argument was that insiders knew their companies best, hence they should be allowed to trade on that knowledge to make the public aware of it.
What constitutes an insider is not a one-size-fits-all. It varies from one country to another. As do prison terms and monetary fines for violators. In Nepal, Chapter 9 of the Securities Act of 2007 deals with insider trading. It is short on details. Those who are found guilty can be sentenced for up to a year in prison and are liable to monetary fines equal to the amount of the ill-gotten gains, or both. At a press meet in early July, officials of the Securities Board of Nepal (Sebon) said they were formulating policies to curb insider trading. These are rudimentary steps, which is not all that surprising given the relatively short history of stock investing in the nation. Sebon, which regulates the nation’s securities markets, was established in June 1993. Nepal’s only stock market, the Nepal Stock Exchange (Nepse) began trading in January 1994.
Compare this with the New York Stock Exchange which was created in 1817, and this was not even the first stock exchange in the US. That honour goes to the Philadelphia Stock Exchange, which was founded in 1790. Hence, the comparison to the US, or any other developed market for that matter, is meaningless if we just use it to point out shortfalls in the Nepali market. It can help if instead we use it as a learning tool. At one point, today’s developed markets went through what unsophisticated markets like Nepal are currently going through. Thus, when insider trading rules are given concrete shape in Nepal—whenever that is—it is important not to have very high hopes right off the bat. This applies to both the regulators and the general public. In fact, the very fact that the stock market in Nepal is so young raises the odds of abuse.
Grey area aplenty
It is nearly impossible to completely stop insider trading. Arguably, this is one reason why technical analysis works. People with the inside track act ahead of the general public, which then gets reflected in the chart. Even in the developed markets such as the US, we constantly hear of abuses. Some of the prominent Americans busted this century include Jeff Skilling (CEO, Enron), Martha Stewart (founder, Martha Stewart Living Omnimedia) and Raj Rajaratnam (founder, Galleon Group). There are countless others we probably have never heard of. Countless others—minor offenders, in particular—probably never get caught. The latter fact should come as a surprise given these are markets with multiple decades of data accompanied by sophisticated technological tools. These exchanges have even developed software to try to identify unusual trading patterns. In the US, there are paid services that constantly glean the options market to detect abnormal trading.
That is why in the developed markets, insiders in the know avoid options when indulging in illegal trades. That is the first place the authorities look. Some others may buy a boatload of shares and then sell some before the information becomes public, just to show it was all a part of normal trading. They can also, let us say, short a competitor’s stock if an impending acquisition by a rival company results in loss of market share. The same way some thieves are one step ahead of the cops, abusers of insider information come up with ways to outwit the regulators. Their job is made easier particularly because there is so much grey area.
Here are a couple of hypotheticals. You are having dinner at a restaurant and overhear a conversation at the next table that Company A has just won a massive contract, which will significantly boost its earnings. Tomorrow, you go long Company A shares. Once the news is announced, the stock goes through the roof, and you quickly make a bundle. Did you trade on insider information? Or, consider this. Company X just got acquired by Company Y. It turns out that just a few days before, Mr Smart had built a massive position in Company X. He had no knowledge of the impending acquisition, but knew from an inside source that Company Z had looked into Company X’s books. Something is cooking, he thought. Was he acting on a hunch or trading on insider information?
Mergers and acquisitions (M&A) offer a fertile ground for insider trading. There are so many parties involved that the chances of abuse rise significantly. Not much M&A takes place in Nepal. Only 210 companies are listed on Nepse. But the odds of abuse increase around announcements of earnings and so forth. (In the US, employees are subject to blackout periods during which they cannot trade their employer’s stock.)
When the cat is away, the mice will play. There may be times when even though a suspicious trade has occurred, Sebon may have difficulty in connecting the dots. What is the extent of their investigative powers? Are they allowed to even look at the phone records of persons they are investigating? Or how about the accounts of relatives, friends and so forth? The online trading system that just began might help, but it is not a panacea. Even the definition of insider trading is not an easy task. The sooner Sebon begins to cut its teeth into the matter, the better it is for its own learning curve. Yes, greed is as certain as gravity, but for those who like to play fast and loose, it has no limit. Fear of getting caught is what can reduce greed, if not stop it outright.
Pandey specialises in portfolio investment and economic issues