Applying due diligence in preventing insider trading

Nironjan Roy | Published: May 31, 2018 21:33:47 | Updated: May 31, 2018 22:12:26

[This is the concluding part of a three-part article titled 'Price sensitive information and insider trading']

Persons dealing with investors or involved in share trading activity require adequate knowledge and commitment to maintaining high ethical standards. This can be achieved through introducing certifications for the dealing officers. Certification process can be made mandatory for those who will be involved in providing investment advice to the investors and will be performing the job of share trading. Not only in the developed world but also in many developing countries, the share traders have to be certified by the professional bodies. The certified traders have to maintain certain standards by complying with all relevant rules and regulations, and through application of due diligence as well as professional ethics in order to keep their certification valid. Any deviation from the standard practice will disqualify them, and their certification remains withheld until the concerned trader restores his/ her capacity by dint of further screening process.

The way the share market is moving and the economy is growing, Bangladesh should actively consider introducing certification process for not only the shareholders, but also for those who will be working in the back office. Certification process not only minimises the scope for insider trading to a great extent, but also ensures fair investments and improves investment services.

TIMELY INFORMATION DISSEMINATION & HALTING TRADE: Converting non-public information into public information is crucial in avoiding insider trading. Any information prior to public dissemination is considered as non-public information and therefore should be maintained with strict confidentiality. The same information when publicly announced is considered as public information; so no question of confidentiality arises. In practice, any information related to material decision is first approved at the highest level of authority and then disseminated. But there is always a gap between the lip and the cup, and previous experiences show that information is mostly leaked during the period of decision approval and public announcement.

Hence, arrangement can be made to hold board meetings of the companies after the trading is closed - especially where price sensitive information (PSI) gets approved. Alternatively, if such board meeting is held in the morning, then trading of the company's share may be temporarily halted till the meeting is over and information is publicly announced. Similarly, directives may be issued to the companies compelling them to disseminate PSI after the closure of trading and prior to the opening of trading the following day. Time of conducting board meeting, time of disseminating PSI and temporary halting of the trade, when necessitated, are very important factors for dealing with insider trading. Halting trade is commonly followed by stock exchanges in Bangladesh, but this should be done in a more effective and professional manner.

APPLYING DUE DILIGENCE AND KEEPING CUSTOMER PROFILE: Applying due diligence by every stakeholder is very important in preventing insider trading based on PSI. At the same time, proper diligence can only be applied if customer profile via KYC (Know Your Customer) is accurately maintained. Investments in shares and debentures, particularly in share trading, are also a part of the country's financial system. Applying due diligence and maintaining customer profile with regard to KYC are being strictly complied in other areas of the country's financial market. So the same standard procedure must be followed in the share business as well.

Customers' request for buying any volume of share should not be blindly executed, as his sources of fund, objectives of investment, and risk appetite must be examined. It should comply with the investor's profile and KYC matrix. It is true that the investor's risk appetite, investment knowledge, and investable fund may be change. So his/ her profile must be updated and made effective accordingly.

Investment decision based on the updated investor profile cannot be executed immediately after changing the profile. For example, once investor profile is changed, the investor will have to wait for at least 15 days to execute his buy order based on the new profile. If the investor is considered to have low risk appetite, he should not be allowed to invest in highly risky shares. After certain time, however, the investor may gain investment knowledge and as such his risk appetite may be upgraded from low to average and his profile can be updated accordingly. But on the following day after this update, purchase of shares having moderately higher risks cannot be allowed. After waiting for some time, preferably 15 days, the changed profile can be made effective and investment decision based on new profile may be activated. This practice will undoubtedly help control insider trading based on PSI, as any attempt by the investor to trade shares by acting on insider information will be automatically barred.

LIMIT CONTROL PREVENTS INSIDER TRADING: It has been historically evident that limit control plays an effective role against insider trading based on PSI. At the time of creating investor's profile, a maximum investment cap can be set for both individual stocks and total investment volume. At any given point of time, the investor's buy order should not exceed the maximum cap. Usually people acting on insider information tend to buy substantial amount of share, which should not be permitted under a maximum cap.

Thus, attempts of insider trading would be initially filtered by the limit control technique. Some may argue that the investor's ability may rise with time and as such he may arrange more funds to invest. This is true and there is no reason for denying this fact. However, under this situation the investor's maximum cap for both individual stock and overall investment volume may be increased. But this increased cap should be made applicable after a certain period, preferably 15 days, following the change.

It is unlikely that investors having access to privileged information would reap benefit of insider trading after a period of two-week wait. This is because non-public material information becomes public within a very short time. Insider trading, which is very swift and short-cut action, cannot be executed if limit control mechanism is in place.

This limit control technique may not influence the investor's sale decision, as he may dispose off his previously-purchased stake based on insider information. In this context, declaration by the investor as an alternative approach may serve the purpose. When an investor intends to sell his substantial holding of any particular company, s/he will have to submit a declaration wherein he s/he will expressly state that s/he is not acting on any insider information. If s/he provides false statement and sells his/her holdings based on insider information, the given statement would help the investigator in unearthing insider trading.

Extensive use of technology is, however, inevitably required for enforcing these strategies, particularly in ensuring compliance with the investors' profile and limit control. This is because it is very difficult to enforce these parameters manually. If investors' profile and maximum cap are preloaded in the automated technologically-developed trading system, every investor action can be screened by the system. With this in place, any buy or sale order exceeding the preloaded parameter can be verified and accepted or rejected by the system. Insider trading is a financial malaise that cannot be completely eradicated, but can be contained to a great extent if appropriate measures are taken.

Nironjan Roy, CPA, CMA, is a banker based in Toronto, Canada.

Share if you like