Australian Institute of Criminology

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Chapter 6 - The effects of insider trading

Published in:
Casino capitalism? Insider trading in Australia / R Tomasic
Canberra : Australian Institute of Criminology, 1991
ISBN 0 642 15877 0
(Australian studies in law, crime and justice series) ; pp 55-67


Insider trading is unfair in the same way as a fixed horse race is unfair; it gives the Australian market a bad image.
(Melbourne regulator)

Regulation is about equity not about efficiency.
(Sydney market observer)

In determining the appropriate legislative responses and enforcement strategies to deal with insider trading it is necessary to understand both the extent to which it occurs and the effect of insider trading on the market, on individuals and, indeed, on the international reputation of Australia. Is it serious enough to warrant legislative intervention?

Harmful effects of insider trading

Almost all of the brokers said that insider trading is harmful and the most commonly expressed view was that the harm was done to the market. Some said that small shareholders suffered. Some of those who expressed contrary views said that there were no losers because there were willing sellers. Amongst those who agreed that there was harm to the market there were various qualifications of that view. According to one broker, "in its rawest form insider trading dislocates the market. It upsets overseas investors". Similarly, a Sydney broker asserted that "sophisticated insider trading done on a big scale erodes market confidence. Australia's image was damaged by insider trading in the mining boom. "Innocent" insider trading has negligible effect". A more specific statement was that "the harm is to confidence in the marketplace. It is necessary to protect smaller people-insider trading hurts small people". A similar opinion was that "it is a form of stealing. It damages the system, especially small people. The entrepreneurs steal from the weak".

A more general explanation was that "the vast majority of shareholders suffer. They miss out on value; they should be able to share profits". A somewhat different assessment of the damage was that quot;there is more money lost by people acting on what they think is inside information than by those who sold".

Some brokers were more specific about where the harm is felt. A Melbourne broker said "smaller shareholders are disadvantaged. The institutions are not. They are in a privileged position, in a favoured position and are getting all the information that is around-but are not necessarily insider trading".

Those who felt that no harm was caused by insider trading offered several views. One was that "there is a willing seller who would have sold anyway. It is caveat emptor in the marketplace". Another was that it is "a swings and roundabouts situation. There is some damage in blatant cases such as in pre-takeovers". One of the very senior brokers described insider trading as "a victimless crime. In the equities market you cannot totally protect everybody. It has an unfortunate effect on the market".

Most of the financial advisers felt that insider trading is harmful and for the most part they identified the victim as the market. In more specific terms they said that investor confidence is eroded; the raising of capital is made more difficult; the efficiency of the market is destroyed; the perception of unfairness leads to disinvestment and that the international reputation of the Australian market suffers. One view was that the market does not suffer from insider trading because it is always in need of information. Other victims of insider trading were identified as the "Mums and Dads" investors, small traders, and those who do not have the information and trade in that state of ignorance. The fund manager who thought differently said that "there is not really any harm. Although the game is not played with fair rules I believe that people buy and sell shares at prices they find attractive".

The stock exchange officials believed that there was some harm associated with insider trading. They said that the market suffers, the seller is the victim and mathematically, persons who conduct transactions without being properly informed are banned. The one dissenting view was that there is no harm, "particularly in Australia as the market is so thin. The seller is not forced to sell. He sells at a price he thinks is fair".

In the market observer group the view was that insider trading is harmful and the words "unfair", "wrong", and "defrauds" were used in describing its effect. The views as to the victim of the harm fell into the two usual categories - the market, and those who were on the other side of the transaction. An answer that perhaps summed up the views of the group was that "it distorts the market; it is unfair to small shareholders; it creates an unfair advantage and it destroys the level playing field".

The concept of a group of uninformed shareholders being taken advantage of was summarised as "people on the outer ring of the market are disadvantaged". A more robust view was that "the real harm is that the game is not straight. We need an informed, honest market" but less concerned with the effect on investors was the observer who said that "in some situations insider trading could undo a deal".

