By Andrew Lumsden, Corrs Chambers Westgarth

SYDNEY: 18 June 2014 - Australia has navigated a tumultuous period of change for the global financial system comparatively well.  But, being spared from the darkest depths of the GFC does not mean the current model does not have shortcomings.  Failures and scandals at home and overseas have eroded trust in the integrity of Australia’s financial markets and its participants.  This is not helped by a general sense that Australia’s equity markets leaks to a greater extent than other global markets.

The objective of the current Financial System Inquiry, chaired by Mr. David Murray, is to examine “how Australia’s financial system could be positioned to best meet Australia’s evolving needs and support Australia’s growth.” In doing so, the current Financial System Inquiry represents an opportunity to recalibrate the philosophy underpinning the financial system.  The FSI can help to move the model beyond simply ensuring that the “most efficient players and processes prevail” – instead it can look to ensure that market participants engage with the system  in substantive compliance with a functioning ethical framework.  In the context of handling of price sensitive information it means managing information in an ethically responsible way.

Leaks happen

ASIC’s report on confidential information contains little that is surprising.  It confirms that while selective disclosure of confidential information, particularly through analyst and investor briefings, remains a significant area of risk there was no evidence of selective disclosure.  What it did find was that the number of leaks reported in the media remains significant. This is rightly recognised as a threat to Australia’s financial system. 

The findings are consistent with the results of ASIC’s report in 2009 that saw it issue Handling confidential information CP128.  In the years since that report ASIC has worked with the market to help develop industry standards on the management of confidential information, for example: Handling confidential, market-sensitive information: Principles of good practice issued by AIRA and the Governance Institute of Australia.  

Despite this work the general perception remains that that “Australia by far is the leakiest market I have ever worked in,” as was reported by Bruce MacDiarmid, co-head of Rothschild Australia, who has worked in Sydney, London, Singapore and Hong Kong. “There is a culture of some people getting information out to the press.”  ASIC however found that overall, Australia compared favourably to Hong Kong in relation to leakage of confidential, market sensitive information and “the Asia-Pacific region as a whole compared favourably to Europe, the Middle East and Asia, but did not perform as well as North America.”  Let’s call that a B-, or “could do better.”

In 2013 a study titled M&A Confidential: What happens when deals leak carried out by Intralinks in conjunction with the M&A Research Centre at Cass Business School and Mergermarket analysed over 4,000 global M&A transactions.  That report suggests that transactional information will continue being leaked for as long as the associated benefits outweigh the costs, or risks.  Indeed, the predecessor to the UK Financial Conduct Authority (the Financial Services Authority - FSA) admitted as much in its 2012/13 annual report on the topic.  So why do deals leak?

Interestingly, the study shows that those deals that were leaked completed with an acquisition premium 18% higher than those that weren’t.  Conversely, if an acquiring company considers the target’s board is dragging its feet, it will leak a deal in order to increase the pressure on its board.

So, while the practice of leaks continues around the world – both buy-side and sell-side – there are significant differences in frequency depending on the jurisdiction in which the leaks take place.  The study also acknowledges that transactions are not directly comparable.

Overall though, that study found that the practice of leaking has declined.  Conversations with those responsible for carrying out deals helped identify key reasons behind this decline. Other than market conditions it seemed the key reason was that despite regional differences, regulation had become far stricter and more actively enforced.

In its report, ASIC provides recommendations to help prevent future leaks.  Given that they largely accord with existing best practice guidance, we doubt the advice will rise above what might be described by some as “a penetrating glimpse of the obvious”.

So what to do?

For most companies the various suggestions probably boil down to:

• Having systems in place to protect confidential, market sensitive information.
• Keeping an insider list when conducting a confidential, market sensitive transaction.
• Making sure all key personnel are aware of their confidentiality obligations.
• Knowing who, how and when people are being sounded on their behalf in relation to a transaction.

ASIC seems worried that many small- to mid-market listed entities did not have specific procedures to deal with transaction-related confidential, market sensitive information, although they usually had more general policies in place regarding confidentiality and continuous disclosure.  Really, that is the reason for leaks in our market?  Frankly, you can have confidentiality policies and other arrangements in place, as ASIC suggests, but as a practical matter the best way to minimise leaks is to involve as few people as possible.  You don’t protect the formula for Coca Cola with a policy, you use a safe!

Already there have been some calls for increased regulation and heightened disclosure requirements in response to ASIC’s findings.  But this begs the broader question of why does market sensitive information continue to leak?  Is the Australian market different from other markets?  And is increased regulation, larger penalties or a bigger regulatory budget for enforcement the best path forward?

In fact, after concluding that the existing ASIC and (plentiful) market guidance on the topic is “largely sound”, ASIC’s solution is a renewed focus on enforcement efforts and to continue urging entities, their advisers, and analysts to comply with their existing obligations – a call on everyone to ‘please, be more vigilant’.

No doubt, analysts and companies alike will watch their step until ASIC’s report moves out of the headlines.  Then it may simply be a matter of time before individual self interest again overrides compliance.

