An ASIC team is advancing the prosecution of insider trading offences. With the corporate world on notice that it will be held accountable for breaches of insider trading legislation, Paul Hardman and Shane Jury outline how to minimise the risks of transgression.

The offence of insider trading has been the subject of significant media attention in recent times. The publicity has hitherto focused on the commission of the offence by individuals, but less known is the fact that corporations can also be held responsible for instances of insider trading committed by their employees.

Indeed, evidence suggests that a large number of executives time their trading decisions to take advan tage of inside information. As such, it is a significant regulatory issue that warrants closer examination.

An increased regulatory interest in the identification of insider trading offences and commitment to making those legally liable accountable is evidenced by ASIC’s recent prosecution of Citigroup, the first corporation to appear in an Australian court for such an offence. Cor porations that fail to adequately address the risk may face maximum fines of $1 million for each offence.

However, the risk of liability can be minimised by ensuring that compliance programs are in place, such as so-called Chinese Walls (the ethical barrier between different divisions of an institution to avoid conflict of interest) and/or share trading policies. That said, a num ber of issues arise when considering and implementing these risk management measures.

Insider trading

Insider trading is defined as “the offence of dealing in a company’s securities while in possession of infor mation that is not generally available, which would materially affect the price or value of those securities if it were generally available”. Such activity is pro hibited by the Corporations Act 2001 (Cth) (the Act). The operative provision prohibits a person who is aware or ought reasonably be aware that they possess inside information from engaging in certain prohib ited conduct, such as the acquisition or disposal of financial products.

The ambit of the offence is extended to corporations by section 1042G, which provides that a body corporate is taken to possess any information which an officer of the corporation has, and which came into the officer’s possession in the course of employment.

It is essential to identify the officers of a body cor porate because if an employee engages in prohibited conduct, while an officer is in possession of inside infor mation, the corporation will be held liable.

The Act defines an officer to include:

(a) a director or secretary of the corporation; or

(b) a person:

(i) who makes, or participates in making, deci sions that affect the whole, or a substantial part, of the business of the corporation; or

(ii) who has the capacity to affect significantly the corporation’s financial standing; or

(iii) in accordance with whose instructions or wishes the directors of the corporation are accustomed to act.

In ASIC v Citigroup, the court was required to interpret this definition. It rejected an argument that it followed necessarily from an employee’s $10 mil lion trading limit that he was an officer of Citigroup. Rather, it was emphasised that these categories are concerned with identifying persons who are involved in policy-making and the management of the corpo ration. Once the corporation has identified its offi cers, the risk management process can be structured more effectively.

Citigroup litigation (2007)

In the ASIC v Citigroup case, Citigroup was acting as an adviser to Toll Holdings during the proposed takeover of Patrick Corporation. Citigroup’s advis ers, who were called private-side employees, were frequently exposed to confidential, market-sensi tive information and were, therefore, quarantined from dealing with other employees, known as pub lic-side employees.

The case concerned one of Citigroup’s proprietary traders who invested heavily in Patrick Corporation. When this trading came to the attention of private-side employees, the head of equities instructed the trader’s supervisor to minimise the extent of the investment, but the supervisor was not given details about the proposed takeover. The supervisor relayed these instructions to the trader in terms of risk minimisation.

Chinese Walls

The segregation of public-side and private-side employees by Citigroup was an example of a Chinese Wall. This type of segregation is a defence under sec tion 1043F of the Act. The defence is available where a corporation has arrangements in place to limit the communication of price-sensitive information. If these arrangements are sufficiently implemented and the decision to trade or otherwise deal in financial prod ucts was made independently, by an employee who did not have possession of inside information, then a corporation will not be held liable for insider trading.

The court held that the Chinese Wall defence met the requirements of the Act. Justice Jacobson emphasised that the defence does “not require a standard of absolute perfection”. Therefore, it can be invoked if there are suf ficient arrangements in place, which could reasonably be expected to prevent the spread of inside information.

Despite this finding, the case highlighted the poten tial fragility of Chinese Walls. The instructions given by private-side employees created a risk of informing those on the public side of the inside information. If this had occurred, the defence would not have been available to shield Citigroup from liability. Accord ingly, Justice Jacobson noted that “such a result may not always prevail in the pressured environment of business banking”.