Most lawyers agreed that there was harm caused by insider trading but they also said that it was a question of perspective. As one Sydney lawyer put it, "it all depends upon where you stand. I've never been interested in little old ladies and orphans. There must however be a minimum level of regulation. It seems wrong when you hear of cases of insider trading. The law has a role to inhibit it but not to stop insider trading entirely". In a similar vein, a Melbourne lawyer observed that "the degree of harm depends upon the circumstances of a particular stock. Insider trading can both advantage and disadvantage an individual". The most common view was that insider trading was harmful because of its unfairness to the person who does not have the inside information.

A strong view was taken by a Melbourne practitioner, who said that "insider trading distorts securities markets. Insider trading is a fraud. People should be fully informed or have the capacity to be so if they seek advice". A Sydney lawyer expressed the view that "no economic loss is caused by insider trading, but insider trading is a question of fairness". Lawyer interviewees sometimes also held more complex or ambiguous views. The strongest critic of the view that insider trading causes harm emphatically answered that "insider trading is not the major evil it is made out to be". He acknowledged however that "a problem arises from an insider's ability to get out before the market knows what the real problems are. But most big investors and individuals don't invest in anything but blue chip companies and the latter do not insider trade as insider trading is too risky". The predominant view of the lawyers was that insider trading was undesirable on the ground of fairness.

Amongst the regulators, the issue of perceived unfairness was common. Frequent references were made to the level playing field. One regulator observed that 11 an uninformed market is not a fair market, as it may not represent the true value of the securities. The end detriment is to the general public who are indirectly affected through their commitments to superannuation funds and the like" It was also said that "if a market is seen as being 'unfair' then both the confidence of the players and the credibility of the Australian market are harmed". The regulators commonly observed that the company itself was harmed by insider trading, because it became difficult for the company to raise capital. One regulator said that "the company is harmed by the misuse of information which belongs to it. In some large corporations or groups this is not so simple because managers expect to benefit from insider trading as a spin-off from the company's deals".

The regulators were in no doubt that insider trading was harmful for a range of reasons, but again ranked fairness as the main reason for the perceived harm caused by insider trading. Former NCSC Chairman, Henry Bosch, argued before the Griffiths Committee, that damage to shareholders is not the most important damage which arises from insider trading activity. He began by putting insider trading in the context of other corporate law offences when he said:

I would like to argue that insider trading is not the malefaction that does the most harm. I believe, and the Commission believes, that misleading accounts, secret deals, the reversible put and call options that have recently become quite popular, the misuse of controlling shareholders' positions, market manipulation and warehousing, all cause more damage to shareholders, and more identifiable damage, than insider trading.

He went on to add:

However, I do not think that damage is the most important argument. Confidence is the most important argument. People recognise or believe that a certain amount of insider trading is going on and they stay away from the market as a result... I believe that we should be very concerned about that because in Australia only about 9 per cent of our population holds shares, whereas in the United States and the United Kingdom over 20 per cent of the population holds shares (Griffiths Committee, Hansard, p. 77).

The New South Wales Corporate Affairs chief, Barry French, said:

... the view of my agency is that while insider trading exists, we do not see it as being the major corporate crime that seems to be running around the country at present. It is certainly one of a number but we see it as no more rampant and difficult than some of the other things happening such as directors within companies moving money around and manipulating things. Perhaps, at the end of the day, those sons of crimes are even worse than insider trading" (Griffiths Committee, Hansard, p. 179).

It is difficult to accept that insider trading is the victimless crime that it is said to be. Perhaps those who hold to this view mean to say that insider trading is a crime without an obvious victim. Harm is caused whether it be to an individual or the corporation, or to the market. Individuals might not realise that they are victims, but they nevertheless suffer at the hands of an insider trader. They either sell shares for less than their true value or purchase shares that are about to lose value. In either case, they are at least taken advantage of or deceived. There was also a strong feeling that the market is banned by insider trading because it detracts from an honest and informed market. Insider trading has the effect of corrupting or debasing the market.

Beneficial effects of insider trading

Professor Henry Manne (1966a) has argued in defence of insider trading that it acts as a price accelerator and brings the price of securities to their proper level more quickly than would otherwise be the case. Another argument identified with Manne is that insider trading is beneficial because it provides an additional incentive to management to be more entrepreneurial in running the companies that they control.

