The Financial Markets Authority (FMA) has published the report, Shadow insider trading: Regulatory expectations and emerging conduct risk (the Report), which highlights the concept of ‘shadow insider trading’, and when the prohibitions in the Financial Markets Conduct Act 2013 (FMCA) may apply. The Report signals a potential shift in the regulator’s market conduct expectations and could have a significant impact on the way in which some market participants trade and operate.
In this article we discuss the Report and our views, including what businesses should be doing in response.
A link to the Report is available here.
Who should read this? Why?
All market participants, such as fund managers, investment banks, brokers and other intermediaries, as well as investors and issuers, should understand the FMA’s view that the insider trading regime has a broader application than many may have historically assumed.
What does it cover?
The Report introduces the concept of ‘shadow insider trading’, which broadly refers to the use of non-public, material information about one listed issuer to trade in the financial products of another, economically related issuer.
Under Part 5 of the FMCA, trading is prohibited when a person is an ‘information insider’, meaning someone who possesses non-public, material information (information that could reasonably have a material effect on the price of quoted financial products of a listed issuer). Traditionally, insider trading involves the use of non-public material information relating to a listed issuer to trade in that same issuer.
However, as the FMA points out, the prohibition is not limited to those circumstances, as information about a listed issuer, or about a particular sector, industry or other matter in relation to a listed issuer, is capable of also being material information in relation to one or more other listed issuers. For example, share prices may be more likely to be indirectly impacted due to sectoral, operational or financial similarities e.g. within concentrated sectors or between issuers whose financial products demonstrate a degree of correlation.
This is a wider application of the prohibitions than many in the industry have generally assumed and the FMA directly acknowledges this in its Report, saying “[we] understand from market participants that shadow insider trading is common industry practice”.
The Report sets out two example scenarios of prohibited shadow insider trading:
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Capital raises: Where a person becomes aware of non-public information about the upcoming capital raise of a listed issuer in a small, concentrated market – trading in a peer listed issuer within that market. Where the issuers operate within a small sector, the link between one issuer’s capital event and its effect on a peer’s share price may be sufficiently material that trading in the peer’s listed shares could fall within the scope of insider trading prohibitions.
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M&A: Where a person becomes aware of a confidential merger or acquisition involving a listed issuer, and trades in a closely comparable peer listed issuer before the transaction is made public, on the basis that the transaction may lead to positive investor sentiment and/or valuation benchmarking across the sector.
The Report sets out the FMA’s practical expectations for businesses engaging in trading activities. The FMA encourages entities to:
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carefully assess whether non-public information about one issuer could materially affect the price of other, related issuers – taking into account correlations between shares and the sector’s level of concentration;
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be vigilant in documenting and reviewing trade rationales – particularly for significant transactions outside of normal trading patterns or coinciding with known market-moving events;
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maintain robust internal governance and compliance frameworks, including clear policies for handling and using non-public information; and
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foster a culture of ethical decision-making.
Our view
The Report acts as a timely reminder for market participants and fund managers to review and update their insider trading policies and practices, in light of the insights from the Report. It may also be a trigger to reflect on market practices in capital raise and M&A scenarios (being the examples given by the FMA). Takeovers and block trades may also raise similar issues.
The FMA’s shadow insider trading concept does fit with the literal language of the sections in the FMCA, which do not require that the non-public material information is sourced from the relevant issuer, or that the trader is motivated to use it for an improper purpose. It merely requires that a trader has material information relating to the listed issuer that is not generally available to the market, and ought reasonably to know that is the case.
Information is ‘material information’ if a reasonable person would expect to it to have a material effect on the price of a listed issuer’s quoted financial products if generally available; and it relates to particular financial products, a particular listed issuer, or particular listed issuers, rather than to financial products or listed issuers generally. Importantly, from the FMA’s view it does not need to relate to the same listed issuer. In this regard, the legislation broadly follows the approach in other jurisdictions such as Australia.
However, in a small, and in parts illiquid, stock market like the NZX, capital raises, M&A transactions and other activities can have significant market impacts across multiple issuers in a sector – potentially even the whole market in the event of very large capital raises.
Accordingly, in light of the FMA’s evident concern, market participants such as fund managers will need to take care, before agreeing to receive non-public material information in relation to potential transactions, to identify all the listed issuers whose quoted products’ prices might be affected, whether or not they are a party to the transaction. This may not be straightforward, and will require judgment as to what the “reasonable person” might expect.
If they do receive the information, they will need to have robust systems in place to prevent trading in all of those quoted financial products, not just those of the listed issuer to which the information directly relates, until the information is made public. Alternatively, the business should have processes to allow them to maintain effective information barriers to permit trading to continue only by those without access to the information. Sometimes this could be for several business days.
For fund managers without the resources to maintain separation or to predict price correlations quickly, this may lead to the conclusion that it is simpler not to agree to be wall-crossed, rather than risk being locked out of trading in a whole sector, to the detriment of their own investors. Alternatively, they might insist, as the only palatable option, on only being wall-crossed on the business day prior to launch, with a requirement that they are informed by the following business day if the capital raise is not proceeding. This option, of course, may not work for longer-tailed information (such as being approached for a pre-bid lock up).
Any reluctance by funds to be wall-crossed may impact pricing, to reflect underwriting risk.
What next?
The FMA acknowledges that some firms may consider its view on shadow insider trading poses practical difficulties for intermediaries. They encourage those who would like to discuss it further to contact the FMA via [email protected], attention the Market Conduct team.
We encourage businesses to review their internal trading policies and processes, including record keeping practices in relation to trade rationales and the handling of non-public material information.
If you have any questions about the Report, or would like to discuss your insider trading policies and processes, please contact one of our experts.
This article was co-authored by Hannah Cross, a Solicitor from our Financial Services team.
