Recent actions by the US Securities and Exchange Commission (SEC) against Gulf investors and businessmen, and the unfortunate death of Hazem Khalid al Braikan of Al Raya Investment, apparently by suicide arising from his alleged connections to an illegal insider trading case lodged by the SEC, have highlighted the shift of regulators from "light touch" to active enforcement of their regulations, as they seek to re-build trust in the markets.
Starting in the US, Saudi Arabia and Kuwait, regulators are flexing their muscles and showing companies their resolve to implement market-strengthening regulations. In the post-Bernie Madoff world, regulators know that insider trading is bad for markets as it discourages transparency, indicates an unfair playing field, and kills investor trust and confidence. But what exactly is insider trading? In a capital market system based on "equal access to information" for all investors, abuse of insider information drives investors away from the market. Liquidity is achieved by the common belief among participants that no investor has "special information". If investors believe that they will always lose out to those with superior information, they will not invest.
Put another way, governments provide limited liability protection to corporations and allow access to the savings of the public in exchange for a commitment by the corporation's board and management to treat the public fairly and abide by certain rules, namely to run the enterprises for the interest of all shareholders. Management has a "fiduciary relationship of trust" to behave that way. That process is "good corporate governance". If both sides play by the rules, the corporation has dependable access to liquid sources of capital, which generate investment returns that ultimately benefit the society as a whole.
The basic structure of today's insider trading rules stems from Section 10(b) of the US Securities Act of 1934, as interpreted by the SEC and the courts. It is fairly simple to state but complex in application. There are three categories of "bad" behaviour. The standard case is when a person who is an officer, director, or similar has knowledge of information, an event or act that has a "material" impact on the company which is not known to the public, and acts to gain profit or reduce loss.
The second case, the "tipper/tippee" situation, occurs when "inside" information is passed on to an outsider who then acts upon that information. For the person who receives the inside information to be held accountable, the recipient must know that the person who gave him the information has breached his duty. In practice this is very difficult to prove. Third is the "misappropriation" case, where an outsider receives information from any source to which the recipient owes a "duty of trust and loyalty" and uses it to trade for his own benefit. This is the category into which lawyers, accountants, consultants and public officials usually fall.
The Hawkamah Institute for Corporate Governance partnered the Institute for International Finance (IIF) to survey the corporate governance framework in the GCC markets in 2006. One of the notable recommendations was the need for regulators in the region to work together to strengthen capital markets in the GCC, particularly by eliminating structural weaknesses such as by requiring companies to obtain credit ratings for debt issuances, developing stronger IPO markets through book-building measures with the help of investment banks, and providing better oversight of mutual fund managers to prevent front-running. We also recommended developing and enforcing insider trading laws.
There have been a number of initiatives to further define insider trading and create anti-insider trading legal frameworks in the GCC, with Oman and Bahrain introducing frameworks as early as 2007 and Saudi, UAE, Kuwait and Qatar respectively following suit. Regulators have recently started clamping down on rogue traders. Stepping up enforcement action by regulators is a confidence-building measure. The developing insider trading framework will be tested through the courts and administrative proceedings. However, traditional courts and the judiciary will typically be unfamiliar with dealing with insider trading cases.
I am in favour of setting up specialised financial courts with appropriately trained judges. Stricter enforcement and punishment are important for the rule and respect of the law. The key point, however, is that insider trading is difficult to prove and is more prevalent in a climate of poor disclosure. Improved transparency by companies with full and timely disclosure on all material matters will do more to reduce the opportunity and incentive for insider trading than tough enforcement of laws and regulation. Better disclosure by companies is still a key challenge for the region: as much as one third of GCC listed companies do not have a publicly available annual report in English, nor a website.
A corporate culture of secrecy and relationship-based transactions still prevails in the region. The main idea behind insider trading frameworks is to clarify the distinction between what is confidential or inside information and what information should be publicly disclosed. Individuals that may come across what would be considered "insider information" should be beholden to act responsibly. Transparency, fairness, accountability and responsibility are core governance values that help build trust in businesses and modern financial markets. As the region's capital markets take to the global stage, we need to internalise these values and start looking at our old habits with an eye towards reform.
Dr Nasser Saidi is director at Hawkamah Institute for Corporate Governance and chief economist at the Dubai International Financial Centre