The brokers were equally divided about whether or not insider trading had any beneficial effect (apart from the profit made by the insider trader). Many of them offered answers because they were asked. There was very little support for Manne's arguments. The usual form of the negative answer was a flat "no". One expanded response was that "the only beneficiary is self-interest". According to one broker, insider trading could 'warn the market and thus stop premature selling [and it] could upset a takeover bid".

The most common answer of those who saw benefits was that "insider trading is good for the market by providing increased activity" and that "insider trading drives the market". Other views about the possible benefits of insider trading included the obvious point that "it is beneficial for the people getting out". A more serious commentary was that "it forces information into the market". One dimension of insider trading spoken about widely was that: "maybe it puts pressure on the bidders in takeovers to go higher. It is in the bidder's interest to reduce insider trading; for the shareholders in targets perhaps it helps".

The responses to the market accelerator argument were almost all unfavourable. Some brokers challenged the premise on which the argument rests. One said that "the price mechanism is not necessarily efficient". A stronger rejection of the argument came from a Sydney broker who said: "[the market accelerator argument is] rubbish; it is for the benefit of a few. It is patently absurd. What is the proper price level? It should be determined in a free market". Another broker asked "what is the proper level?" Manne's price accelerator argument was dismissed by others as 'Justifying the black market", "a rationalisation" and as "nonsense".

One of the brokers who acknowledged that there was some appeal in the Manne view said, "it sounds fine, but if somebody benefits along the way that is not right. It is good for forcing information on to the market". A reaction to that was "that is fair enough but it is better to make the announcement before insider trading starts".

The brokers' views about the management reward argument were expressed strongly and were almost universally condemnatory. One broker simply said that "this should never occur". Several said that "they should be rewarded by a company profits incentive scheme" or, "they should be rewarded in remuneration. They should get a reward for extra effort". Others felt strongly about the impact of the practice on shareholders. According to one broker "[the argument is] rubbish. Executives should be rewarded on performance by their employers not by participants in the market". A similar view was that "it is wrong to bribe them. Their job is riskless, they do not put up any capital. They want to take it from the shareholders". A similar view was that "it is wrong. Executives are being paid from the profits of the company. They cannot trade". One view which raised an important issue was that "if trading by insiders in the absence of price sensitive information were publicised, as it is under the US system, that would be a good thing. If an insider sells and people know, it gets a message to the public. Insiders who hold shares should do so for a year or longer. People jobbing in and out of their shares is a disgrace". This broker strongly endorsed the short swing profits rule. The reactions to these questions were a significant demonstration that the brokers have an aversion to insider trading, at least in principle, but of more significance is the commentary they provide on the way the market is affected.

The majority view amongst financial advisers was that there are no benefits. As one respondent put it "insider trading accelerates the market and this is okay from an efficiency viewpoint but it is not ethical or moral". Those who were not part of the majority said that insider trading brings news to the market more quickly. There was total rejection of both strands of the Manne defence. Several financial advisers commented that if bringing news to the market is a good thing it would be better if the disclosure were made by the company itself and some doubt was expressed as to whether it accelerates the price. The reward argument was described as "a twisted form of logic" and another said that "it is a sad case if you have to rely on insider trading to provide an incentive". Without exception the stock exchange officials said that insider trading has no beneficial effect. Referring to the accelerator element of the argument one said that "it is better for the information to come from the company" and another said that he did not agree with the Manne view "especially when prices are going down". The reward aspect of the Manne theory was described as "a pretty weak argument" as "it forgets who owns the company. The incentive should be in other forms".

The observers shared the same attitude to the Manne view of insider trading. It "is contrary to basic traditions of business" said one, "it only benefits the winner. Insider trading should never be legalised". Another stated: "regulation is about equity not about efficiency". The benefits from insider trading were that "it allows the market to reassess the stock price. It is informationally efficient" and, perhaps in an effort to say something good about insider trading, one person remarked that "the lenders of money used to buy shares benefit". The mainstream of opinion reflected a variety of criticisms of the accelerator argument "... it is true, but even if it advantages only a few it is crook"; "there are other ways of publicising information; there should be regular announcements, more than an annual report, especially for volatile stock". The reaction to the management reward aspect of the theory was much stronger. "Outrageous"; "it's trying to legitimise something that is wrong"; "an incentive for badly managed companies"; and "it is a form of robbery of shareholders". One of the observers said that it would lead to "managers running the company for their own benefit".

