This is the sale or purchase of company securities by or on behalf of a person whose relationship with the company is such that he is likely to have access to material information on the company not generally available to the public.
It takes place when a person buys or sells securities while knowingly in possession of price sensitive information not available to the public which if made available will affect the price or value of those securities. It is the taking advantage of confidential information on the company for personal gain.
Insider trading occurs where an individual or organization buys or sells securities while knowingly in possession of some piece of confidential information which is not generally available and which is not likely, if made available to the general public, to materially affect the price of the securities.
For example, where a company director who is aware that the company is in a bad financial state and will consequently cut its dividend pay-out sells his shares before a public announcement to this effect is made. This is also the case when the director buys shares in the company with knowledge that the company is declaring super profits or is acquiring a competitor.
Regulation of Insider Trading in Kenya
In Kenya, Insider Trading is prohibited and criminalised by Section 32B of the Capital Markets Act Cap 485A.
Under Section 32B, a person who deals in listed securities or their derivatives that are price-affected in relation to the information in his possession commits an offence of insider trading if that person:
- Encourages another person, whether or not that other person knows it, to deal in securities or their derivatives which are price-affected securities in relation to the information in the possession of the insider, knowing or having reasonable cause to believe that the trading would take place; or
- Discloses the information, otherwise than in the proper performance of the functions of his employment, office or profession, to another person.
A person deals in securities or their derivatives if, whether as principal or agent, he sells, purchases, exchanges or subscribes for any listed securities or their derivatives.
The provisions of Section 32B provide that “insider” means a person in possession of inside information.
Section 2 of Cap 485A defines an “insider” to mean any person who, is or was connected with a company or is deemed to have been connected with a company, and who is reasonably expected to have access, by virtue of such connection to unpublished information which if made generally available would be likely to materially affect the price or value of the securities of the company, or who has received or has had access to such unpublished information.
Such a person is prohibited from trading in the company securities.
Section 2 of the Act further explains “trading in securities” to mean making or offering to make with any person, or inducing or attempting to induce any person to enter into or to offer to enter into:
- any agreement for or with a view to acquiring, disposing of, subscribing for or underwriting securities; or
- any agreement the purpose or intended purpose of which is to secure a profit to any of the parties from the yield of securities or by reference to fluctuations in the price of securities.
Under Section 32A of the Capital Markets Act securities are “price-affected securities” in relation to inside information if the information is likely to, if made public, materially affect the price of the securities;
Information shall also be treated as relating to an issuer of securities where it may affect the business prospects of the company.
Under Section 32C “insideinformation” means information which:
- relates to particular securities or to a particular issuer of securities;
- has not been made public; and
- if it were made public is likely to have a material effect on the price of the securities;
For the purposes of section 32C, information is made public if:
- it is published in accordance with the rules of a securities exchange for the purpose of informing investors and their professional advisers;
- it is contained in records which by virtue of any law are open to inspection by the public;
- it can readily be acquired by those likely to deal in any securities to which the information relates; or of an issuer to which the information relates; or
- it is derived from information which has been made public.
Information may be treated as having been made public even though the information:
- Can be acquired by persons exercising diligence or expertise;
- Is communicated to a section of the public;
- Can be acquired by observation;
- Is communicated on the payment of a fee; or
- Is published outside Kenya
Section 32E of the Capital Markets Act imposes stiff penalties for persons convicted of insider trading e.g. on the first conviction a convicted company may be fined up to KES 5,000,000 and payment of the amount of gain made or loss avoided while a convicted individual may be fined up to KES 2,500,000 or be imprisoned for a duration of not more than 2 years and payment of the amount of gain made or loss avoided.
On a subsequent conviction a company may be fined up to KES 10,000,000 and twice the amount of gain made or loss avoided while an individual may be imprisoned for up to 7 years or fined up to KES 5,000,000 and payment of twice the amount of gain made or loss avoided.
Who suffers in Insider Trading?
In order to understand insider trading, it is essential to distinguish between the nominal value of shares and the market value of the share, what the share is actually worth. Whilst the former is fixed in the company’s memorandum of association, the latter is free to fluctuate with demand. It is, of course, the fact that share prices fluctuate in this way that provides the possibility of individuals making large profits, or losses, in speculating in shares.
At a basic level, the value of shares may be seen as a reflection of the underlying profitability of the company; the more profitable the company, the greater it’s potential to pay dividends and the higher the value of its shares. Once the actual performance of a company is revealed in its accounts and statements, the market value of its share capital will be adjusted in the market to reflect its true worth, either upwards if it has done better than expected, or downwards if it has done worse than was expected.
Share valuation depends upon accurate information as to a company’s performance or its prospects. To that extent knowledge is money, but such price sensitive/affected information is usually only available to the individual share purchaser after the company has issued its information to the public. If, however, the share buyer could gain prior access to such information, then they would be in the position to predict the way in which share prices would be likely to move and consequently to make substantial profits. Such trading in shares, on the basis of access to unpublished price sensitive information, provides the basis for the offence of insider trading.
