The Network Lecture Series: Professor Nicholas C. Howson’s Insider Trading and China’s Administrative Law Crisis

Information is relevant to many exchanges. Those familiar with capital markets will appreciate the important role that information plays in capital trading. Securities regulators across the globe attempt to regulate the flow of information in markets to ensure efficiency and protect the interests of reasonable investors.

Prof. Nicholas Howson made a very interesting presentation regarding the nuances of Securities Law of the People’s Republic of China, 2006 (‘2006 Statute’) last Wednesday as a part of BCLBE’s lunch lecture series. His presentation addressed three broad subjects: 1) Section IV of the 2006 Statute concerning insider trading; 2) enforcement issues presented by the internal guidance issued under Article 74; and 3) general comments on the creation and reception of law in China.

Provisions of the 2006 Statute:

Section IV of the 2006 Statute covers insider trading. Generally, a prohibition against insider trading can follow either of two alternatives:

1. Focus on the insider. This approach is most closely analogous to the Fiduciary Duty Theory of the Supreme Court’s decision in Chiarella v. United States. In Chiarella, the Court held that not every instance of insider trading can trigger a Rule 10b-5 action. Instead, a relationship of trust and confidence must exist that obligates placing shareholder welfare above personal benefit.

2. Focus on the information. This approach is similar to the approach taken by the Second Circuit in SEC v. Texas Sulphur. Texas Sulphur held that trading on non-public material information can lead to liability since all investors must have “equal access” to the rewards of participating in the market. However, Supreme Court curtailed the basis of liability for insider trading by endorsing the Misappropriation Theory. As the Supreme Court’s decision in U.S. v. O’Hagan states, Misappropriation Theory imposes liability only when there exists a special relationship or a duty between the violator and the source of the information.

The 2006 Statute proceeds first by setting out the general prohibition against insider trading in Article 73. As Professor Howson notes, this article seems to provide for a very expansive definition of insider that goes beyond the traditional definition of insider as corporate officers, directors, etc., and instead embraces anyone with insider knowledge. However, the very next article, Article 74, explicitly narrows the scope of Article 73 by delineating a very specific set of insider trading defendants. Here, Professor Howson notes that a joint reading of Articles 73 and 74 results in a general rejection of the “equal access” theory, and very more closely embraces the Chiarella Court’s holding.

However, understanding the statutory scheme does not end there. Professor Howson notes that reading Article 73 in conjunction with Article 76 reveals something akin to a Misappropriation Theory of insider liability. Under that theory, the insider need not be specifically enumerated under Article 74. Instead, such persons are identified separately and need only be “persons with knowledge of inside information.” Thus, as Professor Howson points out in his paper, “the government only needs to demonstrate: (i) ‘illegal procurement’ of information, (ii) that such information is ‘inside information,’ (iii) use of that inside information to trade, and (iv) trading of trading securities . . . to effect a successful enforcement action.”

Finally, Article 76 provide for yet another type of liability: Tipper Liability. Tipper Liability provides for insider trading liability for those who “suggest[] that others purchase of sell securities” based on the tippers insider knowledge.

Enforcement Issues Related to Internal Guidance:

Article 74(7) empowers the China Securities Regulatory Commission (‘CSRC’) to prescribe additional classes of insiders. As a part of this mandate, the CSRC issued Internal Guidance in 2007.  Professor Howson contends that the enforcement regime created by the Internal Guidance is legally unenforceable for the following reasons:

1. Textual Analysis: The 2006 Statute provides the following alternatives for the CSRC when prescribing new classes of insiders: (a)  Recognize and confirm (ren’ding); (b) Formulate (zhiding); (c) Regulate or stipulate in regulation (gui’ding); or (d) Stipulate in law (fa’ding). The verb used in Article 74 is “gui’ding” meaning to “regulate or stipulate in regulation”. However, the CSRC has actually issued internal guidance. Guidance, as opposed to regulation, is not published in Government sources and is meant to service the agency internally. Thus, with no transparency, there is room for arbitrary exercise of power.

2. Guidance as ultra vires:  As noted above, Article 74 explicitly lists insiders that could be held liable for insider trading, and a careful reading of the 2006 Statute reveals a movement toward a Misappropriation Theory of insider trading. However, the internal guidance further enlarges the scope of insider trading law by creating liability for anyone trading in possession of nonpublic material information. The internal guidance’s expansion of liability effectively creates a Texas Sulphur version of insider trading liability as opposed to the Statues much more narrowly tailored standards of liability.

Creation and Reception:

Though clearly open to criticism, the wide latitude taken by the CSRC is not without reason when taken in the  historical context of Chinese securities markets. Insider trading has plagued the domestic capital markets for a long time. Furthermore, Professor Howson mentioned that that CSRC, unlike some governmental bodies in China, is highly technical and staffed with sophisticated officials.  Thus, the internal guidance issued by the agency is not merely the action of an aggressive regulator but a conscious choice to strongly curtail insider trading for the benefit of the trading public.

However, one problem that continues to plague Chinese securities law despite the efforts of the CSRC and the 2006 Statute is selective disclosure. Selective disclosure is when government officials with access to information before public disclosure trade on that information for personal gain. There is a growing feeling that the profits officials are deriving from these transactions are being earned at the cost of the average investor. Some posit that lack of a mechanism like the SEC’s Regulation FD may be to blame for this regulatory failure.

Professor Howson’s lecture is available here and his full paper is available here.