The price accelerator argument was generally rejected by most lawyers. One Melbourne lawyer argued that "insider trading tends to cause the correct price to be reached more quickly. It is an incentive for small companies to go public". A Sydney lawyer who agreed with the Manne thesis showed that he was not entirely comfortable with it when he remarked "the price accelerator argument is probably true, but it is inconsistent with the prevailing philosophy of equality of information. There is a need for better disclosure rules". Most lawyers were more vehement in their responses to the supposed benefits of insider trading. A Perth lawyer remarked the Manne argument is bullshit. It is just a rationalisafion for dishonesty". Another said:

The only benefit is for the participant in insider trading who enhances his profit or reduces his loss. The executive rewards argument is not acceptable as it is just ripping off the community. There is a moral question that is, that someone will lose out. The price accelerator argument is wrong.

A Sydney lawyer took the same view:

there are no beneficial effects of insider trading. Instead of escalating the price to the proper price, inside information should be announced to the stock exchange. The executive incentives argument has no credence as executives should be rewarded in other ways.

Regulators saw few, if any, benefits arising from insider trading activity, apart from the obvious benefits to the insider trader. Some saw benefits arising "from the turnover of money in the economy". A less plausible benefit referred to was that "insider trading adds liquidity to the market, so perhaps the State governments benefit from the additional stamp duty revenue". None of these factors were enough to justify insider trading. There was equally little support for the Manne arguments which were repeatedly described as immoral - "the Manne approach that insider trading encourages entrepreneurial activity is a short term view which ignores the longer term moral question".

Generally, most respondents, especially those in the marketplace rejected the Manne thesis. The strength of the rejection was surprising. It might have been expected that a rational economists view of insider trading would have appealed to the marketplace participants. Prac6tioners in the Australian market did not, however, accept that Manne's views apply in this country. The reasons are that the views are academic and are based on a market that is very different to the Australian market. The comprehensive rejection of the Manne theory carries a warning about too readily importing academic theories from other countries with quite different securities markets.

Attempts to justify insider trading were strained and advanced without much confidence. There is a need for companies to improve their mechanisms for disclosing price sensitive information to the market as a whole rather than to the privileged few. Insider trading is clearly not accepted as a means of ensuring that information is brought into the market efficiently and quickly. Significantly, the complete dismissal of the executive incentives argument as a justification for insider trading strongly suggests that shareholders' interests should receive far more attention than they do.

The defence of insider trading on the grounds of its "informational efficiency" paints a sorry picture indeed. If the market is forced to rely for information, even to a limited extent, on a practice that is, if not corrupt, at least highly questionable on ethical grounds, it is not an impressive commentary on the process of informing the market. It is clear that as in other dimensions of corporate activity, disclosure practices are severely deficient and require improvement. Such an improvement would at once contribute to a more informed market and go some way to eliminating a form of market abuse.

Insider trading and market confidence

It is often argued that insider trading undermines investors' confidence. Respondents were asked to comment on this argument. The brokers said that insider trading has not undermined confidence in the stock market. A common line of argument was that a certain level of inside- trading was acceptable; another was that the incidence of insider trading was too low to have an effect. The former view was summed up by one broker who said that "people are prepared to live with a degree of insider trading and other market abuse". A Sydney broker described the market as being "like the race track. Everyone tries to get a piece of the action. Are players concerned enough not to play? They still play. Turnover figures disprove any theory of lost confidence". A similar thesis was that: "in speculative stocks people are basically gamblers. The low end of the market is like a casino with people trying to make a dollar. Does it matter there? Most people are philosophical about selling early. In a takeover you wait until a certain point; if the price goes further that is bad luck". According to other brokers, insider trading is not bad enough for the average sensible investor to take too negative a view". Insider trading affected confidence in the 196971 period but "there is now so little that it does not". Perceived, rather than actual, insider trading has an effect "but it has not in recent years because of the lower level of insider trading and more serious forms of abuse like the Bond-SGIC-Bell deal".

