Blending fairness and efficiency

Author:Afroza Begum
Position:Department of Law, University of Wollongong, Wollongong, Australia

Purpose – The regulatory approach to insider trading (IT) in Australia is premised on a “blend” of fairness and efficiency which has generated an important controversy. The study aims to investigate this controversy by critically analysing the way the policy maker and judiciary have been striving to accomplish the regulatory goals based on this blend. Design/methodology/approach –... (see full summary)

1 Introduction

Market fairness and market efficiency are primary policy rationales that fuelled the regulatory reforms in Australia to redress a number of fundamental flaws in the earlier provisions dealing with insider trading (IT) ( Lyon and du Plessis, 2005, pp. 8-10 ). The fairness approach (grounded on the equal access theory) advocates that IT provides an unfair advantage for the holder of information who can exploit its benefits, and correspondingly disadvantages/incapacitates the remaining market participants to obtain the same information by competitive means, which are morally and legally unacceptable ( Carlton and Fischel, 1983, p. 858 ; Carney, 1987, pp. 868-876 )1.

In contrast, efficiency's traditional enquiry focus highlights IT's beneficial effects, suggesting that it encourages more effective, accurate and particularly timely price signalling for securities to the market. It has also been suggested that IT represents a legitimate reward for enterprise and as a form of “compensation” for those decision takers in companies ( Anabtawi, 1989, pp. 385-399 )2. Arguably, the merger of these two rationales is very unlikely to produce the desired outcome of IT regulation, especially when they are conceptually designed and committed to pursue distinctive goals ( R v. Firn, 2001, NSWCCA 191 ; Mannolini, 1996, p. 151 ). Yet, empirical evidence is unavailable to suggest that endorsing either one or the other will advance the regulatory goal. Instead, academic research confidently demonstrate that efficiency cannot be generated in and of itself but rather is best achieved through the promotion of a transparent securities market that stimulates and sustains some core notions of fairness, such as the equality of access to information, the creation and maintenance of an informed market, and improved investor confidence ( North, 2009, pp. 249-253 ).

By adhering to the perceived spirit of the merged concepts as entrenched in the regulatory reforms in Australia, this paper argues that an appropriate interaction between “fairness” and “efficiency” is not only desirable but also inevitable to facilitate the goal of IT legislation, and that the regulatory objectives can be best ensured in an increasingly technologically advanced securities market through the combination of the core values of the two instead of trying to separate one from the other. In an attempt to substantiate this argument, the study develops a hypothetical scenario (where each – “fairness” then “efficiency” – is held up as a separate approach) based on available primary and secondary sources. It critically examines the appropriateness and effectiveness of the blend by placing a special focus on the way policy makers and the judiciary have striven to accomplish the two fundamental objectives – market fairness and market efficiency – in terms of both their extent and degree of sophistication, despite the absence of a convincing past record of successful IT law enforcement in Australia (at least until very recently)3.

Drawing upon the findings from an application of the above hypothesis, the paper concludes that fairness and efficiency are complementary in the Australian context where the blend has been endorsed on the basis of the need to promote investor confidence in the fairness and integrity of the market, rather than to espouse either of the two contrasting goals separately.

The following section begins with a brief exploration of the “fairness” and “efficiency” rationales in dealing with IT and highlights only a few contrasting aspects of these two approaches relevant to the main argument of the paper. Section 3 examines the background of IT regulation in Australia with special reference to the fundamental policy justifications that have been drawn from a merger of the two rationales. Section 4 analyses how the policy maker and courts have endeavoured to achieve the regulatory goals by striking a balance between the two rationales. Section 5 provides a conclusion.

2 Fairness and efficiency as competing approaches

The long standing legal controversy over the feasibility and desirability of regulating IT remains unresolved in many jurisdictions, including the USA ( Beny, 2007, p. 238 ). The “fairness approach” – supporting the need for regulation – claims that IT generates an unethical corporate culture by resisting a transparent and informed market, noting that such a corporate culture inevitably promotes unfair disadvantages of the ignorant market participants to evaluate all relevant information for investment decision-making ( Carlton and Fischel, 1983, p. 873 )4. This ultimately leads to illiquidity, disinvestment, and an erosion of investor confidence in the securities market. This fairness rationale aims to ensure that the market operates freely and fairly with all participants having equal access and opportunity to relevant information (Griffith Report, 1989, 3.3.6; Rubenstein, 2002, p. 93 ).

