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New Zealand Law Students Journal |
Last Updated: 14 January 2013
MATERIALITY: AN OBSTACLE TO ENFORCEMENT OF INSIDER TRADING LAW
SOPHIE CUNLIFFE∗
Introduction
Materiality is a murky concept.1 It has been labelled a
“workhorse” to be mastered by the practitioner and is commonly known
as an “ulcerating experience”.2 It has also been
labelled a “gotcha” standard because it is often seen to be
determinable only ex post facto.3 Materiality is an important
gatekeeper in the area of financial disclosure4and insider trading.
Unfortunately despite its importance in sorting legitimate trading from insider
trading it is an unobservable
threshold that relies entirely on the hindsight of
the courts.
The recent Australian litigation involving Citigroup Global Markets
highlighted the difficulty of materiality determinations
in a market fairness
insider trading regime. In Citigroup5 Mr Manchee, an
employee of Citigroup’s “public side”, bought and sold shares
in a company (“Patrick”)
that was the target of a takeover attempt.
Unknown to Manchee, Citigroup’s “private side” was advising
Toll (the
acquirer).
At the time of Manchee’s sale, the market had already moved the share
price to a level that reflected “the substantial
likelihood” of a
takeover. The further non-public information that Manchee held, that Citigroup
was acting for the bidder,
was not material. But the Court analysed the
materiality of other information held by senior Citigroup officers: knowledge of
the
timing of the announcement of the takeover bid. The
∗ BCom/LLB(Hons), University of Otago. The author would like to acknowledge
Shelley Griffiths, Faculty of Law, University of Otago.
1Glenn F Miller, 'Comment, Staff Accounting Bulletin No. 99: Another Ill-Advised Foray into the Murky World of Qualitative Materiality' (2000) 361 Northwestern University Law Review 389 at 363.
2 Yvonne Ching Ling Lee, 'The Elusive Concept of Materiality under U.S. Federal
Securities Laws' (2004) 40 Willamette Law Review 661 at 664.
3 Ibid.
4 Miller, above n 1, at 368.
5 Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty
Limited (ACN 113 114832) (No. 4) [2007] FCA 963.
Court's materiality analysis of this information reflected a pure "market
impact test". Before the start of trading on Monday, the
takeover was announced
to the market. The Court decided knowledge of the timing of the release was
material because the Patrick shares
opened the day of the announcement at $7.19,
10.9% higher than the closing price the Friday before.
The price movement between the close of trading on the Friday and the open of
trading on Monday after the announcement could have
been attributed to a number
of factors. Perhaps the speculation in the market that existed on Friday
had convinced investors
over the weekend to buy shares at the open of
trading on Monday. Or perhaps the 10.9% rise was in part the market's response
to
the announcement itself, not purely knowledge of the timing of the
announcement. On Sunday, none of the insiders could have known
the exact extent
of the reaction of the market. Knowledge of the timing of the announcement is
of little value to an inside
trader without the accompanying knowledge
of the likely direction and extent of the reaction of the market.
This article will look at the new definition of material information and
investigate how the change in the underlying rationale for
regulating insider
trading might affect this element of insider trading. An attempt will be made to
elucidate the threshold for materiality
based on the decided cases in New
Zealand, Australia, and the United States (US). It will also consider whether
the adoption of the
concept of materiality as the threshold test for defining
'inside' information is a barrier to enforcement rather than serving to
facilitate the enforcement of insider trading prohibitions
A. The change from a fiduciary rationale to a market fairness
rationale
The explanatory note to the Securities Legislation Bill 2006 (“the
Bill”) proposed that the Bill would strengthen the
law relating to insider
trading by adopting a regime that is based on upholding market
integrity and confidence of the
investing public as opposed to one based on a
breach of a duty owed to the company.6 The Securities
6 Explanatory Note, Securities Legislation Bill
(2006).
Markets Amendment Act 2006 "SMAA" removes the requirement that an insider is
connected to the company.7 An insider is defined solely by possession
of inside information. In the absence of a connection to the company, the
material and
non public qualities assume increased significance.
Under the SMAA there are 5 elements to insider trading:
1. There needs to be some material information;8
2. The information must not be generally available; 9
3. A person must have possession of the information;10
4. A person must know, or ought to reasonably know,11
that the information is material and not generally available.
Once these elements have been satisfied the person is an “information
insider” of the public issuer12 who possesses “inside
information”13 and must not: trade in the shares of the
issuer;14 disclose the information to anyone where they might act on
the information;15 or advise or discourage trading in the shares of
the issuer.16
Information is not defined under the SMAA. A definition is important because
an assessment of materiality can ultimately depend on
the substantive content of
the information.17 In Australia, information can be as broad as an
“un-communicated supposition”18 and need not
be
7 Section 3 Securities Markets Act 1988 (SMA) defines an insider as:
a) the public issuer; or
b) a principle officer, employee or company secretary who has information by virtue of their position; or
c) a tippee who receives information in confidence from a principle officer, employee or company secretary; or
d) a tippee of the first tippee.
8 SMAA section 8A(1)(a).
9 SMAA section 8A(1)(a).
10 SMAA section 8A(1.
11 SMAA section 8A(1)(b)(c).
12 SMAA section 8A.
13 SMAA section 8B.
14 SMAA section 8C.
15 SMAA section 8D.
16 SMAA section 8E.
17 Hannes v Director of Public Prosecutions (Cth) (No.2) [2006] NSWCCA 373.
18 Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty
Limited (ACN 113 114832) (No. 4) [2007] FCA 963, at paragraph
542.
specific.19 Courts in New Zealand and Australia do not explicitly
categorise different types of information like the US courts.20 The
different types of information (hard, soft, forward looking, and backward
looking) complicate materiality assessments.
Reliability is one of the main factors an investor takes into account when deciding whether to act on information.21 Hard information is information about the past or present. It can be verified by objective facts in the past or present, therefore it has a high degree of reliability.22
Conversely, soft information is defined by the fact it cannot be verified
by objective facts.23 It may contain an element of opinion or judgement, or may be information about something unquantifiable.24
Soft information contains a much lower degree of verifiability, and therefore
reliability.
Although it may be less reliable, forward looking predictive information
probably holds the most utility for investors.25 For a person looking
for a sound investment, predictions about the future profitability and
opportunities for the company are more
relevant than past performance26
(therefore more likely to be material than backwards looking
information). This reveals the second important feature of
19 Corporations Act 2001 section 1042A; Ampolex Ltd v Perpetual Trustee Trading Co (Canberra) Ltd (1996) 20 ACSR 649 at 658; Hannes v Director of Public Prosecutions (Cth) (No.2) [2006] NSWCCA 373; Cf the UK approach, Alexander F Loke, 'From the Fiduciary Theory to Information Abuse: The Changing Fabric of Insider Trading Law in the U.K., Australia and Singapore' (2006) 54 American Journal of Comparative Law 123 at
147-148.
20 Basic Inc v Levinson [1988] USSC 36; (1988) 485 US 224 at 984.
21 Regina v Rivkin [2004] NSWCCA 7 at paragraph 51- 52, paragraph 73 “if he (McGowan) had been the source it was relatively authoritative and would have been taken more seriously.”
22 Re Bank of New Zealand: Kincaid v Capital Market Equities Limited (1995) 7 NZCLC
260,718.
23 Ahal Besorai, 'The Insider and Tentative Information' in Barry Alexander K. Rider and Michael. Ashe (eds), The Fiduciary, the Insider, and the Conflict: a Compendium of Essays (1995) at 244.
24 Jude Sullivan, 'Materiality of Predictive Information after Basic: A Proposed Two-Part Test of Materiality' (1990) University of Illinois Law Review 207 at 207; Victor Brudney, 'A Note on Materiality and Soft Information under the Federal Securities Laws' (1989) 75
Virginia Law Review 723 at 723-724; Besorai, above n 27, at 244.
25 Besorai, above n 23, at 245; Brudney, above n 24 at 723.
26 Besorai, above n 23, at 245; Bodie, Zvi, Kane, Alex and Marcus, Alan J, Investments
(Sixth edition, 2005) at 607.
information that contributes to materiality: significance.27
From this analysis, two features of information may affect materiality;
its reliability and its significance.
B. Material information under the new market fairness regime
Material information is defined in the SMAA as information that:
1. A reasonable person would expect, if it were generally available to the market, to have a material effect on the price of listed securities of the public issuer;28 and
2. Relates to particular securities, a particular public issuer, or
particular public issuers, rather than to securities generally
or public issuers
generally. 29
1. A material effect on the price of securities?
Many insider trading regimes contain a requirement that the inside
information in question is material.30 Where information is clearly
not generally available, materiality will be the sole concept to sort illegal
insider trading from legal
trading.31 Three tests can be
identified: the reasonable investor test, the probability/magnitude test, and
the market impact test.32
(a) The market impact test
The market impact test measures materiality by the
information’s impact on the share price.33 This raises
the question whether any impact however insignificant can qualify as material
under the market impact test? If this
proposition is accepted then virtually any
factor
27 Emerging Markets Committee of the International Organisation of Securities
Commissions, Insider Trading: How Jurisdictions Regulate It (2003) at 3.
