Provenco, insider trading and regulators

Martha Stewart and some of Provenco Group’s current and former directors would not normally have much in common. Perhaps they both know that red wine stains are best treated with table salt and ice water, followed by hot water, detergent and non-chlorine bleach and then a gentle cold hand rinse and dry. Much less likely, one would have thought, would have been their sharing claims of insider trading. Yet, so it is. Martha has just spent some time contemplating prison décor for offences related to an investigation of her trading of ImClone shares. Provenco and certain of its directors (two current and one past) have just paid $622,000 to the Securities Commission to settle claims of breaching insider trading laws with regard to Provenco shares. No admission of liability was made and no judgments were entered against the company or directors.

While it may be easy to denounce insider trading as a concept, the reality is more subtle. Trading in a company’s shares while engaged as a director, officer or employee of that company is itself not unlawful. It is entirely proper for these persons (and their associates) to buy and sell the company’s shares. Problems arise however when this trading involves trading with “inside” information, information which is relevant to value and not available to everyone else. “Insider” relates to information, not employment status. Provided the transaction is based on the same information that is available to everyone else then trading is not only lawful but also highly desirable. A director with funds invested in a company for the long term will be more motivated to ensure the company survives and prospers.

To get to the long term however, one must negotiate the short term. Directors, as the ultimate insiders, are not only best placed to push for improved company performance but their knowledge of a company’s probable future performance positions them perfectly to benefit personally from short term opportunities; buying before a share appreciation, selling before a share depreciation or ‘tipping” someone else to do the same. Such behaviour offends two separate principles.

First, directors acts as fiduciaries. This means they occupy a position of trust, managing and controlling assets ultimately owned through the company by shareholders. They must always act in the company’s best interests with due care, diligence and a complete lack of self interest. Secondly, gains achieved or losses averted by the use of inside information amount to misappropriation of market returns from other market participants. This erodes the confidence and trust of all in the integrity of the markets.

Regulation has a clear role to play in punishing insider trading and protecting shareholders. Is Provenco an example of this?

Critics say no. Shareholders saw $300,000 of company funds paid away. No trading with inside information was identified and the directors were neither denounced nor vindicated. There is a hazard that settlements negotiated rather than judgments delivered will prompt “insiders” to see proceedings against them only as a threat to their finances and not to their reputations. Regulatory challenges thus become business costs to be absorbed, rather than damaging and permanent denunciations to be avoided at all costs.

Furthermore, episodes such as Provenco can encourage more directors to take their companies “private” by removing them from disclosure requirements and liabilities attendant upon an NZX listing and/or issuance of securities to the public. Access to capital and talent is increasingly available through private equity structures and investment vehicles where strong self-regulation is achieved by large overlaps of ownership and control.

The counter argument is that under present law, where insider trading is not a crime but cause for civil action, the Securities Commission did very well. It extracted compensation from both the directors and the company for those counterparties allegedly cheated of fair prices by the directors and the company, together with amounts by way of penalty and cost recovery. Shareholders who did not trade were unaffected in any event. Furthermore, such a settlement avoided a pyrrhic victory where a costly judgment is finally reached but nothing is left over for those who suffered loss. With regard to going “private”, such structures are not subject to the same degree of regulation and thus could see investors more likely to suffer from less transparent pricing and hence more trading where information is not equally shared.

Provenco shows that ideal solutions are hard to find. The Institute of Directors is a firm supporter of insider traders being brought to account fully and publicly for their misdeeds. Excellence in corporate governance demands this. Ultimately, the answer must lie within each director. Engaged by a company to exercise judgment and skill with honesty and integrity, directors need to apply these same qualities to their own actions. After all is said and done, and despite Martha Stewart’s ministrations, there are some stains that cannot be removed, and those to one’s reputation and character are the most damaging and the most enduring.