Last week, after the publication of my article on the subject of "Insider trading at stock exchanges" in the Business Recorder, I was asked how we could eliminate or minimise these acts of insider trading from the equity market, when the market ought to generate volumes and volatility and that can only be based upon rumours and inside information. If these two elements are withdrawn from the equity market, it may be dull, volume less and without any noticeable for day traders.
ROLE OF REGULATORS: Every now and then, reports are appearing in the press that insider trading is very common in the multinational companies. Despite the fact that there are adequate rules and regulations in place to check this illegal activity, there are no visible signs that it would be minimised unless some structural changes are introduced that may help to minimise these activities so that the confidence of small investors is restored.
The recent stories relating to insider trading has been reported in the press frequently and I am sure the SECP is trying its best to deal with these cases to restore the investors confidence, it is right time for the regulators as well as the management of the Stock Exchanges to pay attention towards this activity and restructure some of the rules to make them unfriendlier towards insider trading.
INDEPENDENT NON- EXECUTIVE CHAIRMAN AND DIRECTORS: It is proposed that the Code of Corporate Governance should be up-dated and tailored with the other code of corporate governance to make them more compatible by making it compulsory for all the listed companies to appoint an independent non-executive Chairman. He should not be a chairman of any other listed company that is listed on any stock exchange in Pakistan.
This may require that the present code of corporate governance should redefine the word "Independent" as the present definition of independent adopted by the current code of corporate governance is outdated and does not meet the present day requirements.
THIS DEFINITION SHOULD BE REPLACED WITH THE FOLLOWING: With the above change in the code of corporate governance, non-executive directors representing groups or institutions like Mutual Funds and large institutions holding company's stock should be excluded from the definition of "Independent" and thus listed companies would have to justify the appointment of independent non-executive directors on their board.
Initially, it should be made obligatory to have at least three independent non-executive directors but later on this should be increased to five.
That means that the majority of the directors should be independent non-executive directors.
CONFIDENTIALITY AGREEMENT: The directors representing Mutual Funds, National Investment Trust and other banks that trade in securities should not be appointed as non-executive directors as of a right.
They should only be represented at the board of directors by virtue of their holding as a director.
Their appointment should only be approved if they are made party to a confidentiality agreement that binds them not to disclose classified information that may lead to insider trading. By virtue of this confidentiality agreement it should be made obligatory that they should be barred from trading in that company's security on the basis of confidential information that may be treated as insider trading.
However, they would be allowed to trade in the security on any other reason if they would be able to establish their case, in case it is raised against them. This is the normal practice in the United States and the United Kingdom. If the trading of equities is due to special information that has been obtained by virtue of their being as a director in the board, the law should follow suit and take the desired actions against the institution that has committed this criminal act.
It should be made part of the code of corporate governance that all the executive directors, senior managers, bankers, auditors and other stakeholders should be made aware of the fact that releasing any of the confidential information that they may come across by virtue of their dealing with the company or in any other capacity would amount to a breach of confidentiality and if this disclosure is the basis of insider information then the person would be held responsible criminally.
Currently, we are not conscious about the fallouts of the release of confidential information that may become the basis for insider trading. It is being argued that most of the time the auditor's junior staff is the source of this information and on several occasions' copies of the draft accounts revealing this confidential information have been in circulation with the big brokerage houses. Due attention must be paid that draft audit accounts are dealt with and prepared by senior members of the profession or partners of the auditing firms that have signed the confidentiality agreement to minimise the leakage of this sensitive information that could form the basis of insider trading.
DISCLOSURE OF TRADING: Disclosure of information regarding directors and senior management's trading should be advised by the close of the day to the stock exchange by the brokerage house and also by the buyer himself and that should appear in the daily transaction list of the concerned stock exchange.
The SECP should also be advised about this transaction within seven days of the date of trading. At present this information is disclosed in an annual report of the company and for all practical purposes, there is no use of this information as it is stale information that cannot be used as a whistleblower for others and is therefore of no use to the shareholders of the company.
BLOCK TRADING SHOULD BE BANNED:Block trading at the stock exchange should be prohibited. These tradings should be conducted through normal business procedures. I understand the systems' weaknesses in this area. These systems should be up-graded. The strong argument in favour of this change is transparency.
The offer and bidding process should be transparent and any other buyer or seller should have the opportunity to participate in this block deal. The trading done on the prices would reflect market prices and not arbitrary practice as normally the block deals are conducted with a substantial difference in price and that difference misleads the other investors.
This should be enforced strictly for national institutions like the NIT, EOIB and State Life Insurance and nationalised banks.
These institutions should come out transparent from these deals otherwise, it is being argued that these block deals are made either to favour a particular party or brokerage house or is used as a bail out process if a party has been stuck with inactive stock.
These block deals are also seen as activity leading towards insider trading as an ordinary investor is influenced by the volume and the price of a deal that does not represent the true market by price.
This represents a false indicator to small investors. It is surprising why the Stock Exchange system is being bypassed for these transactions and how we could claim or justify the transparency of these transactions.
In addition to this, this practice is being used to manipulate the market also where equity prices are lowered by a group of brokerage house trading between themselves and later on reversing these transactions privately?
