Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of Parallelewelten.
Insider dealing is understood to be the act of dealing in unpublished price sensitive information and it is seen to go against the principle of equal access to information. There have been controversies regarding whether insider dealing should be prohibited, this dissertation aims to justify the need for its prohibition. It would examine the basis of such prohibition and the form in which the law should intervene. It would then examine the problem of the regulation of insider dealing in financial markets in three jurisdictions namely Nigeria, US and the UK. It analyses the shortcomings of this regulation and how it can be improved. The primary objective of the dissertation is to identify the shortcomings of its regulation in the above stated jurisdictions and to render reasonable recommendations for reform where necessary. This dissertation will attempt to provide its own approach to the problem of insider dealing. This approach forwards the proposition that allowing insider dealing on the basis of inside information is against the principle of equal access to information and it is detrimental to market transparency. Based on this proposition, the dissertation investigates the shortcomings of the current regulation of insider dealing in Nigeria. The study carried out will consist mostly of secondary sources gotten from Nigeria, UK and US. It will provide a clearer picture of the current regulation in the above listed countries. The study aims at measuring opinions and attitudes of legal professionals and investors towards the basis and effectiveness of the regulation of insider dealing in. This is followed by a legal comparative study between the regulations of insider dealing in the three jurisdictions. The comparison draws conclusions from comparing the broader systems of regulation in the three jurisdictions. It concentrates on a functional comparison between the specific rules related to insider dealing.
The main problem examined in this dissertation is the subject of insider dealing. Although there seems to be a broad agreement to the prohibition of insider dealing, the debate on insider dealing is not completely settled. Insider dealing is identified as an area that affects equal opportunities amongst various categories of people. A variety of discussions show eagerness to regulate it. However, it is still unsettled over how the law should intervene. Over the years, different methods have been employed in order to prevent this activity. Emphasis has been placed on different policies and forms of legal interference; for example; a criminal regime deterring the act of insider dealing, or an administrative regime empowering the regulator to face insider dealing and market abuse and enforce a disclosure system. Insider dealing has however, generated various legal solutions, but it appears that all forms of legal interference are needed in order to attain an efficient system of regulation. A critical analysis of each form of legal interference reveals its individual shortcomings, but it is hardly suggested that a certain form should be completely abandoned. The suggestion seems to be to keep all forms of legal interference and highlight areas of priority.
Different sanctions are being employed for insider dealing Although the initial results of adopting different sanctions for insider dealing are not encouraging, the argument remains that regulation can be applied in certain cases. The common argument is that the immorality and the harm the act causes to the general public is one of the main reasons for the use of criminal sanctions and it seems to be a popular method. Its popularity is based on achieving deterrence and just punishment. However, there are arguments against criminal sanctions and the main one is that deterrence and punishment cannot be met due to difficulties in actual enforcement. The present development is towards authorising the regulator to face market-place problems, a system which is proficient in deterring insider dealing. An efficient regulator with clear regulatory priorities helps maintain a transparent market. Civil or administrative penalties, recent codes of conduct or disclosure requirements are all methods that have been used in controlling insider dealing.
Criminal sanctions seem to be the last and most severe course of action. Studying insider dealing regulations critically focuses attention on both its shortcomings and advantages. This helps in the further understanding of regulation and practice. Analysing the details of the long experience of those countries that first identified and faced insider dealing will add to the arguments. There are necessary lessons to be learnt by developing countries e.g. (Nigeria) from the experience of developed countries. Understanding the problem of insider dealing and the policy of its regulation would be the first step in discussing the law of insider dealing.
PURPOSE OF THE RESEARCH
This dissertation will attempt to investigate the need to prohibit and regulate insider dealing. It will identify the problems associated with its regulation in Nigeria, the UK and the US. It will look at the shortcomings of this regulation and how it can be improved. Insider dealing has been an area of interest for researchers for many years. Examining this area through a dissertation, with the added dimension of Nigeria, will be a valuable input to the current debate. In its formation and plan, this dissertation will attempt to be insightful. Insider dealing is a problematic legal area and as a result has attracted the interest of jurists who have tried to recommend different solutions to its regulation. However, this has led to the conclusion that insider dealing stimulates different views. A social study and Legal comparative methodology in this subject will therefore provide a useful resource for the legal profession and in particular the legal profession in Nigeria. The aim of the dissertation is to develop a broad understanding of the regulation of insider dealing. It may be appropriate to state that the aim/objective of this dissertation can be achieved by the following subsidiary steps:
- Examining the nature of insider dealing in the Nigerian financial markets.
