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Application of the Securities Markets Act 1988 to Commodities Futures Contracts [2010] NZSecCom 8 (16 July 2010)

Last Updated: 16 November 2014

16 July 2010

_{Guidance Note}

Application of Securities Markets Act 1988 to Commodities

Futures Contracts

1. The Securities Commission is responsible for enforcing New Zealand’s insider trading laws under Part 1 of the Securities Markets Act 1988 (“Act”). This Guidance Note (“Note”) sets out the Commission’s approach to aspects of the insider trading provisions of the Act as they apply to the trading of commodities futures listed on an authorised futures exchange. By extension this approach will also apply to the full range of futures contracts as defined under section 37 of the Act.

Background – the insider trading prohibition

2. Section 8C of the Act prohibits information insiders trading securities of the public issuer which they are an insider of. Sections 9 through to 10D of the Act provide exceptions from and defences to the insider trading prohibition.

3. Section 11E sets out various modifications that are to be made when applying the insider trading provisions to futures contracts.

Application of the Act to futures

4. The Act extends the insider trading regime to futures contracts that are listed on an authorised futures exchange.

5. In the case of such futures contracts the insider trading prohibition and the associated exceptions and defences are modified by section 11E of the Act in the following manner (excluding section 11E(g), which is not relevant to commodities futures):

• The term information insider of a public issuer must be read as information insider in relation to a futures contract (section 11E(a));

• The term information insider of the public issuer must be read as information insider in relation to the futures contract (section 11E(b));

• the term material information relating to the public issuer must be read as material information relating to—

ƒ (i) the futures contract; or

ƒ (ii) the underlying commodity, index, or asset that is the subject of the

futures contract; or

ƒ (iii) the issuer of a security underlying the futures contract (section

11E(c)):

• The term security must be read as futures contract (section 11E(d));

• The term trade the securities of the public issuer must be read as trade the futures contract (section 11E(e));

• The term trade or hold securities of the public issuer must be read as trade or hold the futures contract (section 11E(f)); and

• “All other necessary modifications” (section 11E(h)).

6. Section 8C of the Act therefore should be read, in relation to futures contracts, as providing that an information insider in relation to a futures contract must not trade that futures contract.

7. An information insider, in turn, is any person who:

• Has material information relating to the futures contract; the underlying commodity, index or asset that is the subject of the futures contract, or the issuer of a security underlying the futures contract;

• Knows or reasonably ought to know that the information is material information; and

• Knows or reasonably ought to know that the information is not generally available to the market.

8. Section 3A of the Act provides that material information is defined, in relation to commodity futures contracts, as information in relation to a particular futures contract that a reasonable person would expect, if it were generally available to the market, to have a material effect on the value of the futures contract.

9. Potential participants seeking to trade in listed commodities futures are likely to hold material information in respect of the underlying commodities by reason of their own non-public production, consumption and trading information. Such firms may seek to undertake trading activity for a number of reasons, including the hedging of their commodity positions. Consequently, unless one of the exceptions or defences set out in sections 9 to 10D of the Act applies such producers would be prevented from trading.

Section 9C(1)

10. The Act provides a key exception from the insider trading prohibition in section

9C(1), which provides that:

A person (A) does not contravene section 8C merely because A trades the securities with the knowledge that A proposes to enter into, or has previously entered into, 1 or more transactions or agreements in relation to the securities or the public issuer or its business activities.

11. In the case of equity securities this exception operates to ensure that parties can seek to acquire holdings in public issuers without being at risk of liability for insider trading. A potential acquisition of shares may be large enough to constitute “material information” as defined in the Act. Certainly if person B knows that person A intends to make a takeover bid for a listed issuer, and that information is not public, then B is an information insider and would be prohibited from trading by action of section 8C. Person A, however, would also be prohibited by reason of his or her own knowledge, but for the application of section 9C(1).

12. In its ordinary form, therefore, section 9C applies to permit takeover bids or other large acquisitions. This type of conduct does not apply in the case of futures, but there is a similar issue of industry participants being penalised – the common theme being that participants are prevented from acting by reason of their own knowledge.