28 SMAA section 3(a).
29 SMAA section 3(b).
30 Ministry of Economic Development, Reform of Securities Trading Law: Volume One Insider Trading, Discussion Document, (May 2002) at 39; Emerging Markets Committee of the International Organisation of Securities Commissions, above n 27 at 2.
31 Joan MacLeod Heminway, 'Materiality Guidance in the Context of Insider Trading: a
Call for Action' (Annual 2004) 52 American University Law Review 1131 at 1148.
32 Ministry of Economic Development, above n 30 at 39; Gordon Walker, Brent Fisse, and Ian Ramsay, (eds), Securities Regulation in Australia and New Zealand (1998) at 606;
33 Ministry of Economic Development, above n 30 at 40.
influencing a person to buy or sell could qualify as “material”
because almost all large trades will influence a share
price slightly.34
This does not sit well with the wording of the SMAA. The section reads
“a reasonable person would expect, if it were generally
available to the
market, to have a material effect on the price of listed
securities”.35 If the test for materiality was any change in
price “material” in the above definition would be
superfluous.36 A minimum threshold must be found.
(b) The reasonable investor test
This test measures materiality of information by the importance a reasonable
investor would assign it.37 The US test for materiality, established
in the case of TSC Industries v Northway Inc38 (the "TSC
test"), is: “An omitted fact is material if there is a substantial
likelihood that a reasonable shareholder would
consider it important in deciding
how to vote.”39 Under the TSC test the information need
not actually change the decision of the shareholder when voting40 it
is enough the information “assumed actual significance in the
deliberations of the reasonable shareholder”.41
It has been suggested this test is wider than the other materiality tests.42
What becomes crucial is deciding what level of influence the
information must have on the shareholder or investor.
Voting and buying or
selling shares are distinct actions and imply different levels of materiality.
Also the decision of whether
to buy or sell could vary depending on the
investor’s style. In Leadenhall43 a distinction was made
between short and medium term investors, and long term investors.
34 Bodie, Kane, and Marcus, above n 26, this phenomenon is called price impact.
35 SMAA section 3(a), emphasis added.
36 Emerging Markets Committee of the International Organisation of Securities
Commissions, above n 27 at 4.
37 Walker, Fisse, and Ramsay, above n 32, at 606; Ministry of Economic Development, above n 30 at 39.
38 TSC Industries v Northway Inc [1976] USSC 119; (1976) 426 US 438,449 at 2132.
39 Ibid.
40 Ibid.
41 Ibid.
42 Emerging Markets Committee of the International Organisation of Securities
Commissions, above n 27 at 4.
43 Leadenhall Australia Ltd v Peptech Ltd [1999] NSWSC 1136; (1999) 33 ACSR
301.
This is because short and medium term investors would find it significant
that a large portion of shares were coming out of escrow
in the near future.
They would be likely to wait until that had occurred to measure the effect on
the share price. However for long
term investors the evidence of materiality was
more equivocal.44 If this test is to be used the courts should make
explicit the required effect on the investor.
(c) The probability/magnitude test
The probability/magnitude test balances the probability an event will occur
with the magnitude of the event for the company if it
does occur.45
In Texas Gulf Sulphur46 the test was laid out:
“In each case, then, whether facts are material ... will depend at any
given time upon a balancing of
both the indicated probability that the event
will occur and the anticipated magnitude of the event in light of the totality
of the
company activity.”47 This test is particularly useful
for measuring soft, predictive information because it takes account of the
uncertainty in the information
(by looking at the probability something will
eventuate), and the significance of the information (by looking at its
magnitude).
The tests have two features in common: they seek to evaluate the significance
of the information and the reliability of the information.
These two features
are relevant to an assessment of all types of information whether it is hard
(objectively verifiable or measurable),
soft (subjective or impossible to
objectively measure), backward, or forward looking. Its
“significance” covers:
3. The magnitude under the probability/magnitude test.
The “reliability” of information covers:
44 Ibid.
45 Walker, Fisse, and Ramsay, above n 32, at 606; Ministry of Economic Development, above n 30 at 39; Basic Inc v Levinson [1988] USSC 36; (1988) 485 US 224.
46 SEC v. Texas Gulf Sulpher Co [1968] USCA2 483; 401 F.2d 833 (2d. Cir.1968).
47 Ibid. at 849.
2. The “probability” side of the probability magnitude test.
When the different tests are simplified in this way it is much easier to see
the importance of setting a threshold for both the reliability
and significance
of information to establish a clearer materiality test.
C. The approach to materiality in a fiduciary regime
Coleman was the first case to expressly adopt a test for materiality
in New Zealand, and in Coleman it is clear that fiduciary duty underpins
the definition of materiality. Coleman adopts the TSC 48
test for materiality and displays a true “reasonable investor
test”.
Cooke J stated the test as “those considerations which can reasonably
be said, in a particular case, to be likely materially
to affect the mind of a
vendor or purchaser”.49 The TSC test50 was
expressly adopted in support. It is clear a high level of disclosure was
required. The inherent nature of the fiduciary duty required
the utmost
candour.51 Cooke J rejected that the mind of the purchaser
had to be dominated by the vendor (the directors).52
Because Coleman did not involve transactions on an anonymous exchange
evidence of a share price movement was irrelevant. The focus was on the
deliberative
process of the reasonable shareholder. It seems the CA accepted,
in accordance with TSC, that to be material, the information need not
actually changes the mind of the shareholder, vendor or
purchaser.
48 TSC Industries v Northway Inc [1976] USSC 119; (1976) 426 US 438,449.
49 Coleman v Myers [1976] NZHC 5; [1977] 2 NZLR 225 at 334; Hatrick v Commissioner of Inland Revenue
50 Above n 48 at 2132.
51 Tufton v Sperni [1952] 2 TLR 516 at 520.
52 Above n 49 at 332
1. “Materiality” in the US (a) The TSC test
TSC was an action brought by a shareholder (Northway) claiming that
TSC’s proxy statement was materially misleading in violation
of the
Securities Exchange Act section 14(a).53 Northway argued that the
statement was incomplete, therefore misleading because it failed to state
that this prior transfer
of interests in TSC had resulted in a change of
control.
On materiality, the Court stated that it is “universally
agreed”54 the question is one involving the significance of an
omitted or misrepresented fact to a reasonable investor. The Court also
recognised
that “variations in the formulation of a general test....occur
in the articulation of just how significant a fact must be or,
put another way,
how certain it must be that the fact would affect a reasonable investor’s
judgment.”55
The Court settled on the following test: “An omitted fact is material
if there is a substantial likelihood that a reasonable
shareholder would
consider it important in deciding how to vote.”56 The proxy
statement contained some information about the control of TSC, for example it
was “prominently displayed” that
National owned 34% of the shares
and that 5 out of 10 TSC directors were National nominees. In these
circumstances it could not be
said that the omission of a statement expressly
identifying the chairman of the board, or the omission of a statement explaining
that National “may be deemed a parent of TSC” was a material
omission as a matter of law.57
Despite being predominantly a “reasonable investor”
test, TSC combines elements the market impact test. The Court stated
further that a fact would be material if it altered the total mix:
58
53 TSC Industries v Northway Inc [1976] USSC 119; (1976) 426 US 438,449 at page 2128.
54 Ibid at 2130.
55 TSC Industries v Northway Inc [1976] USSC 119; (1976) 426 US 438,449 at 2130; TSC Industries v Northway
Inc [1976] USSC 119; (1976) 426 US 438,449 at 2132.
56 Above n 53 at 2132
57 Above n 53 at 2138.
58 TSC Industries v Northway Inc [1976] USSC 119; (1976) 426 US 438,449
2132.
Under all the circumstances, the omitted fact would have assumed actual
significance in the deliberations of the reasonable shareholder.
Put another
way, there must be a substantial likelihood that the disclosure of
the omitted fact would have been viewed
by the reasonable investor as having
significantly altered the “total mix” of information.
To determine whether the total mix has been significantly altered,
courts have frequently resorted to evidence of price movements
to ascertain the
significance of the information.59 Therefore TSC leaves room
for the application of market impact factors to supplement an argument that the
information was material.
(i) The distinction between merger negotiations and other soft, forward
looking information
US courts and commentators treat information about mergers differently to other types of predictive information and therefore use a different materiality test. Commentators have distinguished this type of information from other types of soft information on the basis that the existence of the possibility of a takeover or merger can be so significant that regardless of its probability it is a hard fact representing a present state of affairs.60 Brudney distinguishes information about possible mergers and takeovers from the previous information due to the fact the information does not itself contain any especially knowledgeable estimates of the likelihood that the contingent events will occur.61
Brudney suggests this information is analytically like many other forms of
information, for example statement of expenditures
made on research and
development. This information expresses corporate estimates of contingent
events but does not embody
“express inferences about intermediate
components of, or ultimate effect on, price.”62 The
information simply “informs about the possibility that is likely to be of
importance to an investor”.63
59 Lee, above n 2, at 655.
60 Sullivan, above n 24, at 221.
61 Brudney, above n 24, at 723.
62 Ibid.
63 Ibid.
Basic Inc v Levinson64 adopted the TSC test in a
case of insider trading leading up to a merger. Sellers of stock during the
period prior to the formal announcement of a
merger alleged that material
misrepresentations had been made because Basic had denied the existence of
merger negotiations prior
to this official announcement. Following this it was
revealed that the company had been approached and the following day the board
endorsed Combustion’s offer of $46 per share.