Another said that "it is not a major issue in Australia. The market punishes brokers who do it. Clients never raise the issue". Of course the person who was upset by insider trading would not be a client. The contrary view was that "the smaller person is disillusioned, they think that the stock exchange is a closed shop and that they won't win". It is this investor cynicism that keeps people away. Perhaps the attitude of investors to insider trading depends on their own experience and whether they know that they are victims. One broker felt that "in blatant cases victims would be sour". But a more accurate assessment might be that "people hate insider trading if they do not have the information or did not make the profit".

The financial advisers generally said that there had not been any undermining of confidence. One view was that "on the contrary, insider trading makes people get involved in the market". Another approach was to say that "people accept insider trading as part of the market background. In some markets such as Asia and New Zealand where insider trading is rife there may be more damage".

Another said that "to some extent confidence has been damaged. People who have been hurt now put their money into trusts or real estate". One of the accountants interviewed felt that "the community is cynical about the market and there may be some classes of investors who lose confidence". Another view was that "the perception that insider trading is rife has undermined the confidence of small investors but not the big players-the professionals". It was suggested that insider trading is not the only feature of the market to affect confidence "... events have a cumulative effect. The Holmes a Court sellout [of Bell shares to Bond Corp] has damaged confidence".

The ASX officials also did not think that insider trading of itself had affected market confidence but that what had been said about it had done more damage. There was a mixture of answers from the market observers, the strongest opinion being that "insider trading creates a casino image and investors have abandoned the market because of a lack of faith in it". Another offered the opinion that "people think that business is a bit dirty and that success comes from corruption". One observer asserted that "people are aware of insider trading going on and have not been stopped from trading in shares". Another said that "the real damage to public confidence is done by people like [the entrepreneurs]". The view that publicity has distorted the impact of insider trading was repeated by some observers. It was put that:

the low participation rate in Australia suggests that there is a lack of confidence in the market. Most people must be aware of the chance of a loss on the Stock Exchange. Confidence is undermined in the eyes of the naive. People will accept a level of corruption but it is much worse in horse racing than in the Stock Exchange.

There was a high degree of unanimity amongst lawyers to the effect that insider trading has not undermined confidence at afl. A number of reasons were advanced such as, "people will still have a flutter. Insider trading is almost accepted as one o the risks of trading. In any event, confidence in the market is a cyclical thing". A more cynical view was that, "insider trading hasn't undermined confidence as people think it is normal. It actually takes a lot to deter people from being greedy. Successful enforcement of the law may disillusion people more".

The lawyers clearly saw the stock market as being like a casino or horse race, where a degree of "fixing" was accepted as a part of the risk and excitement. One Sydney lawyer provided some perspective when he observed that "you have to look at market confidence in parts. There has been no material effect in respect to industrial stocks. In regard to the exploration market, people would believe the press that insider trading is rife. But most people regard the Australian mining market as a bit of a casino anyhow. There might even be some beneficial effects of insider trading at that end of the market". Similarly, the regulators as a group did not think that insider trading significantly undermines confidence in the stock market. Those few who did, limited it to small investors.

It is reassuring to know that insider trading has not impacted on confidence in the marketplace. It is less reassuring to hear that a significant reason for this is that investors tend to regard the stock market as something of a gamble. Although it was not really within the scope of this study, it was hoped to survey in a limited way the level of public confidence in the stock market. The Australian Stock Exchange Ltd has apparently commissioned such a study and the results might be a useful starting point in developing a higher stock market participation rate by the Australian public.

Interviewees were asked about the likely effect on market confidence of the repeal of the prohibition on insider trading. The majority view of brokers was that it would adversely affect confidence both in the domestic market and internationally. A typical view was that "it would not be a plus. The market needs some regulatory arrangement to stop people exploiting their position. Internationally it would be detrimental. European investors need to have confidence in the market".

The reassurance value of the law appeared in the answer that "any impression of lesser control would be a concern". Another opinion was that "it would be criminal. Any director could buy up before a major development. The Australian image overseas would suffer". A similar view was that "it would be internationally damaging; we would be treated as cowboys as in the 1969-71 period". A Sydney broker's approach to the issue was that "legislation is a make-work thing but spivs should not be allowed to run the country. On balance the authorities must be seen to be doing something. Every now and then it is necessary to make examples. The market is not overregulated".

