A recent report on illegal insider trading commissioned by the Canadian Securities Administrators -- an umbrella group that represents provincial securities regulators — contained a number of recommendations, including a call to tighten restrictions on the various players who come into contact with important information about a company (lawyers, accountants, and so on). But one of the most interesting suggestions in the report was that "markers identifying trading by insiders be made available on a real-time basis to all investors."
This idea goes straight to the heart of the problem with illegal insider trading. It may be too much to hope that the task force's recommendation will become reality any time soon — after all, it took years just to get the existing stale insider reports available on-line — but of all the group's proposals for dealing with insider trading, it is the one that has the best chance of actually succeeding.
To understand why, you have to look at the underlying reality of insider trading itself. Why is it wrong? Because it involves someone profiting from information that other investors don't have access to, and that makes the market a non-level playing field -- in other words, it makes it unfair. Company insiders take advantage of non-insiders by buying or selling their shares, and in some cases injure their own shareholders as a result, and the stock market as a whole becomes less effective if it is perceived as being rigged.
But the key to illegal insider trading is the information that the insider has access to that the average investor does not. New rules such as Regulation FD (for "full disclosure") in the United States are an attempt to increase the flow of material information, but they are difficult to police. What is "material information"? In many cases, that is left up to the company to decide. Some have decided in the past that even the departure of key executives isn't really material, and therefore doesn't need to be disclosed.
Some market theorists -- including Nobel Prize-winning economist Milton Friedman -- argue that the best way to deal with insider trading is to make it legal. This theory holds that making insider trading illegal effectively drives the value of inside information up by making it scarce, which actually makes it more attractive for executives to trade on it. According to Mr. Friedman, if insiders were allowed to trade shares based on their knowledge of future events, that information would then be communicated to investors through the behaviour of the company's share price -- since stock prices are supposed to be a reflection of all the available information about a company.
There are a couple of flaws in this argument, however. One is that it would force investors who want to profit from insider trading to become obsessive stock-watchers and momentum players, glued to the share price at all times, watching for any sudden movement. Then they would have to somehow determine if this movement represented actual insider knowledge or if it was merely "noise" caused by some other event (of course, some investors already try to do this).
While legalizing all insider trading is a somewhat drastic step, increasing the flow of information about insider trading is definitely a good thing. Market watchers may debate the usefulness of this information -- especially given the widespread use of stock options as executive compensation -- but in general the more information that an investor has the better. And as the CSA task force points out in its report, there is no reason why insider trading can't be reported immediately.
Universal Market Integrity Rules (UMIR) govern trading on all of Canada's major stock markets and are administered by Regulation Services (the former regulatory arm of the Toronto Stock Exchange that was spun off as a separate entity when the TSX went public). These rules require brokers to mark on a stock trade whether the person doing the trade is an insider or not, and that information is available to Regulation Services in real time, according to the CSA report.
In other words, it shouldn't be that difficult to take this information and make it public, so that anyone watching activity on the TSX would instantly know when an insider was making a trade. Obviously, this would only cover actual insiders, and not trades made by individuals who were "tipped" about key information by insiders -- nor would it preclude an insider from getting someone else to make his trade for him, or funnelling a trade through an offshore account or holding company.
Still, it would be a big improvement on the current state of insider information, which is woefully outdated by the time investors get to see it. After several years of fiddling and delays, insider trading reports are finally available on-line through the System for Electronic Disclosure by Insiders (SEDI), but those reports still only have to be filed within 10 days of a trade, and in too many cases executives file their reports weeks or even months late and receive no penalty. Even 10 days later, insider trading data is all but worthless to investors (the U.S. rule is two days).
Providing more immediate information won't do away with illegal insider trading -- but it could level the playing field a little bit.
© The Globe and Mail
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