The Court in Basic rejected that information about mergers should not
have to be disclosed until an agreement as to price and structure had been
made.65 The Court expressly adopted the TSC test. The
Court also cites the probability/magnitude test set out in Texas. The
Court emphasised that, the existence of merger negotiations could be so
important in a small corporation that information
to this effect
becomes material at an earlier stage than other types of transactions. To
determine the probability element, the
Court suggested the following will be
relevant: signs of interest in the transaction in the highest corporate
levels66 such as board resolutions, instructions to investment
bankers and actual negotiations between principals. To determine the magnitude
of the transaction factors such as the size of the two corporate entities, and
the potential premiums over market value will be relevant.67 However
no particular event or factor is necessary by itself to render information
material.68 In conclusion the Court stated “as we clarify
today, materiality depends on the significance the reasonable investor would
place
on the withheld or misrepresented information”,69 thus
enforcing that the “reasonable investor” standard is still the
dominant test.
The US materiality standard contains no requirement the information would
actually make the insider trade. Also, the US standard includes
qualitative
information that would not necessarily affect the company’s share price.
The US courts seem to distinguish merger
information from other types. In the
context of mergers the high significance of the
64 Basic Inc v Levinson [1988] USSC 36; (1988) 485 US 224.
65 Ibid at 984.
66 Ibid at 987.
67 Ibid.
68 Ibid at 987.
69 Ibid at 988.
existence of negotiations overrides the reliability element. The TSC
test is still accepted as the relevant legal standard to judge
materiality.70
2. How was the fiduciary rationale expressed in the SMA?
Under the SMA there was no express requirement for a fiduciary relationship
to be established between the insider and the person with
whom he or she
trades.71 However, the influence of the fiduciary theory is
clear from the requirement the offender must be an
“insider”72 and receive the information by reason of his
or her position as an insider.73 By requiring that a person is a
true “insider” of the company, and has the information by reason of
his or her position,
the Act deems a fiduciary-like relationship to exist
between the insiders and the person with whom they trade.74
Because of the strong influence of the fiduciary theory on the SMA and the
fact the US materiality test had been adopted in Coleman, it was
predicted at the outset the court’s approach to materiality under the SMA
would be closely aligned to the US test.
3. Materiality under the SMA
The Commission’s Report to the Minister of Justice did
not recommend the use of the word “material”
to define inside
information.75 The Report described the approach to
inside information in the following way: 76
It is a difficult question to decide whether any particular item
of information has affected prices or is likely
to affect them. Those
are matters of opinion. They are, we think, proper questions for resolution on
the evidence of experts
familiar with the market. If the evidence becomes
disclosed to the market, evidence of a market reaction should be admissible and
would, we believe, have a strong effect upon the result of a
disputed
70 “SEC Staff Accounting Bulletin 99”, August 12 1999, 17 CFR Part 211.
71 Ratner, P and Quinn, C, Insider Trading, New Zealand Law Society Seminar (1990), at 1.
72 SMA section 3.
73 SMA sections 3(b), (d) and (f).
74 Securities Commission, Insider Trading: Report to the Minister of Justice (1987) at paragraph
1.4.
75 Securities Commission, above n 74 at 38.
76 Securities Commission, above n 74 at 8.
case. If the information does not become disclosed to the market, the
likelihood of a price reaction if the market had known is debatable.
That
likelihood should be assessed by applying robust common sense aided by expert
evidence. Powerful considerations would be the
nature of the information, the
lapse of time, and intermediate announcements and price movements.
However, subsequently the word “material” was included in the SMA
in the definition of “inside information”.77 Although
little trace of the underlying fiduciary basis can be found in the
Commission’s suggestions above, it
must be remembered this proposed test,
(an analysis of the nature time and intermediate and subsequent price movements)
is to apply
where a link to the company has been established. The fiduciary
theory has already done work by ensuring the person is an insider,
and that they
received the information by virtue of that position.
It was clear under the SMA there was no requirement for a prosecutor to “establish affirmatively” any state of mind on the part of an insider.78
Therefore in Wilson Neill the fact the company directors had
not analysed the material containing the inside information was irrelevant to
liability.
The courts have been willing to look at the potential for price
movement or actual subsequent price movements, utilising
the market impact test.
In Kincaid79 Henry J focussed on the likelihood the
information would impact the share price, rather than focusing on the influence
on the reasonable
investor.80 The level of impact on the share price
necessary to meet the material threshold is not clear from this judgment.
However the Commission’s
report into the dealing said “on any
measure a 55 million net influence is material.”81
Henry J concluded the information was probably material despite a number
of
77 SMA section 2.
78 Securities Commission, above n 74 at 37, 4.9.5(b); Re Wilson Neill Ltd; Colonial Mutual
Life Assurance Society Ltd v Wilson Neill Ltd [1994] 2 NZLR 152.
79 Re Bank of New Zealand: Kincaid v Capital Market Equities Limited (1995) 7 NZCLC
260,718.
80 Ibid. at 23.
81 Securities Commission, Report of an Enquiry into
Arrangements Entered Into By Bank of New Zealand in March 1988 (May 1993)
paragraph 23.40(c); Re Bank of New Zealand: Kincaid v Capital Market Equities
Limited (1995) 7 NZCLC 260,718 at 23.
experts giving evidence to the contrary. The experts argued that since the users of the accounts would be able to see the general trend in the company’s performance (the company had recovered slightly from
1989 position) the fact this recovery was overstated would not be
significant. This approach stressed the effect on the users of the accounts,
stating they would not be misled.82 The approach was akin to the
“reasonable investor” test however Henry J clearly favoured the
market impact approach.
In Wilson Neill the CA clearly favoured a market impact test to
establish materiality. The CA stressed “price sensitive” actually
meant
“price material”.83 The CA (preferring a
“real or substantial risk”84) stated a “bare
possibility” of a price movement did equate to “likely” but
this did not clarify the significance
of the price movement required.
The influence of a market impact test was also evident in the
Commission’s Regal Salmon Report.85 In this report the news of
a loss of $3.36 million “took the market by surprise”86
and the share price dropped from 147 cents to 115 per share87
(a movement of approximately 22%) and eventually traded as low as 72
cents. The Commission held there were material overstatements,
according to
accounting standards, in the financial reports prior to the report that caused
the share price drop.88 Despite this the Commission found
Shagin, the director who had sold shares after the release of this materially
overstated report,
did not possess material information because he had not
undertaken a skilled analysis of the data.
The market impact test was once again dominant in the
Commission’s
82 Above n 79 at 21:“He gave the opinion that users of the 1990 accounts would not be misled because they would see the results were still a long way less than the profits of
1987 and 1988, but with a recovery from the 1989 position.”
83 Re Wilson Neill Ltd; Colonial Mutual Life Assurance Society Ltd v Wilson Neill Ltd [1994] 2
NZLR 152 at 161.
84 Ibid.
85 Securities Commission, Report of an Enquiry into Aspects of the Affairs of Regal Salmon
Limited Including Trading in Its Listed Securities (July 1994).
86 Ibid.
87 Ibid.
88 SSAP No 6 Materiality in Financial Statements (revised 1985) affirmed by the Accounting
Standards Review Board in a release of 10 November 2000 (release of ASRB Release 7
Accounting Standards that Still have Authoritative Support Within the Accounting Profession (issued
11/00).
Fortex Report.89 The Commission took account of the drop in the share price of 43 cents to 7 cents following the announcement of a 40 -
45 million dollar loss.90 Amongst the information analysed was the
fact of the appointment of an independent investigation accountant, Mr Stiassny.
This had
been communicated to Fortex’s farmer suppliers. On this
information the Commission commented, “We think that news of
an
appointment of such a person in such a position might also have acted as a
signal to investors that all was not well with Fortex.”
The Commission
only went as far as saying this was potentially price sensitive. It is unclear
what “test” of materiality
the Commission is using. However the
reference of “signal to investors” perhaps indicates a reasonable
investor standard.
