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• 5. Detection Insider Trading

• Financial Sector Policy

• Securities Law

• Review of Securities Legislation

• Discussion Documents

• Introduction
• Present New Zealand Practice
• Australian Practice
• USA Practice
• Hong Kong Practice
• Options
• Option 1: Introduce a Sophisticated Electronic Detection System
• Option 2: Make the Relationship between the NZSE and the Commission more Formal
• Questions for Submissions

Introduction

5.1 As noted in paragraph 1.3, despite the SA Act having been in force for over 10 years, no person has yet been found liable by the courts for insider trading under the Act although several insider trading investigations have been initiated by the Commission and a number of reports published ⁵. This may be because insider trading is not widespread in New Zealand, or insider trading is not easy to detect, or the law is difficult to enforce, or a combination of these. Whatever the reason, it may be helpful to review the present detection mechanisms for the purpose of ascertaining whether they can usefully be improved.

Present New Zealand Practice

5.2 The NZSE presently monitors share market activity and advises the Commission if it appears that any insider trading activity may have occurred.

5.3 At present the Commission and the NZSE operate on an informal basis to share information about trading of securities quoted on the NZSE.

5.4 The Commission will generally investigate possible breaches of insider trading law either on referral from the NZSE or on receipt of a complaint from a member of the public. The process for detection and investigation of breaches is as follows:

1. The NZSE's market control staff monitor price movements and trading volumes. If unusual price movement or trading volume is detected the market control staff will usually seek the advice of a designated panel of brokers in relation to any unusual trading activity identified.
2. After taking the advice of the broker panel the market control staff may refer the matter to the secretary of the Market Surveillance Panel, who can make a price inquiry of the public issuer concerned.
3. If there has been significant trading prior to an announcement by a public issuer the Market Surveillance Panel will usually refer the matter to the Commission. The NZSE will not usually play a further role in the investigation.
4. The referral from the Panel to the Commission will describe the unusual trading or price movement and any relevant announcement, and will be accompanied by a printout of trades taken from the NZSE's trading system.
5. On receipt of this referral the Commission staff will examine the trades. Commission staff will seek details of trades from certain brokers. The initial responses from brokers are in the form of printouts from the brokers' trading system. These will display trades completed, current names, price, and the date of each trade.
6. After reviewing the initial responses the Commission may seek further details of certain individual clients or trades from brokers. The Commission may also require production of brokers' trading records, including audio tapes of telephone calls.
7. Where this review highlights the trading of particular persons the Commission may then require explanations from these persons of their trading. At this stage the Commission might formally institute an inquiry and may take evidence from persons involved in trading.

5.5 At present, matters are referred to the Commission on the basis of information on the NZSE's trading system. The NZSE does not obtain trading records or client details from brokers.

Australian Practice

5.6 Under the Australian Corporations Law the ASX has certain statutory duties to assist the ASIC and to refer possible breaches of the Corporations Law to the ASIC. The ASX must also respond to requests for information from the ASIC.

5.7 The ASIC and the ASX have agreed certain memoranda of understanding relating to markets, company affairs, and membership matters. The markets memorandum of understanding is relevant to insider trading.

5.8 The Australian Corporations Law contains prohibitions on several specific types of market manipulation in addition to insider trading. The same surveillance and referral process applies to each activity.

5.9 The ASX has a proprietary electronic surveillance system which can detect a number of different events in the market. This system has programmable parameters for price movement and volume of trading of ASX quoted securities. The system can detect unusual movements both across the market and by any one or more broking firms. In this way the system is able to pick up signs of possible market manipulation in addition to insider trading.

5.10 Where an alert is triggered within the electronic system this will be examined by an ASX analyst. The analyst is able to call up a history of recent trading in the relevant securities and to detect patterns of alerts. Analysts are also able to replay bidding and trading for the securities.

5.11 Where the analyst believes that further investigation is warranted the ASX can require brokers to provide details of their trades including client names and other personal information. The ASX has power to do this under its Business Rules. These rules are a matter of contract between the ASX and its brokers, and are backed by a statutory duty of compliance.

5.12 The ASX will make a formal referral to the ASIC where the ASX is satisfied that a serious market matter may have occurred. The question of what constitutes a "serious market matter" in relation to either insider trading or market manipulation is agreed formally between the ASX and the ASIC.