- Investigating what its effects on the financial markets are.
- Exploring the shortcomings of the current rules directed to regulating insider dealing.
- Examining ways in which the law and regulation can be improved to prohibit insider dealing.
- Comparing the experiences of developed countries (UK and the US).
- Determining how to empower the regulators to enforce the rules.
- Working out the appropriate punishment to deter insider dealing.
- Looking at how insider dealing can be reduced
In this dissertation, an essential element for attaining the planned objectives lies in the research methodology. The research methodology is based on secondary evidence of comparative law methods.
Since I would be studying different legal systems it would require me comparing the ways in which the different systems provide solutions to the legal problems. The comparative law method of the study will be split into two. Firstly, there would be a literature review which will be used as the main method of gathering information. This will be carried out by examining academic resources from the comparative jurisdictions, and using them in support of the arguments in the study. Secondly, because this area of law continues changing, there will be a need to examine current statutes, drafts etc.
The structure of the dissertation is reasonably intended to represent the problem, the methodology and the objective. The dissertation begins with a literature review which examines theories concerning the regulation of insider dealing: The arguments for and against regulation. This is important for introducing the basis of the study. The specificities of the problem and the law of insider dealing regulation in Nigeria will then be identified. The dissertation will also investigate a comparative regulation of insider dealing. The comparison is a device for providing solutions to the problems raised. The jurisdictions that will be compared are the US, the UK and the Nigerian financial market. The comparative study provides a detailed functional comparison of the rules directed at insider dealing in the three jurisdictions. The structure of the dissertation concludes by introducing my opinions and recommendations.
THE PROBLEM OF INSIDER DEALING AND ITS POLICY
The aim of this chapter is to provide a literature review. Its aim is to discuss extensively the theories concerning the problem of insider dealing and the Arguments in support and against its regulation.
It is certainly not universally agreed that insider dealing should be prohibited or that it is wrong. Even for countries such as Japan where insider dealing is being regulated, the people of the country still believe that there is no harm in making money by getting inside information of a corporation. However, Insider dealing is said to be the unacceptable face of capitalism. But some others do not see anything wrong with it and even think it should be encouraged although this latter view has been less heard of late. It is however a view which economists and lawyers have put forward ever since the publication in 1966 of Professor Manne’s book, Insider Trading and the Stock Market. This book stresses that Insider dealing is, in the economic sense, positively beneficial and ought not to be prohibited. Since then the debate on regulation has raged between those who would support Professor Manne’s position and consider the problem in terms of economic efficiency alone and those whose arguments for prohibition would be based on, market integrity, notions of fairness, and morality. This debate is worth considering for it is interesting and while it is obvious that various jurisdictions regulate against insider dealing, the lack of consensus in this regard is evident. It is to these arguments that I turn.
THE ARGUMENTS FOR AND AGAINST
FAIRNESS AND EQUALITY OF INFORMATION
It is understood that one of the reasons why the debate over whether insider dealing should be regulated came about due to the‘fairness’ concept to justify regulation in the US by the Securities and Exchange Commission (SEC) and the courts. In re Cady Roberts & Co. the SEC based its decision to prohibit insider dealing on grounds of‘fairness’ and it was the same outcome in SEC v. Texas Gulf Sulphur. The court’s finding was:
“…to prevent inequitable and unfair practices and to insure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on exchanges …the Rule [meaning Rule 10b-5] is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information”.
Professor Manne, one of the defendants of insider dealing, argued that insider dealing should not be regulated at all and he criticised the legal grounds for regulating insider dealing. He argues that there has been no careful analysis of the subject. He believes that in the absence of sufficient economic analysis, the attitude of the debate turns to moralistic and emotional issues instead of one of logic. Moore (1990) does not support the theory of fairness. She explains that one is not morally obligated to tell those whom we deal with everything that is in their interest to know. However, there is the idea that there should be absolute equality between market participants. What about the moral obligation to threat others as we would ourselves? Due to the observation that insider dealing is largely based on the idea that it is unfair, In order to maintain fair transactions, it would only be reasonable that investors in the market have equal access to information. Now, since insider dealing opposes equal access to information, it is considered to offend the notion of fairness.‘Fairness’ as a concept has therefore been resorted to as a justification for regulating insider dealing. The legal philosophy of fairness considers it unfair when insiders have an advantage and a better bargaining position than outsiders. Based on this, probably the most practicable justification for the regulation of insider dealing is‘equality of information’. Information as to the basis of decisions made by investors should be equally available to all investors. Thus, all traders owe a duty to the market either to disclose or abstain from dealing based on non-public information. This approach is compatible with the need to make public as much information as possible so investors will be equally informed.
