20 October 2018
Insider trading was not criminalized in Hong Kong until 2003, and conviction didn’t occur until five years later. Photo: Bloomberg
Insider trading was not criminalized in Hong Kong until 2003, and conviction didn’t occur until five years later. Photo: Bloomberg

Why HK needs to get tougher on insider trading before China does

He was called the Warren Buffett of China, as well as the Carl Icahn of China. But there were telltale differences.

Neither Buffett nor Icahn purported to have earned 4,000 percent fund returns since 2010. Neither Buffett nor Icahn seems likely to captain a group of risk-loving hedge fund managers called the “Limit Up Kamikaze Squad”.

And neither Buffett nor Icahn has been arrested in a manhunt that ended with the closure of one of world’s longest bridges for 40 minutes.

“Kamikaze” ended up being an accurate term for Xu Xiang, who became a billionaire and one of China’s most prominent fund managers by allegedly investing with more than just intellect, hard work and skill.

If the allegations of insider trading are true, Xu Xiang is obviously responsible for his own undoing. But a change in attitudes from the Chinese government helped.

The initial catalyst was simple: Beijing was unhappy with the collapse of the A-share market this summer, so it sought out “culprits” to punish.

But regardless of the reason, China is suddenly moving seriously to prosecute insider trading. Hong Kong needs to pay attention.

Hong Kong: a ‘paradise’ for insider trading

Although Hong Kong’s stock exchange is 100 years older than Shanghai’s, it didn’t see its first insider trading prosecution until 2008.

Prosecutions in Hong Kong started rising in 2013 after the Securities and Futures Commission implemented a special task force, but this may not be enough considering China’s newfound momentum. Hong Kong needs to do more.

Both markets still suffer from rampant insider trading, but Hong Kong’s reputation depends on its being the clean, well-regulated brother of mainland China — a trusted bastion of capitalism and proper order.

Hong Kong — a city The Economist magazine dubbed “a paradise” for insider trading — faces a sluggish stock market, demographic challenges, slow GDP growth, and worries about China’s gradual encroachment. At a time like this, it can’t afford to fall behind its northern neighbor.

Besides, isn’t enforcing the law something any government should be doing in earnest anyway?

What is insider trading?

Insider trading is an indirect form of securities fraud, but it’s often confused with traditional securities fraud, which involves deceiving other market participants, or with market manipulation, which involves attempting to push stock prices up or down to undeserved prices.

These are harmful and illegal, but separate from insider trading.

Illegal insider trading involves trading based on information that’s both nonpublic and “material”, meaning that an informed investor would want to know it before making a decision.

Although the term nearly always denotes illegality in common use, not all “insider trading” is illegal: in fact, most isn’t. Insiders have rights to buy and sell like other investors. It’s when they inappropriately exploit their advantages as insiders that they violate the law.

A common misconception is that insider trading is a victimless crime. It isn’t. It devalues entire markets by disrupting their most hallowed function: channeling funds from legitimate investors into legitimate companies at legitimate prices.

Nobody wants to buy a stock — or a car, or a house — from a seller who knows more than he does. And when investors are unwilling to provide financing at reasonable rates, ripe opportunities can go unharvested, forsaking potential new jobs, wealth and economic growth.

Consider Xu’s faulty — and now prior — comparisons to Warren Buffett. Both are rich, but the similarities end there.

Xu traded quickly and is famed for cleverly taking advantage of loopholes. Buffett values integrity, invests in companies with ethical leaders, and says that his favorite holding period is “forever”. He’s even proposed a punitive tax on short-term trading.

Both men are brilliant, but Xu’s focus seems exclusively on enriching himself (apparently by any means) whereas Buffett seeks to enrich himself while contributing to the overall economy.

When Xu is prosecuted, his wrongdoing is likely to be regarded as a personal cheating incident, rather than an act that damaged the ability of China’s economy to add value.

Incidentally, it’s incredible that the law didn’t reach Xu sooner.

Xu has boasted returns of 4,023 percent over the past five years for one of his funds, and sources estimated his returns in 2015 — a rough year for most Chinese fund managers — at between 120 percent and 360 percent.

These sustained high returns are too high to be real, especially for one of China’s largest fund managers. Warren Buffett, who has racked up the most impressive known investment record over a lifetime, has averaged approximately 19 percent annually.

Rules and penalties: China vs Hong Kong

In both Hong Kong and China, the rules themselves have been gray. Chinese law borrows heavily from US law, and lawmakers don’t lack for effort: They issued proclamations in 1993, 1999 and 2005, along with a supplemental Insider Trading Interpretation.

