Introduction to Company Law Note 5 of 7 Notes

Insider trading

Universiti Kebangsaan Malaysia Faculty of Law Pursuing PHD Program in Law

Musbri Mohamed DIL; ADIL ( ITM ) MBL ( UKM ) 1

On November 4, 2011.Malaysian Finance Ministry has launched investigations into the allegations of insider trading between national carrier Malaysian Airlines (MAS) and Air Asia..It was claimed that the trading occurred during the recent swap deal between the 2 national carriers. According to Datuk Dr Awang Adek Hussin, the Deputy Finance Minister, Bursa Malaysia and The Securities Commission will first analyse the details and when the ministry has enough concrete evidence, then they will take the appropriate action. He said that investigations would take some time for all the evidence to be reviewed. He also said that there is no need to call in the MACC (Malaysian Anti-Corruption Commission) at this stage.

BOSTON December 6, 2011 : Hedge fund multimillionaire Raj Rajaratnam began serving his 11-year prison sentence on Monday the longest on record for insider trading at a former military base near a small, leafy Massachusetts town. The 54-year-old Galleon Group founder reported to the prison about 40 miles northwest of Boston, said Robert Lanza, a spokesman for the Federal Medical Center Devens in Ayer, Massachusetts. He gave no further details. The prison specializes in housing prisoners with long-term medical needs. Rajaratnam is diabetic and is likely to soon need a kidney transplant, according to court records presented at his sentencing in Manhattan federal court in October. The central figure in a broad government crackdown on insider trading, Rajaratnam was convicted by a jury in May of running a network of friends and associates who leaked corporate secrets to him for years. The sentence imposed by U.S. District Judge Richard Holwell was the longest on record for insider trading by one year.

Insider trading is a term that most investors have heard and usually associate with illegal conduct. In a laymans term, insider trading or dealing can be considered as the purchase or sale of a companys securities effected by or on behalf the corporate insiders of a company, namely officers, directors, management, employees, etc, by using relevant non-public material information (pricesensitive information) regarding that company. Insider trading violations may also include tipping such information, securities trading by the person tipped, and securities trading by those who misappropriate such information.

One might question the reason why insider trading activity is considered misconduct in most markets. The reason is pretty simple and straight forward, that is, insider trading undermines investors confidence in the fairness and integrity of the securities markets. In a market where insider trading activities are rampant, investors might shy away from investing in the market because information that can be considered sensitive to the company can be easily leaked to the investing public before it is supposed to be made public. The investors can then make an unfair gain in the trading of the companys securities using the inside information. In other words, the market lacks fairness and integrity.

Basically, there are two important elements that make up an insider trading; one, the information that can be constituted as inside information and is price sensitive, and two, the person with the insider knowledge. Under the recently enforced Capital Markets Services Act 2007 (CMSA), insider trading is considered as market misconduct and is covered comprehensively under Subdivision 2 of Part V of the act, particularly under Section 183 to Section 211. The information has to fulfill certain criteria to be considered as an inside information. The type of information under insider trading is explained under Section 183 CMSA.

An information is not considered to be an inside information if the information is made available to the general public. In other words, the public can have equal access to the information and may use it to trade in the securities. This is provided under Section 184 CMSA.

How shall one ascertain the characteristic of an inside information? Apart from what is explained under Section 184, an information is considered as an inside information if and when it becomes publicly available, it would have a material effect on the price or value of the securities related to it and it would affect the decision of the reasonable investors whether or not to trade on such securities. This is clearly explained under Section 185.

CMSA covers a broad definition of persons who can be caught as an insider. Firstly, any person who possesses inside information is prohibited from trading in the relevant securities. Secondly, a person who possesses inside information is also prohibited from communicating that information. Insiders are not limited to persons with fiduciary duties such as CEOs or directors but can include all persons who have in their possession information that is not generally available. Such persons may include a member of a directors family, a body corporate that is associated with that director, or a substantial shareholder. In addition, a person who communicates inside information to enable another person to use it for his advantage, that person, known as tippee, can also be charged for insider trading.

The act does not only prohibit a person from trading using inside information, but it also prohibits company and partnership from doing the same. This is provided under Section 190 (1) and 191 (1)(c) CMSA.

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So, what does an insider prohibited from doing? A person who is in possession of the information is prohibited from using such information to trade in the securities where the information relates and shall not communicate it to any other person with the attention to influence the other person to trade in such securities. Section 188 (2) and (3) explains such provision.

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In essence, this section prohibits and insider from buying and selling securities to which the information relates, or entering into an agreement to buy or sell securities using the related information. It also prohibits procuring another person to buy or sell or even enter into an agreement to buy or sell securities using the related information. Apart from that, the insider is also prohibited from communicating or tipping the information to other parties if he knows that the other person will buy or sell securities or enter into an agreement to buy or sell securities to which the information relates. Penalty for those who contravene Section 188 (2) or (3), he/she is tantamount to a criminal offence and can be imprisoned not exceeding 10 years and a fine of at least one million ringgit. This is explained under Section 188 (4) .

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This section explains that for a corporation, does not contravene an insider trading offense under section 188 (2) if the decision to enter into the transaction was taken by a non-insider a third party other than the officer who has the information. This section is in place to ensure that: the information was not communicated to the person involved in the transaction or agreement no advice was given to the person involved in the transaction or agreement by the person in possession with the inside information the insider is not involved in the in the decision to enter into the transaction or agreement . The same section also applies to partnerships. A person is also not considered as an insider if he is an underwriter or sub underwrites the transaction, as explained under section 192 .