The Commission also looked at the fact the company had lost
16% market share, saying “a number of variables exist that leave
unclear
the question of how the market would react to this information. Was the loss of
market share recoverable? How significant
was the loss of market share given the
supply of lambs in the season to date had been well below what Fortex had
expected? How sensitive
to market share did other share analysts consider
Fortex’s profit to be?”91
In Haylock92 the market impact test was clearly influential
although once again it is difficult to ascertain a threshold for the degree of
impact
necessary. When assessing the materiality of the information93
Gault P stated “it will be difficult to contend that the information
would not have been price-sensitive when the receipt of
new licenses for un-
investigated areas was seen as justifying an increase in the price offered for
the shares”.94 Gault P accepted there are difficulties with
respect to disclosure in the gas and exploration industries. He stated
“that may
bear heavily on aspects of the claim, for example any assessment
of loss involving notional disclosure would need to take account
of the
reservations or qualifications that would be necessary to ensure only
appropriate impact on share values. The lure
of hindsight,
often
89 Securities Commission, Report on an Inquiry into Aspects of the Affairs of Fortex Group Limited (In Receivership and Liquidation) Including Trading in Its Listed Securities (October 1995) at paragraph 12.19.
90 Securities Commission, Fortex Report, above n 89, at 3.6.
91 Securities Commission, Fortex Report, above n 89 at 12.21.
92 Southern Petroleum v Haylock [2003] 3 NZLR 518.
93 Ibid.
94 Southern Petroleum v Haylock [2003] 3 NZLR 518 at
paragraph 63.
attractive to claimants, must be resisted.”95 This indicated
a clear willingness to look at share price impact to measure materiality and
recognises that only the movement in share
price attributable to the information
itself should be taken into account.
In the Commission’s Fletcher Challenge Report,96 the information was a draft press release revealing “FCL management were considering options for a possible merger of FCL Paper with Fletcher Challenge Canada”.97 On materiality the Commission commented: “it seems clear that an announcement that a company is considering a major restructuring of one of its divisions is likely to materially affect the price of the shares of that division. This is so whether the release is known to be a draft document or a final news release, and whether there has been speculation in the market on these matters. An authoritative statement from within FCL on the subject would be an important event.”98 This analysis puts weight on the source of the information (the fact it was a draft from within the company) highlighting its increased reliability. The Commission also looked at the subsequent price movements of FCL shares.99 After a halt on trading due to the leakage of the information, the share price peaked at 13% higher than when trading restarted, before dropping to a level 6% higher than at the start of the trading halt. The price then dropped sharply on 11 May at
$1.68 (2.3% below the level before the trading halt). The Commission found
this effect to be material. Clearly this was based on a
market impact
test.
95 Southern Petroleum v Haylock [2003] 3 NZLR 518 at paragraph 67.
96 Securities Commission, Report on Questions Arising from an Inquiry into Trading in the Shares of Fletcher Challenge Limited in May 1999, Insider Trading Law and Practice (20 November
2000).
97 Securities Commission, Fletcher Challenge Report, above n 96, at 19.
98 Ibid.
99 The week of 26 to 30 April saw FCL Paper share prices rise on very heavy trading from around $1.43 at the start of the week to close the week on $1.67 (a rise of around 17% in
5 days). The following week the price rose to $1.75 before falling back to around $1.72 at
2 pm on Friday 7 May. Ibid, at paragraph 56; after the release of the leaked page to stockbrokers at 2 pm on the Friday the price of these shares began to rise further. The price peaked at $1.94 at around 10 am on Monday 10 May (a rise of about 13% in a little over 2 trading hours) before dropping to close at $1.82 (up 6% on the 2 pm price for 7
May). The price continued to drop sharply on 11 May, closing at $1.68. Securities
Commission, Fletcher Challenge Report, above n 96, at 58.
In Midavia100 the Court displayed a clear preference for
the market impact test stating “because much inside information, such as
the issuer’s
results being unexpectedly better or worse than earlier
publicly forecast- will rapidly become public and bring in its train an impact
on the price of the issuer’s securities”.101
In Wilson Neill, and Kincaid the market impact test is clearly
dominant and is preferred over evidence based on standards that are more akin to
a “reasonable
investor” analysis. This is further supported by the
Commission’s reports into Gulf Resources, Regal Salmon, Fortex.
The more
recent statement by the Commission in the Fletcher Challenge Report further
enforces the dominance of market impact as they
were able to conclude
materiality on a temporary, equivocal, share price movement. The most
recent New Zealand insider
trading cases, Haylock and
Midavia, provide little discussion of materiality however statements of
the courts seem to take for granted the appropriate approach is “market
impact”. Regardless of the approach taken by the courts to materiality,
the cases do little to resolve the two important thresholds
that are common to
all materiality tests, the significance threshold and the reliability
threshold.
D. The approach to materiality in a market fairness regime
The market fairness approach represents the idea that all participants in a
market should have equal access to information about a
public issuer.102
If investors feel the market is unfair the flow-on effect will be a
decrease in the amount of money people will invest, therefore
increasing the
cost of capital.103 “So long as insider trading serves as an
indication of the character of the securities market, 'fairness' is likely to
have
economic consequences through the reaction of investors and must be taken
into account in any attempt to predict or enhance the market’s
efficiency”.104
100 Securities Commission v Midavia Rail Investments BBVA [2006] NZCA 505; [2007] 2 NZLR 454.
101 Securities Commission v Midavia Rail Investments BBVA Unreported, High Court, Auckland, CIV-2004-485-2174, 28/9/05, Williams J at paragraph 86.
102 Securities Commission, above n 79 at 15; Michael Gething, 'Insider Trading
Enforcement: Where Are We Now and Where do We Go From Here?' (1998) 16
Company and Securities Law Journal 607 at 608.
103R v Doff [2005] NSWCCA 119 at [56]; Regina v Rivkin [2004] NSWCCA 7.
104 Phillip Anisman, Insider Trading Legislation for Australia: An Outline of the Issues and
Alternatives. An Issues Paper prepared for the Working Party on Insider
Trading of the National
The market fairness rationale is evident in the Australian legislation as
there is no requirement that the insider is connected to
company. The Australian
section 1042D of the Corporations Act reads: 105
A reasonable person would be taken to expect information to have a material
effect on the price or value of securities of...financial
products if (and only
if) the information would, or would be likely to, influence persons who
commonly acquire...financial
products in deciding whether or not to acquire or
dispose of the first mentioned financial products.
Materiality under the market fairness rationale utilises a combination of the
three tests: reasonable investor, market impact, and
magnitude/probability. One
recurring feature is the absence of any sensitivity to the different types of
information that can arise.
As a result the materiality analysis is much cruder
than the analysis in the US. Also in a couple of instances the obvious choice
of
test (the probability/magnitude test where information is forward looking) is
ignored and subsequent share price movements are
used instead.
The reasonable investor approach is present in the background of all the
cases due to the wording of the materiality definition. However,
the courts do
not seem content to rely on the reasonable investor test alone, using the market
impact or magnitude/probability tests
to supplement it. Many cases equate the
reasonable investor test with “price sensitivity”. This indicates
the Australian
courts’ view the reasonable investor test as more
restrictive than the wide approach of the US courts where qualitative
information
can be included. For example in Ampolex,106 Rolfe
J said “one must ask whether such a reasonable person would expect that
the intention, being an intention of persons who
hold a parcel of the
convertible notes to so advise the ASX could or would be likely to influence the
designated persons”107 but then Rolfe J equated this
requirement with “price sensitivity” returning to a market impact
analysis.108
Companies and Securities Commission (1986) at 9.
105 Corporations Act 2001, section 1042D.
106 Ampolex Ltd v Perpetual Trustee Co (Canberra) Ltd (1996) 20 ACSR 649 at 1523.
107 Ibid.
108 Ibid.
In Evans v Doyle109 the material information was the test
results of mineral exploration. Mt Kersey Mining NL held licenses to mine the
land adjoining
where test results had discovered a shoot of high-grade nickel
sulphide.110 The discovery was significant in the mineral grade, but
was un-quantified. However, the discovery suggested the minerals extended
onto
the company’s land. This information falls squarely within the
category of soft predictive information. The outcome
of the information on the
fortune of the company was uncertain despite its potential to be significant.
Evidence was admitted
to illustrate the impact of the information on the
price of the shares once the information was disseminated.111
Surprisingly on facts broadly similar to Texas Gulf in the
US,112 there was no attempt to analyse the information in terms its
probability/magnitude. The Court ignored the subtleties of the types
of
information that can occur in favour of market impact evidence.
Rivkin113 was the first prosecution of an
“outsider” under a market fairness regime and illustrated how
“materiality”
would operate where there was no connection to the
company.114 Mr Rivkin wished to sell his house, and instructed a
real estate agent, Doff to act on his behalf. Mr McGowan, Executive
Chairperson
of Impulse Airlines was interested in purchasing the house.
He approached Doff and eventually spoke to Rivkin in a phone
conversation on 24
April 2001 in which he revealed information about his company’s
affairs. He explained to Rivkin
he wished to make the purchase conditional as
he was waiting to “merge” businesses with Qantas. Rivkin expressed
disbelief
that the company’s would get the necessary regulatory approval,
but was reassured by McGowan. Further McGowan warned Rivkin
he could not now
trade in the Qantas shares. Following the conversation Rivkin purchased 50 000
Qantas shares. On 1 May 2001 on Rivkin’s
instructions the shares were sold
making a profit of $2664.94. Later that day the merger was announced and there
was a significant
rise in the price of Qantas shares.
