How pervasive is insider trading?

WHEN a stock rises or falls in unusual fashion prior to a major corporate announcement there are invariably complaints that the information was somehow leaked. And the talk is that insiders have benefited, either by buying or selling before the rest of the market. Because this is unfair and undermines confidence, calls are then made for regulators to investigate.

However, once the dust has settled and the clamour for official intervention subsided, there is usually resigned acceptance that because proving insider trading is so difficult, pushing for official probes would probably be a waste of time. As time passes, such incidents of what could have been insider trading are then forgotten.

Just how widespread is insider trading? Speak to market observers here and the response anecdotally is that it is fairly common. One dealer said: "It goes on all the time." This is arguably neither here nor there but over in the US, three North American finance professors recently attempted to answer this question through rigorous statistical analysis.

Professors P Augustin, M Brenner and M G Subrahmanyam in their May 2014 paper "Informed Options Trading prior to M&A Announcements: Insider Trading?" (reported in The New York Times on June 16, "Study asserts startling numbers of insider trading rogues") examined trading in the options market up to 30 days before M&A announcements and found that about 25 per cent of deals may involve some kind of insider trading.

The researchers also found that the Securities & Exchange Commission (SEC) litigated only 4.7 per cent of the 1,859 M&A deals in the study, that the average profit from insider trades was US$1.6 million, that the average insider transacts 16 days before the announcement date and that it took the SEC an average of 756 days or just over two years to publicly announce its first litigation in a given case.

To lend support to these findings, it was also calculated that the probability of such trades occurring through sheer chance was three in one trillion.

The suggestion from these findings, of course, is that US regulators are woefully behind the curve when it comes to prosecuting insider trading - not overly surprising, as was evidence that the SEC is more likely to prosecute the bigger deals since being resource-constrained, the regulator prefers cases which offer the biggest "bang for the buck" and are more widely covered in the press.

However, even though regulatory action appears slow and overly selective, once insider trading was proven, the penalty was on average US$3.5 million - more than twice the average profit and so painful enough to convey some sense of justice having been served.

The relevance in the local context of such a study should be obvious - ever since the US Federal Reserve announced in May 2013 that it was to taper its money printing, the consequent withdrawal of cash from these shores in favour of Western markets has meant the local market has had to rely on its own internal steam to keep the ball rolling.

In this regard, the corporate sector has not disappointed - since May last year there have been plenty to get traders excited. There have been reverse takeovers, large-scale investment in small companies by bigger, stronger names, the taking private of several financially sound firms by parent or controlling shareholders, dozens of rights issues and placements, profit-guaranteed agreements and various mega deals with eye-catching headline numbers.

All have helped keep alive flagging interest in the local stock market; all have offered insiders the potential to benefit illegally from privileged information.

Since there are no concrete indications that foreign money is looking to return in any big or lasting manner to emerging markets - at least not yet - it is to such corporate announcements that the local market will look in the days and months ahead for support and to keep interest alive.

Clearly, local regulators will have their work cut out for them, keeping an eye out for suspicious trades as more companies unveil projects, tie-ups and M&A deals to boost share prices.

After all, if one in four material announcements in the US probably involves insider trading, what might the proportion here be?