Caught in the Net

With the growth of social networks and electronic trading systems, it's easier now than ever before to trip over insider trading prohibitions

This article appears in the August issue of Oilweek

By Peter McKenzie-Brown
If you don’t get caught, breaking the law can pay quite nicely – especially the offense of insider trading. Consider the case of William Bint. As the indexes of publicly traded oil companies were stretching toward their May 2008 peaks, he bought 38,000 shares of Canadian Quantum Energy Corporation at just under $.30 per share. At the close of trading that Friday afternoon – just after he’d bought his shares – Quantum issued a press release disclosing the acquisition of a prospective natural gas property in Québec.

When the markets opened the following Monday, Bint was richly rewarded. He liquidated his $11,110 investment from the previous Friday, netting $156,443 through a few simple trades. From beginning to end, less than a week had elapsed.

Unfortunately for his reputation and his net worth, the Alberta Securities Commission (ASC) investigated and suggested that Bint had benefitted from illegal insider trading. He had, after all, helped negotiate the deal that drove Quantum’s stock price into the stratosphere. After a hearing by an ASC tribunal, Bint agreed to pay an administrative penalty of $234,000 and $5,000 to cover investigation costs. In addition, the commission restricted his trading privileges for two years.

Now retired, Bint is one of eight Albertans listed in the Canadian Securities Administrators’ list of found to have participated in illegal insider trading last year. Six of those prosecuted traded in energy shares. Looking outside the province, last year three Quebeckers were found to have committed insider trading, and so were two Ontarians. No one else in Canada was found to be at fault. Put another way, a province with 10% of Canada’s population was responsible for 60% of the country’s infractions.

Really?
Is this tabulation credible? For example, did absolutely no one in British Columbia trade a mining stock without inside information? That seems unlikely, and it lends support to the idea that the ASC is a very effective commission.

But now consider the case from the other point of view: Forty per cent of the world’s 995 energy companies are headquartered in Calgary, and those companies represent about 30% of Canadian stocks by market value. In all of Canada, are there only six people per year, say, who use illegal insider trading to profit from this dynamic sector? Really?

To find out, I talked to Marc Arseneault – the ASC’s enforcer. As the manager for assessment, market surveillance and investigation, he is responsible for enforcing the rules that apply to this form of white-collar crime. “This is a very difficult problem to investigate” he says. The commission has an insider trading team of five, plus access to legal staff when litigation is required.

"Under our act we can prosecute these cases in provincial court or we can go before an administrative tribunal. Those are the two avenues available to us. We don’t take the case to court unless our evidence is beyond all reasonable doubt. When our evidence is simply a matter of balance of probabilities, we use an administrative tribunal. Those are important distinctions." In either case, the matter is likely to become a matter of public record. For example, tribunal decisions, which summarize evidence and agreed sanctions, are posted on the organization’s website.

Avoiding that kind of public humiliation is a big motivator for those who are caught, and the commission does offer an informal third alternative. According to Arseneault, “Sometimes we have settlement discussions that make the need for an administrative tribunal unnecessary. If we can get someone to give us an admission and agree to sanctions that would be within the proper realm, that frees up resources for us and it works for everyone. If someone says ‘Yeah, I did it’ and is willing to make amends, then we are willing to have that conversation” outside the tribunal process.

“We aren’t here to penalize people,” he says. “Criminal law penalizes. Our goal is to deter people from illegal trading. We aren’t here to punish them, but to discourage them.”

Pace of Change
Insider trading in general is not illegal. If you are a designated insider – a director or executive of a company, for example – you can trade in company shares. You just can’t do it on the basis of privileged information, and you have to report your trades to the ASC within ten days.

Illegal insider trading is different, and it’s is a surprisingly complex problem. It has two elements: first, you have access to undisclosed material information; second, you trade on that information before it is publically released. And critically, you don’t have to be an insider to be guilty of insider trading. You don’t have to be a director or officer of the company to be at fault. In fact, the people caught are rarely corporate executives or directors. They are actually more likely to be outsiders than insiders – for example, employees familiar with a deal or a new development at law firms, investment banks, geological consulting firms, drilling service companies and even printers.

Illegal insider trading and the related infraction of “tipping” are increasingly difficult to control – and part of the problem is partly that they are poorly understood. The key is that if you have access to undisclosed material information you automatically become an insider by virtue of having a “special relationship” with the company.

According to Arseneault “I can’t tip someone if I have insider information. If I (break the rules and) provide someone with that information, I put them in the category of having a special relationship with the company, and their trading would be considered illegal insider trading.” Thus, even if the information you have is fifth-hand and you’ve never even heard of the company in question before, trading on the basis of undisclosed material information makes you guilty of illegal insider trading. If you pass this information on to another person, you’ve committed the offence of “tipping,” which is also subject to fines, sanctions and, in extreme cases, jail time.

The rules are strict. However “because of the nature of the oil and gas industry in Calgary there is a lot of opportunity to trade on insider information,” acknowledges Arseneault. “That information should be contained. Once it gets out of the container, troubles begin” – and that trouble is increasingly difficult to reign in. There are many new platforms on which people can trade, and even micro-cap companies can be listed on a number of exchanges. There is computer trading, there are social networks and there are online sites that promote stocks. Also it’s increasingly easy to put smaller trades into different accounts – your own, but perhaps also those of a spouse or a trusted accomplice – to ward off suspicion.

“The system is evolving very quickly,” Arseneault concedes. “We have to respond to that, so we’re pushing harder.” As evidence of the pace of change, the legislation governing securities regulation has changed several times since receiving royal assent a decade ago. Changes through order-in-council have been even more frequent.

Penalties
Is enforcement more stringent in Alberta or are acts of commission more common? It’s possible that the ASC had more successful prosecutions than Canada’s other securities commissions in recent years because the commission is more vigilant and aggressive in combatting insider trading. It’s also possible that there are more prosecutions in the province because there is a bigger pool of offences. The answer to this conundrum is unknowable, although Gary Leach – the executive director of SEPAC – thinks senior people in the patch have powerful financial reasons not to transgress. “The oil industry is a close-knit community, and you have to have a sterling reputation to succeed. You want to go back to capital markets year after year. One offense will make it a lot harder to do that.” If caught, an offense could also get you fired or expelled from the board.

The ASC’s investigation and enforcement tools seem relatively limited, making the challenge a big one. “We work with other agencies and we have a network of contacts that help us stay informed,” Arseneault explains. “We have to stay on top of the news and the markets. We carry out market surveillance, including real-time computer surveys. We analyse trading in individual stocks, we analyse trading by individuals, we talk to people and we summon documents. This enables us to develop a case.”

Most of the ASC’s cases are generated through market surveillance conducted by the Investment Industry Regulatory Organization of Canada (IIROC) and through post-trade investigations conducted by commission staff. Arseneault is reluctant to provide details about his investigations, but a couple of red flags are obvious. If people have traded in large numbers just before a deal is announced market, share volume spikes. This sends up a flag that IIROC can easily detect. The discovery that an individual under investigation recently opened new accounts for trading is a different kind of flag – one that would greatly interest commission investigators.

Most illegal insider trading is treated under administrative law, and therefore isn’t criminal – but don’t let that lull you into complacency. In 2004 Canada created the first specific Criminal Code offences of improper insider trading and tipping. The legislation also made it a crime to threaten or retaliate against employees who blow the whistle. The legislation applies to the “most egregious cases” of illegal insider trading.

The penalties? Conviction carries up to ten years in the slammer for each offence. Tipping carries a maximum five-year term. They aren’t worth the risk.