A weak law is an opportunity missed. A study by academics at Indiana University in the US shows that the cost of capital in markets with a strong insider-dealing regime can be 5% lower than in those without.
Conviction rates for insider dealing in Europe are dismal. In the UK, for example, only 12 convictions have been secured against insider dealers during the past five years. Across the entire EU, there were only 19 convictions in the years 1995 to 2000.
The EU directive on insider dealing, which is due to take effect this month, is unlikely to improve this. The root of the problem is the directive’s requirement that companies disclose all inside information. The thinking goes: no inside information, no insider dealing. This seems a good idea in principle. But regulators have been forced to narrow the definition of what is and what isn’t inside information to ease the disclosure burden on issuers.
It has fallen to the Committee of European Securities Regulators (CESR) to set the details of the single test on which the directive is based. Under the Lamfalussy plan for financial lawmaking in Europe, the European Commission will pass CESR’s advice into law.
To begin with, CESR stuck to a broad test. But lobby groups, notably the City of London Law Society, said the disclosure requirements for companies would be unfair. Issuers would be forced to publicize events that would have no material impact on their business but might lead investors to sell stocks, they said.
So the regulators narrowed the definition to include only information that a reasonable investor would consider when buying or selling securities.
Take UK construction company Wolseley, whose share price fell by 12% last September after it announced asbestos liabilities, even though profits were up 15% and the company was insured against any damages. (There has been no suggestion of insider dealing in Wolseley stock.) Under the new rules, an insider could have got away with dealing in its stock before the announcement by claiming that a reasonable investor would discount the information on asbestos as immaterial. A reasonable investor would have ignored it because Wolseley had adequate insurance.
But investors and markets aren’t always reasonable and the asbestos news did move the stock price.
Weaker than now
European regulators admit that the inside information test in the final directive will be even weaker than some existing laws in individual EU countries. “The UK market abuse regime outlaws dealing based on relevant information,” says one regulator. “But sometimes what is deemed relevant might not come up to the bar set by a price-sensitive test like CESR’s.”
Professor Juan Fernández-Armesto, who chaired the working group of European regulators that drafted the original directive for the Commission, says: “The reasonable investor test is technically unfortunate. It looks like the result of last minute lobbying. It does not improve the test, and creates additional confusion in the minds of the judges and regulators who apply the law. As such, it is an additional hurdle to enforcement.”
The worry is that regulators will let through transactions that would previously have been precluded as insider dealing because they have got one eye on companies managing disclosure. William Underhill, a partner at law firm Slaughter and May in London, says: “The changes are a good thing from an issuer’s point of view, but they have considerably weakened the insider dealing regulation.”
Blaming the CESR for this may be unfair. The regulators were limited by the framework legislation passed down from the European Commission. The decision to tie insider dealing and corporate disclosure rules together in the framework directive caused the problem, which cannot now be undone.
In its comments on the CESR’s consultation document leading up to the January advice, the City of London Law Society made the point well. It said: “By adopting a single standard of inside information to define both the issuer’s duty to disclose and the scope of insider dealing there is a real risk of either imposing a requirement on issuers which is wholly impractical or significantly limiting the scope of the insider dealing prohibition.”
Nigel Phipps, a member of the CESR secretariat responsible for drawing up the committee’s advice on the market abuse directive, admits: “If CESR had used a professional investor test, companies might have been forced to disclose if they produced even one less widget than before. We believe [the reasonable investor definition] strikes the right balance between the need to keep the market informed and damaging market integrity through an endless flow of detailed information.”
Nevertheless, sources close to CESR suggest that not all its members were entirely comfortable with the one-test-only approach taken by the directive.
Is there any solution? One option would be to broaden the single test so it would catch all information that would affect prices. This would be bad for companies. But lawmakers could then extend exemptions that allow issuers to delay disclosure of inside information, which at present cover circumstances such as merger or restructuring negotiations, where disclosure could scupper a deal or lead to the collapse of the business.
For now, though, it seems Europe is stuck with the directive as it stands. “We are too far down the line,” says a UK lawyer. “You have to make it work the best way you can.”
Rob Mannix (mannix@iflr.com) is editor of International Financial Law Review
