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Chapter 7 - The crime and opportunity thesis

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 69-78


You can succeed by relying on fundamentals but inside information beats fundamentals.
(A Sydney broker)

The reasons for the apparent proliferation of insider trading both in Australia and overseas are manifold. The recent rash of insider trading activity is often attributed to the level of greed which is said to drive the securities industry. This factor should not be discounted, but it is clear that other factors are also at work not the least of which has been the unprecedented range of opportunities for insider trading in recent years. The relationship between crime and opportunity is well established within the criminological literature but little has been written about how this relationship arises in the context of insider trading, a crime theoretically punishable theoretically until recently by five years gaol and/or a $20,000 fine in the case of individuals and a fine of $50,000 in the case of corporations.

Likely insider trading situations

Almost exclusively, brokers said that insider trading would take place in the market for shares and not in the options market. The range of opinions about the types of shares involved was very wide. On one view, it would depend on "what was flavour of the month". The most commonly identified risk groups were mining, speculative, exploration and gold shares. Various explanations were put forward as to why mining stocks attract insider trading. One broker said that insider trading is most likely to occur in this broad area because "there are all sorts of people on the site". Other reasons were that this is "where there are things like drilling reports" and "a leak from a geologist could create insider trading". Also, "drillers and assayers know and word filters through". As the mining boom of the late 1960s and early 1970s showed, there is ample scope for mine site workers to insider trade or to act as agents for brokers and others in transmitting the latest data.

Among the less specific opinions was one that insider trading is more likely in new, up and coming super stocks which involve newer players". It was said to occur "in less professional areas where there are more opportunistic stocks". A Melbourne broker said that it is more likely in relation to "smaller less frequently researched stocks, rather than larger [company securities]". An obvious point often referred to is that for insider trading to be successful, it is necessary to move the price and in this respect gold mining stocks were described as the most reactive to any information. Where the companies have lower capitalisation insider trading will have greater effect on prices and it is easier to move prices of these stocks. Shares in entrepreneurial mining companies, described as Western Australian cowboy companies, and perhaps in high technology companies, are said to be tightly capitalised and likely to move quickly on a rumour. The number of people in a company was also said to be a factor as "insider trading tends to occur more in smaller companies controlled by one or two people" or in second board stock "which is more tightly held by a small group of people".

There was no consensus amongst brokers about whether insider trading is more or less likely in second board stock. But despite their differences on this point most brokers shared an uncomplimentary opinion of second board companies. However, the financial advisers agreed uniformly that the area of the market where insider trading is most likely to occur seems to be in the lower quality stocks, such as the speculative, mining and second board stocks. An interesting observation was that originally insider trading was limited to tightly held stock, but in the last two years vast amounts of money have been available and this leads to more insider trading. Cross directorships, trading on rumours, stocks that respond to good news, and stocks whom players are share trading to enlarge their business profits, were seen as situations which led to insider trading. There was no common view among Stock Exchange officials on this matter.

The general view among the market observers was that insider trading is more likely to happen in lower quality stock. One observation was that insider trading occurs across the whole spectrum but another was that "it is less likely in trading bank stock. It happens on a bulk scale in speculative stock. The second board is an invitation to misbehaviour". A journalist said that "insider trading occurs even in reputable companies and share dividend schemes using options are the likely methods". The views about the second board were as conflicting here as they were amongst other groups. On the one hand "the second board is not deep enough", and on the other, "insider trading occurs in the second board, but not exclusively".

It was rare to find lawyers saying that insider trading was likely to be found in industrial or blue chip securities. The nearest exceptions to this occurred when they were speaking of takeover stocks generally, although it seemed likely that "insider trading will occur in relation to anything which is volatile". Generally, the lawyers considered that insider trading would be most likely to occur in relation to speculative, volatile, mining, second board, or lower quality securities, or in respect of securities in smaller companies where there was a high level of ownership by a relatively small number of shareholders. To this extent, their expectations were similar to those of the brokers. The regulatory community saw speculative, mining, takeover, high technology and low price/high volume stock as the most likely areas. Gold stocks in particular were often identified. Many of the regulators took the view that insider trading was prevalent "over the whole range of market activity".