109 R v Evans & Doyle [1999] VSC 488 (15 November 1999).
110 Ibid.
111 R v Evans & Doyle [1999] VSC 488 (15 November 1999) at 548.
112 SEC v. Texas Gulf Sulpher Co [1968] USCA2 483; 401 F.2d 833 (2d. Cir.1968).
113 Regina v Rivkin [2004] NSWCCA 7; see also R v Doff [2005] NSWSC 50.
114 Juliette Overland, 'The Future of Insider Trading in Australia: What Did Rene Rivkin
Teach Us' [2005] DeakinLawRw 38; (2005) 10 Deakin Law Review 708 at 709.
Rivkin established the source of information can be included in the
information itself.115 It was argued the information possessed was
not the actual state of affairs conveyed but was the fact that Mr McGowan had
stated that
such a state of affairs existed. This was rejected because it was
held a person need not believe the underlying state of affairs
to be true
(the essence of the argument against including this information).
The Court considered a number of expert
opinions that expressed the source of
the information would be crucial to its reliability and therefore its
materiality:116 “It was also abundantly clear that the
circumstance that Mr McGowan was the source was relevant to the question of the
reliability
of the information, and hence its
materiality.”117
In the US the question of the source of the information is distinct from
materiality. For example, an outsider who receives
the information from
an insider is required to know that it is being disclosed in breach of
confidence.118 This requirement was expressly rejected in Rivkin
as it was held there was nothing in the legislation to suggest such a
requirement.119 This creates a challenge for materiality
determinations as there is now a third feature to analyse. Strangely the
arguments to support
this proposition were based on the idea that to allow such
an argument would allow insiders to avoid the scheme where the source
is
reliable but a mere rumour was conveyed. It was acknowledged that the market
“operated on matters of sentiment, rumour
and tips”120
therefore this type of situation should be covered by insider trading law.
The main problem with such an assertion is that in most
cases “sentiment
and rumour” in the market contains only information that is generally
available and therefore not material.
Petsas121 involved merger negotiations; however,
unlike the US approach a probability/magnitude test was not expressly
addressed.
The information was confirmation of the existence of
confidential
115 Regina v Rivkin [2004] NSWCCA 7 at paragraph 131.
116 Ibid. at paragraph 51 and paragraph 73.
117 Ibid. at paragraph 137.
118 Chiarella v. United States [1980] USSC 45; (1980) 445 U.S. 222.
119 Above n 115 at paragraph 139.
120 Above n 115 at paragraph 72.
121 ASIC v Petsas & Miot [2005] FCA 88; [2005] 23 ACLC
269.
merger negotiations between BRL Hardy Ltd and Constellation Brands, and
confirmation that ANZ had been engaged by BRL to perform work
in relation to
this merger. The Court recognised “because of their tentative nature the
discussions were highly confidential”.
However this “soft”
quality of the information did not factor into the Court’s materiality
analysis. The Court
stated “Mr Petsas and Mr Miot knew that if the
information about the merger discussions became public it would affect the price
of BRL’s shares as well as the price of the call options over those
shares.”122 Under the US approach this information would have
also been material because Constellation Brands Inc is one of the world’s
largest producers and suppliers of alcohol. Because of its relative size, the
existence of negotiations would be a significant fact
to a shareholder
regardless of the level of probability that they would eventuate into a merger.
The US Court would have reached
this conclusion by looking at the information
from the perspective of a reasonable investor. However the Court skipped an
analysis
of this kind. The strong evidence of market impact made it unnecessary
to elaborate. When the information was released the stock
price rose immediately
by around 17% and continued to rise.
Hannes123demonstrated a mixed approach to materiality
equating the reasonable investor test with the market impact test. The Court
summarised
its approach stating: 124
Materiality is concerned with investor conduct and, more particularly, with
the question as to whether the particularised information
would or would be
likely to influence...(the reasonable investor). This might generally be said to
be concerned with the capacity
of information to influence investor behaviour
which in turn, has a material effect on the price or value of securities.
Accordingly,
materiality is concerned with information which might be said to be
price sensitive.
The information on which the information was based in the charge was
“it was likely that shares in TNT Limited would be the
subject of a
takeover at a price in excess of $2 per share.” specifying merely a floor
price at which the offer would be made.
122 Ibid. at paragraph 7.
123 Hannes v Director of Public Prosecutions (Cth) (No.2) [2006] NSWCCA 373.
124 Ibid. at paragraph 384-385.
Because of the way the information was particularised there was considerable
objection to the use of evidence of the share price movement
of the announcement
of a takeover at $2.45. It was argued that the evidence of what actually
occurred on the day of the announcement
was information of a
“qualitatively different nature” than the information
particularised (the “possibility
of a takeover at a price above
$2.01”). When evaluating whether the particularised information was
generally available the
Court found “there is a difference for example,
between speculation as to a 'takeover valuation', on the one hand, and
information
as to the likelihood of a particular takeover, on the other. It was
the combination of the information particularised which was significant
in
relation to the offence charged.”125 The Court held these
differences did not mean the evidence of what actually happened was
irrelevant to materiality.126 The Court clearly favoured the evidence
of share price movements over other evidence stating: 127
The possibility that other factors may have affected the market for a
particular security at a particular time must always be borne
in mind, but to
reject information as to price movements out of hand on that basis is at least
to risk inviting the jury to speculate,
without the assistance of the only
concrete evidence of which might be thought to provide some assistance in
undertaking that evaluation.
So despite the Court’s recognition that it was applying a reasonable
investor test it relied heavily on market impact evidence.
Significantly, in Hannes the Court was directed to US
authority128 in an attempt to limit the influence of evidence of
share price movements. However the Court felt there were two important points
of
distinction to be made. Firstly the US cases dealt with whether a failure to
disclose was misleading (as opposed to an insider
trading case) “an issue
to which any increase in the value of the stock after disclosure was clearly not
compelling”.129 Secondly the US cases only described the
evidence as of “limited value” which is different from saying it has
no probative
125 Above n 123 at paragraph 382.
126 Above n 123 at paragraph 299.
127 Above n 123 at paragraph 351.
128 Reiss v Pan American World Airways Inc [1983] USCA2 706; 711 F.2d 11 (2d Cir. 1983); Securities and Exchange
Commission v Texas Gulf Sulphur CO [1968] USCA2 483; 401 F.2d 833 (2d Cir. 1968) at 863.
129 Above n 123 at paragraph 352.
value.130 The Court commented, “it is readily apparent that
the law in question in that case was a materially different form of insider
trading prohibition to that with which the present charge is concerned, the
reasoning nevertheless demonstrates that evidence
of subsequent trading is
treated in US law as potentially relevant to issues similar to that of
“general availability”
under Australian
Law.”131
In 2007, Citigroup132 demonstrated the full dominance of
the market impact test. The first insider trading claim failed because Manchee
was not considered
an “officer” of Citigroup and was not found to
have made the supposition contended. It was argued that after the
“cigarette
conversation” in which his supervisor told him not to buy
any more Patrick shares, Manchee formed an “un-communicated
supposition” that the rumours about the takeover were true and that
Citigroup was acting for Toll. The court went on to analyse
the “price
sensitivity” of this information. It was held that at the time of
Manchee’s sale, the market had already
moved the share price to a level
that reflected “the substantial likelihood” of a takeover.
The further
non-public information that Manchee held, that Citigroup
was acting for the Bidder, was not material. The second
insider
trading claim failed because an effective Chinese wall was in place. However
the materiality analysis undertaken by the
court reflected a pure market impact
test. The information was the knowledge that Citigroup was acting for the
Bidder, and the
timing of the announcement of the takeover bid. Before
the start of trading on Monday, the takeover was announced to the
market. The
court found it was likely knowledge of the timing of the release was material
because the Patrick shares opened the day
of the announcement at $7.19, 10.9%
higher than the closing price the Friday before. This price rise, and the
subsequent price rise
to $7.38 seemed to establish the materiality of the
information. The information in question (for the second charge) was
“knowledge
of the timing” of the announcement of the takeover by
Toll. This was in an environment where the market contained such a high
degree
of speculation that it knowledge of the “substantial likelihood” of
a takeover was generally available. The only
factor relied on to establish the
materiality of the above information was a price rise between the close of
trading on
130 Ibid. at paragraph 352.
131 Above n 123 at paragraph 354.
132 Above n 5.
Friday and the opening price of the stock after the announcement had been
made early Monday morning. This is clearly a market impact
test.
The test adopted by the Australian courts seems to be predominantly market
impact despite section1042D suggesting a reasonable investor
test. From the
heavy emphasis on the share price movements and the repeated references to price
sensitivity, it seems that the information
must be of a kind that would actually
induce the reasonable investor to buy or sell shares thereby creating a price
impact. The Australian
courts do not address the possibility that information
that would create an impact once released might not be recognised as such
by a
reasonable investor prior to its release.
