Corporate lenders – a new focus for insider trading?
The Australian Securities and Investments Commission's enthusiasm for insider trading cases and the difficulties of managing Chinese walls ought to give hedge and private equity fund managers pause. In the United States the growth of activity by private equity and hedge funds in the debt and quasi-equity market has resulted in the Securities Exchange Commission reviewing one situation and it's unlikely to be unique.
Like the SEC, it is likely that ASIC will be closely watching private equity and hedge funds. These funds have become active lenders in the Australian market, offering alternative sources of debt and quasi-debt funding to companies such as Advance Healthcare Group Limited, Nylex Limited and PBL Media. Often, the debt will be structured to provide a yield as well as an opportunity to participate in increased equity value via the ability to convert debt into shares.
Apart from the funding structure itself, one of the key differences between being a debt provider and being a shareholder is the level of information the borrower is required to provide. Typically, a lender will receive more frequent and more detailed financial information than anyone outside of the key management team. Generally, this information will be material and price sensitive.
Of course, being in possession of inside information is not of itself a problem. The difficulty arises when someone with inside information deals in those securities. Where lenders who possess inside information are also in the business of trading the debt or trading the company’s securities, or where the debt instrument itself can be converted into securities, the potential for trading on the basis of inside information is significantly increased.
In the case of the US movie rental chain company, Movie Gallery it is currently receiving attention by the SEC. In early March of this year, Movie Gallery held a private conference call with its lenders, most of whom were hedge funds, to discuss the company’s poor results for 2005. Over the 2 day period following the call, Movie Gallery’s shares were heavily traded and its share price fell by 25%. However, the company didn’t announce its earnings results to the public until nearly two weeks after the private call with its lenders. The SEC is now investigating whether any of the lenders traded on the basis of their inside knowledge of the company’s poor trading results.
If there are Chinese walls in place a fund will not breach the insider trading rules merely because one of its employees has inside information and another employee trades. What they need to establish is that the person with inside information is not involved in trading decisions and there are adequate arrangements in place to ensure that inside information is not communicated to those who are and that therefore no benefit has been unfairly obtained by having the inside information.
The critical question is how effective are the Chinese walls? Do they really prevent the inappropriate use of inside information? To have any effect the arrangements need to be established with clear protocols and those protocols must adhered to and monitored. There needs to be a clear separation between those who possess or have access to inside information and those who make trading decisions.
While it may be possible to implement such arrangements within large organisations that can physically separate different work groups, clearly this is much more difficult to achieve for organisations operating with small teams, as is often the case with private equity/hedge funds.
Even where Chinese walls can be established, they do not provide absolute protection from liability. It is virtually impossible to prevent staff members from coming into contact with each other and potentially communicating inside information. If you possess inside information at the time of making a transaction, it is no defence to say that you did not use or rely on that information at the time.
For the majority of private equity/hedge funds, the ‘pared back’ styles of doing business will create a real problem when they need to show effective Chinese walls. A two person team sitting next to each other are never going to be effectively separated by a wall, let alone a Chinese wall.
Like the SEC, it is likely that ASIC will be closely watching private equity and hedge funds. These funds have become active lenders in the Australian market, offering alternative sources of debt and quasi-debt funding to companies such as Advance Healthcare Group Limited, Nylex Limited and PBL Media. Often, the debt will be structured to provide a yield as well as an opportunity to participate in increased equity value via the ability to convert debt into shares.
Apart from the funding structure itself, one of the key differences between being a debt provider and being a shareholder is the level of information the borrower is required to provide. Typically, a lender will receive more frequent and more detailed financial information than anyone outside of the key management team. Generally, this information will be material and price sensitive.
Of course, being in possession of inside information is not of itself a problem. The difficulty arises when someone with inside information deals in those securities. Where lenders who possess inside information are also in the business of trading the debt or trading the company’s securities, or where the debt instrument itself can be converted into securities, the potential for trading on the basis of inside information is significantly increased.
In the case of the US movie rental chain company, Movie Gallery it is currently receiving attention by the SEC. In early March of this year, Movie Gallery held a private conference call with its lenders, most of whom were hedge funds, to discuss the company’s poor results for 2005. Over the 2 day period following the call, Movie Gallery’s shares were heavily traded and its share price fell by 25%. However, the company didn’t announce its earnings results to the public until nearly two weeks after the private call with its lenders. The SEC is now investigating whether any of the lenders traded on the basis of their inside knowledge of the company’s poor trading results.
If there are Chinese walls in place a fund will not breach the insider trading rules merely because one of its employees has inside information and another employee trades. What they need to establish is that the person with inside information is not involved in trading decisions and there are adequate arrangements in place to ensure that inside information is not communicated to those who are and that therefore no benefit has been unfairly obtained by having the inside information.
The critical question is how effective are the Chinese walls? Do they really prevent the inappropriate use of inside information? To have any effect the arrangements need to be established with clear protocols and those protocols must adhered to and monitored. There needs to be a clear separation between those who possess or have access to inside information and those who make trading decisions.
While it may be possible to implement such arrangements within large organisations that can physically separate different work groups, clearly this is much more difficult to achieve for organisations operating with small teams, as is often the case with private equity/hedge funds.
Even where Chinese walls can be established, they do not provide absolute protection from liability. It is virtually impossible to prevent staff members from coming into contact with each other and potentially communicating inside information. If you possess inside information at the time of making a transaction, it is no defence to say that you did not use or rely on that information at the time.
For the majority of private equity/hedge funds, the ‘pared back’ styles of doing business will create a real problem when they need to show effective Chinese walls. A two person team sitting next to each other are never going to be effectively separated by a wall, let alone a Chinese wall.
posted by Andrew Lumsden @ Wednesday, December 06, 2006
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