USA Practice⁶

5.13 The SEC is the agency charged with principal responsibility for the enforcement and administration of the Federal securities laws. The SEC has supervisory authority over stock exchanges and other self-regulatory organisations. The SEC's relations with the self-regulatory organisations is important in the enforcement procedure.

5.14 One of the largest divisions of the SEC is the Division of Enforcement which is responsible for investigating and bringing actions against securities firms, corporate officers and others who violate the Federal securities laws. The other major division is the Division of Corporation Finance which administers the SEC's full disclosure system.

5.15 The SEC conducts an extensive investigatory and enforcement programme. The New York Stock Exchange has an automated transaction audit trail which monitors its own performance and that of other exchanges. It also has a stop watch system of surveillance of share prices for manipulation.

5.16 The SEC has a Market Oversight and Surveillance System which gives it fully automated surveillance and oversight capabilities.

5.17 The majority of enforcement cases come to the attention of the SEC through complaints by disgruntled investors and tip offs from professionals in the industry. Other cases are picked up by online computer systems, like "Market Watch", operated by the National Association of Securities Dealers, that flag down a stock when trading exceeds certain parameters in the absence of material public information. The SEC's own Securities Compliance Examiners conduct routine oversight examinations of all broker dealers. The SEC also conducts cause examinations, for example when a broker is sacked in order to determine the "cause" of the dismissal.

5.19 Where appropriate, the SEC will conduct a formal investigation by issuing subpoenas, compelling testimony or production of documents. Depending upon the outcome of the investigation, the SEC may apply to the appropriate court for a civil injunction, institute an administrative remedy of its own, or refer the matter to the Department of Justice for criminal prosecution.

Hong Kong Practice⁷

5.19 In Hong Kong, both the Securities and Futures Commission ("SFC") and the Stock Exchange of Hong Kong Ltd ("SEHK") have full-time surveillance units to monitor trading activity. The functions of each unit are different -

• the SEHK surveillance unit monitors the market to detect price and trading volume movements for the purpose of keeping the market properly informed by ensuring proper corporate disclosure;
• the SFC's surveillance unit monitors the market to detect infringements of the law and to ensure that the SEHK is fulfilling its surveillance responsibilities.

There is close liaison between the SFC and the SEHK on a daily basis.

5.20 The SFC uses a sophisticated automated surveillance programme, called Securities Markets Automated Research, Training and Surveillance ("SMARTS") to assist its surveillance unit. SMARTS uses a real time connection to the SEHK's trading system. Alerts as to unusual price or trading volume movements are provided to surveillance unit staff on the basis of certain pre-set price and volume parameters which SMARTS automatically monitor. SMARTS also provides surveillance unit staff with various analytical tools for the visual display of trading data over a chosen time period. In effect, SMARTS can reconstruct a market transaction by providing an exact mirror image of the state of the market at a specific time and date.

5.21 SMARTS is not a solution to the SFC's surveillance needs on its own. It is primarily a tool for alerting surveillance unit staff to unusual price and trading volume movements and for analysing those movements. The surveillance unit also needs other sources of information.

5.22 The SFC has found that the keeping of a detailed intelligence database is essential. The SFC surveillance unit's database consists of two sorts of intelligence. First, the database has intelligence on listed companies, including records of corporate announcements, the directors and (to the extent that it is available) employees of listed companies and press articles concerning listed companies. The database also contains market intelligence including a database of traders to assist in establishing possible connections with listed companies or between traders. Also surveillance staff keep regular contact with market participants, especially brokers, to obtain details of market rumours.

5.23 Once all the information is gathered, surveillance unit staff analyse the movements to identify both clear trading patterns and possible suspicious activities based on the identified traders. The matter must then be referred to the SFC investigations unit, at which time a decision must be made on whether the matter warrants investigation. The SFC may commence an investigation when it has "reason to believe" that certain grounds of investigation are established. This threshold is a low one and an investigation can be justified on unusual price or trading volume movements alone.

Options

5.24 The following non-exclusive options have been identified for improving the detection of insider trading in New Zealand:

Option 1: Introduce a sophisticated electronic detection system;

Option 2: Make the relationship between the NZSE and the Commission more formal.