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The insider trading activities should and must be curbed to ensure and enhance the integrity of the capital market. The integrity of a capital market is measured by the confidence that an investor can have that the companies in which he invests provides regular, timely and accurate disclosures. Information is a key to enabling investors to make sound investment decisions, permitting price discovery and ensuring that the funds are raised in the most efficient manner. A market is not considered to be of high integrity if information in the market is not disseminated fairly timely and orderly manner, as it would only benefits a group of investors and not the market as a whole.

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There are many repercussions from not being a market with integrity. One, investors, both local and international, will not have confidence in the market as they consider the market not competent and will unable them to make sound investment decisions. Second, as investors consider the stock market of a country as the market barometer of the economy as a whole, foreign direct investments (FDI) will be jeopardized. This will then lead to a reduction in the foreign currency flow into the country. And this may give a huge impact to the Gross Domestic Product (GDP) of the economy. The snow ball effect does not end there. It may roll fiercely and ferociously and make everything flat on its path.

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The Securities Commission, as the sole regulatory of the capital market in Malaysia, has taken several measures to ensure more transparent capital market. One of the measures is to move towards a disclosure-based regulatory (DBR) system. The objective of DBR is to promote greater efficiency and transparency. Under this regulatory regime, transparency is to be enhanced through comprehensive and timely disclosure. Among the measures undertaken by the SC to promote transparency are: Amendments to the Bursa Malaysia listing requirements requiring publiclisted companies to provide financial statements on a quaterly basis to ensure corporate information is available on a timely basis Rules on related-party and interested-party transactions have been changed to better protect minority shareholders. Amongst other things, the revised rules also call for enhanced disclosure to be made in the announcement and circular to shareholders in respect of such transactions, before such transactions may be approved by the investors. Apart from the CMSA, insider trading is also an offense under the Bursa Malaysia Rule (Bursa Rule). This is mentioned under Rule 404.1(13)

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In Malaysia, insider trading is an offense under Section 188(2) of the newly launched Capital Markets and Services Act 2007, a retrospect from Section 89E(2) of Securities Industry Act 1983. If convicted, the insider may be penalized with a fined of not less than one million ringgit or imprisonment for a term not exceeding to years. Besides that, the person(s) who fall victim to an insider trading activities may take civil action against the perpetrators to recover any loss or damages as a result of such activities.

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Not everyone views the regulation of insider trading as being desirable or effective in improving market efficiency. Eminent and experienced authors have articulately presented many arguments both for and against such regulation. The existence and enforcement of insider trading regulation in stock markets is a phenomenon of the 1990s.

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A study of the 103 countries that have stock markets reveals that 87 countries have insider trading laws, out of only 37 have seen one or more proceedings being initiated under the legislation. Prior to 1990s, the respective numbers were 39 and 4. Among other reasons includes the onerous burden of proof required to secure convictions, the loopholes existing in the relevant legislation and the lack of political will and resources for the regulators to initiate proceedings.

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Basically there are four main theoretical foundations that provide the legal basis for regulating insider trading: Classical Theory Misappropriation theory Unfair advantage theory Market stability theory The classical theory of insider trading imposes liability on corporate insiders who trade on the basis of confidential information obtained by reason of their position with the corporation. It requires that there be some form of fiduciary relationship or relationship of confidence between the offender and the corporation for liability to be established. The liability is based on the notion that a corporate insider breaches a duty of trust and confidence to the shareholders of his corporation.
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This so called connected person to the corporation is prohibited from dealing with securities of that corporation hes connected to while in possession of price sensitive information that is not generally available. Connected person are broadly defined to include directors, officers, substantial shareholders of the company and related company who have access to such information by virtue of any business or professional relationship with the company. On the other hand, misappropriation theory does not emphasis on the existence of a relationship between the insider and the corporation whose securities are traded. Any person is prohibited from dealing in securities when he is in possession of price-sensitive information concerning the corporation that is not generally by proscribing all such persons as insiders.

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Misappropriation theory relies on the principle that all information generated by or through the company belongs to the company. That company owns proprietary rights to information and particularly the exclusive right to the use of the information. Consequently, persons who come into possession of such information in circumstances that warrant confidentiality are not permitted to misappropriate the information for their personal gain for benefit.

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The prohibition is also based on the notion that the outsider breaches a duty of loyalty and confidentiality to the person who shared the confidential information with him. Therefore all third parties are also precluded from using the information generated by a corporation pursuant to an anticipated transaction or event such as a takeover or a resignation of a key executive without the corporations consent. Not only are the insiders and the outsiders forbidden from trading on the basis of the confidential information they have received, they are forbidden from tipping such information to someone else.

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Another theory is the unfair advantage theory which stems from a policy that trading should only take place between parties where there is equality access to information. It has been suggested that the function of insider trading regulations is to allow fair play in the marketplace. An insider, trading with the benefit of inside information, would have an informational advantage over the other trading party. This is undesirable and should be prohibited.

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The last but important theory is the market stability theory. For investors to have confidence in a market where securities are traded there must be some assurance that everyone who is trading in the market is doing so on an equal footing. Proponents if this theory argues that there must be equality of information for participants in the market. An absence of such equality would result in a loss of confidence in the transparency and efficiency of the market and would discourage participation.

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1. Why is insider trading prohibited? 2. Who is an insider? 3. What is meant by the term price sensitive information?

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As a conclusion, insider trading activities if not curbed can undermine investors confidence in the fairness and integrity of the securities markets. The insider may make an unfair decision to enter into the transaction, either to buy or sell a certain securities, using the information not publicly known. Musbri Mohamed February 2012

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