Surprisingly the courts do not differentiate between hard, soft, or
predictive information, particularly information about mergers.
This could
be due to the heavy reliance on a price impact analysis, where, regardless of
its nature before the announcement
a price impact indicates its
materiality after its release. The subtleties of information seem to have more
relevance when analysing
the deliberative process of the investor or shareholder
under the US test.
Clearly, there is no way to determine a threshold for the level of
significance or reliability required for information to be material.
This
criticism is not isolated to the Australian approach as the US and New Zealand
approaches were also incapable of setting such
a threshold.
E. A comparison of the approaches.
1. Does the underlying rationale affect materiality?
Firstly, the threshold for materiality in Australia under a market fairness
approach is more demanding than in the US because
of the requirement
the information would be viewed by the reasonable investor as likely
to affect the share price.133 At first it might be expected
that in essence both tests are the reasonable investor test, therefore
materiality should be the
same. However the inclusion of the words “effect
on price” in the Australian section (and consequently SMAA) is
significant.
It has led to the approach being closely aligned to
133 Corporations Act 2001 section 1002(1)(2).
a “market impact” analysis, as the courts have viewed evidence of
share price movements as highly relevant and sometimes
determinative. The US
test focuses more on the deliberative process of the investor. It does not
demand that the information would
have induced the investor to buy or sell but
requires that it “assume actual significance” in the
investor’s deliberations.134 Because the second limb of the
TSC test refers to the “total mix” of information available,
evidence of share price movements are admissible in the US but
not
determinative.135 It has also been suggested by Cox that there is
little difference in practice between the tests, but without evidence of more
“hard
cases” being determined by the courts in this area it is
impossible to know.136
Secondly, one clear difference between the versions of the reasonable
investor test is the inclusion or exclusion of qualitative information.
The fact
the US test potentially encompasses both qualitative and quantitative
information means it is much wider than the Australian
approach.
Thirdly, under the market fairness approach the source of the information
blends into its materiality. It has been illustrated that
the tests employed by
the courts search for a threshold level of significance and reliability. Very
significant information can be
material despite a low level of reliability
(for example the existence of merger discussions). Alternatively,
very
reliable information, with a low level of significance may well be material
(for example a financial reporting error of 3%). The
two features together
determine materiality. However Rivkin adds a third element into the
Australian analysis: reliability of the source of the information.
The importance of the source of the information is recognised in both
fiduciary and market fairness regimes.137 However under a fiduciary
approach the “reliability” of the source of information is much more
easily established. This
is because the US cases all involve
information
134 James D Cox, 'An Outsider's Perspective of Insider Trading Regulation in Australia' [1990] SydLawRw 7; (1989-1990) 12 Sydney Law Review 455 at 470; TSC Industries v Northway Inc (1976) 426 US
438,449 at 449.
135 U.S.v. Bilzerian (1991) Fed. Sec. L.R. 98283, 98290-98291.
136 Cox, above n 134, at 470.
137 Richard C Sauer, 'The Erosion of the Materiality Standard in the Enforcement of the
Federal Securities Laws' (2007) 62(2) Business Lawyer 317(41) at
322.
that was sourced (albeit sometimes indirectly) from the company. The source
of the information forms part of the threshold question
of whether a duty
exists: the trader needs to know that the information was received in breach of
confidence to the owner of the
information. This is particularly important
in tippee liability. Because an insider knows they are already
“inside”
the company, and information that comes their way is
probably reliable, it sends a clear signal to the insider to analyse the
significance
and reliability of the content of the information carefully. The
materiality question is engaged after this initial determination
of the source
is made. As a consequence the “reliability” element in the US
focuses on the actual measurable probability
of the information occurring and
its verifiability.
On the other hand under market fairness approach the reliability aspect of
the information is more difficult to deal with. Rivkin demonstrates the
“source of the information” is included in the information itself.
Under the market fairness approach
information’s significance is largely
dealt with using a market impact method, by resorting to evidence of the
likelihood of
price movements and their magnitude as opposed to asking whether a
shareholder would consider it important. Taking such an approach
means an
inclusion of the source of the information in the market fairness approach
substitutes for the “connection”138 under a fiduciary
approach. Because under a market impact approach there is a much wider range of
circumstances that information may
be imparted to an investor the reliability
aspect takes on a new dimension: it must also analyse the circumstances in which
the information
arose. This makes finding a threshold even harder.
If the source of the information is included there is a possibility
information insiders may elevate themselves to tippers where the
bare
information would not have been material. The facts of Citigroup139
demonstrate this risk. An employee of a large investment bank
speculates (forms an uncommunicated supposition) that his investment
bank is
working on a merger of two companies. There is already a large amount of
speculation in the market that the two companies
will merge to the point the
market is relatively certain the event will take place in the near future. The
identity of an advising
firm would not by itself
138 Alexander F Loke, above n 19.
139 Above n 5.
provide any additional significant information to the market because, by
itself, it does not confirm the firms will in fact merge
only reasserts what is
generally available that it is likely the firms will merge (and with that it is
certain they will both have
a firm acting for them). However if the employee
conveys this supposition to someone, the fact it is information from within
the
advising firm elevates his speculation about the identity of the
advising firm to a material fact and therefore is guilty of
tipping. His own
possession of that information would probably be unlikely to tip the balance of
information in the market. Under
a fiduciary regime the fact it came from within
the firm would establish it was a breach of confidence, then the focus would be
on
whether or not the confirmation that that particular firm was acting for one
of the parties was sufficiently significant to alter
the total mix. However
under a market fairness regime the source and the information
are combined. The fact that
it is from an “inside source” appears to
concrete the reliability of the information and therefore makes it more likely
the information will be material.
2. The interaction with the “generally available” limb of inside information
The source of the information is often an indication of whether the
information is generally available. Under a fiduciary approach
the
source would relate to whether the tippee knows that the information is being
communicated in circumstances that constitute
a breach of duty. If the source
and circumstances of receiving the information does not go to the availability
of the information
how can this be determined? Overland gives the example of
three examples of information: 140
1. A press release addressed to the ASX and signed by the company secretary of ABC Ltd which states that ABC Ltd is about to launch a takeover bid for XYZ Ltd.
2. A statement from a trusted stockbroker that he has heard that ABC
Ltd is about to launch a takeover bid for XYZ Ltd.
3. A statement overheard whilst walking in the street that a
passer-by’s brother has heard that ABC Ltd is about to launch
a take-over
bid for XYZ Ltd.
Overland argues if you imagine a person overhearing the
above
140 Overland, above n 114, at 716.
information it becomes clear that the source of each piece of information
forms a vital part of the information itself.141 Without the
inclusion of the source, each piece of information seems identical.
However an alternative approach would be to
look at the information as
identical, but at different stages of availability: the first being clearly not
generally available and
the third probably common knowledge.
Overland commends the development in Rivkin. She argues speculation and rumour can have an impact on the price of securities and so people acting on rumour or speculation should also be caught by the regime.142
However the real damage caused by rumour or speculation arises from an
insider in breach of his or her duty to the company. Where,
for reasons of
commercial sensitivity, the information has been kept confidential such a tip
could cause damage to the company’s
plans and therefore its current
shareholders. However, sometimes rumour or speculation in the market (and
trading on it) can be a
good thing. If extensive enough to have an impact on the
share price, speculation is usually “generally available”,
particularly
where it has not originated from the company. In a number of cases
“rumour” in the market has been admitted as
evidence of
what information was generally available.143 Trading on such
information often improves the accuracy of the share price meaning that official
announcements often have a smaller
impact on the share price than if there had
been no leakage of the information. This reduces the opportunity for
“real”
insiders to take advantage of the information. Often rumours
are the result of market analysts piecing together industry factors
with the
specific circumstance to accurately predict what might occur. Citigroup
is a clear example of this as a high degree of speculation and rumour
created by a number of objectively observable circumstances
moved the share
price.
New Zealand's poor record of insider trading enforcement144 does
not
141 Ibid.
142 Ibid.
143 Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty
Limited (ACN 113 114832) (No. 4) [2007] FCA 963.
144 In Australia from 1985 to 2005 only 14 people have been tried for insider trading in Australia, of whom 10 were found not guilty (R v Martin (Unreported, District Court, WA, 1 August 2003; R v Kruse (Unreported, District Court, NSW, 2 December, 1999, O’Rielly J, 98/11/0908); R v Firns (Unreported, District Court, NSW, 4 Nov 1999,
98/11/0895); (2001) 51 NSWLR 548; [2001] NSWCCA 191 (convicted at trial but
overturned on appeal); R v Evans & Doyle [1999] VSC 488.
necessarily indicate a low level of insider trading: it can only be
speculated to what extent the regime is actually complied with.
Materiality
prevents a more rigorous enforcement of the regime and also an obstacle to
compliance with the regime. The New Zealand
Business Round Table
(“NZBRT”) stated in its submission on the Bill: “If businesses
are expected to pay for clarifying
rulings or interpretations, some may be
commercially driven to fly blind and risk technical
non-compliance.”145 As a result the purpose of the insider
trading law is frustrated.