The brokers who disagreed about the loss of confidence offered a diverse range of reasons. A feature of the responses was the number of references to other more damaging factors in the marketplace. A Melbourne broker said "confidence is suffering now because of the conduct of the big players. Investor confidence is so low it could not go any further". That sentiment was shared by a Sydney broker who remarked that "in mining companies there would be no effect. People treat these like horse races. In takeovers a different type of investor is involved. There are more things to tighten up before insider trading-4he Bond/Bell deal really worries people. On the international scene we are regarded as cowboys but not as bad as New Zealand or Western Australia".

A view that was perhaps more realistic was that there would be no effect on confidence because "investors are not aware of the laws". The impact of laws was explained in the response of a broker who said "it would depend on how it was done. Probably there would be no change because the market could depend on the ethics of business. The laws on insider trading affect the law abiding. Internationally, Australia would lose credibility and it would reinforce the cowboy image. New Zealand does not have an insider trading law and they do things we would not contemplate". A more robust assessment was that "it would be business as usual. Overseas investors are out to make money and would not worry too much about it. Overseas pressure and greed often drive prices up".

A totally different view, challenging the notion of external regulation, was that "the regulatory process tends to seek a short-term solution and penalises long term honesty and gives a false sense of protection. The regulatory process does not catch the crooks. They damage and impede the people who do the right thing. Th common law covers it and is much safer but it has not been explored. The regulator have not done much better and will not catch the serious ones". This view was no expressed elsewhere but it was perhaps the most profound commentary made on the state of the market. The predominant view of the financial advisers seemed to be that repeal would be a bad thing. It was often said that there would be "an outcry against any such repeal" and that "if there was open slather the market would collapse". One of the merchant bankers said "the public would lose confidence if they could not see something being done. If insider trading was not illegal many more people would be involved".

According to an investment adviser, "small investors provide the liquidity for the market although most investors are professionals. If the small investors were t withdraw this would affect the market". Another investment adviser said that he di not know what the outcome would be "but that is not an argument for Rafferty's rules". The majority view from the stock exchange officials was that it would not b a good thing to repeal the law. A detailed response was that "it would be a bad thing - it would damage the stock exchange - people would suspect something was wrong with the market. Internationally it would not be as damaging. They are more interested in the currency aspects of trading".

Amongst the market observers there was, however, slightly more support for the view that there would be no difference - "nothing is happening now. Perhaps it might suffer at the margin". However, there was a strongly held view amongst lawyers that the repeal of the insider trading prohibition would adversely affect confidence in Australian stock markets, both internationally and at home. A Sydney lawyer summed up this sentiment when he said that "repeal would be a hopeless idea. I would affect confidence significantly. Internationally, repeal would deter those investors who are worried about a level playing field".

A different view of the likely effects of repeal was that "investor confidence in Australia would not suffer, but internationally, there would be a dampening effect". I was also said that "If section 128 were repealed, the US investor would see on market as like that of Hong Kong, that is less reliable as a market. The effect of [the law] is always in the background. People don't see a casino as long as [the law] is there". The symbolic importance of the statutory prohibition was a recurrent theme "The rules stop people from engaging in the worst excesses" according to one lawyer An apocalyptic vision was that: "There would be an enormous adverse reaction if is was a free for all. The system would break down". However, not all lawyers felt such a dire consequence would flow from repeal. As one pointed out, "there is no much awareness of insider trading. It probably wouldn't make much difference t investors if the laws were repealed, but the principle should be there [that is that insider trading is wrong]".

Most of the regulators felt that if insider trading laws were to be repealed, there would be "more insider trading" or that there would be "open slather" or a "free for all" and that Australia's international reputation would be harmed. It was felt that the current insider trading law "deters blatant insider trading". Those who did not believe that investor confidence would be harmed felt this way because "Australia is a nation of gamblers". One observed that "people still invest despite the knowledge that insider trading is common". The present laws have some deterrent effect and as one regulator put it, they provide some reassurance. Perhaps the most balanced assessment was offered by another regulator when he observed, "... the fact that insider trading is an offence and that share prices are monitored by the regulatory bodies must instil some confidence in the investors. The mere act of removing or radically changing the laws would only serve to convince investors that insider trading had become prolific".

