Brent Sheather: Buy the rumour, sell the fact

Insider trading occurs when an individual or institution obtains price sensitive information from an insider which has not been released to the broad market as a whole. Photo / Thinkstock

The Financial Times reported the other day that US law makers have successfully prosecuted 80 cases of insider trading in the last five years.

What about the local scene? I can't think of any cases at all happening locally for a long time. It is difficult to know if the lack of action locally is good or bad news. Are Americans that much more dishonest than Kiwis? The paralysis is probably explained by two factors.

Firstly, the Securities Commission, the predecessor of the FMA, which was in charge of things for most of the last twenty years, have been criticised for not being as proactive as they should have been.

Secondly before a law change in December 2002 court actions for insider trading could only be taken by the company involved or by a shareholder with the consent of the Court.

The Securities Commission's first insider trading action was in 2004 for trading in shares of Provenco.

The last time insider trading made the news locally was when a Canadian based fund manager complained to the NZX that it may have occurred in the Fonterra Shareholders Fund on the basis of a large number of shares trading just before it announced a substantial dividend cut.

The NZX apparently investigated and found no evidence of insider trading. Its explanation was that the trading was most likely linked to a broker sell report and an international investor selling out all of its NZ shares.

Insider trading occurs when an individual or institution obtains price sensitive information, usually about a company, from an insider, typically a company executive, which has not been released to the broad market as a whole. Armed with this information the individual or institution then buys or sells a security like a share, in the knowledge that the security is mis-priced.

In the past insider trading has been viewed as something of a victimless crime and the perpetrators have been afforded a degree of notoriety as "expert traders".

In the US and Australia over the last 20 years views have hardened and they are now regarded as criminals just like the bad guys who steal from a bank. The reality of insider trading is that it is not victimless, the insiders are stealing money from the people who sell to them or buy from them without the benefit of the inside knowledge.

Anecdotal evidence and common sense suggests that insider trading is almost certainly happening on the NZX. Certainly there is a lot of it in other markets around the world including Australia where, in a recent prosecution, a foreign exchange trader was caught colluding with an individual at the Australian Bureau of Statistics whereby jointly they traded the foreign exchange market ahead of material statistics announcements. They got caught and down they went.

In a former life, as a member of the NZ Stock Exchange from 1985 to 2000, from time to time I was aware of lots of dealing before "material news releases" and that is all I am saying on that matter although the statute of limitations probably applies.

The pursuit of material information is what active investment management is all about thus, at the risk of stating the obvious, the reason fund managers and stock brokers spend so much time meeting with company executives is the hope of getting some actionable intelligence.

There is an old stockmarket saying "sell the rumour, buy the fact". What this alludes to is the tendency for a share to rise prior to the announcement of good news then fall once the good news is announced. The implication being that the price adjusts due to the action of insiders prior to the announcement then falls once the announcement is made as the insiders sell out.

There are three alternative scenarios which could explain the absence of insider trading prosecutions in NZ:

• There is no insider trading occurring (and Rolf Harris is innocent).
• The insider trading is not being discovered.
• The insider trading is being discovered but isn't able to be prosecuted.

At the moment the NZ Stock Exchange is responsible for monitoring share market transactions to determine if insider trading has occurred. If it sees anything suspicious it refers the matter to the FMA.

In March the NZX Chief Executive, Tim Bennett, told the Herald that insider trading was a very rare event in NZ and that although the NZX receives one or two complaints a month most prove to be unfounded.

Unfortunately the public and investors are pretty much kept in the dark about insider trading because, despite the FMAs objective of encouraging fairness and transparency in the financial markets, none of the unsuccessful allegations or investigations are made public.

The FMA advises that despite the apparent lack of action both the NZX and the FMA do look closely at indications of suspicious activity but to date there has not been sufficient evidence of wrong doing to take any matter to Court.

The FMA also said that the fact that prosecutions are rare does not mean it is not policing the area and it noted that commenting on open investigations is not advisable because it might prejudice the outcome and also potentially do significant damage to innocent parties.

It is also slightly incongruous that the NZX is the FMA's point man on insider trading not least because stock exchange members frequently have an opportunity to insider trade.

Recall the recent prosecution by the FMA of an individual for manipulating the Diligent share price. The FMA prosecuted the individual involved but in order to manipulate the Diligent share price one suspects that he had to engage the services of a stock broker.

It is possible that the stock broker was materially involved in the transaction yet there was no comment as to this person's involvement or potential culpability. If a deal was made that information should be made public.

As mentioned earlier the regulator of matters financial in NZ, the Financial Markets Authority (FMA), has as one of its prime objectives the promotion of "fairness and transparency in financial markets". Insider trading is the absolute antithesis of fairness so the FMA has every reason to come down hard on this sort of anti-social behaviour, providing of course it is made aware of the naughtiness.

Many residential property investors cite the lack of a level playing field in the stock market as a reason they do not invest. Although this is obviously a ridiculous position to take given the relatively illiquid and unregulated nature of the local residential property market the opaque nature of the NZX and FMA's actions in policing insider trading doesn't do as much as it could to engender confidence amongst the skeptics.

Both the NZX and the FMA should consider making public limited information on all complaints and the outcomes of its investigations.

It doesn't, as the following example illustrates. Back in April, Thursday the 24th of April to be precise, the price of Goodman Fielder (GFF) shares inexplicably rose on the NZX from 57 cents to 67 cents. That's a rise of 17.5 per cent on a day when the broad market went nowhere.

There was no announcement from GFF that day either before or after the price move. Then, surprise surprise, on the following Monday a takeover bid for GFF was announced. Commonsense would suggest that someone knew on Thursday that a takeover bid was coming on Monday.

The FMA/NZX to their credit noticed these dealings, as did this writer, but almost four months later there has been no public acknowledgement of this highly suspicious price move and no prosecution.

The FMA have advised that they have investigated the matter and are satisfied that no insider trading was involved. In this writer's view the GFF dealings were a lost opportunity because the NZX and FMA, by making such matters public, would confirm that they are awake and "on the ball" and would thus signal to investors, and would-be insiders, that the "fair and transparent" mantra was alive and well.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.