Whilst some would argue that insider trading is a victimless crime, in that no one is forced, or tricked, into buying or selling shares: the shares in question are, after all, bought ‘at arm’s length’ on the stock exchange. Nonetheless such activity is treated as criminal. The underlying justification for this would appear to be that those who engage in the activity gain an unjustified return based in their access to price sensitive information that is not available to the general public. In addition it is recognized that the existence of insider trading tends to undermine the integrity of the share market generally as the public may exhibit reluctance to participate in a market that is being, at least in part, run to the benefit of a few individuals with privileged access to such information.
The Case for Regulation
It is generally accepted that insider trading is wrong and unethical and ought to be regulated.
It is argued that insider trading should be regulated for the following reasons:
- It gives companies a negative reputation which may affect trading in their securities.
- It interferes with the principle of equality of information in the market as some investors rely on confidential information.
- It amounts to a breach of trust in the case of fiduciaries such as directors.
- It has a negative effect on market confidence and the entire securities sector.
This is on understanding the basis within which companies’ stock trade in the stock market and how price-sensitive information affects the value of a listed company.
In the realm of company law, it may be necessary to regulate insider trading or trading since the insider with access to confidential information is in potential conflict of interest situation, in particular where his position in the company enables him to dictate or influence when the public disclosure of price-sensitive information is to be made.
In such a case, the officer’s decision and his own desire to trade advantageously in the company’s shares may conflict and such conduct is likely to bring the company into disrepute.
It is therefore recognised that it is wrong for a director or any other insider to deal in a company’s securities knowing of some development which is likely to affect the price of the securities which other members of the public are generally not yet privy to.
Liability for Insider Trading/Trading
At common law, officers of the company are free to hold and deal in the shares of the company. However, use of confidential information is actionable.
This legal position is traceable to the decision in Percival v Wright where joint holders of some shares of an unlisted colliery company offered them for sale to the chairman of the company and two other directors at a price determined by an independent value at £12.10 but after conclusion of the sale, it was discovered that while negotiating the purchase, the chairman was involved in discussions of the possible sale of the whole colliery at a price that would have made each share in the company worth more than £12.10. However, the colliery was never sold. In an action by Percival and his co-shareholders to have the sale set aside on the ground of non-disclosure by the chairman, it was held that since the directors owed their duties to the company, there was no duty to disclose. In the words of Swinfen Eady J:
“The contrary view would place directors in a most invidious position, as they could not buy or sell shares without disclosing negotiations, a premature disclosure of which might well be against the best interest of the company. I am of the opinion that directors are not in that position.”
The decision in Percival v Wright was upheld in Tent v Phoenix Property & Invest Co. Ltd. (1984.)
In Multinational gas & Petrochemical Co. v Multinational Gas and Petrochemical Services Ltd. (1983), Dillon L. J. observed:
“The directors stand in a fiduciary relationship to the company and they owe fiduciary duties to the company though not to individual shareholders”.
However, in Allen v Hyatt (1914) where shareholders had engaged directors to invest on their behalf and the directors benefited, it was held that since the directors were agents of the shareholders, they were liable to account to the shareholders.
The challenge of using criminal law to regulate insider trading is that detection of insider trading and procuring its conviction is difficult as evidence is hard to come by.
However a conviction may be secured in obvious circumstances as was the case in R.V Goodman where the accused who was the chairman of the BOD of a company sold his entire shareholding in the company and resigned from office before the company announced that it had made a loss of £ 900,000 in circumstances in which many investor expected it to declare profit. The accused was convicted of insider trading and disqualified from acting as a company director for 10 years.
Both the Kenyan Companies Act and the Capital Markets Act adopt the disclosure principle to regulate insider trading. It is argued that the best weapon to fight insider trading is to ensure that price sensitive information reaches the market promptly.
Although the Companies Act does not recognize the offence of insider trading it provides for disclosure by directors. However these provisions do not go far enough neither do they cover relatives of directors.
The Capital Markets (Securities Public Offers Listing and Disclosure Regulations) of 2002 provide the framework for disclosure by companies in relation to IPOs and continual obligations. They prescribe the contents of the company’s prospects.
Courts of law have enforced the disclosure philosophy embodied in the company’s act. InDiamond V Oreamuno (1969) where directors of the company being aware that due to an increase in expenses, the company’s profit and dropped, sold their share in the company at £28 each before the company’s accounts were released and thereafter the prices fell to £11, it was held that the directors were guilty of insider trading and had to account the profit to the company.
The only justification for insider trading is that it is not wrong to use private information for personal gain as this is the primal basis for the capitalistic markets.
Defences to a charge of Insider Trading
- The trader did not honestly anticipate to make a profit or avoid making a significant loss
- The trade would have been undertaken at the same time with or without the inside information (scheduled trades)
- The trader honestly believed that the information had been made public or the trader utilized public information
- The information was already made public.