Interpretation of section 9C(1) in respect of futures contracts

13. Interested parties have queried how section 9C(1) should be read when modified by section 11E in the context of commodities futures contracts.

14. The problem that industry participants are presented with is that section 11E does not provide a direct “patch” to apply section 9C to futures. Section 11E does contain a general “all other necessary modifications” reference, but this alone does not provide certainty for market participants, hence the concerns that have led to the Commission to publish this Note.

15. Section 11E(d) requires “security” to be read as “futures contract”. “Public issuer” and “business activities” do not, however, have direct “patches” and so it is necessary to apply section 11E(h) to interpret these appropriately to apply section 9C to commodities futures contracts.

16. The appropriate starting point is to consider the legislative intent behind sections 9C and 11E. As noted above, the intent of section 9C is to prevent parties from being unable to trade as a result of their own knowledge about their actions. Section 11E’s intention, in turn, is to adapt existing statutory provisions to apply them to futures contracts, which may be based on commodities, indexes or other assets.

17. It does not appear plausible to the Commission that there would be a legislative intent to exclude market participants from utilising futures markets, and so the exception provided by section 9C(1) should be read in order to adapt its protection to futures contracts, and to ensure that the insider trading legislation does not operate to stifle legitimate market activity, such as hedging commodity positions.

18. Applying that principle to futures contracts, and the wider definition of “material information” given in section 11E(c), the Commission considers that it is appropriate to interpret the exception as applying to a party’s information regarding its own business activities and information in respect of the underlying commodity.

19. The Commission has considered how to read section 9C(1) in this light. In its view, the appropriate reading (with our emphasis added) is:

A person (A) does not contravene section 8C merely because A trades the futures contracts with the knowledge that A has about its own business activities, transactions or agreements either in respect of the futures contracts or in respect of the underlying commodity, index or asset.

20. The Commission considers that this reading enables section 9C(1) in a manner that is consistent with the legislative intent and able to provide confidence for market users to participate in the Proposed Market.

21. In reaching this view the Commission took into account difficulties in distinguishing categories of information held by market participants. Participants in commodity futures markets who are themselves producing, consuming and trading in the underlying commodity will tend to hold a range of information, both in respect of their own expected production, consumption, and trading activities, and the industry as a whole. Some information held by electricity producers, for example, may relate to both an individual producer and the industry as a whole, making the assessments of materiality that would be required more difficult. For this reason the Commission takes into account all information held by an industry participant.

22. Further, the Commission was concerned to avoid interpreting section 9C in such a manner as to create an intention test. If the Commission was to limit section 9C to hedging type activity, for example, this would add an element of assessing the motive behind trading that does not usually apply in respect of the Act. Generally speaking the Act’s provisions do not apply a test of a trading party’s intentions, and the Commission is concerned that a “narrower” interpretation may present such a risk that the protection afforded by section 9C would only apply to hedging type activities, and not portfolio management type activities.

Other applicable exceptions and defences

23. While the Commission’s primary concern has been the application of section 9C to potential trading activity by industry participants, we note for the sake of completeness that potentially other exceptions and/or defences may apply.

24. The Commission would favour approaching section 9C(2), which is intended to protect professional advisers, in a consistent manner with section 9C(1) as outlined above.

25. The defence provided by sections 10A (independent research and analysis) may potentially apply to industry participants in addition to section 9C.

26. Section 10D and its Chinese Walls defence could also potentially be available but the Commission notes that in practice it would appear unlikely that many industry participants would avail themselves of this defence. Chinese Wall defences are usually only used in financial services firms combining proprietary trading with providing services to third parties, and as such are unlikely to apply.

Note

27. The Commission cannot give rulings on the interpretation of the law or provide legal advice. Accordingly this Note is provided for guidance only. It signals the approach that the Commission intends to take in its interpretation of the law. The Commission may amend or withdraw guidance notes from time to time.