Jacques Magliolo looks at the profile of a typical insider trader
Meet Henry — well educated, well dressed and well-off. A highly respected member of the stockbroking fraternity and a well- known socialite, he knows everyone who is anyone. Henry drives an imported sports car, lives in a mansion in an exclusive Johannesburg suburb — filled with art treasures and rare antiques — and jets around the world.
But delve under his ultra-chic facade and you will find that he is moody. A once glib perfectionist, he has become nervous and fidgety. There seems to be no reason for Henry’s mood swings. His days are busy and often stressful, and he works hard as a dealer and earns much more than most — over R1- million a year.
Over time, reasons for this tension become clear. Without realising what he is doing, Henry begins to reveal his formula for successful share trading. With monotonous regularity, he accurately forecasts which shares to buy or sell.
Henry is envied by his colleagues. His work day consists of a series of phone calls advising financial institutions which instruments to buy or sell.
The problem arises when these institutions begin to tell him which instruments they will be trading.
This exposes him to information which he can use for his own gain. The temptation to use this information, with little chance of being caught, is often too great to resist. This is a potentially fabulous money-making trap which stockbrokers, dealers, analysts or portfolio managers can fall into.
The first sign that the JSE authorities look for when they suspect someone of insider trading is a link between that person’s personal investment in the stock market and his ties with institutions.
In Henry’s case, it doesn’t require an investigator to figure out that he succumbed to financial fraud. His access to information which can affect share prices, his “perfect timing” in trading shares and a quick and massive increase in his personal wealth are factors which can prompt a secret investigation by the JSE into his dealings.
This is a typical profile of an insider trader — that elusive animal the Kahn Commission of Enquiry was authorised to stop.
Has the Commission succeeded?
Market pundits refuse to be quoted on the subject of insider trading, or on any subject relating to the Commission, but they do admit that “the Commission has only succeeded to a limited extent”. They assert that the line between insider trading — defined as buying or selling shares on price sensitive information before such data is released to the public — or trading on mere rumour, is so fine that the authorities will always have difficulty in arresting culprits. The best that JSE surveillance head Rob Barrow’s office can do is to make penalties so severe that possible offenders will be deterred.
Dealers say the atmosphere on the trading floor was “subdued” when the Kahn Commission began investigating allegations of insider trading and especially after the arrest and successful conviction of ex-Frankel Pollak stockbroker Greg Blank. However, dealers are quick to add that insiders only took a respite, while undoubtedly looking at new methods to outsmart the authorities. This became evident when gilts traders pre-empted Derek Keys’ resignation as minister of finance.
One dealer described insiders as “a problem stock exchanges have to live with, not unlike death and taxes”. Another added that the difficulty authorities face is that insiders can operate under any condition, in open cry systems like South Africa, or where deals are conducted solely by computer such as in Japan and England.
It is thus nearly impossible to stamp out white collar fraud. Over the last few years, millions of rand, dollars and yen have been stolen by insiders, ranging from Wall Street’s Junk Bond fiasco, Japan’s 1991 stock market scandal, to the JSE’s trial against Old Mutual and Greg Blank.
To make matters worse, Blank was found guilty of fraud and not of insider trading.
In his 1994 annual report, JSE President Roy Andersen admits that this is a cause for concern: “It is still a cause for concern that there have been no successful prosecutions for insider trading.”
Yet market pundits say that these cases form only a small percentage of total insiders in the market. The job of stopping insiders is complex and often fails at the eleventh hour. Not only do the authorities have to define what encompasses a breach of trading regulations, but the actual implementation of these rules can be a problem. This arduous task has been complicated over time by the different computer systems stockbrokers used in the past to register deals.
The JSE has taken a number of steps to curtail fraud. Firstly, in 1990, it introduced a unified computer system to register such deals and ordered all stockbrokers to shift their operations to this system.
While the JSE disputes that its aim is to police members of the JSE, it is obvious that the mechanism was not implemented — as they claim it was — to unify firms to a more efficient way of registering deals.
The second step, in 1991, was the formation of a “Code” to outline new laws on insider trading. This was a historic event for South African corporate finance.
The JSE is able, for the first time, to define insiders and monitor deals via computer. There is no doubt that the procedures have worked. By the end of the 1991 financial year, the JSE had carried out 20 investigations and found 15 members guilty. In the 1993-1994 year four stockbrokers were expelled and two suspended for a period of time. Penalties ranged from reprimands to expulsion.
In his presidential address, then president Tony Norton said: “No market will ever be perfect, but it can be demonstrated that the JSE takes the most relevant form for the community it serves.”
In other words, the JSE will continue to promulgate, enforce and police laws and punish offenders because it “perseveres as it knows that the fairest market is a self-regulated market”. These methods may still not be enough.
Once the JSE has determined that a crime is being committed, they have to collect enough proof to arrest and convict these traders. In addition, South African law requires a crime to be proved beyond a reasonable doubt. This is always a problem when the public doesn’t consider white collar crime as serious as child abuse, murder or rape.
Yet another problem is that stockbrokers fear that if the insider is brought to trial, his modus operandi will result in copycat crimes. Irregularities are thus, more often than not, hushed up, the offender is expelled from the stock exchange, but is not prosecuted.
So how do these “creative” dealers do it?
The most popular method is also the simplest. A dealer, receiving a large order to buy shares for a client, will do so for a third party before completing his duties as agent. It is common knowledge among dealers that large parcels of shares can push up prices, at which point the third party is contacted to sell the shares at a profit.
While this method has become obvious to exchange regulation committees, it remains difficult to prove. This is especially true if such trades are few, the amounts kept to a minimum and a network of third parties is used.
Insiders have made this system more intricate and profitable in past years, by using an accomplice in another country. The basics remain the same, except that he has the benefit of exchange rates and the financial rand.
Deception is also easier if deals are made after the local exchange closes. The transaction is booked as a late deal and does not appear on the trading floor board if the shares are promptly re-sold.
The “buy low and sell high” method is used in a number of ways, but all constitute the illegal use of information — not readily available to the investing public — for personal gain.
In addition, this knowledge is not restricted to the creation of “profit” opportunities, but includes any prior knowledge of a company’s forthcoming results, mergers and takeovers, dissolutions or liquidations. In addition, prior knowledge of political events and Reserve Bank information also constitutes a breach of the code.
Another method, called front running, occurs when a dealer delays reporting the purchase of shares. He then waits to see if the shares increase in price and, if they do, allocates and formally books a portion of them to himself at the purchase price.
However, fraud does not only take place when shares are bought at a low and sold at a high. Undisclosed bear sales occur when a dealer, using inside information that the price of a share is about to fall, sells shares and then re- purchases them at a lower price.
However, dealers are not prevented from selling shares which they believe will depreciate. Accepted procedure is full disclosure to the broking firm concerned and to the purchaser of the shares, special note is made on the trading floor and a technical deposit (about twice the value of the share) has to be made.
There are also cases which are far more difficult to identify. For instance, if a researcher — who collates data on listed companies, which is readily available to the public — uses that information for his own benefit, is he guilty of insider trading?
Or is a financial journalist guilty if he uses information he has gathered? After all, this information is available on request from the company. To complicate matters, some insider traders are excluded from the net. For instance, in South Africa — unlike in the UK — someone who simply passes on privileged information is not guilty. The logic is that despite being in possession of price-sensitive information, he hasn’t used that data. And, to make the JSE’s task of stopping this fraud even more difficult, some insiders cannot be found guilty. For instance, if one director sells shares to another party — and both have the same inside knowledge – – then the insider trading prohibition does not apply.
It is no wonder that this type of white collar crime cannot be stamped out.