Stealing of Insider Information

In most insider trading cases, the wrongdoers were the listed company’s directors and senior management. However, IT specialists who have the access right to sensitive information should not be ignored.

US SEC recently filed insider trading charges against a former MDS Inc. employee who allegedly stole confidential information about MDS's impending tender offer for the shares of Molecular Devices Corp. (Molecular) and, along with his wife, used that information to trade in Molecular securities ahead of the merger's public announcement.

SEC alleges that Shane Bashir Suman, of Toronto, learned about secret merger negotiations through access he had to electronic data in his job as an information technology specialist at MDS, then gave that information to his wife, Monie Rahman. In the days before the tender offer became publicly known, Suman and Rahman made just over US$1m by trading in the securities of Molecular.

Suman's job gave him access to a vast amount of secret corporate information. In particular, he was able to read the contents of confidential e-mails and other electronic data without detection. For example, the circumstances in which Suman was called to restore an electronic document on Jan. 23, 2007, the day before he and his wife started trading, suggested the code name for the MDS-Molecular merger and the sensitivity associated with that project. Later that day, Suman conducted internet searches for both that code name and for "Molecular Devices". Just after running those searches, Suman called Rahman and spoke to her for 100 minutes, much longer than their phone records indicate they usually spoke.

Between 24 Jan and 26 Jan 2007, Suman and Rahman bought 12,000 Molecular shares and 900 Molecular call options. Brokerage account records indicate that a portion of the Molecular securities purchases were financed with a margin loan of approximately US$200,000, and the couple previously did not have a position in Molecular securities. On 29 Jan 2007, MDS and Molecular jointly announced the tender offer for Molecular's shares. The stock price immediately rose from almost US$24 to roughly US$35, making Rahman and Suman's trades worth more than US$1m.

Enhanced Stock Segregated Account with Statement Service

Following the initiatives taken early this year, HKEx has recently introduced additional features to the Stock Segregated Account (SSA) with Statement Service. Investors who choose to entrust their shares to their brokers or custodians can ask their brokers or custodians to open an SSA in HKEx's CCASS for them.

An SSA is owned and operated by the broker or custodian. In using the SSA service, investors can receive statements directly from CCASS or check any share movement and the balance in their accounts through the CCASS Phone / Internet System. The following new services are made available now.

Electronic Voting

Investors who open an SSA through their brokers or custodians can now enjoy access to an electronic voting service in CCASS. Through the CCASS Phone / Internet System, they can choose to attend corporate meetings, appoint a corporate representative or request HKEx to vote on their behalf through HKSCC Nominees Ltd. Investors can also request CCASS to alert them of any upcoming shareholder votes by sending them messages via SMS or email.

Share Movement Affirmation

Investors using the SSA can opt to use the affirmation function via the CCASS Phone / Internet System to confirm transfer of shares out of the SSA. They can also elect to receive notifications via SMS or emails whenever there are share transfer transactions requiring their affirmation.

Money Settlement

Investors using the SSA can now enjoy the CCASS money settlement service. Through their brokers, investors are able to request settlement on a DvP basis when shares are moved out of the SSA. CCASS will issue electronic payment instructions to the bank account designated respectively by the broker and investor. The money will be credited into the investor's bank account on the next business day.

Removal of Limit on Number of SSAs

To assist brokers and custodians to cater for their clients' demand for SSAs, the number of SSAs that can be opened by each broker or custodian is now removed.

With these further enhancements on the SSA service, the Investor Participant Account will become less attractive.

Human Rights in Securities Regulation

I recently attended a seminar presented by Laurence Li, who is currently a Barrister-at-Law and the ex-SFC director in Corporate Finance Division. He talked about an interesting topic: the conflict between HK's securities regulatory regime and protection of human rights. Over the past years, many challenges to SFC's enforcement action on human rights grounds were not successful until the recent legal case of Koon Wing Yee. Laurence Li published an article about this case in July 2007's "Hong Kong Lawyer". Here I just give a summary.

As the public knows, Koon Wing Yee was the chairman of Easyknit International Holdings and Easy Concepts International Holdings. There had been heavy turnover and substantial price increases in both stocks in the few days before their suspension on 31 Jan 2000. The companies announced that a third party was taking over Easy Concepts on 18 Feb 2000. Upon that announcement, the share prices of them soared by several times.

SFC commenced an investigation into suspected insider dealing and exercised its statutory powers by compelling Koon and others to answer questions during the interviews. Then Financial Secretary directed the Insider Dealing Tribunal (IDT) to initiate the proceedings. IDT admitted SFC's interview records into evidence. In 2005, IDT found that Koon had engaged in insider dealing (including "tipping") and thus imposed heavy penalties (about $48m) on him. Koon was also disqualified to act as a director or take part in the management of any company for 5 years.

Koon appealed to the Court of Appeal. The Court held that IDT proceedings involve the determination of a criminal charge within the meaning of the Bill of Rights Ordinance. That means:

• Evidence obtained by SFC by compulsion from a suspected insider dealer is inadmissible in IDT proceedings.
• IDT can't require a suspected insider dealer to appear before it to give evidence.
• IDT shall apply the criminal standard of proof (i.e. beyond reasonable doubt).