On balance, it seems that the existence of insider trading laws has at least some effect on the level of market confidence. This is so notwithstanding the perception that the market is manipulated and that the laws are ineffective. It is not possible to know how many of the investing public are aware that the law exists, but it would be reasonable to say that an overwhelming majority are not aware of the law. Those who would be so aware, however, would be most unlikely to understand it. Perhaps they know that something is there and it reinforces the view that the law currently serves a function as a form of symbolic reassurance. The overwhelming view was that the law should not be repealed and that if it were, Australia would be ignoring the international trend. This suggests that the prohibition of insider trading must remain a feature of the Australian marketplace and its regulation.

The place of the small investor

It has often been said that insider trading laws are important because they are intended to protect the small investor. There is a whiff of motherhood about the role and place of the small investor and some have advocated that the small investors should leave the market to the big players. This view was scrutinised during the interviews. None of the respondents adopted this view directly, but it was clear that many of them have little direct contact with small investors. The stock response to the question regarding the importance of protecting small investors was merely to affirm their importance, but several different reasons were offered for this.

With only one exception, the brokers all responded to this question affirmatively. The exceptional view was that "it is not very important. Very little capital is raised from small investors". Two consistent themes were the unsatisfactorily low stock market participation rate by Australian investors and the expensive transaction costs for small investors. A sample of the brokers' comments in response to the question is set out below:

  • It is very important there are not enough in Australia; the participation level was improving up to the crash. Their value is in providing stability. Small investors helped in the post-crash period;
  • There is a problem with the antiquated scrip system which is too expensive. Brokers have to ask if they can afford the business. Small investors arc important though. Many are ill-advised and misdirected. They seem to be gambling. Funds are a good way to go for small investors;
  • They are vital. A better participation rate would help eliminate the "them" versus "us" mentality and might improve productivity;
  • They are important for several reasons - they provide scope for retail brokers; they make capitalism work and they get a stake in the country; they help the free market operate by providing the capital; they subscribe to stocks that are currently ignored by institutions;
  • Yes - to raise capital; it makes them better equipped for retirement. Over the long term people must be exposed to equities;
  • Absolutely - they provide fluidity and get a better understanding of how the economy works;
  • We would not have a market otherwise. Institutions used to be loyal;
  • They have a logical place. It is impossible for brokers to give the same information to small and very large clients due to the cost of accumulating and disseminating it;
  • They are the future. If Australia is to grow there needs to be up to 25 per cent participation rate by small investors. [It can be achieved] by union representation on boards and by encouraging employees to buy shares;
  • They are very important as they make the market;
  • Yes, so that people can participate in the market. An alternative like an equity trust is not a good deal because of the up front fees etc, and their performance is poor. Small investors can be profitable for brokers;
  • They have tremendous impact and are very important for the breadth of the market. They are coming in via the funds;
  • Yes, but they should be encouraged to use collective vehicles. They can identify with the corporate identifies of leading companies and provide checks and balances on companies;
  • They are essential. Australia does not use the stock exchange to raise capital - it is a secondary market;
  • The transaction cost is a problem and as a result some have gone to the funds. With a proper settlement system I would like to see more people dealing direct. Not as many small people lost in the 1987 crash;
  • It is a difficult matter in view of the cost of the transaction. It is socially desirable but costly.

The financial advisers were overwhelmingly positive about the importance of small investors in the market and the reasons given were consistent with those of other groups. The enthusiasm for small investors was not, however, shared by one merchant banker who remarked that "small shareholders are a nuisance but they should not be discouraged". All stock exchange officials also responded affirmatively. Those who expanded their answers said "... and in their own right rather than via funds; "absolutely - for the health of Australia"; "... on philosophical grounds - people's capitalism. It is not very efficient but small investors are more stable"; "... but not as chaff in the system. There are millions of reasons in favour". The reactions of the market observers were also unanimously affirmative. The lawyers were least well placed to comment authoritatively on this issue. They were not however inhibited in offering opinions. Generally speaking they saw a place for small investors. Almost all of the regulators thought that it was important for small investors to remain in the securities market.

The weight of opinion in favour of preserving the role of the small investor is an eloquent response to those who have said that there is no place for the small investor. The references to an unsatisfactory participation rate suggest that more work needs to be done to establish why this is so. Perhaps it reflects a degree of disillusionment flowing from the perceived levels of insider trading and market manipulation. It is not clear whether the rate of participation takes account of the extent to which individuals participate through superannuation and management funds.