In contrast, the “market efficiency” approach, originally advanced by Professor Manny (1966) and opposing regulation (“Legalize Insider Trading”), maintains that IT is economically efficient because it ensures stock price accuracy and stock market liquidity by motivating managers to competently allocate information and maximise profits, for themselves and thus for others as the market rapidly moves in tandem with the results of their trades on best available (though initially inside) information ( Carlton and Fischel, 1983, p. 861 ). Supporting Manne's view, some authors affirm that trading on inside information effectively advances an efficient market that rewards individuals' creativity ( Jacobs, 2005, p. 234 ). Australia, however, has adopted a somewhat different approach; its regulatory goals are reached through the combination of fairness and efficiency, which is considered in the following section. While a detailed analysis of Australian legislative responses to IT is beyond the scope of this article, a brief outline of IT provisions and elements is necessary to provide a theoretical framework for part 4 which will concentrate on the main argument of the paper.

3 Background of IT regulation

The first commonwealth legislative provision directly targeting IT was section 128 of the Securities Industry Act 1980 (Cth), which prohibited a person who possessed material information of and had a connection with a body corporate from dealing in or tipping on its securities. As a series of deficiencies in this provision became evident from unsuccessful prosecutions, reforms were sought through, inter alia, the formation of different committees. The Griffiths Committee formed in 1989 was one such committee, a leading government law reform body created to examine the adequacy and effectiveness of IT regulation (Griffith's Report, 1989, p. xi). An amendment subsequently made to the Corporations Act 1989 by the Corporations Legislation Amendment Act, 1991 reflects its recommendations ( Insider Trading: Position and Consultation Paper, 2007 ). This Act, with its fundamental policy objectives of market fairness and market efficiency, signifies an important departure from the earlier legislation in terms of the scope and prosecution process of IT (Explanatory Memorandum, 1991; Parliament of the Commonwealth of Australia, House of Representatives, 1991 ). With some minor modifications in 1998, those IT provisions were incorporated in Part 7.11 Div 2 and 2A in the Corporations Act 2001 and later replaced by the current provisions integrated in Part 7.10 Div 3 of the Corporations Act 2001 as amended by the Financial Services Reform Act 2001 (FSR).

The inherent difficulties of the original provisions and “the overkill by the FSR” have necessitated further reforms of IT provisions by other committees: the Companies and Securities Advisory Committee (CASAC) and then by the Corporations and Market Advisory Committee (CAMAC) ( Harris, 2009, p. xix ). Some of the concerns that CAMAC has been dealing with include whether confidential briefings by corporations to their analysts would amount to “not generally available” information and whether this could lead to the erosion of public confidence in the fairness and integrity of the Australian market.

3. 1 Policy justifications for regulating IT in Australia

Originally, there were four underlying policy rationales that prompted the emergence of IT laws in Australia. First, the fiduciary rationale formed the basis of regulating IT. It recognised a relationship of trust between the insider and the relevant corporation as imposing an obligation on the insider not to misuse its information by virtue of that relationship ( Jacobs, 2005 ; Mannolini, 1996 ). This theory lost its significance with the incorporation of the “information – connection” approach to the current provision which does not require any nexus between insider and the corporation to constitute IT; it vividly extends “possession of inside information” to any person, including those other than fiduciaries or with link to fiduciaries or corporations ( Pompilio, 2007, p. 468 ). A second rationale concerned the misappropriation theory, which considered inside information analogous to a property of a corporation and therefore its use for personal benefits inappropriate ( Jacobs, 2005 ). This theory also fails to motivate the reach of s 1043A of the Act, since a person can come to possess information that is price-sensitive and not generally...

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