F. Materiality as an obstacle to compliance
Underlying the Courts’ reliance on the market impact test is the idea
that the market is efficient.146 Because the market is efficient,
share price movements are an accurate measure of the significance (therefore
materiality) of new
information. Broadly put the Efficient Markets Hypothesis
(EMH) means that share prices already reflect all available information
about
the value of that share. Therefore, because a share price already reflects all
available information its price should only
decrease or increase in response to
the entrance of new information in the market.147
In many cases, courts rely on expert evidence to establish that the
information would have had a material effect on the share price
if it had been
generally available. In cases where the information is disclosed, the
courts also rely on the evidence of
the actual share price movements. At first
sight this suggests that it should be relatively easy to distinguish material
information
from immaterial information. However one author provides a clear
indication that even with a high level of knowledge about the way
the market
reacts, this determination is not an easy, or even possible, one without the
benefit of hindsight.
145 New Zealand Business Round Table, Submission to the Ministry of Economic Development on the Reform of Securities Trading Law (2002) http://www.nzbr.org.nz/documents/submissions/submissions-2002/insider_trading.pdf (at 16 September 2007) at 7.
146 Walker, Fisse, and Ramsay, above n 32 at 607.
147 Donald C Langevoort, “Taming the Animal Spirits of the Stock Markets: a
Behavioural Approach to Securities Regulation” in John Armour and Joseph A McCahery
(eds), After Enron: Improving Corporate Law and Modernising Securities
Regulation in Europe and the US (2006) 65 at 70.
Alister Alcock stated: 148
In my 11 years as a corporate financier working for a large broking house,
the most common question I was asked before the announcement
of a deal was
“What will happen to the share price?” the truthful answer usually
was “I don’t know”.
Substantial purchases or sales could be
seen as cheap or dear, as strengthening the company’s prospects or
weakening them,
as making further share issues more or less likely. Prosecutors
have the advantage of knowing the outcome.
If an experienced corporate financier is unable to predict what will happen
on the disclosure of information, how then can the “reasonable
person” be expected to do so? Even on the assumption that the
sophisticated investor is the appropriate hypothetical person,
it is clear that
analysing materiality based on ex post share price movements provides no
adequate guidance to insiders or outsiders who must decide whether to
trade.
Another problem exists with the market impact test: it uses ex post
price movements to establish the ex ante knowledge of the
reasonable investor. However in Citygoup149 there was an
unwillingness to attribute the same “benefit of hindsight” to
knowledge held by the market generally. When
evaluating the expert evidence
offered in Citigroup as to what information was held by the market
generally, the Court held that the information available was “more
persuasive
after the event than it apparently was on 19 August
2005.”150 Further the Court stated: “Although Mr Harvey
acknowledged that the absence of a report from Mr Smith may have triggered some
of the activity in Patrick shares, this was a clue that was only available with
the benefit of hindsight.”151 It seems extraordinarily
inconsistent to give the market the benefit of the doubt as to whether the
information was available, but
to allow share price movements to be evidence of
the “extra information” held by the insider.
The market impact test is unable to specify a minimum threshold of
the
148 Alistair Alcock, 'Inside Information' in Barry Rider and Michael Ashe (eds), The
Fiduciary, the Insider, and the Conflict: a Compendium of Essays (1995) at 89.
149 Australian Securities and Investments Commission v Citigroup Global Markets Australia Pty
Limited (ACN 113 114832) (No. 4) [2007] FCA.
150 Ibid. at 963, paragraph 557.
151 Ibid. at 963 at paragraph 562.
level of price movement required to establish materiality. Even if the
direction of the movement of the share price can be predicted,
the courts have
not provided a minimum threshold for the magnitude of the share price movement.
In a relatively illiquid market such
as New Zealand, a large trade can move the
share price up or down through price impact.152 If no minimum
threshold is provided, an institutional trader’s knowledge that it is
about to purchase a large block of shares
could, on the market impact test, be
material information. The NZBRT submissions on the market manipulation
regime support
this proposition describing how it is common for brokers to
break up large orders to avoid price impact.153 The practice of
managing large orders in this way is evidence that large orders can create price
impact. Prosecution for insider trading
on such facts is unlikely154
but it highlights a serious flaw in the market impact test as it is
currently applied. If a market impact test is to be applied a
minimum threshold
price movement must be specified.
The market impact approach relies heavily on a contestable concept in modern
securities markets: efficiency. Langevoort explains an
irrational market
reaction in response to media attention. On Sunday 3 May 1998 an edition of the
New York Times ran a story about
Entremed, a Biotech company that held licensing
rights to a medical breakthrough. As a result of the increased media attention
caused
by the article the share price rose dramatically.155
Langevoort reveals this article contained no new information,
everything had already been disclosed in previous Times articles
and company
releases. Therefore, the share price increase directly contradicts the EMH
theory that share prices immediately impound
all available
information.156
Behavioural finance theory stems from the idea that market participants are
influenced by psychological factors, not just fundamental
values.157
152 Bodie, Kane, and Marcus, above n 26.
153 New Zealand Business Round Table, Submission to the Ministry of Economic Development on the Reform of Securities Trading Law (2002) http://www.nzbr.org.nz/documents/submissions/submissions-2002/insider_trading.pdf (at 16 September 2007) at 11.
154 SMAA section 9C.
155 Langevoort, above n 147, at 70.
156 Ibid.
157 Donald C Langevoort, ‘Theories, Assumptions and Securities Regulation: Market
Efficiency Revisited’ (1991) 140 University of Pennsylvania Law
Review 851at 866.
Where investors play the game of second guessing what other investors will
do, the traded share price can stray from its fundamental
value. The problem
this raises for materiality is that it is not clear whether the tests assume
investors make decisions based
on fundamental value or whether the tests
allow room for this speculative element.158
Commentators have reflected this uncertainty without explicitly recognising
the link to the behavioural finance theory. The
market reaction to
information has been labelled too crude to reflect a hypothetical reasonable
investor’s reaction: 159
Holders of a small amount of a company’s securities may have different
priorities than institutional investors and thus react
differently to particular
corporate developments. That holders of a small number of company’s shares
do not act in numbers
sufficient to affect stock prices does not make their
views unreasonable....Given that the great bulk of securities transactions
are
now made by institutional investors, to say otherwise would make the 'reasonable
investor' synonymous with the well-funded money
manager.
If all investors reacted in an economically rational way to information,
sophisticated, unsophisticated, large, and small investors
would react the same
way but it is clear they do not. Richard Sauer highlights a well known bias that
investors react disproportionately
to a change in news:160
Even when a company’s disclosure is, clear, complete, and can be
isolated from all background noise, market reaction may not
provide a perfect
measure of its materiality. The very event of a corrective disclosure of a
previous misstatement, for example,
may seem more significant to
investors than the substance of the disclosure if the disclosure gives rise to
investors’
fears of civil or criminal liability or it is suspected to be
the first instalment of what will likely be a series of escalating
abd news
items.161
Another example of behavioural finance at work is the phenomenon of price
momentum.162 Simplified this is the theory that good or bad
158 Ibid. at 866.
159 Sauer, above n 137, at 325.
160 Bodie, Kane, and Marcus, above n 26.
161 Sauer, above n 137, at 325.
162 Narasimhan Jegadeesh and Sheridan Titman, 'Returns to Buying Winners and Selling
Losers: Implications for Stock Market Efficiency' (1993) 48 Journal of
Finance 65.
recent performance of particular shares continues over time without any new
information being released to the market. This defies
the EMH claim that
subsequent price movements are independent of their antecedents.163
For example in the instance good news is released to the market, a slow
upward trend in the share price following the announcement
suggests the initial
reaction was an under reaction and the price is slowly adjusting. An instant but
excessive reaction leading
to a downward trend suggests the initial
response was an overreaction.164 This is called the overreaction
effect.165 The overreaction effect has been evident in share price
movements relied on in several instances to establish materiality.
For
example the Securities Commission, in its Gulf Rescources Report,166
found evidence of a settling in the price of the shares after the
initial announcement. The shares rose briefly from a 40-45 cent
range up to a
48-50 cent range, and then fell to a 43-48 cent range two days after the
announcement. Also, in its Fletcher Challenge Report167, the
Commission found that the leaked page had a material effect on the price of
Fletcher Challenge shares even though the market
initially overreacted. After
the release of the leaked page to stockbrokers at 2 pm on the Friday the price
of these shares began
to rise. The price peaked at $1.94 at around 10am on
Monday 10 May (a rise of about 13% in a little over 2 trading hours) before
dropping to close at $1.82 (up 6% on the 2 pm price for 7 May). The price
continued to drop sharply the next day, closing at $1.68.
These reports show
how, if overreaction factors are not taken into account when using a market
impact test, potential exists for
unfairness to an investor who cannot predict
the severity of the market’s reaction.