It seems likely that insider trading occurs throughout the whole of the Australian securities market, but it is more likely to occur in certain specific areas than in others. The market's evaluation of particular classes of securities, such as mining and exploration stock during the late 1960s mining boom, and high technology and takeover stocks in the early 1980s, gave rise to insider trading which suggests strongly that insider trading is often a matter of opportunity. The extent of insider trading can also be influenced by the volatility of the stock in question and the degree to which the ownership of securities is tightly held amongst a relatively narrow group of shareholders. This is not to suggest that insider trading does not occur in relation to the "blue chip" securities of large public companies, but it is more likely to be successful in moving market prices in lower quality stocks. The likelihood of insider trading occurring in large Australian public companies should not be discounted, especially in takeover situations.

Opportunities for insider trading

Insider Trading has been described as an opportunistic crime. It is carried out when an opportunity presents itself and by persons who take advantage of the opportunity. The difficulties of quantifying the extent of insider trading and perhaps in detecting it, might be due to the opportunistic and random nature of the practice. It was therefore of particular interest to find out what opportunities existed for insider trading. The first questions on this topic asked interviewees about the frequency of conflicts of interest arising from access to price sensitive information. The brokers reported that conflicts of interest were a constant factor in the industry or, at least, that they were very common. They were said to arise especially when a broker is engaged in corporate advisory work. It was claimed that these conflicts were usually resolved properly. In the context of conflicts it is useful to refer to comments with respect to the treatment of information gathered in the course of research, especially information provided to brokers by listed companies. A Melbourne broker explained that in his firm, "any research undertaken by the firm goes back to the company first". The same practice is followed by another Melbourne firm where "the research information is kept secret until it is checked with the company and then it is published".

It was of interest to establish whether there is any house trading by brokers on the information collected by them in the course of research. Several brokers explained the position in their firms and at the same time described the process of gathering information. A Sydney broker responded, "some companies refuse to see brokers; they rely on section 128 to avoid them. Others, with less market status, are anxious to see them to build up the share price. Of those who talk, it is amazing what they say, but some companies do not tell the truth. There is a great deal of monitoring of companies these days. Here, there is no house trading but some institutional analysts are not prevented from trading". Another perspective on the practice was obtained from a senior broker who said that "market research is done in the hope that it picks up price sensitive information. This is only ever done on a formal basis; it does not disclose inside information. The information is ultimately used by the firm to disseminate to its clients. The firm does not trade on this information but we will pass it on early to institutions. Trading on research information is common elsewhere, especially in those stocks where a small amount could move the price".

Another explanation of how research information is dealt with was provided by a broker who responded that "research obtains price sensitive information but how often is it inside? At presentations the companies should be more guarded. Information that is not generally available to the public comes out. The information then goes to clients. In this firm advisers would not go out and buy shares; the house would buy shares and disclose to clients that it is selling as a principal. It is more likely in small firms for brokers to trade on research information". An enigmatic statement was that "companies are always giving information but it is not insider trading. The research reports go to clients. Trading by the house before advising clients could go on but the information could be wrong or your interpretation wrong. Profit forecasts do not affect prices much".

Another insight into industry practices came from a Sydney broker who asked, "how often is information from research price sensitive?" He pointed out that "high level executives do not give much away" and asked, "is it inside information or smart analysis?" In his firm, "there is no house trading on this information - it goes to the client first. It would be stupid to breach trust. Not many brokers have the same degree of self-control. This firm is always aware of surveillance and the potential danger to its business". Perhaps the frankest exposition of the treatment of information gathered from companies came from a broker who told us that he sees companies "at least once a week and gets superior information. Some managements talk freely and you get price sensitive information from them. With research information we either trade for the house or send it to institutions. We trade in big companies only if it is inside information from leaks from banks or advisers. It will be a problem with screen trading. All companies try to bull the price of their shares". When financial advisers were asked about the frequency of conflicts of interest, the overwhelming view was that it was a common event. There was little comment about the way in which such conflicts were resolved but it was interesting to note that the accountants made similar replies to the effect that, "professionals don't find it a problem". The merchant bankers suggested that they can handle conflicts better than brokers.

