Chapter 2 Literature Review and Regulatory Framework
2.2 The Regulatory Framework of Directors’ Trades in the US and UK
2.2.1 The Regulatory Framework of Directors’ Trades in the US
In the US Insiders are defined as officers, directors, other key employees, and shareholders holding more than 10% of any equity class (Lakonishok and Lee, 2001) and insider trading is regulated by the SEC with the 1934 Securities and Exchange Act and its amendments imposing restrictions on insider trading. The essence of the US rules on insider trading is that insiders must either abstain from trading on undisclosed information or release this information to the public before they trade (Hu and Noe, 1997).
In the US insiders only have to report their holdings within the first 10 days of the month following the month of the trade (Persons, 1997). Insider transactions are published in the SEC's online Insider Trading Report. Chang and Suk (1998) noted that trades normally appear in the online report the same day that the SEC is informed, then shortly afterwards the information is published in the Wall Street Journal and other publications.
In the US the Insider Trading and Securities Fraud Enforcement Act (ITSFEA) of 1988 raised the maximum fine for insider trading to $1 million and 10 years imprisonment in response to frequent violations of the existing insider regulations. The Act also placed the liability for illegal insider trading by any of the company's employees with the top management.
The Sarbanes-Oxley Act of 2002 (hereafter SOX) constitutes a far-reaching federal law aimed at improving the reliability of corporate governance and the financial reporting process in the US. Until August 2002 the reporting requirements consisted of filing a Form 4 to the SEC within 10 days after the close of the calendar month in which the transaction occurred, which could result in a delay of up to 40 days. Section 403 of SOX amends this provision of Section 16(b) of the Exchange Act of 1934 as of August 29, 2002 by requiring
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insiders to file their Form 4 to the SEC within 2 business days of the transaction date. Furthermore, effective from June 30, 2003, Form 4 must be filed electronically, and companies with websites are required to post information online about the trades the day after they are filed with the SEC.
2.2.2 The Regulatory Framework of Directors’ Trades in the UK
Director trading in the UK is regulated by The Companies Act 1985, The Criminal Justice Act 1993 (Part V), The Financial Services and Markets Act 2000 and the Listing Rules for publicly listed companies on the London Stock Exchange (LSE).
Under the Criminal Justice Act 1993, when a director has inside information acquired by virtue of his/her employment, office or profession, he/she is prohibited from dealing in any securities that are affected by that information. Inside information, broadly defined, is specific or precise information about particular securities or an issuer that has not been made public and would be likely to have a significant effect on the price of those securities if it were made public. Directors must also not disclose inside information, except in the proper performance of their job. Breach of the Criminal Justice Act is a criminal offence punishable by imprisonment or a fine or both.
The Companies Act 1985 specifies that a director is obliged to disclose to the company any interests in its securities. They must notify the company of all changes in those interests and of dealings connected with them within five business days. The company must keep a register of the interests notified, which must be kept available for inspection. Under the listing rules for companies trading on the LSE, the company must notify a regulatory information service (RIS) of interests and changes in those interests before the end of the next business day following receipt of the information from the director. Guidance for companies and directors is available in the Continuing Obligations Guide and the Price Sensitive Information Guide which can be obtained from the FSA. From 15 April 2002 a new mechanism for disseminating regulatory information became effective, allowing listed companies the choice of which RIS to use to disclose their regulatory information to the market. The RIS
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providers include: Business Wire Regulatory Disclosure, Newslink Financial, PimsWire, PR Newswire Disclose, and the Regulatory News Service (RNS) provided by the LSE.
Listing rules also require that listed companies must have a code of dealing in securities that meets the minimum standards set out in the model code. Directors must not deal on considerations of a short-term nature, or during a two-month ‘close period’ before the announcement or publication of the annual report, the half-yearly (or quarterly) results, or when the director is in possession of unpublished price-sensitive information about the company’s listed securities, or before receiving clearance from the company chairman or other designated director that the proposed dealing may proceed. The model code requirements are more extensive than the prohibitions on insider dealing in the Criminal Justice Act 1993.
The Financial Services and Markets Act 2000 (FSMA) provides the statutory framework for the new UK market abuse regime, which became effective on 1 December 2001. Under the market abuse regime introduced by the FSMA, the FSA can impose penalties on companies or individuals. These may comprise either an appropriate financial penalty or a public censure.
The FSA may also apply to the court for injunctions or restitution orders in cases of market abuse. Market abuse is widely defined and includes behaviour by a person in relation to securities traded on the LSE that amounts to misuse of information, the creation of a false or misleading impression, or market distortions.
Since July 2005, the FSA has implemented the market abuse directive (MAD). The MAD is an important part of the EU financial services action plan, which aims to introduce a common approach to prevent and detect market abuse, including insider trading. The MAD is the Directive of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation (market abuse) (No. 2003/6/EC). The existing UK regime is generally considered to be more extensive than the MAD and therefore the MAD regime has been superimposed over the existing UK structure. However,
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the MAD insider dealing provisions are more specific than the UK regime. The revised definition of inside information is that it is information of a precise nature which, is not generally available, relates directly or indirectly to one or more issuers of qualifying investments or to one or more of the qualifying investments and would, if generally available, be likely to have a significant effect on the price of the qualifying investments or on the price of related investments (e.g. derivatives). The MAD requires an issuer and persons working on its behalf to draw up a list of those persons working for them who have access to insider information relating to the issuer on a regular or occasional basis. If requested, the issuer must provide this list to the FSA. The list must identity each person who has access to inside information, the reason why such person is on the insider list and the date on which the list was created and updated.
In summary, there are substantial differences between the US and UK regulatory framework on insider/director trading. Among these, a very important difference within the UK regulatory regime is that unlike the US, ‘insiders’ are more broadly defined, and in particular include large shareholders, who are subject to the same reporting requirements as company officers and directors. The UK also discloses director trading information to the public more quickly than the US system, even after the execution of SOX.
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