But the law remains embedded with confusion and loopholes surrounding what constitutes an insider. This makes prosecution difficult; in fact, for many years, Chinese enforcement averaged about 1 percent of US insider trading enforcement.

And US insider laws were refined over time as judges encountered challenging new court cases and began sewing the concepts developed to remedy those cases into the US common law system.

China follows the civil law system. It also has an unrefined concept of fiduciary duty, which complicates assessing insider trading liability.

Despite — or perhaps because of — the fact that equity ownership in Hong Kong’s stock market is concentrated among large family investors, insider trading wasn’t formally restricted in 1991. It was not criminalized until 2003, and Hong Kong’s debut insider trading conviction didn’t occur until five years later. (By contrast, insider trading became illegal in the US in 1933.)

Hong Kong’s procedures make sense: Insider trading charges are investigated by the SFC and then either referred to the Market Misconduct Tribunal (MMT) for civil cases, or a court for criminal cases, but not both.

Yet there are clear reminders that an aggressive stance against insider trading is not favored by everyone: In 2008, an appeals court removed the MMT’s right to compel evidence and right to impose fines greater than the culprit’s ill-gotten profits.

Penalties in China and Hong Kong are weak compared to those in the US and UK. In October 2015, the China Securities Regulatory Commission issued US$16 million of insider trading fines, spread across 10 violators. China’s largest fine ever was an US$85 million penalty imposed on Everbright Securities for violations that destabilized the entire market in 2013.

Contrast that to a US$1.8 billion fine that US regulators issued to just one firm — SAC Capital — for insider trading violations. Hong Kong’s MMT can no longer impose fines; Hong Kong courts can, but only up to HK$10 million; they can also assign prison terms of up to 10 years, but this is rare.

It’s not hard to see one reason why insider trading is so common: The negative consequences simply aren’t that bad.

Arguably, loss of face is the more serious deterrent in many cases. For an investor who could potentially make massive amounts of money by trading on non-public information, the threat of disgorging ill-gotten profits, being temporarily blocked from one’s profession and paying a relatively modest fine is an insufficient deterrent.

Big fines and jail sentences — which stand a reasonable chance of being enforced — are necessary to deter big insider traders.

Why enforcement is so weak

But soft punishments aren’t the biggest problem. Enforcement is.

Academic evidence shows that enacting insider trading laws in a new market isn’t enough to lower that market’s implied cost of equity (a lower cost of equity increases share prices). Cost of equity drops only after the first prosecution of insider trading.

Like most criminals, inside traders are pragmatic: Regardless of what the law says, if they don’t think they’ll be caught, they’ll commit the crime.

So although enforcement — in both Hong Kong and China — has taken small steps toward improvement, why has it been so slow overall?

Lack of resources is the simplest reason. This is a prioritization issue underneath, directly arising from different views on who, or what, is injured by insider trading, on what constitutes criminal or immoral behavior, and from cultural views that often value providing favors and enhancing interpersonal relationships above adherence to seldom-enforced laws.

Logistically, Hong Kong’s insiders own so many shares that separating legitimate from illegitimate insider trades can be difficult.

And about half of Hong Kong’s equity trading is done from offshore, yet Hong Kong has no extradition provisions for insider traders. It’s hard to prosecute someone who’s not there.

In the mainland, endemic corruption is an obvious block to justice, especially when boundaries between government and industry are blurry. And illegal insider traders are often wealthy and powerful, so prosecutors or witnesses may fear retribution in some instances.

But if China was previously reluctant to prosecute insiders for fear of publicizing a national problem, it’s not anymore — even though it may be because the government now considers assigning “blame” for stock market volatility to be the greater priority.

China’s market is far closer to a casino than Hong Kong’s and its insider trading problems are far worse. But China’s market systems don’t need to rival Hong Kong’s to be a threat on the margin.

Hong Kong can’t compete with the size, growth or momentum of its northern neighbor, but it has the clear advantage in legitimacy and trust — an advantage it’s wise to protect. And Hong Kong is rightfully a paradise for many things. Insider trading should not be among them.

The full article appeared in the December 2015 issue of Hong Kong Economic Journal Monthly.

James Early and Alex Pape, CFA, are CEO and Chief Investment Officer of Iwaitou.

– Contact us at [email protected]


James Early is chief executive of Iwaitou. Alex Pape is Chief Investment Officer of the firm.

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