The response to this question from the Stock Exchange officials suggested that they are not close enough to the daily workings of the market to be able to comment accurately. On the subject of the use of research, one official felt able to tell us that "in section 128 terms, brokers do engage in insider trading but some of the information could be found out by individuals". He admitted having "some difficulty with the practice of trading first before passing on the information to clients. It is unwise and unethical". From what the market observers reported, it seems that conflict of interest is ever present. When asked about the treatment of price sensitive information gathered during market research, the answers provided were varied. One observer reported that he was "not able to say how often price sensitive information is given out by companies". Another of the group was of the opinion that "brokers obtain price sensitive information but it is not devastatingly inside information. They probably trade on it and then pass it on to the client. Small investors are not treated as well. Some brokers are subsidiaries of the companies whose shares they are ramping". A more emphatic response was that "research is used before it is made public". But even stronger was the explanation that "analysts quite often get price sensitive information; boards tell them what they want to tell them; circulars are speculation, puffery, to get the price up. Larger companies are better scrutinised and much cleaner in insider trading terms. I would not be surprised if there is house trading nor if there was passing on to affiliates. This is consistent with the ethical standards in the broking world". An authoritative explanation came from the ex-broker who reported that "talks with companies are directed at getting sensitive information. A skilful broker will get it wittingly or unwittingly. Brokers do house trade on it. They buy shares to provide them to persons who are acting on their recommendation".

The lawyers were able to appreciate the issue of conflicts better than other groups in the study. Their views were that conflicts of interest are a particular problem for persons in company management who trade in shares. Brokers were also identified as a group for whom conflict situations were common and several lawyers pointed out that brokers tend not to be able to manage such situations well. While the regulators considered that conflicts were not likely to arise in CACS, they tended to the view that conflicts would be common in the private sector for merchant bankers, advisers and within companies. One assessment was that "such conflict is probably quite frequent, it depends on the opportunities which arise".

Insider trading and corporate control

A view is sometimes put that traders deliberately build up their holdings in order to obtain price sensitive information to assist them in their trading. The almost universal view amongst brokers was that traders would not seek a place on the board solely as a method of obtaining price sensitive information. The main reasons for such a view were that "it is an expensive way of doing it; a long way for a quick trade" as one broker put it. Once on the board, "your hands are tied" said another broker. Those who did not dismiss the possibility said that "it could happen" and that "it is not common but it certainly happens" or that it might happen "in smaller companies".

The qualifications to some responses provide insights into the process of obtaining information. A Melbourne broker responded that "boards do not necessarily know everything; the information flow is controlled by CEOs and accountants. It is not an efficient way of obtaining information". A Sydney broker explained that "a lot of information is wrong. Banks get better information than brokers; auditors get better information; lower level people get information probably before the directors do". The ease of obtaining price sensitive information was referred to by one broker when he responded that "some brokers might take this approach but it is too expensive. Non-brokers can obtain information and do research without going on to the board" Just how easy this was, was demonstrated by the comment that "brokers can go to the company and get information".

This question also yielded some insights into how insider trading is conducted. A Sydney broker responded that "most is unplanned, it depends on information falling into your lap". According to a Perth broker "it is easier to insider trade off the board [of directors]" and according to another "it is sometimes better not to go on to the board". A Perth broker expressed the opinion that "going on to the board does not give rise to an insider trading problem, it is more a long-term propositions.

Most of the financial advisers thought that it was not common to build up holdings in a company merely in an effort to obtain access to price sensitive information. Going onto the board was either a very expensive way of obtaining information or a means of achieving other goals such as the control of the company. The majority view of the ASX officials was that this does not happen, "[b]ut, a person would be dumb not to use a position on the board or to ignore information".

The market observers had similar views to other groups. A wide range of views were provided by them. It was said to be "quite common" or "routine", that "it happens in second board and lower main board companies" and that "it often occurs". A different view was that "it is done mainly to get control and participate in the company". Another observer repeated the point that "it is a very expensive way of doing it. The board is the last place to do it". One of them responded that "they don't really need to, they can use contacts as Boesky did".