The current framework

Since the Wallis Financial System Inquiry ASIC has been the sole market regulator.  Responsibility for consumer protection in the financial services sector was moved to it from the ACCC in 2001, giving it exclusive jurisdiction in this area.  ASIC regulates market integrity and consumer protection in the market through a legal framework that relies on the Corporations Act, provisions designed to control continuous disclosure and insider trading and the more general obligations on market participants through AFS licensee obligations. 

Consistent with the findings of the Wallis Financial System Inquiry, ASIC’s objective is to balance competition, innovation, and efficiency with market stability and the protection of consumers.  Ultimately, this system is predicated on legal obligations (derived from broadly applicable, generic principles) which are imposed on all market participants.

This is a structure-centric system in which market participants self-police based on rules and principles.  However, rules are not always honoured and there is little genuine expectation that confidentiality will be preserved.  People involved with transactions half expect someone to break ranks and leak the story to the press, usually for reasons resembling little more than shameless self promotion or the particular interest of one side to a transaction.  What we seem to lack is an effective mechanism with sufficient scope and function to ensure accountability.

In the UK, where there has been an acknowledged improvement, the FSA (as it then was) went after the problem with some gusto:

Our enquiries revealed that media reports containing leaks were often closely preceded by telephone conversations between insiders occupying senior roles on a corporate transaction, and the journalists who published those media reports. Due to their position as insiders, these senior individuals held detailed knowledge of the transaction. The calls between the insiders and journalists lasted up to 20 minutes in length and in some cases took place with journalists the afternoon or evening before the leak was first published. Such suspicious communication between the insiders occupying senior roles and journalists is a cause for concern, especially in the context of the level of leaks that occur in our markets. While we acknowledge that some of the insiders we identified as speaking to journalists may have been asked to confirm details the journalist already held, insiders who confirm information put to them by a journalist still potentially commit market abuse as they are in effect disclosing inside information through affirmation (even though the information was sourced first elsewhere).

In the end, in addition to recommending robust and detailed policies and investigating leaks, the FSA concluded that addressing cultural aspects of the issue was important as well, stating that it was essential for regulated/unregulated firms and issuers to ensure that senior management establish a robust anti-leaking culture in their organisations. 

Percentage of UK Bids Displaying Significant Pre-announcement trading

Source: Intralinks Survey 2013

The 2013 Intralinks report M&A Confidential suggests that the FSA policy has had some effect – see the chart.  The report quoted an unnamed source as saying:

Earlier everyone just accepted deal leaks in the UK, but not now. The government has come down hard on deals that were leaked and I believe there will now not be a large disparity in the number of leaks seen in the UK and US. It’s not only the government, as companies in the UK have also become more responsible and therefore the probability of a leak has reduced.

What would it take for people to say the same thing in this market?

Recalibrating the system- Murray?

There is room for the current Financial System Inquiry to consider recommendations beyond simply being more vigilant in maintaining the status quo.  Doing so may not be futile - ASIC itself stated that the current Financial System Inquiry “provides an opportunity to reconsider some of the philosophical or economic underpinnings of the financial system and associated financial regulation”  Perhaps, to fulfil its mandate and properly position Australia’s financial system for the future, the current Financial System Inquiry should consider including in its recommendations a shift from the present system to one with an embedded ethical restraint on misbehaviour.  This is consistent with the comments of Pamela Hanrahan and Justin O'Brien calling for a new philosophical underpinning for the regulation of the financial system, one that would help to move the behaviour from ‘ethic of obedience’ rather than an ‘ethic of conduct.’

Could it be a philosophy founded on an explicit fairness standard?  Such a concept is not new; fairness underpins our insider trading and continuous disclosure rules.  Without them, potential investors might consider that the markets operate on the strength of "insider" information, a perception of informational disadvantage sufficient to deter them from investing.  The fairness principle says that for a market to operate efficiently, its participants and potential participants must have trust in its ability to function equitably.

The confidence that investors have in the fairness of the securities markets has a significant impact on the amount of capital available for businesses to use.  If the general public believes that investing is for a privileged few who can profit from insider connections, the result may be limited investment and limited economic growth.  In contrast, one of the explanations economists provide for the abundant capital available in the U.S. markets is the public’s perception that the financial markets are basically fair.

The concept of trust in markets and its role is also explored by O’Brien when he says:  the current FSI allows for a much more holistic approach to regulatory design, revisiting in the process the extent to which the underpinning philosophy envisaged by Wallis remains justified.

By all means, persist with the present approach, which will predictably involve strengthened regulations, enhanced disclosure requirements and more reports, but that does not seem to be getting us where we need to be, it is not restoring trust.  Instead, we need a stronger philosophy that underpins a narrative about the duties, responsibilities, and rights of individuals and institutions when it comes to handling sensitive information.

As ASIC says, leaking confidential, market sensitive information about a proposed corporate transaction ahead of a market announcement threatens market integrity because it impairs the flow of market sensitive information to the market in an equitable manner.  The current Financial System Inquiry should see this as part of its mandate and foster a corporate, professional and regulatory framework that is capable of providing reasons for behaving in an ethically responsible manner when handling price sensitive information.

Andrew Lumsden and Dylan Vandervecht are from Corrs