Equality of information (Market Egalitarianism) requires that all investors trading on impersonal exchanges should have relatively equal access to material information. However, regulating insider dealing has attracted its share of criticism. Professor Manne tried to argue against the ethics of insider dealing by stating that he thinks fairness as an argument for regulating insider dealing is a respected concept, but is difficult to determine. He thinks relying on fairness is vague and cannot be defined, let alone be used as an argument for regulation. However, those who argue fairness as a justification for regulation reject these contentions. Their belief is that Professor Manne ignores the fact that‘fairness’ is the dominant premise underlying our understanding of the law. In challenging the ground of fairness, Manne depended on two grounds:
His first ground being that the inequality in bargaining positions between the parties in a share transaction or between investors in the market is an inevitable fact. He believes that no law or regulation can ensure equality of bargaining position and he also believes that there is always inequality in terms of information between the parties in share transactions. The stock market, according to him, is an information exchange. The second ground for criticism is that he believes that insider dealing is a victimless crime and indeed it is frequently asserted to be a victimless crime He believes that in anonymous market dealings, the insider deals with a person as a result of the random matching of orders and this person would have dealt anyway at the same market price at the same moment in time. So in his view, this goes to show that the other party to insider dealing is not misled or harmed by the insider and there is no unfairness to him. However, It should be noted that although it is not possible to show the casual link between the activities of the insider and the outsider’s dealings which then incurs a loss, it may still be possible to regard the outsider as a victim because he is a victim of an informational advantage possessed by the other people in the market of which he is ignorant, and which he could not have obtained. Although it is accepted that it is not possible to put people on a completely equal footing, for there will always be transactional inequalities and informational advantages based on superior experience, foresight and diligence, It is argued that it should be possible to remove informational advantages achieved unfairly through access to information which cannot be obtained by others and which in all probability is being used by the insider in breach of some fiduciary or other duty
All things considered, Manne’s hypotheses seem weak and simplistic. One significant response to Manne’s arguments is that the‘fairness’ principle should not be narrowly interpreted as equivalent to the protection of investors. It is maintained that‘fairness’ as a principle is equivalent to a public policy. Meaning that the concept of fairness can be depended on even if the harm cannot be pin pointed to the particular investor. If it is expected that insider dealing will be harmful, not necessarily to a particular investor but rather to the market as a whole, for reasons of public policy, such acts should be regulated.
INSIDER DEALING AS A MEANS OF COMPENSATION
Manne maintains that his main argument is that allowing insider dealing is the only effective means of compensating entrepreneurs. He argued against the notion that insider dealing harms investors. He distinguished between corporate managers and entrepreneurs. He stated that Managers’ do not include innovators. He believes that their work is a mere service which includes operating the firm normally and that such work is predictable therefore a salary can be sufficient compensation. On the other hand, He believes that entrepreneurs provide innovative contributions to the productivity of the firm. Manne argues that allowing insider dealing is the only appropriate means of compensating entrepreneurs so that they will be given an incentive to produce more information. He stated that a predetermined salary may not reflect the service provided by the entrepreneur, since it does not reflect the value of the innovation. He argues that only allowing entrepreneurs to buy securities prior to a public disclosure, and to sell them after the price rises following the disclosure, is the appropriate method to value his innovation.
Carlton and Fischel maintain this view. They argue that advanced salary agreements fail to compensate innovators. They believe that allowing insider dealing enables agents to receive their compensation. Insider dealing provides more accurate valuing of agents’ innovations than a salary. It is therefore argued that more incentives should be given to agents in other that they produce information.
These proponents of insider dealing argue that by permitting insider dealing, the interests of the insider will be aligned into that of the company. They believe that at the end of the day, the shareholders benefit from the acts of the insiders and this is because the corporate insiders may find it beneficial to enhance corporate risk taking thereby, developing growth and opportunities that will increase the value of shares of the company to which the shareholders will benefit from. However, this idea has been criticised as being flawed because a person who benefits from trading on insider information is not necessarily the innovator. Insider dealing enables the insider profit whether their ideas fail or are successful in that they profit from both negative and positive information whereas the company may not. Say even if the negative or false information did not pose problems for the company, the argument for insider dealing as an incentive overlooks the difficulties posed by “free riders” _ those who do not actually contribute to the creation of the information, but who nevertheless are aware of it and can profit by trading on it. Unless those who do not contribute can be excluded from trading on it, there will be no incentive to produce the desired information. Besides to create added value to the company will entail a significant investment of time and energy on the part of the insider to generate new information in order to profit from inside dealing. It is often said that it would be equally profitable and much easier for the insider to start a rumour that the company is about to strike a deal or has acquired a new product rather than actually invent a new product.