Any information or announcement that is not complete should not be announced by the management of the stock exchanges as was done in the case of Pakistan Oilfields that the profitability of the company was announced for their half yearly results but no distribution was declared.
Then after ten minutes part of the announcement was made and the company announced nil distribution.
This happened during the announcement of the half yearly results in the early part of 2004. This announcement in parts was made at the Karachi Stock Exchange with the result that due to good operational results the share price went up and was traded heavily at a higher price and the price dropped soon after the announcement was made that the company had declared a nil dividend. This incident caused severe losses to the small investors.
Later on an explanation was given that the stock exchange received page two as garbled. It remains arguable, whether it was intentional.
RESTRICTION OF TRADING BY BROKERAGE HOUSES: The brokerage houses should be restricted to trading for themselves in the securities as this trading is considered a conflict of interest.
Their core business is to deal as brokerage houses for others and if they themselves indulge in their own trading, it may be argued that it may be treated a conflict of interest and it may be argued that insider-trading laws may be applicable on them as they are aware of the sellers' and buyers' identity.
In case they wish to trade securities for themselves or for their family members, this should be done either through other brokerage houses so that it becomes a transparent activity or by forming another separate company that deals in share trading under separate and independent management. This may be a solution to avoid conflict of interest.
This step should also minimise insider trading and should promote the confidence of small investors.
ELECTRONIC MEDIA AND INVESTMENT ANALYSTS: Recently, the electronic media has also played an important role in disclosing some of the confidential information that could have been the basis of insider trading. If we look at the Tezi-Mandi programme of Geo, it may be argued that it becomes visible that some of the information being disclosed may lead to either insider trading or may mislead the general public.
It is being argued that the recommendations normally given by the analyst of certain brokerage houses are related to securities that are owned by this analyst group and are communicated to the general public with some special motives.
These, in most of the cases, mislead the general public and investors who lack the accounting and financial knowledge of a company.
The regulator and stock exchange should discourage this sort of practice by asserting their writ. It may be the right time for the SECP to revisit the rules and regulation of insider trading to ensure that the media does not get a free hand to disclose any information that may lead to insider trading.
Few analysts advise openly their recommendations to sell purchase and hold by providing that may be treated as confidential and it is being argued that it may mislead the investors. These practices need to be checked and curtailed.
DISCLOSURES AND EXPLANATIONS: The company should be made aware that any material information that may affect the nature of the business must be disclosed immediately through the stock exchange to the investors in general and the shareholders in particular so that insider trading is minimised or does not take place.
It can only happen if the disclosure is timely and it accompanies an adequate, quick and timely explanation.
In the case of Hubco, it took three days to disown a fake fax. Had there been a denial at the right time, losses could have been averted. Again, it probably took almost a week to make an announcement by Hubco that seventy five percent of its capacity was not in working condition.
This was material information that should have been disclosed earlier than it was done.
In the case of Pakistan Oilfields Limited, it was material information that should have been disclosed to the shareholders that the company, as part of a consortium formed for obtaining a GSM Telecom License participated in the bidding process.
The director's report admits that as negatively propagated by some quarters, the company does not carry any financial exposure in this deal. This should have been disclosed to the shareholders earlier than done in October, six months after the event occurred.
It is also surprising to note that the company being a pioneer in the business of oil and gas exploration and production is associating itself with a group of consortium to carry an activity that does not relate to its core business. It is yet to be argued how the management would justify going for this type of venture without getting the approval from shareholders.
Is it not material information that requires a disclosure and the approval of the shareholders as part of good corporate governance?
The shareholders have invested in the company's security with the intention to participate in the oil and gas exploration and production business and not for a "TELEPHONEY BUSINESS".
It may be allowed by the Memorandum and Articles of Association of this company under "any other business" but it is certainly not appreciated as part of good corporate governance not "to disclose and explain" to the shareholders at the earliest opportunity available.
RELATIONS WITH SHAREHOLDERS: It seems surprising that shareholders are very important stakeholders in the whole process of corporate governance. In Pakistan no attention or any material importance has been given to the stakeholders.
We look at the employees as stakeholders that are given so much importance that within the corporate culture we have senior and well-paid staff to look after the employees, to keep their morale high, but we see no efforts being made to improve relations with shareholders or investors by "disclosing or explaining" the corporate policies.
In developed economies, the perception has changed and more attention is being paid to this area. In the British Code of Corporate Governance, a non-executive independent lead director has been assigned this responsibility to interface with the shareholder for better relations, in case the Chief Executive or Chairman is unable to do this job. It is time that the corporate sector endeavours to improve relations with stakeholders that have financial interest at stake and that could only be done if they, as the real owners, should be disclosed and explained the company's material information.
This timely disclosure should minimise insider trading based upon rumours and persons having access to confidential information.
QUICK ACTION AND PROBING: It is required that any allegations of insider trading must be probed properly and without wasting time.
The company should be made a party to the investigation. It may be desirable to suspend the trading of the shares of that company in the interest of the public in case the management does not provide a reasonable and satisfactory response.
The findings should be made public in this respect. It is also advisable that the media should also participate to identify cases of insider trading.