Some lawyers shared the view that "some people who have got on to major company boards have only paid lip service to insider trading controls", but the more common view was that it would be a very expensive way of trying to obtain price sensitive information and that "there are usually better ways of getting price sensitive information". The regulators likewise felt that getting onto the board for this purpose would be rare because, as one regulator observed, "persons who insider trade can obtain the inside information without being on the board". Once on the board, additional constraints upon the traders are seen to operate - "... once a person is on the board he is an insider and the risks of being caught increase".

Is price sensitive information necessary for success?

For the most part, brokers believed that it was possible to succeed without access to price sensitive information and that success comes from relying on fundamentals. A Sydney broker thought that "price sensitive information is just a help. It is not vital". Another of his colleagues went so far as to say that "it is probably better not to rely on it". One surprising view was that "inside information is not important at all" to success in the stock market. Price sensitive information was, however, generally seen as valuable, particularly as fundamentals are of more long term importance. Price sensitive information is seen to be very important for making short term profits but over the long haul, success is seen to be based on the fundamentals. Access to price sensitive information, but not necessarily inside information, will enhance the prospects of success. For quick profits, it appears necessary to have access to price sensitive information.

The almost unanimous view of the financial advisers was similar to that of the broke price sensitive information is not necessary for success. Good research, astuteness, and relying on the fundamentals were mentioned as the factors for success. It was pointed out by some that price sensitive information is not necessarily inside information and that if a person has access to such information the chances of success are greater. Likewise, the most common view of the market observers was that success is possible without price sensitive information and that the approach of relying on fundamentals was the best method for success. The view that price sensitive information was not essential was also held by most of the lawyers.

The general view amongst Stock Exchange officials, predictably, was that success is possible without price sensitive information. One view was that "you can succeed without it. The Stock Exchange runs not on facts but on fashion - there is always good value stock that is ignored. Success does not depend on insider trading". The regulators' majority view was that it was possible to succeed without access to price sensitive information, but some had serious qualifications and there were a good proportion who doubted the possibility of success without it, especially in the long term.

Market conditions and insider trading

The overwhelming view within the broking group was that insider trading was more likely to occur during periods when the market is very active in a bull market and when there are takeovers. Most brokers felt that takeovers were more likely to occur during bullish market conditions. A bull market was said to be the most likely time for insider trading to occur because, "there is more activity" and "more people are interested". A development of this theme was that in a bullish period, the level of activity means a lower chance of detection. Special events, such as "during periods when there are takeovers and discoveries, special breakthroughs or sudden developments" were seen as likely to contribute to the level of insider trading. A comment consistent with the majority view was that insider trading "will occur in any market, but it can be pin-pointed more in a bear or drifting market".

The financial advisers said that active markets and periods during which takeovers and major reconstructions were taking place were more likely to sustain insider trading. One fund manager thought that it was more likely to occur in "a bear market where assets have been undervalued". A merchant banker summarised the conditions in which insider trading is likely to be found as follows: "in a bull market, when there is good news, and in a bear market, when there is bad news". The Stock Exchange officials were once again unable to express a single community view. "It is more likely in an illiquid market" said one. Another replied that "I cannot say whether it would be a bull or bear market". Insider trading appears likely to be most prevalent during periods of heightened market activity, such as ill a bull market, takeover situations and in situations where major discoveries or innovations were known to have occurred. It was also evident however that insider trading could occur in a bear market, when there was bad news about to break. The level of volatility in the market could also be important in encouraging persons to insider trade. Volatility in prices is a critical factor in undertaking a successful insider trading operation.

