SYDNEY: 6 December 2013 - Insider trading has been a recurrent news item in the US and Australia with large financial penalties or gaol time catching attention.  One eye-catching headline has been the US case of SAC Capital which entered into a plea agreement with the Department of Justice that involved SAC paying $1.8 billion (of which $616 million had already been paid to the Securities and Exchange Commission) and agreeing not to manage any outside money.  Another high profile case has been the litigation against Raj Rajaratnam and his New York-based hedge fund Galleon Management that ensnared corporate executives, consultants, rating agency personnel, proprietary traders, hedge fund executives and public relations personnel.  However, insider trading is not just being pursued against a few large targets.  The SEC brought 58 insider trading actions in financial year 2012 against 131 individuals and entities. Over the last three years, the SEC has filed more insider trading actions (168 total) than in any three-year period in the agency's history.

Similarly in Australia, insider trading has become a major focus of the Australian Securities and Investments Commission.  ASIC’s report on enforcement outcomes for January to June 2013 stated that it had brought 19 criminal and 1 civil action for insider trading between 1 July 2011 and 30 June 2013 and would “continue to dedicate significant resources and the energy to fighting this crime”.  Penalties for contraventions are becoming more serious as shown by the Crown appeals against the inadequacy of the sentence in R v Donald and R v Glynatsis.  In both cases the Crown successfully argued that a custodial sentence should be imposed. 

Insider trading has historically been notoriously difficult to detect due to its clandestine nature.  However, technology and greater powers for regulators has meant that the possibility of detection is increasing.  Why should companies be concerned with the possibility that their employees may be prosecuted?  Directors may say that they cannot be the guardians of a large group of typically highly motivated and intelligent individuals who, if they choose, will find a way to circumvent the system.  However, a finding of insider trading reflects on the culture and compliance of the organisation.  To some degree it taints trust in the organisation.  It is a classic reputational risk.  

However, it can also directly lead to litigation involving the company and the directors.  Civil penalty and criminal prosecutions can be brought against the corporation as well as individuals.  A breach of director’s duties may follow if there has been a failure to exercise care and diligence.  In today’s environment, contraventions that impact share price may also give rise to class actions. 

Having recognised the need for the corporation and its directors to guard against insider trading, is it sufficient then to merely rely on the existence of a company Insider Trading Policy as a defensive mechanism?  In our view, probably not, as directors will need to be able to demonstrate that they have taken positive action to ensure that key legislative requirements and company policy have been brought to life in the company, and received assurance that key laws and policies are understood and applied.

The Board must gain an understanding of business operations and ensure that there are appropriate systems for the timely flow of information.  This includes a proper system of oversight of the culture that needs to be in place to support adherence to the relevant law or company policy.  It must ensure appropriate resources and processes are available and actually used.  For example, training in compliance with the insider trading policy must not just be available, it must be undertaken.  Application of the policy to a range of circumstances by employees must be tested.

The Board also needs to concentrate its mind on the risks of particular operations – particularly those that are “high risk”.  It cannot simply rely on management to undertake this assessment; the Board must take reasonable steps to identify and predict potential risks and address them.  In relation to insider trading this can start by simple things such as identifying who comes into possession of inside information in the organisation.

The Board cannot merely hope management and employees will do what they are told –  it must undertake probative inquiries to determine the effectiveness of the policy by establishing a process for both formal and random reviews and audits to ensure adherence to policies and procedures. Directors may need to seek independent appraisal of the company’s risk management processes, including those aimed at preventing insider trading, so as to obtain independent evidence of the effectiveness of policies and procedures.

It is up to Boards to look carefully at the assurance they receive.