The Financial Markets Authority (FMA) recently published its views on 'shadow insider trading' and clarifying its regulatory expectations under the Financial Markets Conduct Act 2013 (FMCA). The publication aims to educate market participants on the application of insider trading prohibitions to trading activity involving related issuers, and to reinforce the importance of robust compliance frameworks in maintaining market integrity.
'Shadow insider trading' is not a new concept. However, the publication and guidance (which was unexpected and not subject to consultation) may stifle legitimate behaviour – particularly in the context of capital raising activity where wall crossing conventionally occurs. We set out a summary of the publication below, as well as our comments on implications and our views on the applicable law.
Understanding shadow insider trading
For the purposes of the publication, shadow insider trading refers to the use of non-public, material information about one listed issuer to inform trading in the quoted financial products of another listed issuer, where the two issuers are economically or operationally connected. Unlike traditional insider trading, which involves trading in the securities of the issuer directly associated with the information, 'shadow insider trading' targets related issuers whose share prices may be indirectly affected by the material information, due to a sectoral, operational or financial link.
It should be noted that there is no separate prohibition – the issue falls within the general question of whether the information is material non-public information in respect of the financial products of the issuer that is the subject of the proposed trading or advisory activity. We discuss this further below.
Application of the FMCA
The FMCA prohibits insider trading by 'information insiders', being individuals who possess material information not generally available to the market and who know, or ought reasonably to know, the materiality and non-public nature of that information. The publication sets out the FMA's view that material information about one issuer can, in certain circumstances, constitute material information about another issuer if a reasonable person would expect it to have a material effect on the price of the second issuer’s quoted financial products.
The FMA considers that 'shadow insider trading' may breach the prohibitions on insider conduct under section 240 of the FMCA, including trading, disclosing, or advising/encouraging trading based on such information.
Illustrative scenarios
The publication sets out two illustrative example scenarios of what the FMA considers to be 'shadow insider trading':
- Capital raise scenario: In sectors with a small number of dominant issuers, non-public information about a capital raise by one issuer may materially affect the share prices of its peers. Trading in a peer issuer based on this information may constitute shadow insider trading.
- Merger and acquisition scenario: Knowledge of a confidential merger or acquisition involving one issuer may lead to trading in a comparable peer, anticipating positive revaluation or sector-wide effects. Such conduct may also fall within the scope of insider trading prohibitions.
Regulatory expectations and compliance
The publication sets out the FMA's expectations for market participants, including to:
- carefully assess whether non-public information held about one issuer could be material to related issuers;
- document and review the rationale for trades, especially those outside normal patterns or coinciding with market-moving events;
- maintain robust internal governance and compliance frameworks, including clear policies on the handling of non-public information and sector peer trading; and
- foster a culture of ethical decision-making, with timely disclosure, meaningful trade approvals, and contemporaneous documentation.
Issues with the publication
Uncertain scope: While the publication does not represent a change in the law, it does appear to expand the scope (from the FMA's perspective) of what market participants have generally understood insider trading to be. Traditionally, this has been understood to apply to trading in the financial products of the issuer to which the information directly relates, which could include another issuer if there was a direct link, such as in relation to a contractual counterparty. The publication provides a very broad and undefined set of potential factors that could give rise to a link between issuers, without providing any clear guidance on how much of a link is needed to meet the threshold of 'shadow insider trading'.
Purpose of the publication: The publication suggests that "We understand from market participants that shadow insider trading is common industry practice". This statement has anecdotally caused some unrest in the market. No actual real-world examples or instances of 'shadow insider trading' have been called out, and it is unclear why this has been published at this time. The FMA does not seem to be responding to any particular event, though we understand it is in response to the FMA looking at trading in peer firms of an issuer that occurred during a recent capital raise. Nor is the FMA following a trend of international market counterparts. Outside of the United States (where a recent judgement 1 relating to 'shadow insider trading' is under appeal), there is limited precedent for applying insider trading laws to economically related issuers. It is also unclear whether the FMA is suggesting that market participants have been breaching the insider trading provisions of the FMC Act on a regular basis, which, given it is a criminal offence, would suggest that the market has not been operating at an appropriate standard of market integrity for some time.
Implications
We expect that the publication will result in a number of unintended consequences in terms of the behaviour and conduct of market participants, potentially restricting ordinary course and valid market activity. For example, it is common in the case of a capital raising for significant investors to be wall crossed to assess demand for the purposes of supporting a cost-effective underwriting arrangement and also determining a discount. This certainty supports market efficiency in price discovery for a significant capital raise and underwriting. It is also common for market participants, such as managed funds, who have voluntarily imposed limits on sector weightings (albeit enforced through the FMCA) to reduce their sector weightings if they are to participate in a capital raise, to ensure they are not 'overweight' in that sector once the newly offered securities are allocated. We would of course expect any such participant to comply with the FMCA in adjusting its position.
Given the potentially serious consequences that attach to breaches of the insider trading regime (with potential criminal liability), and the uncertainty that has arisen as a consequence of the publication, it appears that issuers, institutional investors, and fund managers would take a conservative approach to trading and transactions as a result of the positions put forward by the FMA.
We have already heard anecdotal reports of market participants now declining to be wall crossed in connection with any capital raises or transactions as a matter of standard practice as a result of the publication, which will affect the certainty and price discovery for issuers in being able to raise capital.
To alleviate concerns and clarify expectations, it would be helpful for the FMA to reconsider its publication and engage in consultation with the market. We would welcome an opportunity to discuss the FMA's concerns as to what it is seeking to address and how best to address such concerns.
The fundamental question is always whether the information is material non-public information in respect of the financial products of the issuer that is the subject to the proposed trading or advisory activity. That is always a case-by-case assessment and one of fact and degree. It is prudent for that assessment to be made carefully, and records of the decision kept before the activity takes place, particularly if the question is not clear cut on its face. However, in our view this does not necessarily require all of the expectations that the FMA has laid out to be met.
It is also interesting to observe that at the time of publication, while one of the large listed property companies on the NZX is conducting a significant capital raising transaction – stocks in the same sector traded down between 2% and 4.5% on a day when the NZX50 was down 0.8% overall, which suggests it may be quite a high threshold in the majority of cases before the materiality threshold for shadow inside trading is reached, although this is clearly fact and circumstance specific.
If you would like to discuss the FMA's publication on 'shadow insider trading' or how it may impact you or your business, please feel free to get in touch with one of the experts below.
If you would like to discuss the FMA's publication on 'shadow insider trading' or how it may impact you or your business, please feel free to get in touch with one of the experts below.