Takeovers and insider trading

It has often been said, and other research tends to show, that there is a distinct relationship between takeover activity and the level of insider trading. Participants in the study were asked whether they could think of takeovers where they suspected that insider trading had taken place. Most brokers at least suspected that insider trading is associated with takeover activity. According to one, "takeovers are a great example of insider trading. The majority of cases involve leaks. This is the easiest form of insider trading to prove". Takeovers are regarded as the special events that are likely to move prices and create the climate for insider trading. The basis for this widely held suspicion is the movement in prices prior to the announcement. One broker considered it "interesting that share prices lift pre-takeover". An explanation commonly referred to was the fact that in just about every takeover, there are so many people involved. It is very rare that the price does not move and part of that movement comes from insider trading". According to a Sydney broker, "some merchant banks leak, especially on West Australian deals". Of course, it is possible that share prices move upward in the pre-takeover period because takeover targets are often identified in the course of market analysis and because prices tend to move on rumours of takeovers An interesting feature of this phase of the interviews was that even though participants were not asked to do so, it was not uncommon for them to name specific takeovers where they thought that there had been insider trading and, in fact, discuss chapter and verse the insider trading that took place.

Financial advisers said that there is a link between takeovers and insider trading. Some said that they knew of specific cases while others suspected that there was a link. This question inspired a mixed reaction from the ASX officials. Some quite clearly doubted that there was such a link, but one replied that "in takeovers it is hard to believe that there is no insider trading". The observer group most strongly suspected that insider trading took place during takeovers. One respondent said that "it is frequent and it is demonstrated on graphs". An even more emphatic response was "hell yes-just look at the price movements and turnover a month to two weeks prior to a takeover. The leaks are in the targets - [from their] clerks, lawyers, CACS, bankers and accountants". On the subject of leaks, another view was that "the leaks vary. Sometimes they come from the board but more often well below the board in the advisory groups where there is terrible chicanery". One person who has been associated with many spectacular takeovers reported that it was common for members of the advisory team to be encouraged by directors to engage in share trading. The attitude of lawyers to this link was probably best summarised by a Sydney lawyer who explained that, "you often wonder about some large takeovers. Insider trading need not only occur in small corporations, but associate and warehousing questions are more common in takeovers". The regulators on balance believed that there was a relationship, although there was once again a problem of hard evidence of insider trading being available. It seems clear that there is often a connection between insider trading activity and takeovers. Those closest to the market, such as brokers and merchant bankers, were particularly certain of the existence of this relationship and most other groups on balance also saw a link. Only the ASX officials seemed to question the existence of this linkage. Their views need to be treated with caution in this regard in view of the preponderance of industry opinion to the contrary.

Takeovers were pin-pointed as likely insider trading situations due to the profits which could be made by buying shares ahead of a takeover and because of the long chain of advisers and other persons who are involved in preparing the takeover.

Insider trading as a crime - how serious?

One might speculate whether, if insider trading is not regarded as a serious matter by people within the securities market, it is tolerated more than if it were seen to be serious. It was found that insider trading is generally not regarded by brokers to be serious or as significant as other forms of market conduct. A Melbourne broker responded that he could "think of many more examples of forms of abuse other than insider trading". The more significant forms of conduct were market rigging, which is "more serious and easier to do"; manipulation by false rumours; corporate fraud; churning of clients; staff malpractices; linked advisers; ramping; warehousing, and "other rorts such as loans to directors, and asset purchases by directors in smaller listed companies. The public is being ripped off left right and centre by these rorts". Perhaps the comment that best reflected the brokers' view was that "within the industry we are laid back about insider trading. Warehousing, circumventing the Takeovers Code and the actions of the big players are serious matters. Insider trading is one of a number of imperfections in the market".

Only one of the financial advisers was prepared to describe insider trading as a serious problem but a number shared the view that "in terms of its frequency, insider trading is a small matter but it has the potential to destroy the market". None of the Stock Exchange officials ranked insider trading highly as a problem. One described it as "no more serious than other abuses". On the scale of market abuses one official observed that "insider trading is comparatively minor. Ramping is much more serious for shareholders than insider trading, as many shareholders are likely to suffer. Insider trading gets undue attention because of the public perception. We are very concerned about unenforced legislation or poorly written legislations. The lawyers generally did not rank insider trading as the most important form of market abuse but they acknowledged that it was often a difficult assessment to make. One explained in these terms, "it is hard to say how important insider trading is. Honesty is an important thing about securities markets. Emphasis should be placed upon making people tell the truth. Insider trading is in this category".