Option 1: Introduce a Sophisticated Electronic Detection System

Introduction

5.25 Monitoring of trading on the NZSE by means of a sophisticated electronic detection system could be achieved -

• by the NZSE or the Commission, or both acting together, acquiring and implementing such a system; or
• by the NZSE or the Commission, or both acting together, entering into an agreement with a third party to provide monitoring by means of such a system.

The feasibility and costs of each of these possibilities would need to be examined.

Comment

5.26 Improving the detection system for insider trading in New Zealand could reduce insider trading by deterring those who otherwise may be tempted to take the risk of being caught. Investment in this area would also have an important signaling effect to the public at large as well as investors. The perception of insider trading occurring at the expense of other investors could therefore be downsized. However, the costs of introducing and maintaining a sophisticated electronic system should be considered and balanced against the likely benefits.

5.27 In addition to determining whether the benefits of any new system outweigh its costs, an important consideration may be to determine who should pay the costs of introducing and maintaining the system. Those who may be liable to pay some or all of the costs include:

• the NZSE, from transaction fees paid by investors and its members ;
• public issuers, by means of an increase in listing fees payable to the NZSE or application of part of the filing fees payable to the Registrar of Companies on filing annual reports; or
• the Commission, out of money provided by the Government.

5.28 Contracting a third party (such as the ASX) which already has a sophisticated electronic detection system to provide such a system for New Zealand may be an alternative means of improving detection in New Zealand. However, the feasibility of implementing such an arrangement would need to be carefully considered.

Option 2: Make the Relationship between the NZSE and the Commission more Formal

Introduction

5.29 The relationship between the NZSE and the Commission as to insider trading could be made more formal, for example -

• by the two bodies entering into a memorandum of understanding covering what and when insider trading information should be supplied by the NZSE to the Commission; or
• imposing on NZSE a statutory obligation to report insider trading information to, and respond to requests from, the Commission.

Comment

5.30 There is currently good cooperation between the NZSE and the Commission in regard to the possible detection of insider trading under the procedures set out above.

5.31 However, the introduction of a more formal relationship between the NZSE and the Commission may improve and extend the existing detection systems and procedures and accordingly deter potential insider traders.

5.32 A memorandum of understanding could cover the following matters:

• the scope of the relative surveillance roles of the NZSE and the Commission;
• matters which must be referred by the NZSE to the Commission, including possible insider trading and market manipulation;
• the referral procedure, including the information to be provided, timetables for action of referrals, and procedures for ongoing co-operation following a referral; and
• confidentiality.

5.33 A memorandum of understanding would be a voluntary arrangement between the two bodies. There is the potential disadvantage that a memorandum of understanding might not be entered into because agreement could not be reached. On the other hand, an advantage of such an arrangement is that a memorandum of understanding can be amended from time to time as circumstances require, providing, of course, that both bodies agree.

5.34 A statutory obligation on the NZSE to report relevant information to, and to respond to requests from, the Commission could cover similar matters as are referred to above in regard to a memorandum of understanding. A statutory obligation would not require the agreement of either body, but may be inflexible in that changes required by changing circumstances would need to be enacted by Parliament (or, possibly, by order in council if the legislation so provided).

5.35 A further issue that needs to be considered is the nature of any remedies or penalties for breach of a memorandum of understanding or statutory obligation. As a memorandum of understanding is voluntary, it may be unlikely that either the NZSE or the Commission would agree to the memorandum of understanding providing for significant penalties being imposed upon them in the event of their breaching the memorandum. If a statutory obligation were to be adopted, Parliament could decide what remedies or penalties were appropriate. It is possible that the statutory obligation could include provision for the NZSE to be fined for failure to comply with the obligation.

5.36 The costs of entering into and implementing a memorandum of understanding are not likely to be significant. The memorandum of understanding could specify how these costs were to be shared between the parties.

5.37The costs of introducing and complying with a statutory obligation are also not likely to be significant. The costs of complying with a statutory obligation are borne normally by the persons on whom the obligation falls.

Questions for Submissions

⁵  In addition, the High Court has recently granted leave for several shareholders of Fletcher Challenge Ltd to take insider trading proceedings in the company's name against a former chairman of directors of that company.

⁶The following information largely comes from "The Enforcement Dilemma in Australian Securities Regulation" by Dr V.R. Goldwasser, Australian Business Law Review, Vol 27 Dec 1999.

⁷The following information largely comes from a speech given by a member of the Hong Kong Securities and Futures Commission in December 1999.