Risk minimisation

Clearly, it is prudent to consider the steps an organisa tion should take to minimise this risk by preventing a Chinese Wall from “breaking”.

First and foremost, a procedure must be in place to quarantine the spread of price-sensitive information. Generally speaking, this will entail the segregation of employees who are frequently exposed to it, such as business consultants/advisers, and those who are not.

In addition to segregation, the Chinese Wall should establish a procedure for communication between pri vate-side and public-side employees, in circumstances where a public-side employee is acting contrary to the interests of the corporation. As illustrated by the ASIC v Citigroup case, private-side employees should care fully frame any advice or directions they issue in order to prevent disclosure of sensitive information.

Significantly, the court confirmed that inside infor mation can extend to internal thought processes, including an inference drawn from the conduct of others. If the conduct of the private-side employee had conveyed even an inference that Citigroup was acting for Toll Holdings when he or she directed the trader to minimise the investment, the Chinese Wall would have been broken. .

The procedures – for bringing an employee over the Chinese Wall – should be formalised and pro moted by senior management. It is one thing to have a Chinese Wall policy, but it is quite another for it to be adhered to in practice. As a consequence, poli cies should adopt the default position that, if pos sible, no communication take place at all. If this is not feasible, then private-side employees should carefully draft and convey instructions in a way that does not arouse suspicion about their content.

The efficacy of Chinese Walls, in minimising the risk of liability for insider trading, will differ vastly between organisations. Clearly, the defence is well suited to an investment bank such as Citigroup, which has both proprietary trading and corporate advisory business units.

Share trading policies

In addition or as an alternative to Chinese Walls, corporations should implement a suitable share trad ing policy. These policies provide a simplified, non- legalistic explanation of the relevant law and should include practical examples of inside information which, if acted on, may give rise to liability for insider trading.

Examples may include profit projections, the discovery of resources, and proposed mergers or acquisitions. The policy should also emphasise the broad proposition that employees are never to deal in the company’s securities while in possession of price-sensitive information.

Share trading policies are used to identify “win dows” during which it is appropriate and/or inappro priate for employees to deal in shares. The windows must be adapted to meet the particularities of a given business. A one-size-fits-all approach is not satisfac tory. For instance, if certain business units are fre quently exposed to material, non-public information such as the private-side employees of Citigroup, they should be prohibited from trading altogether.

Broad restrictions on dealing

In addition to identifying particular windows dur ing which trading is restricted or authorised, a share trading policy may set out broad restrictions on employees. For example, it may be appropriate to prohibit employees from engaging in short-term trading of the corporation’s securities at any time because insider traders typically trade short-term.

This section may also require employees to give notice, prior to dealing in securities, of significant transactions concerning the company. Therefore, the company has a degree of oversight, and may gauge whether particular transactions are under pinned by inside information.

Enforcement and implementation

In order to ensure the effective enforcement and imple mentation of the policy, corporations should appoint a compliance officer. The company secretary must notify the officer before every significant employee transac tion in the company’s securities, and the transaction should be appropriately investigated by the compli ance officer. The role of the officer should also entail employee education, because the efficacy of the policy depends on its promotion within the organisation.

The company secretary must provide each direc tor, senior executive and officer of the company with a copy of the policy and ask them to provide a signed acknowledgement of their obligations in relation to insider trading.

Two key points to remember

Corporate liability for insider trading is an emerging risk management issue that all corporations must consider. This is especially true given ASIC’s increased commitment to the investigation and prosecution of the offence. Although Citigroup was ultimately absolved of liability in ASIC’s prosecution, the case highlighted the vulnerability of Chinese Walls, particularly in stressful business environments where decisions must be made quickly. It is clear that a corporation’s response is critical in these circumstances. Therefore, it is essential that the officers of a corporation are identified and fully apprised of the law relating to insider trading, so that they can respond to exigencies in a manner that avoids potentially significant liability. In this respect, a clear Chinese Wall procedure and well-drafted share trading policy are imperative.

Paul Hardman is a partner with law firm Holding Redlich in Brisbane. He was formerly a federal prosecutor responsible for the prosecution of ASIC matters. Shane Jury is a legal research assistant with Holding Redlich in Brisbane.