After the commencement of SFO in Apr 2003, SFC can establish the Market Misconduct Tribunal (MMT) to replace the old IDT. MMT can cover market misconducts other than insider dealing, like false trading, price rigging, disclosure of false or misleading information. MMT has the advantages of requiring less restrictive rules of evidence and lower standard of proof. However, the Koon Wing Yee case indicates that MMT's sanction powers are subject to human rights challenges. As Laurence Li said: for the dog to bite civilly, it cannot have teeth.

Whistle Blowing

Since the Enron incident, whistle blowing has become a controversial topic in corporate governance. With whistle blowing arrangement, staff of an organization should be encouraged to report any serious malpractices that they observe, first to their supervisors within the organization and, if that way is not feasible, to external authorities.

This arrangement would alert senior management to malpractices committed by lower levels of the organization, the board to malpractices committed by senior management, and even the outside stakeholders (e.g. shareholders, creditors, regulators, etc.) to malpractices committed by the board.

So how should the whistle blowing policy of an organization be formulated? The UK Corporate Governance Committee of the Commerce & Industry Group (the Law Society’s recognised body for in-house lawyers) has just published a report which seeks to provide such guidance to in-house lawyers on corporate governance.

This report, "Blowing the Whistle", aims to:

• provide an overview of the law on whistleblowing, including: whether employees have a legal obligation to blow the whistle; and if they do so, what protection the law provides them with against victimization or other detrimental treatment by their organizations;
• provide some guidance on how to help their organization to implement a good whistle blowing policy;
• examine the in-house lawyer’s own position as a whistle blower, especially: whether they have a greater legal or ethical obligation to blow the whistle than other staff members? how effectively will the law protect them if they blow the whistle? how should the extent of such legal protection affect their decision whether to blow the whistle? and
• identify gaps in the law protecting whistle blowers.

The report finds that there are some gaps in the law to protect the whistle blowers. In some cases in-house lawyers may have greater obligations than other staff to blow the whistle, but may have less (or no) protection. Compliance officers and money-laundering reporting officers are particularly exposed, because they may have to make disclosures outside of their organisations, and this was not contemplated when the whistle blowing legislation was drafted.

Perhaps owing to cultural differences, whistle blowing is not a phenomenon in Chinese societies. In-house lawyers and compliance officers usually choose to quit for self-protection after identifying serious malpractices within the organization.

Analyst's Employment with Covered Company

Analyst conflicts of interest remains one of the key regulatory issues. Neutrality of research reports is often undermined when the research analyst is under the pressure of investment banking unit. But the problem is more prominent if the analyst receives a direct benefit from the covered company.

NASD censured and fined Wells Fargo Securities US$250,000 and imposed a US$40,000 fine and 60-day supervisory suspension against its former Director of Research, Douglas van Dorsten - for failing to disclose in a research report that the lead analyst on the report had accepted a job at Cadence Design Systems, a San Jose, CA company that was the subject of the report.

NASD also announced that it filed a complaint against Jennifer Jordan, the former Wells Fargo research analyst, for failing to disclose in a series of three research reports that she was pursuing employment and then had accepted a job with Cadence, which was the subject of all three reports. As part of her compensation package with Cadence, Jordan was to receive 15,000 shares of Cadence stock, along with the option to purchase an additional 75,000 shares, once she started working at Cadence.

NASD's disciplinary actions concern three research reports issued by Wells Fargo in February, March, and April of 2005. The subject of the research reports, Cadence, designs semi-conductors for use in the global electronics market. In each report, Jordan was listed as the lead analyst.

From Jan to Apr 2005, Jordan applied for, interviewed for, and then accepted a job at Cadence. On 4 Feb 2005, after Jordan had applied for a job at Cadence, Wells Fargo issued a research report covering Cadence that increased the price target for the company from US$16 per share to US$18 per share. The report did not disclose that Jordan had applied for a job at Cadence. On 2 Mar 2005 - after Jordan had met with Cadence senior management twice to interview for a job with the company - Wells Fargo issued a research report reiterating the $18 per share price target. That report did not disclose that Jordan had applied for a job at Cadence or that she was in employment discussions with the company.

After Wells Fargo issued the 2 Mar 2005 report, Jordan was offered a position at Cadence as Corporate Vice President of Investor Relations. As part of the offer, Cadence agreed to pay Jordan over US$300,000 in salary and bonuses, provide her with 15,000 shares of Cadence stock and an option to purchase 75,000 additional shares, and provide her a US$1m interest-free loan. Shortly after she accepted the offer on 9 Apr 2005, Jordan told van Dorsten and others at Wells Fargo that she had accepted a job at Cadence.

On 28 Apr 2005, Wells Fargo published another research report concerning Cadence. That report raised revenue estimates for Cadence for the second quarter of fiscal year 2005 and increased both revenue and price-per-share estimates for the company for fiscal years 2005 and 2006. On the morning the report was issued, Jordan flew to Cadence's offices to attend a management meeting as a future employee of the company.

Although Wells Fargo and van Dorsten had learned nearly three weeks prior to the 28 Apr report that Jordan had accepted a position at Cadence as Vice President of Investor Relations, that information was not disclosed in the report. In his position as Director of Research, van Dorsten approved the 28 Apr report without requiring that the report disclose that Jordan had accepted a position with Cadence.

Having learnt the lesson from this case, shall analysts be subject to a cool-off period for changing job to a previously covered company?