The fairness of the market

Interviewees were asked whether or not the market was unfair to any particular group. The overwhelming view was that it was not unfair but that there were disadvantages suffered by specific groups. It appears that larger investors are treated better by brokers. Cost is a factor in this regard. One broker pointed out that "clients should get benefits according to their size. Brokers do not run a social service; they must look after their best customers". An example of a disadvantage was that "... it is harder for small investors to get information". But on the other hand, another broker believed that "the market compensates. Small investors can get out faster". That was also the view of another who said "the big guys cannot get out as easily as the small ones. The small investors do not get serviced as well".

Only a small proportion of the financial advisers felt that the market is unfair to any particular group. Most of them distinguished unfairness and advantages and as one pointed out "the larger investor gets a better deal from brokers but this is just a fact of life-it is not unfair".

The exchange officials, not surprisingly, denied that the market was unfair. One powerfully expressed statement from an observer was that:

it is unfair to individuals; regulation does not protect them, it is mainly symbolic; the big operators are not taken on; there are notable omissions in the existing package which allows the larger members to rip off the small. The NCSC is not interested in small investors; the lack of class actions penalises the small investor, institutions override the interests of the small investors and some of their deals rip off the small investor.

Other views were that "there is a lack of corporate democracy" and that "small shareholders have no chance to participate in market action". One observer made the point that while there are disadvantages in being small "it is not always possible to protect small investors". One of this group saw no unfairness in this and reminded us that "it is up to investors to inform themselves".

Few of the lawyers thought that the market was unfair in a discriminatory sense. One Sydney lawyer said that "the market is fairer to those who can move more quickly than others. Smaller investors will also pay a higher brokerage, this is because their orders are uneconomic". Regulators also generally felt that the market was not necessarily unfair to any particular groups, although a number criticised the attitudes of brokers towards small investors who received less information from brokers than the larger players. Others pointed out that the costs of entering the market and undertaking transactions tend to be higher for smaller investors.

It was clear that distinct advantages are enjoyed by larger investors and institutions, largely due to their market power. Small investors lack the economies of scale available to larger investors. There was some evidence that small investors have been treated poorly by some brokers with the unfortunate consequence that small investors could be driven away from the securities market.

Conclusions

Insider trading is a practice that the market can do without. The overwhelming view of the participants in the study was that insider trading is not only harmful, but that it brings no benefits. Insider trading harms the market in a number of ways. It is said to erode confidence; to inhibit the capital raising process and to damage the efficiency of the market. It also of course directly harms investors who lose money to those who are engaged in insider trading. The view of insider trading as a victimless crime ignores the fact that in an insider trading transaction there is a party who loses value from the securities involved or is forced to take a loss. Perhaps it might be more accurate to say that insider trading is a crime with an unknowing victim.

The discussion of the impact of insider trading on market confidence was rich in irony. On the one hand, it was said that insider trading erodes confidence yet on the other hand, it was stated that it has not affected confidence, but if the law were to be repealed, confidence would suffer. One element of the confidence issue is that the impact of insider trading cannot be measured because confidence is already at a very low level and, in any event, investors expect that insider trading will occur. Whether the generally perceived low rate of participation by individuals in the market is attributable to the effect of insider trading or to a general lack of faith in the market does not emerge clearly from the study. The recent examples of failed entrepreneurial empires and collapses of funds would certainly have shaken even the most faithful adherent of the securities market.

There was scant support for the Manne arguments in favour of insider trading. This suggests that the value of an academic theory can only be tested in the marketplace and that some of the legal and economic arguments based on Manne's work should be reassessed in the light of market reality, particularly the realities of small markets such as that in Australia. The references to the usefulness of insider trading in bringing news to the market reflect poorly on the efficiency of the market and are clearly another illustration of the poor performance of listed companies in disclosing price sensitive information. There can be little doubt that the Stock Exchange needs to improve the enforcement of its listing rules. The interviews leave no doubt that small investors are considered to be important players in the market. Although there was no evidence that the market is unfair to small investors the strength of the feeling that they are not well treated suggests that there is considerable scope for improving the lot of small investors.