Clamping down on insider trading

Looking to the futures market

Pursuant to Article 1 of the Interpretation, insiders on the futures market are defined under Paragraph 12 of Article 85 of the Regulations on the Administration of Futures Trading (期货交易管理条例). For example, people who have access to or can obtain inside information by virtue of being managers, supervisors, practitioners, employees or professional consultants, including the management of futures exchanges and other practitioners who can obtain inside information because of their position, staff members of the CSRC and other relevant authorities and other personnel stipulated by the CSRC.

The CSRC has not issued any detailed rules regarding the definition of insiders on the futures market and nearly all reported cases are related to the securities market. Nevertheless, along with the development of China's futures market, especially the stock index futures, which is closely connected with the securities market, there may be more insider trading cases. That is also why the Interpretation tries to consider the futures market.

Guilty before proven innocent

Typically in criminal cases, a defendant is presumed to be innocent until the prosecutor can prove their guilt. However, according to the judicial practice in western countries, like the US, for insider trading cases, as long as a defendant is aware of the inside information and trades the relevant securities, they are presumed to be guilty unless they can prove their innocence. This is believed to be the most efficient way to control and punish insider trading crimes. The US Securities and Exchange Commission (SEC) has no obligation to prove the reason why the defendant trades the securities or the relationship between their knowledge of inside information and trade executions.

This is the first time China has accepted the doctrine of presumed guilty during insider trading cases. According to Article 2 of the Interpretation, a person who is a close family member of the insider or has any close relationship with the insider, or otherwise has any communication or contact with the insider during the price sensitive period, and; trades the relevant securities or futures contract in an apparently abnormal manner, will be presumed to be guilty for the crime of insider trading unless they can prove that they had a justifiable reason to do so or has another legitimate source of information. For example, the obligation of the prosecutor is not to exclude any reasonable doubt but to place reasonable doubt and then it is the defendant who shall prove their innocence.

In practice, it is much easier to prove that certain trade executions are abnormal. Pursuant to Article 3 of the Interpretation, the court may determine whether a trade execution is abnormal from three perspectives: (i) time of trading (whether the time to open, activate and cancel the account or the time to purchase and sell the relevant securities or futures contract is substantially consistent with the time of formation, change and publication of the inside information); (ii) deviation (whether a trade execution apparently deviated from the defendant's historical trading records or customary trading habits, or apparently deviated from the situation that is reflected by the publicly available information); and (iii) connection of interest (transfer of funds into and out of the relevant brokerage account does have some connection with the defendant or the defendant does have an interest in such transfer).

Price sensitive periods

For insider trading cases, the price sensitive period or the time from the date when the inside information is formed to the date when it is published, is a crucial element. Only a trade executed within the price sensitive period constitutes insider trading.

The rules to determine the price sensitive period under the Interpretation are different from past CSRC policies. The spirit of the law is to make the price sensitive period as long as possible. According to the CSRC Guidelines, the start point of the period is the date when the inside information is formed, while under the Interpretation, for those proposing or planning the event constituting inside information, the start point shall be moved back to the date when the proposal or plan is formed.

Under the CSRC Guidelines, the end point of the price sensitive period is the date when the inside information is published, or the date when the inside information will not have any impact on the price of the securities (which is normally earlier than the publication date). According to the Interpretation, the end point shall be the date of publication only and is further clarified to be exactly the date when the inside information is disclosed through public media like newspapers and websites designated by the CSRC for listed companies to make information disclosures.

Calculating gained profit and avoided loss

Pursuant to the Interpretation, an insider trading is criminal if the trading volume reaches Rmb500,000 ($80,000) or the deposit used to trade futures contracts reaches Rmb300,000, or the gained profit or avoided loss reaches Rmb150,000, or the defendant has committed at least three instances of insider trading. The question is how to calculate the gained profit or avoided loss. The CSRC Guidelines have provided formulas shown in table 2, which can be used as reference.

How to comply

The law is trying to establish a stricter and harsher regulatory system to prevent and punish insider trading activities. In addition, considering Article 11 of the Interpretation, insider trading can be a corporate crime, so it is possible that the management of a company may also be at risk of prosecution. To comply with China's legal environment, companies and their professional advisors that participate in the securities market may consider:

n Establishing a sound system of internal rules and regulations for access to, confidentiality of and prevention of inside information being leaked. This includes carrying out the relevant internal training sessions for employees and requiring them to sign training records. However, records may not be used as a good defence for the company, but the management who have complied with these rules and regulations may claim their personal innocence due to the lack of knowledge of others' wrongdoings.

n Requiring the finance department to consider the probability of insider trading when monitoring cash flows. In judicial practice, whether the benefit finally comes to the company or some particular people is one of the essential elements to determine whether it is the company or those people who should be blamed and prosecuted.

n Ensuring the employment contracts and the employment manual, which must be signed by all employees, and the relevant business contracts entered into with third parties, state that insider trading is strictly prohibited. The counterparty should have the obligation to prevent insider trading both by itself and by its employees and relatives, and if any insider trading is discovered, the company has an unconditional right to terminate the employment contract or the business contract.

In addition to the above, pursuant to the Provisions on the Establishment of a System for Management of the Registration of Well-informed People with Inside Information by Listed Companies (关于上市公司建立内幕信息知情人登记管理制度的规定) issued by the CSRC on October 25 2011, listed companies are required to establish a system to register all insiders related to it including insiders of its subsidiaries, underwriters, professional advisors and relevant government agencies. The CSRC also has the right to inspect the registration records on a routine basis. Pursuant to Article 8 of the Rules, the underwriters and professional advisors of a listed company have the obligation to collect their own insiders and submit the same to the listed company for inclusion.

Expecting civil Compensation

Article 76 of the Securities Law states that if an insider trading activity causes losses to the investors, the one committing the insider trading shall compensate for the losses. According to Article 232 of the Law, if a person needs to pay both civil compensation and administrative or criminal fines, their assets, when insufficient to pay all such amounts, shall first be used to pay civil compensations.

In the US, when a listed company is delisted because of insider trading or is investigated and determined by regulators to be guilty for the crime of insider trading, endless class actions initiated by the investors must follow to seek compensation from the company. In China, due to the lack of detailed rules (how to calculate the losses of the investors and how to establish the causation between the insider trading and the investors' losses), up to now, it is very rare that the investors receive compensation.

On August 30 2010, the Beijing Higher People's Court ruled that Huang Guangyu, the former chairman of Gome Electric Appliances, one of the leading electrical appliances retailers in China, was found guilty of insider trading. In early 2011, some investors sued Huang Guangyu and his conspiring partner Du Juan for civil compensation and Beijing No. 2 Intermediate People's Court has accepted the case. In the past year, the parties and the court spent much time to solve the issue of jurisdiction. On July 24 2012, the hearing was held by the court and two investors claimed for Rmb7,360,000. This is said to be the first court hearing for civil compensation for an insider trading case.

Along with the issuance of the Interpretation on criminal cases, people expect that in the near future, the Supreme People's Court may issue detailed rules for civil compensation to establish a complete legal system for prevention of insider trading.

Haixiao (Helen) Zhang and Jiakang Zhong, Zhong Lun Law Firm, Shanghai