Citigroup168 provides a good example of where reliance on
EMH theory might lead to a flawed measure of the materiality. The 10.9% increase
in the
share price over the weekend could have been explained by a momentum
effect of the information that was generally available on the
Friday; that there
was a “substantial likelihood” of a takeover. If so, the
163 Langevoort, above n 147, at 72.
164 Ibid.
165 Ibid.
166 Securities Commission, Report on Enquiry into Dealings in the Voting Securities of Gulf Resources Pacific Limited (Formerly City Realities Limited) During the Period November 1989 to January 1990 (June 1992).
167 Securities Commission, Fletcher Challenge Report, above n 96.
168 Above n 5.
price movement is unreliable evidence of the materiality of the knowledge of
the timing of the announcement because it might be a
result of this momentum
effect not the release of the timing of the announcement.169 In such
circumstances it is difficult to define the extent to which the release of the
information caused the further decline/increase
in the shares value, as opposed
to a general trend in the price due to the momentum effect.
An economically irrational overreaction could magnify the appearance of
materiality to the extent even a seemingly insignificant
piece of
information may cross the (unknown) materiality threshold. This is an alarming
possibility. For an insider to profit off
such information, the insider would
need to know the content and the exact time and date at which it the information
would be eventually
released. If information is good but insignificant news, the
insider would need to buy shares on the knowledge that there would be
an
overreaction and he or she could sell in the period of the “bubble”
in the price before it returned to its rational
level. While this is a remote
possibility, it is unclear how the reasonable person would be able to employ
such a strategy.
Despite the increasing recognition of behavioural finance, the courts in
Australia and New Zealand tend to ignore the other possible
causes of share
price movements when determining materiality.170Anomalies in the
reaction of the market are not within the knowledge of the average investor. If
the courts continue to use price
movements to establish materiality of
information they must begin to expressly recognise these anomalies and
accommodate them. It
is too much to ask that the average investor know of these
anomalies therefore a strong case exists to limit the application of such
a test
to insiders who possess a higher degree of knowledge of the market.
F. Materiality: an obstacle to enforcement of insider trading
The cases do not display a clear threshold of the significance or
reliability required for materiality. This is an
obstacle to enforcing
insider trading as regulatory bodies are only going to pursue clear
cases.
169 Re Wilson Neill Ltd; Colonial Mutual Life Assurance Society Ltd v Wilson Neill Ltd [1994] 2
NZLR 152 at 153.
170 Securities Commission v Midavia Rail Investments BBVA
Unreported, High Court, Auckland, CIV-2004-485-2174, 28/9/05, Williams J at
paragraph 86.
This is supported by Gething who suggests three main problems face ASIC in
trying to prosecute insider trading.171 These are: the difficulty of
detection, the problem of proving knowledge, and the necessity to rely on expert
evidence to prove materiality.172 Similarly Tomasic lists the
“materiality” issue as one of nine obstacles to enforcement
of insider trading.173
Cox argues that the American prosecutions for insider trading have not been
hindered by findings that the information was not material.174 He
argues that the essence of insider trading is the fact that the trader has in
fact profited from the trading, and argues that no
prosecution has been
initiated against the bumbling insider trader.175 Several
commentators have related the success of insider trading enforcement in the US
to its less technical anti fraud provision.176
G. How the fiduciary connection reduces obstacles to enforcement and
compliance
A market fairness rationale creates an over inclusive insider trading regime
that puts greater pressure on a materiality standard
that is already
difficult to apply and enforce. It forces materiality to assume a greater role
in “sorting” illegal
insider trades from legitimate trades. The
Australian experience shows this is done for little gain. In Australia only one
person
who could be considered a true outsider has been convicted of insider
trading.177 Even in that case, Rene Rivkin was really an
“insider” of the wider share market community in Australia.
The fiduciary connection reduces obstacles to enforcement and compliance by
accommodating a lower materiality threshold. A lower threshold
is acceptable in
a fiduciary situation because the insiders have knowledge of their privileged
position in terms of access to specially
informed information. The insider has
been given a signal about the
171 Gething, above n 102, at 618.
172 Ibid.
173 Roman Tomasic and Brendan Petony, Casino Capitalism? Insider Trading in Australia
(1991) at 121.
174 Cox, above n 131, at 470.
175 Ibid.
176 Tomasic, Roman, "Corporate Crime: Making the Law more Credible" (1990) 8
Company and Securities Law Journal 369.
177 Regina v Rivkin [2004] NSWCCA 7.
potentially significant quality of any information obtained in this position.
Because for an employee (insider) under the US “disclose
or abstain
rule” full disclosure of information is not a viable option, the rule
amounts to the requirement the employee, completely
abstain from trading.
Langevoort stated: “that seems acceptable given that the position of the
Court seems to be that classical
insiders should not trade based on
informational advantage gained as a result of their corporate
positions.”178 This idea is equally applicable to New Zealand
and justifies a more onerous restriction on insiders through a fiduciary
approach.
Conversely, the market fairness approach increases obstacles to enforcement
and compliance because it necessitates the use of a law
that all market
participants can follow and understand. For a materiality standard to be
effective it must be accessible to even
the most unsophisticated investor. There
has been a complete refusal to adopt “bright line” rules on which
people can
base their trading decisions. It has been demonstrated that the
unsophisticated investor has a limited ability to deal with the subtleties
of
price movements. It seems unfair to impose an ambiguous rule on the whole
market for the sake of catching, in most
cases, company insiders. A trade
off must be made between adopting a stringent rule setting materiality at a low
threshold for insiders
under a fiduciary approach and allowing some outsiders to
trade without consequences. Gething suggests the source of the information
will
usually be the company.179 If this is correct, a prosecution under
the market fairness approach should usually include at least one charge that
would have been
caught under the fiduciary regime anyway.180
It has also been demonstrated that the courts in one way or another, put a
gloss on materiality: information is to be understood from
the perspective of
the sophisticated investor. Under a fiduciary regime such a gloss is more
appropriate as the test’s application
is limited to insiders who are
likely to have a greater understanding of the operation of financial
markets.
178 Donald C Langevoort, ‘The Muddled Duty to Disclose Under Rule 10b-5’ (2004) 57
Vanderbilt Law Review 1639 at 1659.
179 Gething, above n102, at 618.
180 SMAA section 8D.
Materiality under a fiduciary regime can be more carefully measured because
an analysis of the “source” is kept separate
from materiality. A
fiduciary regime removes the extra complication that a person must judge how
reliable the reasonable person would
view the source.
What is most important in an insider trading regime is boosting
investor confidence. The perception that insiders are unjustly
enriched by
inside information has been labelled “corrosive”.181
The general public are not as offended by the idea that someone who
stumbles across inside information by chance (for example
the fax in
the Fletcher Challenge Report) might make a profit. With this in mind the law
should make it easier to enforce against
those insiders not harder. As Stephen
Franks suggested, instead of being extended the law should be more ruthlessly
enforced.182
Conclusion: do insider trading laws matter?
There is a divergence in the underlying rationales for regulating insider
trading in the US, Australia and New Zealand. It has been
suggested that
materiality is easier to establish in a legal setting under a fiduciary approach
similar to the one taken in the US
than the new approach adopted in the SMAA:
a market fairness approach. This matters because where materiality can be
easily
established, it should follow that the whole insider trading regime is
easier to enforce and comply with than where materiality is
an unattainable
standard.
This is important because the existence of insider trading laws does not matter unless they are enforced.183 Evidence suggests that insider trading laws only have an effect on the cost of capital in a market (a good measure of confidence in the market) where they are enforced.184
Also evidence exists suggesting that countries with more stringent
insider trading laws have more dispersed equity ownership,
more
liquid
181 Saikrishna Prakash, 'Our Dysfunctional Insider Trading Regime' (1999) 99 Columbia
Law Review 1491 at 1500.
182 Stephen Franks, ‘Parliament Must Tidy Up Primitive New Zealand Herald, 5 December
2000. Available at http://www.nzherald.co.nz/feature/index.cfm?c_id=729 (at 10
September 2007).
183 Bhattacharya Utpal and Hazem Daouk, 'The World Price of Insider Trading' (2002) 57
The Journal of Finance 75.
184 Ibid.
stock markets, and more informative stock prices.185 However the
stringency of the laws is irrelevant without enforcement. Therefore barriers to
enforcement must be minimised to ensure
insider trading laws reduce the cost of
capital in New Zealand. If the law does not achieve this then the costs of
compliance with
this difficult standard will outweigh the benefits.
A fiduciary regime that requires a relationship to the company to be
established and then adopts a low materiality threshold will
be more effective
than a market fairness approach. A carefully crafted safe harbour can be used to
allow the insiders to trade when
necessary. While this approach puts a heavy
burden on insiders and severely limits their ability to trade it is a necessary
consequence
of holding a position that provides privileged access to
information.
185 Laura Nyantung Beny, 'Insider Trading Laws and Stock Markets around the World: An Empirical Contribution to the Theoretical Law and Economics Debate' (2006-2007)
32 Journal of Corporation Law 237 at 239.
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