It appears that the industry view of insider trading was that it was not as quantitatively serious as other examples of market abuse but that it was perhaps potentially more serious. Some of the evidence that emerged from the round of post1987 corporate collapses supports the view that there are forms of illegal and undesirable activity which are more common. Indeed, the example set by the high profile business identities could encourage insider trading. If it is not regarded as a serious matter in the range of things that happen in the market, where the opportunity arises to engage in insider trading, why not take it? When account is taken of the risks of being prosecuted, the attraction of insider trading is even greater.

Conclusions

The opportunities for insider trading in Australia have been, and continue to be, extensive. This is not simply a matter of greed but the result of a complex web of values, market conditions and professional or peer group tolerance of insider trading. As the Chief Manager of the AMP's Investment Operations Research Division said in evidence before the Griffiths Committee, "(t)he people who would have the clearest idea of what is happening are the people in the broking firms who are taking the orders. Of course, they have to be careful that they do not spoil any good business that they have by dobbing anybody in" (Griffiths Committee, Hansard, p. 207).

The frequency and extent to which conflicts of interests occur within the securities industry are such that many cannot handle these conflicts well. This was particularly said of brokers, especially those who do not have a great deal of background and training in the industry. Price sensitive information gained on a selective basis from corporations seems to be widely used for principal trading especially by brokers and financial advisers, who not infrequently trade in this way before making such information public or releasing it to clients. This is an institutionalised opportunity for insider trading. Insider trading is not likely to be the main motivation for those seeking positions on the company boards. There is considerable pressure within the securities industry to obtain access to price sensitive information as mere good market analysis is often not enough to attract clients. Spectacular gains and quick profits are more easily achieved by insider trading but over the longer term the fundamentals are the more reliable route to success.

One of the more blatant opportunities for insider trading arises from the readiness of companies to selectively divulge price sensitive information about their corporation to brokers, institutions and large shareholders. Often there may be good reasons from the company executives' point of view for doing this, but it is nevertheless grossly unfair and is contrary to the notions of a properly informed market. It has been all too convenient for brokers and others who receive such information to argue that the availability of this information does not guarantee a profit or that this information is often misleading or that it is research. Attempts to explain efforts at obtaining such information as the product of good research, are merely rationalisations. There is room for greater control of the release of corporate information to ensure that all investors are given an equal opportunity to take advantage of the market opportunities which this information creates.

The market operates upon the basis of the comforting myth that success comes from market analysis; so long as your market analysis is correct or you study the fundamentals, you will be able to succeed. Brokers clearly have an interest in perpetuating this abstract, theoretical view of markets. Whilst it is true that this method is likely to bring success in the longer term, particularly with blue chip stock, most interviewees acknowledged that resort to inside information is superior to reliance upon fundamentals, particularly in the shorter term. In an over-analysed and competitive market, the temptation for financial intermediaries to obtain inside information is enormously attractive. Ironically, it is industry insiders, those who are arguably in the best positions to undertake analysis of fundamentals, who rely most upon inside information, rumour and herd instincts. Perhaps this is inevitable to a certain degree, but it seems that too much reliance may be being placed upon such short-cut methods for the market to be healthy and for the public to have confidence in it. Many in the industry seem to share this view. 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. Such disclosure would, as well, contribute positively to greater market efficiency.

It is no surprise to find that situational factors in the market such as technological and mineral discoveries and company takeovers provide major opportunities for insider trading. A bull market, especially where share prices are highly volatile and there is a great deal of activity, provides many easy opportunities for insider trading. Finally, the apparent tolerance of insider trading and peer group support for insider traders who have not been convicted are important factors in enlarging the opportunities for insider trading. When this is associated with the perception of many market professionals that insider trading is not necessarily the most serious problem facing the market, the risks for insider traders seem to be much reduced. Although insider traders would not concede the point, insider trading is a more significant issue than most other forms of market abuse, because of the potentially devastating effects on market confidence and market participation of perceived widespread insider trading.