It appears that in considering insider dealing as a compensation for innovation, Manne has failed to acknowledge the property right of the firm to such information. For If it is established that a company has a property right to the information produced inside the company, or if the case is that the insider is entrusted not to use such information, then obviously it is wrong to propose that the use of such information should be allowed as the most appropriate means of compensation.
Schotland, is of the idea that insider dealing is not necessarily a better compensation than a salary. He believes that a company is best placed to assess whether or not an employee is expected to provide innovative ideas. Rider and Ffrench state that Manne does not explain why insiders should be permitted to benefit from producing negative news. Because allowing insiders to deal on the basis of negative inside information allows them to evade losses whether the company succeeds or not and they are supposed to be acting in the best interest of the company. If a manager was behind a loss to the company, why should he be able to avoid a personal loss by allowing him to sell his own shares before the information is made public? In my opinion anything done on behalf of the company must be in the best interest of the company and insider dealing hurts the company (its reputation, its standing in the capital market) so it is not in the best interest of the company and should therefore be prohibited.
OPTIMAL OR TIMELY DISCLOSURE
Companies generate a lot of information as they carry on their business activities and that is why information plays a vital role in an economy. The extent to which information is made available on the market influences the degree of economic efficiency. Stephen Bainbridge believes that to have successful regulation of insider dealing requires rules relating to the timely disclosure of material information. He believes that if the aim is to put investors on an equal footing in regards to having access to inside information, the rules governing insider dealing are not the proper method to achieve it. And therefore disclosure requirements could be designed to keep to minimum non-public price sensitive information in a way that the opportunities for abusing such information would be reduced. His belief is that disclosure requirements are a better solution than regulating insider dealing in order to achieve in-formativeness in the market. This statement leads to questioning the competence of regulating insider dealing, and supports the case that the problem is better dealt with by continuous disclosure. His belief is that effective regulation of insider dealing requires rules relating to the timely disclosure of material information. In this regard, the equality of information theory has been criticised. It has been argued that prohibiting insider dealing on such a ground would not lead to an advanced disclosure system. This argument was established in the US, where the law had been reluctant to compel issuers to disclose material non-public information. It was therefore declared that, irrespective of permitting insider dealing or not, the investors will not have the same access to information as insiders unless there is a system of timely disclosure. However, the revelations from Enron to World Com have further exposed the inadequate material disclosure of information, not only in the United States, but also in Nigeria.
The information produced is a commodity and is only gathered when it is cost effective to do so. The idea is; the more information available, the greater the economic efficiency. Companies produce information to profit from it and it is argued that where insider dealing is permitted, insiders will be motivated to get more information in order to profit from. Proponents of insider dealing believe that when insiders trade in securities on the secondary market, they speed up the flow of information and feed their knowledge into prices, thereby making market more efficient. Therefore if insider trading is permitted and insiders with fore knowledge trade in the securities of their company, it will be a signal to outsiders observing the price movements to infer that the insiders are optimistic about the company’s future prospects and may in turn buy shares which may cause the price move in a certain direction. However, it is asserted that even when insider trading is informative and could be a channel of communicating information; it would often be preferable if insider information were communicated directly to the public rather than through the stock market. This will be better than an unexplained rise in the price of the securities of the firm through the trading activities of insiders.
However, there is a challenging view that insiders withhold and manipulate information in order to cash in thereby distorting market efficiency. Indeed, insider trading might be expected to induce a variety of perverse behaviours by managers who would compete to acquire and hoard information within the firm.'
The notion that disclosure rules are the primary method of reaching market in-formativeness is reasonable but it should be understood that regulation of insider dealing has a preventive role. In circumstances where an unexpected event occurs, the issuer will need more time to clarify the situation otherwise, an immediate announcement might cause false or misleading disclosure. In certain situation, the issuer is exempted from making a timely disclosure, if it is thought that such disclosure would be detrimental to the legitimate interests of the issuer. In such situation the information should be kept confidential. It is these circumstances which are crucial for insider dealers, and therefore the regulation of insider dealing is essential to prevent misuse of information during this period. Thus, disclosure rules alone are not sufficient enough to achieve in-formativeness in the market and so regulation of insider dealing is essential.
