Monday, March 26, 2007

Tuesday Column: Why not just make insider trading legal?

We expect our politicians to lie. Or at least we expect them to only to tell us those parts of the truth that suit them.

But we hold the directors of our public companies to a higher standard.

It is absolutely illegal under Australian corporate law for the directors of companies such as Qantas, The Coles Group, James Hardie, or AWB to mislead the share market by withholding information or presenting it in a misleading way.

In theory a pensioner managing her investments at home should have as much access to corporate information likely to affect a share price as the company’s own executives or a firm of highly-paid fund managers.

On the whole Australia’s system works well. Most company directors wouldn’t dare mislead the market (the penalties for doing so are far higher than for politicians misleading electors) and nor would most “insider trade”, that is – buy or sell shares on the basis of privileged information that they had before the market.

But recently it is easy to get the impression that the system is breaking down...

Coles told the market in November that the 45 Bi-Lo stores that it had rebranded as Coles supermarkets were “experiencing an average sales uplift of around 7 or 8 per cent.”

Earlier this month the ABC reported that the day before that announcement the Coles finance department had emailed executives saying that in fact those sales had been climbing by only half as much – 3.9 per cent.

The ABC has possession of the emails, and also another internal email from the corporate affairs department stating that notwithstanding the 3.9 per cent figure Coles had decided to “keep 7 per cent in the news release issued to the market and to mention that it was early days”.

Yesterday Coles’ Chairman Rick Allert blamed the leaking of the emails on “disaffected, disgruntled and disenchanted” former employees. He said Coles had misled no-one, although he conceded that as it turned out 7 or 8 percent was not a good guide. Sales in the rebranded Bi-Lo’s are scarcely increasing at all.

Meanwhile Qantas has been accused of attempting to play down a spectacular profit outlook. After recommending a takeover bid in December the Qantas Board gave little away until a fortnight ago when “substantial media commentary” forced it to issue upgraded more positive forecasts.

There is now a very good chance that the belated information will embolden up to three substantial shareholders not to sell and wreck the $1.1 billion takeover - along the way depriving the airline’s executitives of the $91 million in payouts they were expecting had the takeover succeeded.

Also, casual observers of last year’s Cole royal commission might have formed the view that the AWB misled its shareholders about the nature of its wheat sales to Iraq, and the Australian Securities and Investments Commission has formed the view that the then directors of James Hardie Limited misled the market about the health of the fund it had set up to compensate asbestos victims. ASIC has begun action in the NSW Supreme Court seeking bans and fines and it hasn't ruled out criminal charges.

It is enough to make ordinary Australian share holders begin to wonder whether they are being played for mugs. And enough to make me understand why so many of us put our money into real estate instead. At least we can see and touch it and get a good idea for ourselves about what we are buying.

One way to make us feel better about share market trading would be to beef up enforcement of the laws. Yesterday the Treasure Peter Costello gave ASIC an extra $1.6 million to do just that. But even with the money ASIC finds prosecutions difficult. Its claim against James Hardie’s former directors took years to prepare, runs to 200 pages and is backed up by discs full of documents. The former director’s first line of defence is that ASIC didn’t properly serve them in time.

It could be that there is a better way to make us feel confident about share market trading, but it is one that it is the exact opposite of what we are used to. You might not like it.

It is to make insider trading legal.

Michael Adams, the Professor of Corporate Law at the University of Technology, Sydney is promoting the idea. He wants us to get away from what he calls our particularly Australian “underlying concept of fairness”.

In a paper prepared for the Company and Securities Law Journal he argues that insider trading, universally accepted, could actually help ordinary shareholders see what was going on inside Australian companies.

Here’s a hypothetical example. A big retailer says that its sales are going up. The executives collecting the figures feel that that the claim is overblown and so sell their shares in anticipation of a dive in the share price when the truth comes out.

As a result, the price dives straight away and all investors get a wider perspective on what the people on inside actually think.

Or perhaps an airline is keeping quiet about its profit outlook. The executives to whom things look rosy buy shares in anticipation of a price hike, and push the price up straight away.

As Adams puts it: allowing insider trading would move the company’s share price “more quickly to its equilibrium.”

He also says it would “compensate and motivate management”.

Japan and Germany both scarcely enforce insider-trading laws. Australia effectively allows it in betting on politics. If a Labor insider thinks that the party’s leadership is about to change, that person will place a big bet on a change and in so doing let the rest of the country know that a change is brewing (which is what happened in December).

Advanced corporations are now using internal betting markets to tell them what the official chain of command will not. They are inviting their employees to anonymously bet on when projects will really be completed. The results are more accurate.

If at times Centrebet seems better informed about what’s happening in Australian politics than the Australian share market does about what’s happening to shares, it might be time for a new approach – to treat the share market as no more or no less than a betting market and to follow the money rather than try to guess the truth of pronouncements.

3 comments:

Graham Shepherd said...

Professor Michael Adams is hardly original. Hundreds of corporate charlatans have been living the high life off these precepts for years. I am sure that the good professor is not a charlatan, just another naif whose ego has become inflated by his professorial laurels. Unfortunately journalists and politicians feed of the gas these people exude. In this case the gas is noxious!

This is just another version of the trickle down effect: the living standards of the poor are raised by the economic activity of the rich. Rather feudal, one might say, rather than progressive.

Come on Peter Martin, why are you reporting this crap? Economic rationalism has had its 50 years of fame. It is now in terminal decline. How about a return to human and social values?

Andrew Leigh said...

I've always regarded this as one of those equity-efficiency tradeoffs. Sure, if we allowed insider trading, then prices would better reflect the firm's true value. But it would be a wealth transfer from price-sensitive traders to corporate insiders.

Another option would be to allow insider trading, but make it easier for firms to ban it if they so desired, perhaps through enforcing harsh anti-insider trading clauses in employment contracts. That way, firms who want to ensure thick trade in their stock can do so.

LETTER said...

LETTER TO THE EDITOR, April 2, 2007
Trading off nature

Congratulations to your economics editor Peter Martin (''Relaxing the rules a safer bet than truth'', 27 March, p11) for defying ''conventional wisdom'', and suggesting repeal of the law forbidding insider trading. Insider trading occurs when someone buys or sells shares using ''inside'' information which, if generally available, would be likely to materially affect their price. However, as Martin's article explains, preventing insider trading actually reduces market knowledge about a company's affairs by preventing people who know something is going to happen that will affect a company's profitability from buying or selling its shares, it prevents market signals from being given out which would improve the market's knowledge of the company's prospects. It's human nature and normal in other walks of life for people to try to use their knowledge for their benefit. If that's done without harming others (and insider trading law doesn't protect people from crime, it simply gives effect to the academic theory of a ''level playing field'' for everyone), why should it be stopped in one particular activity: sharetrading?

R.S.Gilbert, Turner

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