One other argument Manne postulates is that insider dealing creates market efficiency. He argues that insider dealing acts as a replacement for the public disclosure of inside non-public information. He argues that when insiders deal on the basis of inside information they gradually bring the market price to a more realistic informed level. This is what Gilson and Kraakman call a‘derivatively informed trading mechanism’. The suggestion is that uninformed investors will be informed through‘market information’, meaning, through volume, number and trend of trades. He argues that a gradual adjustment is better than violent price fluctuation. His belief is that insider dealing is an effective way to release information into the market.
Gilson and Kraakman however, point out that derivatively informed trading, function slowly and sporadically. So it is unlikely that allowing insider dealing will have much effect on market efficiency. However said, Insider dealing may be a factor for nudging prices in a particular direction as the up to date position of the company becomes known to the market but in many cases, the disclosure of that information would have occurred regardless of any related insider dealing.
The hypothesis of insider dealing influence on the market price is uncertain. There are circumstances; where insider dealing is influential e.g. the period prior to an announcement of a takeover offer. One of the most interesting facts to emerge from the Boesky investigation in the United States is the links which was exposed between insider dealing and take-over bids. It is however doubtful whether the influence by insider dealing is the usual trend or just an exception.
Assuming, for the sake of argument, that insider dealing moves prices in the right direction, in the long term it is expected that uninformed investors’ inability to acquire information would be detrimental to the market. Those who argue in favour of de-regulation, base their argument on the idea that it is a form of disseminating information into the market. Nevertheless, it hasn’t been proven that indirect disclosure of information into the market is more efficient than direct disclosure.
Insider dealing has an effect on the transaction costs market participants bear. The superior information insiders possess generates informational asymmetry on capital markets. Asymmetric information increases the cost of trading. Insider trading on non-public information might reduce market liquidity. Reduced market liquidity implies higher trading costs. In order to achieve maximum efficiency, the most prompt disclosure possible of material information is therefore necessary.'‘The more efficiently information about a security is reflected in price, the more efficient the market for that security is thought to be.' It is not clear the point to which information quickly becomes public with or without insider trading. However, what is clear is that market prices are more accurate once the information is released. Investors believe that they will earn fair returns on their investments so permitting insider dealing would create opportunities for exploitation of the market by insiders at the shareholders or investors expense. If investors believe that insider trading exists, they may reduce their investment in the securities of that company and this reduced investment will have unsettling effect on the overall liquidity of financial markets and the ability of companies to raise capital. Therefore, this will affect the allocation of resources and hence the attainment of market efficiency.
PROTECTION OF INVESTOR CONFIDENCE
Another ground for regulating insider dealing would be to maintain market confidence. This is vital for the efficiency of the market. If investors perceive that the market is unfairly favouring insiders, they will not direct their investment into the market. It is, therefore, imperative that‘investor confidence’ be protected and that serves as a sufficient justification for regulating insider dealing. Rider and Ashe indicate that “… the main (if not only) convincing justification for controlling insider dealing is that it has a perceived, adverse impact on confidence”. For the financial markets to be effectively operated, confidence and integrity is essential. Investors will only invest into a market they believe to be reasonably managed and regulated. If the public perception of the capital market is negative, investors will direct liquidity to alternatives and companies will therefore lose customers. Capital markets play a major role in allocating resources and confidence in them can be fragile. So there is the need to maintain confidence and the integrity of capital markets. However, Investor confidence as a rationale was criticised as an emotional and sentimental force which is thought to be speculative. Therefore, justifications based on‘protecting investor confidence’ are said to be unsophisticated, and the relationship between insider dealing prohibition and investor confidence is a‘myth’. Investors consider it their right to have‘equal access to information’. So their lack of confidence is only logical if insiders are allowed to be advantaged over other investors. Therefore, investor confidence is not necessarily an emotional force. It is rather based on the expectation of investors that the regulatory system should treat all investors equally in terms of access to information.
One other reason put forth for the regulation of insider dealing is the concept of fiduciary relationship which could be attached to the insider. It is clear that the directors of a company owe a fiduciary relationship to the company but it is not quite clear whether the director is in a similar relationship with shareholders individually. This is also the case at Common Law.
According to the notion of breach of fiduciary relationships, insider dealing regulation is derived from identifying that a precise legal relationship has been breached. The idea here is that corporate insiders owe a disclosure duty based on a pre-existing relationship with the company. Insider dealing here is justified on the basis that the insider is in a position of trust and so should be legally liable when breaching the trust for his personal gain.
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